Letters of credit may be needed by entrepreneurs with business deals overseas
By: Phoenix Lee/
As with many aspects of international business, the game changes, and that sentiment holds true for financing a company with international ties. When you are business deals with issues abroad, you will likely need letters of credit.
Letters of credit are not the most common means of small business financing, but they are an important financing tool for companies that engage in international trade.
A letter of credit (LC) is simply a guarantee of payment upon proof that contract terms between a buyer and seller have been completed. LCs are just fancy, two-way IOUs often used to facilitate international credit purchases.
How Letters of Credit Work
In their most basic forms, obtaining letters of credit involves three steps:
- You, the buyer, go to your bank to request a letter of credit.
- The bank will grant your letter of credit only if you have an adequate line of credit established their.
- On your behalf (and for a fee), your bank promises (via the LC) to pay the purchase price to a seller (or his or her appointed bank) if stipulated and highly detailed conditions are met.
These conditions might include any or all of the following:
- Complete, on-board, ocean bills of lading
- Commercial invoice, original, six copies
- Packing slip, original, six copies
- Insurance certificates
- Inspection certificates
- Strict date limitations
- Precise name, and address of the beneficiary (seller)
- References to mode of transport
- Dozens of other conditions covered by the “Rules”
What are these “Rules” we speak of? They were drafted by the International Chamber of Commerce (ICC) in 1933 and revised as recently as 2007. They govern a standard letter of credit format accepted internationally and are known as the “Uniform Customs and Practice for Commercial Documentary Credits (UCP).”
Your Bank’s Role in Making Your Purchase
Your bank works as a kind of transfer agent, usually with the seller’s bank, to exchange the purchase price for title or claim to goods. The parties thereby use their banks as intermediaries to limit the risks of doing business with foreign trading partners. These risks include foreign currency exchange rate fluctuations as well as frequent shipping delays, not to mention the perils inherent in international trade.
Letters of credit are available in a variety of forms, including:
- Confirmed irrevocable letters of credit
- Confirmed letters of credit
- Acceptance letters of credit
- Back-to-back letters of credit
Each demands differing degrees of bank commitment, but, generally speaking, you will only be dealing with irrevocable LCs.
If you are the importer, for example, you need to be assured that the proper goods will be delivered to you intact, on a date certain, in good condition and at the agreed-upon cost. The sellers (exporters) need to know that when they comply with all the terms you’ve set forth in the letter of credit, they’ll be paid the amount due in a timely manner. And everything must be thoroughly documented at both ends.
Keep in mind that banks deal with documents, not goods, and if the documents are incorrect—even if the goods arrive as promised—the letter of credit can be worthless if any party to the agreement has made a mistake in the paperwork. The converse, of course, is that the paperwork can be perfection personified and the LC therefore honored , but the wrong goods might be delivered. That’s why you need to have an inspector (a customs broker, freight forwarder, etc.) certify what you ordered is what was shipped and that it arrived in good shape.
The Importance of Detail
The key point to remember about LCs is the need for precision. Attention to detail and nit-picking legalese are mandatory. If an error is made or adjustments are needed subsequent to the issuance of an LC, amendments can be made to accommodate all parties to the transaction. But banks will follow these instruments to the letter so you need to be as concise and accurate as possible when specifying terms.
The devil, as usual, is in the details, but the security an LC provides to both buyer and seller is well worth the effort involved. But be also mindful that letters of credit are sometimes used to defraud banks through presentment of false documentation indicating that goods were shipped when they actually were not.
Letters of credit are also sometimes used as part of fraudulent investment schemes. There fraud risks because the payment will be obtained for nonexistent or worthless merchandise against presentation by the beneficiary of forged or falsified documents.
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