Letters of Credit

Buyer asks its bank to issue a letter of credit in favor of seller. Seller ships the merchandise and presents required shipping documents. Payment is then made to seller by the negotiating or paying bank. Two types of L/Cs - standby and commercial -are the most commonly used methods of payment for international commerce.

Risk / Usage: Other than cash in advance, letters of credit offer seller the greatest protection, while providing buyer with certain assurances through L/C documentation. Letters of credit are used to alleviate risk on the part of both buyer and seller in cases where the two parties have not established a long and trusting relationship.

Standby Letter of Credit (SLC): Issued to back an obligation of the applicant, SLCs are not intended to be the primary source of payment, which is often on open account. Standby L/Cs act as a bid or performance bond, backing for open account trade terms or lease obligations, or support for a credit line or other type of financial obligation. Documents are normally not required, but buyer must have access to enough credit to cover the amount of the SLC.

Commercial Letter of Credit: Primary method of international payments because most buyers and sellers are not well known to each other and a commercial L/C facilitates trade when buyer and seller do not have absolute confidence in payment or receipt of merchandise. It covers shipment of goods or payment for services and offers several protections to both parties:

• Minimizes credit risk for the exporter (seller), since payment is made by a negotiating or paying bank
• Alleviates risk in buyer's country
• Provides greater assurance to buyer that goods will arrive as ordered and in good condition
• Assures buyer that shipping documents will be in accordance with terms and conditions of the letter of credit

There are three main types of commercial L/Cs:
Sight L/C requires payment when the beneficiary presents non-discrepant documents.
Usance L/C calls for payment at a future date, e.g., 30 days after shipment date, and requires a draft drawn on the issuing/paying bank for the amount of the invoice.
Deferred Payment L/C is similar to a usance L/C, but does not require a draft. It is often used in European countries that assess high stamp taxes on drafts.
Transferable L/C gives the beneficiary the right, but not the obligation, to transfer the credit fully or partially to a third-party supplier.
Transferable L/Cs are typically used by middlemen or trading companies that do not have the needed capital or do not wish to use their own capital to purchase goods to be delivered to another buyer. They can be structured so that the names of the supplier and final buyer are hidden. The disadvantages are high transfer costs and the difficulty of structuring transactions to hide the buyer and seller names.
 

Documentation
Letters of credit require documentation that must be precisely in accordance with the terms and conditions of the credit before payment will be made. Many payment delays are due to discrepancies in documentation. These documents typically include:

• Draft
• Commercial Invoice

Packing List

• Shipping Document
• Ocean Bill of Lading
• Airway Bill of Lading
• Inland Bill of Lading
• Insurance Policy / Certificate

Reasons for Nonpayment
Nonpayment can result from a number of different causes, however, most happen due to errors in paperwork.