Letter Of Credit
The safest and most common form of payment in international sugar trading, letters of credit provide a means of payment which extends the maximum possible amount of protection to both buyer and seller. A letter of credit provides assurance to the seller that they will be paid upon shipping of goods and presentation of documentary proof to an advising or confirming bank, and to the buyer that payment will not be made to the seller until documentary evidence of the goods being shipped is sighted by bank officials.
A letter of credit is a document which draws upon the credit of the issuing bank, (the buyer’s bank) and functions as a guarantee that the issuing bank will pay the stated amount to a seller on behalf of its client upon sighting certain specified documents.
There are many different elements which must be present in order for a document to be legally considered a letter of credit, and there are also many different types of letters of credit. This is a guide to letters of credit, and how they can, and cannot be used as financial instruments to facilitate international sugar trading, and also some common pitfalls which are often encountered when using letters of credit, and how they may be avoided or amended if they occur.
Commercial Letter Of Credit
A commercial letter of credit is a tool that facilitates payment in international transactions. The issuing and use of commercial letters of credit is governed by the International Chamber of Commerce, Uniform Customs and Practice for Documentary Credits. The International Chamber of Commerce is an international body that facilitates international trade and globalization. There are currently over 90 countries associated with the ICC, and their guidelines are followed by major world banks. The provisions allowed by the guidelines set out by the ICC Uniform Customs and Practice for Documentary Credits are therefore binding on all parties.
A commercial letter of credit is issued from one bank, called the issuing bank, to another bank, the confirming or advising bank, on behalf of the issuing bank’s customer. The commercial letter of credit instructs the confirming bank to make payment to the beneficiary of the letter of credit, who is, in the case of sugar trading, the seller.
Standby Letter Of Credit
A standby letter of credit is known as a secondary payment mechanism, that is to say that it is actually an assurance from the issuing bank to the confirming bank that the issuing bank’s customer, in this case, the buyer, has sufficient funds to purchase from the seller, or beneficiary of the letter of credit. Standby letters of credit are called such as they are issued only as a standby and are not designed to ever be drawn upon.
In the case of the buyer defaulting on the seller, the standby letter of credit can be drawn upon. In order to draw upon the stand by letter of credit, the beneficiary of the standby letter of credit must present documentary evidence in accordance with the terms of the standby letter of credit proving that the issuing bank’s customer has defaulted and failed to meet its obligations. The issuing bank must then pay the beneficiary of the standby letter of credit.
Elements of Letters Of Credit
In order for a document to be considered a letter of credit, it must contain the following elements:
· An undertaking for payment given by a bank.
· This undertaking must be on behalf of the buyer.
· The payment is to be made to a beneficiary (the seller) for a set amount of money.
· Payment is to be made upon presentation of certain documents which are outlined in the letter of credit, and which represent the completed supply of goods.
· Supply of goods must have taken place within a specified time frame.
· The documents presented will need to comply with terms set out in the letter of credit.
· The documents will need to be presented at a specific location in order for payment to be made.
Beneficiary
The beneficiary of a letter of credit is a person or entity named in the document to receive the sum of money stipulated in the letter of credit upon presentation of appropriate documentation as also outlined in the letter of credit. The beneficiary will unconditionally be paid to the full value of the letter of credit once the beneficiary is able to present the correct documentation in accordance with that required in the letter of credit.
Issuing Bank
The issuing bank must pay the beneficiary as soon as the terms and conditions of the letter of credit have been met, and proof of this has been provided. Proof is always in the form of documentation such as a bill of lading, proof of insurance, commercial invoices, and other such documents. Specific documentation is to be agreed upon by the buyer, seller, and issuing bank.
The issuing bank incurs a responsibility to ensure that documentation is properly sighted and examined with all due diligence to ensure that it complies with the terms of the letter of credit.
Advising Bank
The advising bank is normally a foreign correspondent of the issuing bank. This bank advises the beneficiary of the letter of credit. Beneficiaries typically use local banks to ensure that letters of credit are valid, and the advising bank is responsible for sending documentation to the issuing bank. Advising banks do not have any other obligations under the guidelines which regulate letters of credit, and are not under any obligation to pay the beneficiary of the letter of credit, nor are they authorized to do so unless they are also the confirming bank.
Confirming Bank
A confirming bank is obliged to make payment to the beneficiary on the letter of credit upon presentation of the required documentation. Confirming banks will generally confirm the letter of credit once the letter of credit, the country from which it was issued, and the bank which issued it have all been evaluated. If the confirming bank confirms the letter of credit, it takes on responsibility for insuring the paying the beneficiary upon presentation of necessary documentation as outlined in the letter of credit.
Sight And Time Drafts
In order to draw on a letter of credit, the beneficiary must produce the documentation stipulated in the letter of credit, and also a document called a draft, or a bill of exchange. A draft is simply a document written by the beneficiary requesting payment. The beneficiary may either use a sight draft, or a time draft. The type of draft to be used will be stipulated in the letter of credit.
A sight draft is one which demands payment on sight. The bank must make payment immediately , but there are provisions which allow the bank sufficient time to view and verify the accompanying documentation.
A time draft is one that sets a period for payment. Payment must be made by the time that the period ends. Issuing banks must accept time drafts and make payment on them at such time as they become mature, as long as the required supporting documentation is all present and correct.
How To Use A Letter Of Credit
The following procedures outline the proper method for using a letter of credit.
A buyer wishes to purchase sugar, and the seller requests a letter of credit as payment. The buyer must then approach his bank and request a letter of credit, with the seller listed as the beneficiary.
The buyer’s bank will approve the letter of credit, issue it, and send it to the advising or confirming bank, which is normally in the seller’s jurisdiction.
The advising bank is responsible for authenticating the letter of credit, and sending it on to the seller.
The seller then ships the stipulated goods, and collects the necessary documentation to prove that the shipment has been sent.
The seller then presents the documentation, along with a draft to the advising or confirming bank for payment.
The advising or confirming bank checks the documentation for completeness and authenticity. If the documentation is all in order, and the letter of credit has been confirmed, then the advising or confirming bank claims payment by debiting the funds from the account of the issuing bank, and forwarding the documentation onto the issuing bank. The seller is normally paid at this point, unless a time draft has been used, or the letter of credit was unconfirmed, in which case the seller must wait for the issuing bank to sight the documentation and authorize payment.
The issuing bank will then once more view and verify the documentation, and if it is found to be in order, then the buyer’s bank account is debited and the documentation is sent on to the buyer.
Applying For A Letter of Credit
The following elements should be in order when applying for a letter of credit:
Beneficiary details – These must be accurate, as discrepancies between details on the letter of credit and the beneficiary’s actual details can make the letter of credit effectively useless.
Amount – A precise amount for payment should be stipulated when applying for a letter of credit. If there is to be some potential variation in the amount due to quantity variations or currency fluctuations, it is acceptable to state a maximum figure with a percentage of flexibility.
Duration – Be aware that it takes time for the seller to ship goods, obtain documentation, and present it. There may also be minor hiccups and problems that can cause delays in this process, so the letter of credit should be of sufficient duration to reasonably allow the transaction to take place.
Seller’s Bank Details – The advising bank should be listed.
Draft type – Will the seller use a sight draft or a time draft? This should be specified when applying for a letter of credit.
Necessary Documentation – Make sure that all documentation that will need to be sighted in order for payment to be made is listed here. The seller will need to agree to this section of the letter of credit, and if there is disagreement, then amendments will need to be made.
Address for Notification – This is an address at which the buyer can be notified of the arrival of the shipment, or of damage to it.
Description of Goods – This is a very important element of the letter of credit, and the description of goods should be as accurate as possible. If there is to be a possible variance in the amount of goods to be supplied, this should be stated.
Confirmation Order – This is for the seller to have the letter of credit confirmed in his or her own country.
Types of Letters of Credit
Negotiable Letters of Credit
Most letters of credit are negotiable. Negotiability in this context means that the issuing bank must pay the beneficiary, and any bank that the beneficiary nominates. Negotiable letters of credit can be traded between parties in much the same way as cash can. Negotiable letters of credit must include unconditional promises to pay either on demand or at an appointed time.
Revocable Letters of Credit
Revocable letters of credit are instruments that can be revoked by the issuing bank at any time without any form of notification. As would be fairly obvious, revocable letters of credit are not normally accepted as payments by sellers, as they offer no guarantee whatsoever that payment will be made, and also cannot be confirmed. A revocable letter of credit can be paid upon, but only if all terms and conditions in the letter of credit have been met, proof of this has been provided to the issuing bank, and the letter of credit has not yet been revoked.
Irrevocable Letters Of Credit
Irrevocable letters of credit are the most common type of letters of credit. These documents cannot be revoked at any stage, or even amended without the express agreement of the beneficiary, the confirming bank, and the issuing bank. An irrevocable letter of agreement is an unconditional guarantee that the stipulated monies will be paid upon presentation of correct documentation as referenced within the letter of credit.
Documentary Irrevocable Letter of Credit
There are two forms of documentary irrevocable letters of credit, these are unconfirmed, and confirmed letters of credit. An unconfirmed documentary irrevocable letter of credit is only payable by the issuing bank, and is not confirmed by any other bank. The advising bank can make payment to the seller, but only after first receiving payment from the issuing bank.
Confirmed documentary letters of credit are payable directly by the confirming bank at the time that the seller produces the correct documentation and draft. It is then the confirming bank’s responsibility to seek payment from the issuing bank. Confirmed letters of credit are more expensive to obtain, as the confirming bank is much more at risk of financial loss than in the case of unconfirmed documentary letters of credit.
Transferable or Assignable Letters of Credit
Transferable or assignable letters of credit grant the beneficiary the right to transfer or assign the right to draw on the letter of credit to another party. Letters of credit used in sugar trading are normally transferable or assignable. Even if they are unassignable and non transferable, the beneficiary may still transfer their drawing rights as long as they do so before fulfilling the conditions set out in the letter of credit.
Assignment of Proceeds
This is an arrangement in which the seller may assign a portion of the proceeds of the letter of credit, or all of the proceeds, to another party, quite often the ultimate supplier. However the beneficiary (seller) is still obligated to fulfill all the terms of the letter of credit in order to receive payment. This is similar to transferring a letter of credit, but does not provide the assignee with the same responsibilities or security.
Back To Back Letter of Credit
A back to back letter of credit is a letter of credit which is opened on the basis of an existing nontransferable credit. Back to back credits are quite often used to pay the ultimate supplier, such as the sugar mill or the refinery. Once the seller receives a letter of credit from the buyer, the seller opens another letter of credit with the ultimate supplier as the beneficiary, using the buyer’s letter of credit as collateral.
Deferred Payment Letter of Credit
A deferred payment letter of credit is one with which the buyer has a period of time in which to make payment to the issuing bank.
Red Clause Letter of Credit
Red clause letters of credit allow the seller a cash advance prior to the shipping of goods in order for the goods to be produced. This is a rather high risk letter of credit, as the buyer makes payment on the goods not only before they are shipped, but also before they are made.
Revolving Letter of Credit
Common in the sugar trade, revolving letters of credit are documents that can be drawn on multiple times for the same amount within a fixed period. For example, if the buyer and seller come to an arrangement for monthly shipments over a period of twelve months, a revolving letter of credit with the value of one monthly shipment may be drawn upon twelve times by the seller.
Supporting Documentation
Supporting documentation, and the need for it to be correct and in order has been mentioned several times in this article. This section deals with commonly requested forms of supporting documentation.
Commercial Invoice
A commercial invoice is a bill for goods. It must include a description of the goods, the price of the goods, FOB origin, and the names and addresses of both the buyer and the seller. The information in this document must be exactly the same as the information in the letter of credit.
Bill of Lading
A bill of lading is a document which is provided by a freight carrier upon receipt of goods for shipment. This document functions as proof that the goods are no longer in the seller’s control, and that the carrier has undertaken the responsibility of transporting the goods to the buyer.
Warranty of Title
A warranty of title is a document which is issued from the seller to the buyer which asserts that the title over the goods being sold is being transferred rightfully, and that the title is good.
Letter of Indemnity
A letter of indemnity indemnifies the buyer against certain circumstances. This is typically used to guarantee the provision of shipping documentation when it becomes available.
Common Documentation Pitfalls
It may seem that trading via letters of credit is a fairly simple and straightforward affair, and indeed it can be. However there are many common errors made when supplying documentation, and these can cause payment to be delayed as the seller has to fix the errors before they can receive payment under the terms of the letter of credit.
· Letter of credit has expired. This is self explanatory, but it is a common pitfall for sellers who try to claim payment under letters of credit which have already lapsed. Buyers and sellers should ensure that the letter of credit has a long enough life for the goods to be shipped and necessary documentation to be collected for presentation to the advising or confirming bank.
· Bill of lading dated prior to or after the date range which is stated in the letter of credit.
· Incorrect or inconsistent description of goods. The description of goods in the commercial invoice and bill of lading must be consistent with that in the letter of credit.
· Invoice amount different to the draft amount stated in the letter of credit.
· Missing documentation.
· Names and addresses not consistent between the letter of credit, the commercial invoice, and other documentation.
Minor discrepancies can be waived if the issuing bank, the buyer, and the seller all agree to waive them. Major discrepancies can be fixed at the discretion of the issuing bank.
Common Problems Associated With Letters of Credit
Letters of credit are the most secure means of paying for international trades, but they are by no means foolproof. Listed here are some of the more common problems that can occur using letters of credit.
· Documentation stipulated in the letter of credit becomes difficult to obtain.
· The shipment schedule outlined in the letter of credit can not be met due to natural, political, or economic reasons.
· Currency fluctuations push the amount stipulated in the letter of credit below the value of the goods.
· Freight costs rise past reasonable levels.
· Product quantity is not what was agreed upon due to production problems.
International trading is a risky business, and even with the best will in the world, situations can arise which make meeting the terms of a contract or letter of credit simply impossible. It is often possible to negotiate through these differences for a satisfactory result, however sellers should be aware that if the conditions of the letter of credit are not met, then the issuing bank is well within legal rights not to make payment.
Making Amendments To A Letter of Credit
Once an irrevocable letter of credit has been issued, it is necessary for an amendment to be made in order to change any element of it. The process for making amendments is fairly straightforward, and goes thus:
· The seller makes a request to modify the letter of credit.
· If the change is amenable to both the buyer and the issuing bank, then the issuing bank will make the changes to the letter of credit.
· The issuing bank will the notify the advising /confirming bank of the change.
· The advising/confirming bank in turn notifies the seller that the change has been successfully made.
Guidelines For Buyers
Trading on the international market is risky for both buyers and sellers, even when a letter of credit is the method of payment being used. Here are some guidelines for protecting buyers.
Buyers should be aware that international trade fraud does exist. The buyer should take the time to investigate the seller and the seller’s business practices, if at all possible obtaining references about the seller from other satisfied clients. A good reputation can go a long way towards ensuring a happy trade for a buyer.
The buyer should be aware of the payment methods commonly used in the sellers country. A request that seems strange may not actually be so strange after all if it is consistent with trading procedures in that country.
The buyer should make every effort to communicate clearly and effectively with the seller.
The buyer should be prepared to have a certain level of flexibility with regards to the sale. It is not uncommon for buyers and sellers to renegotiate after the terms of a trade have been settled due to factors which are beyond the control of either party. This is what the letter of credit amendment process is for.
The buyer should ensure that their bank are experienced in international trading. A great deal of responsibility falls upon the bank during major international trades, and it is essential that the bank staff know what they are doing.
Allow enough time in the letter of credit for the seller to be able to obtain the goods, ship the goods, and claim payment. Often times in the sugar trade, sugar is purchased before it has actually been refined, and stoppages at the refinery, or transport issued in the seller’s country can delay the shipping of goods. Be aware of this, and also be prepared to amend the letter of credit to allow for these issues if necessary.
Finally, and perhaps most importantly, be aware that although letters of credit are the most secure way to make payment for international shipments, they are not perfect. Because letters of credit deal in documentation and not goods, it is not always possible for the banks involved to verify that the goods the buyer receives are in fact the goods that were paid for. Every effort is taken to ensure that documentation is representative of the goods shipped, and that documentation is complete and authentic, however there are some cases in which the buyer is disappointed by the shipment received, but payment has already been made and there is very little that can be done about this after the fact.