Letters of credit (L/C)

If you are involved in import/export, then you have probably come across the term L/C (letter of credit). Although L/Cs can vary in type, this article will specifically discuss the commercial documentary letter of credit used for business transactions. This particular type of L/C is payable upon the presentation of specific documents.

An L/C can be thought of as a letter from an importer's bank informing an exporter that they will be paid for a shipment upon presentation of the specified documentation. All communication takes place within banking channels and documentation must not contain discrepancies.

For example, if you wanted to import a shipment of clothing and the seller (exporter) has asked for an L/C. If you accept the exporter's terms you will need to apply for an L/C from your bank in favor of the seller. L/C's usually state a time period and manner in which the exporter must provide documentary proof that they have shipped the goods. Other obligations may also be included.

Obtaining an L/C is not as simple as just asking for one. As your bank is pledging to pay the exporter on your behalf, you will be required by your bank to demonstrate that they will be able to recover their funds from you.

Once it has agreed to open an L/C, the opening bank (the importer's bank) will transmit the L/C to its branch or correspondent (the advising bank) closest to the exporter. The advising bank will notify the exporter that credit has been established in their name once they have received the L/C.

Exporters should make sure that they are capable of meeting the terms and conditions of an L/C upon receiving it. This is very important, as if the shipment does not match that described in the L/C; payment will in most cases be delayed until the discrepancy has been resolved.

After shipment and presentation of the necessary documentation to the advising bank, if no discrepancies are found, the exporter is due payment. The paying bank could be the advising bank and thus the exporter can receive payment very quickly. If the opening bank is the paying bank, payment may take a few days. Both importers and exporters may request that the paying bank be in their country as they are looking to the L/C to protect their interests.

Importers can ask for any legal terms to be included within and L/C and exporters must provide documentary evidence to prove that such terms have been met. As most L/C's are irrevocable, once an L/C has been opened and advisement has been made, they cannot be altered or cancelled with the consent of the exporter.

On the occasion where an exporter doubts the solvency of an opening bank, they can request to have the L/C confirmed by the advising bank. This means that if the opening bank is responsible for making payment and cannot do so, the confirming bank will pay. For a cost of approximately 1% of the cost of the L/C an exporter receives a fair amount of added assurance.

In summary, an L/C is:

• A formal document of payment
• Opened by a party wishing to import
• Communicated through banking channels
• Paid by the opening bank within a specified timeframe upon presentation of stipulated documentation

The cost of an L/C to an importer is often a fixed fee plus a percentage or a percentage with a minimum commission. Additionally, exporters will be required to pay a variety of costs. Where an L/C is not payable on sight, costs increase. This is also the case where more than two banks are involved, exporters request confirmation of credit and when discrepancies are found within the documentation or additions/changes to the L/C are necessary.