International Sales Managers often bandy the term “letter of credit” around when talking about export payment terms with their foreign partners. However, in many cases they are not fully aware of which aspects of letter of credit payment terms they need to consider when formulating agreements.
Agreeing on a letter of credit without fully understanding the consequences of the details in practical terms for getting paid can seriously reduce your profitability or even result in you not getting paid. However having an awareness of the main pitfalls can make the whole process considerably smoother.
Definition of a Letter of Credit
This definition from Cleartax was the simplest I could find:
A Letter of Credit (LC) is a document that guarantees the buyer’s payment to the sellers. It is issued by a bank and ensures timely and full payment to the seller. If the buyer is unable to make such a payment, the bank covers the full or the remaining amount on behalf of the buyer.
A letter of credit is issued against a pledge of securities or cash. Banks typically collect a fee, ie, a percentage of the size/amount of the letter of credit.Cleartax
It may not cover all the complexities and variants which are possible with a letter of credit, but it expresses in normal plain English what an L/C is.
Short recap of the factors to consider
For full details on all the factors which you should be considering before deciding upon your international payment terms and conditions see my blog post on this topic.
There are three additional aspects which you need to always consider before deciding on your payment terms:
In international sales at least one of the partners will always be paying in foreign currency meaning that there is a risk of exchange rate fluctuations to be considered when deciding upon the payment terms.
- The length of the payment process.
What I mean here is the amount of time it takes between the importer asking his bank to pay and the exporter actually receiving the money. This can depend upon
- how many banks are involved in the payment process
- How many countries are involved in the payment process and if there are extreme time differences this may also affect the length of the actual transfer process due to banking hours
- The number of currency exchanges which are involved
- The method of transferring money.
Sometimes in North America checks for example are still used and this is a much slower payment process than a SWIFT transfer
- The level of security required.
Of course, the exporter wants to receive the money and the importer wants to be sure that they receive the goods which they have ordered. Documentary payment processes such as cash against documents or a letter of credit offer higher levels of security for both sides.
Why do exporters like letters of credit payment terms?
For exporters, a confirmed irrevocable letter of credit, especially one which is payable at sight, is often seen as the gold standard amongst export payment terms (after payment in advance). That is because it removes the risk of the importer changing his mind about wanting to pay for the goods and it also removes the risk of him being unable to pay. That’s because the credit worthiness of the importer’s bank replaces that of the importer himself.
The flip side of the coin
The reason that a letter of credit is often avoided unless absolutely necessary is because they are expensive to execute. On the one hand that’s because of the bank fees which are associated with them and on the other hand as they are labour intensive to manage. ie. Your admin team won’t love you for agreeing on an L/C, but sometimes it’s the best solution.
What about security for importers?
There is nothing guaranteeing the same level of security for importers though, although there are steps which can be taken to improve the situation
For example, because letter of credit payment terms are a promise that the bank will pay against documents, the importer may not discover any discrepancies in the quantity or the quality of the goods which he has been delivered until it is too late. And there is no come back on the bank as long as the bank has acted in accordance with the conditions of the letter of credit.
One measure which an importer can take to safeguard his interests in this kind of situation is to arrange a pre-shipment inspection by a qualified organisation such as SGS or Bureau Veritas who will check the quantities (& also do analyses if required).
In general, you can say that security for the importer decreases in relation the increase of security for the exporter. This is therefore a key point to remember when negotiating with a new client.
Letter of credit fees are expensive
The costs of issuing and managing a letter of credit are relatively high compared to other forms of international payment term. This reflects the fact that the bank is carrying the risk and has more work to do with checking the documents to ensure that they comply with the conditions specified.
Usually, an importer takes over the majority of the costs of the letter of credit however, as with everything else in a contract, this is a matter for negotiation and agreement. Don’t forget, in the end it is the end customer who has to bear the costs of all the fees incurred in the supply chain so it is in all parties’ interests to keep costs down to an absolute minimum.
Once a letter of credit has been opened an importer already has the obligation to pay for the goods, however on the side of the exporter that obligation only occurs at the point in time when he submits the documents to the bank to obtain payment against the letter of credit.
As a letter of credit is a promise of payment against documentation many importers like to use the option of either a bank guarantee or a standby letter of credit in order to help balance out their risk.
The key point here though is that both partners have to check the conditions of any letter of credit carefully to ensure that they are not only reasonable but also that they are possible to fulfil in the form that they have been agreed.
It’s extremely hard to regulate something in national law which is only actually valid in international business. Consequently, there are very few countries who have regulated letters of credit in national law.
Examples of countries who have include Greece, Mexico, as well as many US states.
The main body which regulates documentary letters of credit is the International Chamber of Commerce (ICC). When opening a letter of credit, it is advisable to specify in the text that it is agreed on the basis of the ICC regulations UCP 600. This framework has been agreed by 175 countries and includes also standard forms which can be used. It also regulates which kind of documents and what are the responsibilities of each party especially the banks in the whole process.
How do letter of credit payment terms work in practice?
A relatively simple structure of a letter of credit could look as follows:
The important goes to the bank and applies for a letter of credit. In realistic terms the bank will only oblige if the importer is in his eyes creditworthy or supplies sufficient collateral. The bank will then issue a letter of credit, however in most cases this letter of credit (L/C) will be communicated to the exporter by a correspondent bank in the same country or at least on the same continent as the exporter. The correspondent bank represents the issuing bank, not the interests of the exporter.
E.g. A bank in the Philippines issues a letter of credit to pay a purchase from Austria and delivers notification of the letter of credit via the Deutsche Bank. In many cases this correspondent bank in a location close to the exporter will be the bank which adds their confirmation to the letter of credit thus guaranteeing the credit worthiness of the issuing bank in the importers home country.
If you are responsible for negotiating payment terms with your import client, you need to be aware that in many countries with currency controls (eg. Vietnam) the bank will oblige the importer to offer collateral to cover the full amount of the credit. So this payment term may not in effect be a line of credit for your partner, but may instead negatively impact his cash flow, if the bank blocks the value of the L/C in his account at the time of issuing.
When do you use a letter of credit?
There are three main cases:
- if the exporter lacks knowledge about the importing company and his credit worthiness an L/C can offer secure payment
- If a letter of credit represents a more acceptable form of credit finance for both parties. This is often the case if the importer would like a longer export payment term than the exporter is able to offer on open account terms (the importer has to check the conditions his bank offers as to whether this is a cheaper option for him)
- in some countries this is an obligation because there are financing and currency controls in place. In such cases you may be obliged to use a letter of credit even if you have a long-standing and extremely trustworthy business partner.
What are the critical points for an international sales manager when agreeing letter of credit payment terms?
In a nutshell it’s imperative to agree in as much detail as possible in the purchase agreement as to how the letter of credit should look, as this is your only chance as an exporter to influence the conditions.
Think through the whole supply chain & delivery process
It is really important for you to think through your whole delivery and supply process in advance before agreeing to terms because otherwise you can find that you’ve promised something that your back office team are not able to deliver.
The letter of credit should include a list of all the documents which are required, as well as the necessary timings and deadlines. That means that you as the exporting sales manager need to define this in the contract as well as which transport terms will be used, whether insurance will be issued (and who will pay for it) and any other clauses which are necessary for the export. Of course, you also need to define who pays for each step of the process and for any additional documentation which may be required.
However, it’s not formally necessary to include ALL the documents required for a shipment in the L/C conditions. So if you have a good relationship with your buyer then you may be able to agree that the documents in the L/C are kept to an absolute minimum (B/L, insurance and invoice) whilst any other documents can be sent separately. This reduces the chances of errors, especially if you have documents such as laboratory analyses which are issued by external parties.
Know your internal processes
Once the L/C has been issued you as an exporter only have three options: –
- you can accept the L/C
- you can refuse the L/C by stating that it hasn’t been issued in accordance with the contract
- you can request changes to the text.
You need to be aware though that changes are usually rather expensive so it is better for all concerned to make sure that the L/C is issued correctly in the first place.
As a sales manager you don’t have to actually prepare the documentation for the L/C of course but it is important that you understand the consequences of the decisions that you make. The bank pays out to your company on the basis of correctly issued documentation, so if there is a clause in the text which your company is not able to comply with, or which it is easy to make mistakes on then this can reduce your profitability on a deal very quickly or even result in you not getting paid.
Define the following carefully
The following points are essential to be specified in detail as a mistake of even one letter or a coma can result in the payment being rejected by the bank.
- The exact name of the company. This is really important as you usually refer to your company name in a short form without all the necessary legal company form. eg Smiths Ltd. Probably you only refer to “Smiths”. And is it Ltd with or without a full stop afterwards? what about capitalisation? (LTD.). Mistakes on any of these points can lead to the bank rejecting your documents.
- a detailed description of the goods and the quantity to be delivered.
Here it is essential that you check and specify in the contract a description of the goods which matches to the description that you have in your in-house ERP system as these often use a shorter description of the goods due to a lack of space if there are character limitations in the computer system. You don’t want your documents to be rejected by the bank.
- Do you have the right INCOTERM? When agreeing letter of credit payment terms you should stick to the “C” terms (CFR, CIF, CPT, CIP) as these give you control over the shipping documents & order ownership
- If you are producing something special for the client for example a specific recipe just for his country then you may want to consider using a so-called circa clause as this allows a difference of up to +/-10% compared to the amount which is specified in the L/C. If nothing specific is agreed then usually a variation of +/-5% is acceptable to the bank
- specify the value of the order and also the currency in which it is to be paid
- make a list of the documents which are needed for both the export and import process and agree with your importer on how many copies of each document are required & whether they need to be legalised (& by whom? Chamber of commerce? Embassy? Notary?).
Ensure ALL of your systems have the same wordings
If you don’t want your back office team to be cursing you, make sure that the importer understands that the L/C needs to be issued with the company name or product details mentioned exactly as the text will print out of your computer. Spending hours making adjustments by hand because your computer can’t print it the way it’s specified in the L/C is no one’s idea of fun.
What you do need to watch out for though is if the L/C has to be issued according to the registration documents (which have to match the text on the products) then you may not be able to avoid the team preparing documents by hand if that isn’t the way the names are in the product master files of your computer. This is a problem that many companies have, if international sales were not considered when setting up the ERP system.
It’s one reason why it’s vital that all departments understand that a lack of standardisation across the board can have expensive consequences in other areas of the business.
It’s essential that you carefully agree with your buyer the deadlines which should be included in the text of the letter of credit.
This includes most importantly the last acceptable shipping date and the expiry date of the L/C by which time the documents have to be submitted to the bank in order to obtain payment.
It’s critical that these two dates are set suitably far apart because the shipping documentation is one of the most important parts of the L/C (this proves that you have shipped the goods and is also the document with which the importer can gain legal possession of the goods on arrival in his port – see also my post about INCOTERMs.
Of course, the shipping document can only be issued after the goods have been shipped which is why you need to have a week or better still at least two weeks between the last shipping date and the last date for submitting the documents to the bank.
What will the bank check?
In detail the bank must check three documents according to the ICC rules:
- The transport document (usually bill of lading) as this proves that the goods have been shipped by the date required
- The insurance document
- The invoice
Other documents will be checked for basic points such as correct name and address and whether they are acceptable of as a document type specified in the text of the L/C, however they won’t be checked in the same level of detail. This is because if the L/C is not specific enough and says for example you should do analysis in a “first class laboratory” then the bank cannot judge if this is met or not.
If you have this kind of requirement, then the importer needs to specify which laboratories would be acceptable. For you as an exporter it’s important to discuss with your buyer prior to the L/C being issued which laboratories would be a possibility for you to do your analyses in. If you don’t take note of this fact it can result in a lot of additional unexpected costs for you.
As a sales manager you need to also consider that the importers bank will also be giving him advice as to how he can reduce his risk. So when the text of an L/C is received in your company you need to check immediately very carefully to ensure it meets your contract agreement & that nothing has been adjusted last minute. You don’t want to discover that there are terms in the L/C which you didn’t agree and which you’re not able to fulfil.
Ultimately anything which you can do which will reduce the risk of your back office making mistakes when preparing the documentation will help to maintain your profitability on the deal. As prevention is usually much cheaper than remedying mistakes later then it’s a good idea to get your operations team to check the details of the conditions you are planning to agree.
When I worked in a company where we used a lot of L/Cs in the past, I had a checklist of conditions for importers that we used to use as an annex to their contracts or at least as a checklist for discussions.
Keeping everything as simple as possible will help to avoid errors and unnecessary additional costs. Remember that as with any kind of negotiation, the terms have to be acceptable for both parties or you won’t be in business together for the long term.
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