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Letter of credit basics Letter of Credit Basics http://www.letterofcredit.biz/What is Letter of Credit
Letter of credit, in a broad perspective, is one of the payment methods in international trade.
Some of the other payment methods in international trade are Cash-in-Advance, Documentary Collections and Open Account. All of these payment methods inherit different risk levels for exporters and importers. Letters of credit is the only payment method, which has a balanced risk structure for both parties.
Figure 1: Payment Risk Diagram
Key Points
• To succeed in today’s global marketplace and win sales against International trade presents a spectrum of risk, which causes uncertainty over the timing of payments between the exporter (seller) and importer (foreign buyer).
• For exporters, any sale is a gift until payment is received.
• Therefore, exporters want to receive payment as soon as possible, preferably as soon as an order is placed or before the goods are sent to the importer.
• For importers, any payment is a donation until the goods are received.
• Therefore, importers want to receive the goods as soon as possible but to delay payment as long as possible, preferably until after the goods are resold to generate enough income to pay the exporter.
Cash-in-Advance
With cash-in-advance payment terms, the exporter can avoid credit risk because payment is received before the ownership of the goods is transferred. Wire transfers and credit cards are the most commonly used cash-in-advance options available to exporters. However, requiring payment in advance is the least attractive option for the buyer, because it creates cash-flow problems. Foreign buyers are also concerned that the goods may not be sent if payment is made in advance. Thus, exporters who insist on this payment method as their sole manner of doing business may lose to competitors who offer more attractive payment terms.
Letters of Credit
Letters of credit (LCs) are one of the most secure instruments available to international traders. An LC is a commitment by a bank on behalf of the buyer that payment will be made to the exporter, provided that the terms and conditions stated in the LC have been met, as verified through the presentation of all required documents. The buyer pays his or her bank to render this service. An LC is useful when reliable credit information about a foreign buyer is difficult to obtain, but the exporter is satisfied with the creditworthiness of the buyer’s foreign bank. An LC also protects the buyer because no payment obligation arises until the goods have been shipped or delivered as promised.
Documentary Collections
A documentary collection (D/C) is a transaction whereby the exporter entrusts the collection of a payment to the remitting bank (exporter’s bank), which sends documents to a collecting bank (importer’s bank), along with instructions for payment. Funds are received from the importer and remitted to the exporter through the banks involved in the collection in exchange for those documents. D/Cs involve using a draft that requires the importer to pay the face amount either at sight (document against payment) or on a specified date (document against acceptance). The draft gives instructions that specify the documents required for the transfer of title to the goods. Although banks do act as facilitators for their clients, D/Cs offer no verification process and limited recourse in the event of non-payment. Drafts are generally less expensive than LCs.
Open Account
An open account transaction is a sale where the goods are shipped and delivered before payment is due, which is usually in 30 to 90 days. Obviously, this option is the most advantageous option to the importer in terms of cash flow and cost, but it is consequently the highest risk option for an exporter. Because of intense competition in export markets, foreign buyers often press exporters for open account terms since the extension of credit by the seller to the buyer is more common abroad. Therefore, exporters who are reluctant to extend credit may lose a sale to their competitors. However,
the exporter can offer competitive open account terms while substantially mitigating the risk of non-payment by using of one or more of the appropriate trade finance techniques, such as export credit insurance.
We have explained above that letters of credit can limit the risks of importers and exporters.
However, how can letters of credit achieve this? Letters of credit can balance the risks of exporters
and importers because responsibility of LC operations is given to a third party, to the banks. We will
explain this later on detailly.
Definition of Letter of Credit:
"Credit means any arrangement, however named or described, that is irrevocable and thereby
constitutes a definite undertaking of the issuing bank to honour a complying presentation." (UCP
600, article 2)
This letter of credit definition is taken from the UCP 600 (ICC Uniform Customs and Practice for
Documentary Credits) which is the latest version of the rules published by ICC (International
Chamber of Commerce ) regulating the letters of credit operations all around the world.
Role of the ICC and UCP in Letters of Credit
International trade is exchange of capital, goods, and services across international borders between
people whom belong to different languages, cultures and laws. As letters of credit are a payment
method of international trade it is obvious that standardized rules are needed to govern letters of
credit in a global scale to make sure that letters of credit transactions run smoothly. ICC,
International Chamber of Commerce, is the organization that publishes the standardized rules. The
rules, which are called UCP, Uniform Customs and Practice for Documentary Credits, are revised
regularly. At the time of this text is written sixth version of the UCP rules is in force.
In this first article, we have seen what letter of credit is, its definition, the rules that apply to them
and the organization that publishes these rules. In the next article, we will examine types of letters
of credit.
Types of Letters of Credit
Traveler's letters of credit, which were commonly used in eighteenth century, were the first financial instrument contains very similar characteristics with the contemporary letters of credit.
From traveler's letters of credit days to today's complex global economy, the letters of credit have been performing their duties as a secure and reliable payment method. Actually, during this period letters of credit have gained a very flexible structure that can satisfy different needs of different types of international trade practitioners. In this article, we will discuss types of letters of credit.
Commercial Letters of Credit
Commercial letters of credit are mainly used as a primary payment tool in international trade such
as exporting and importing transactions. Majority of commercial letters of credit are issued subject
to the latest version of UCP (Uniform Customs and Practice for Documentary Credits). The ICC
publishes UCP, which are the set of rules that governs the commercial letters of credit procedures.
Standby Letters of Credit
Commercial letters of credit are a means of payment to be utilized when the principal perform its
duties. As an example, let us consider an exporter who ships the goods according to the sales
contract and apply to the nominated bank for the payment. If the nominated bank decides that the
presentation is conforming to the terms and conditions of the credit and the UCP rules then
exporter will be paid. This situation is just contrary in standby letters of credit.
A payment is made to the beneficiary of a standby letter of credit when there is a breach of the
principal's obligation. As an example, let us consider a construction company that has been
awarded with a tender. If this construction company cannot fulfill its obligations under the project
contract beneficiary of the standby letter of credit can apply to the nominated bank for the
payment. However, the nominated bank considers only the terms and the conditions of the standby
letter of credit and the rules governing the credit when deciding a complying presentation. One
point that needs to be stressed is that standby letters of credit have their own rules, which are
called The International Standby Practices 1998 (ISP98). They are also published by ICC. However, a
standby letter of credit can be issued subject to either the UCP or the ISP.
Revocable Letters of Credit
Revocable letters of credit give issuer the amendment or cancellation right of the credit any time
without prior notice to the beneficiary. Since revocable letters of credit do not provide any
protection to the beneficiary, they are not used frequently. In addition, UCP 600 has no reference to
revocable letters of credit. All credits issued subject to UCP 600 are irrevocable unless otherwise
agreed between the parties.
Irrevocable Letters of Credit
Irrevocable Letters of Credit cannot be amended or cancelled without the agreement of the credit
parties. Unconfirmed irrevocable letters of credit cannot be modified without the written consent
of both the issuing bank and the beneficiary. Confirmed irrevocable letters of credit need also
confirming bank's written consent in order any modification or cancellation to be effective.
Types of Letters of Credit - Page II
This is the second page of types of letters of credit.
Unconfirmed Letters of Credit
Unconfirmed Letters of Credit can be described as a letter of credit, which has not been guaranteed
or confirmed by any bank other than the bank that opened it. In these types of credits, the only
bank that undertakes to honor a complying presentation is the issuing bank.
Confirmed Letters of Credit It would be easier to understand the confirmed letters of credit if we start from the definition of the confirmation. Confirmation means a definite undertaking of the confirming bank, in addition to that of the issuing bank, to honor or negotiate a complying presentation. If a letter of credit's payment undertaking is guaranteed by a second bank, in addition to the bank originally issuing the credit this kind of credit is called confirmed letter of credit. The confirming bank agrees to pay or accept drafts against the credit even if the issuer refuses to do so. Only irrevocable credits can be confirmed.
Clean Letters of Credit :Below two different definitions of clean letters of credit are given.
A letter of credit payable upon presentation of the draft, without any supporting document being
required.(www.businessdictionary.com)
L/C that does not require any document other than a written demand for payment by its beneficiary.
In effect, a draft.(www.intracen.org)
Clean letters of credit are issued only by the request of the highest credit standing companies. It is
suitable for variety commercial situations where no movement of goods is expected. Historically
these types of credits have been used in traveler's letters of credit. Today direct pay standby letter
of credit can be given as an example of clean letters of credit.
There are also some other form of letters of credits which deserve special attention. We will discuss
them by one by more in detail however; you can find short description of each of them below.
Transferable Letters of Credit Transferable letter of credit is a documentary credit that is issued with the option to allow a trader to transfer its rights and obligations to the supplier. Back-to-Back Letters of Credit Arrangement in which one irrevocable letter of credit serves as the collateral for another; the
advising bank of the first letter of credit becomes the issuing bank of the second L/C. Unlike
transferable letters of credit, there are two separate letter of credits exist in back-to-back letter of
credit transactions.
Advance Payment (Red Clause) Letters of Credit Letter of credit that carries a provision (traditionally written or typed in red ink) which allows a
seller to draw up to a fixed sum from the advising or paying-bank, in advance of the shipment or
before presenting the prescribed documents.
Parties to Letters of Credit
This page dels with the parties of the letter of credit.
Main parties of Letter of Credit transaction such as
applicant,
beneficiary,
issuing bank,
confirming bank,
nominated bank,
will be disscussed in this article.
Applicant Applicant is the buyer of the goods or services supplied by the seller. Letter of credit is opened by
the issuing bank as per applicant's request. However, applicant does not belong one of the parties
to a letter of credit transaction. This is because of the fact that letters of credit are separate
transactions from the sale or other contract on which they may be based.
Beneficiary Beneficiary is the seller of the goods or the provider of the services in a standard commercial letter
of credit transaction. Letter of credit is opened by the issuing bank in favor of the beneficiary.
Issuing Bank Issuing Bank is the bank that issues a letter of credit at the request of an applicant or its own behalf.
Issuing bank undertakes to honor a complying presentation of the beneficiary without recourse.
Nominated Bank Nominated bank is the bank with which the credit is available or any bank in the case of a credit
available with any bank.
Advising Bank Advising bank is the bank that advises the credit at the request of the issuing bank. An advising bank
that is not a confirming bank advises the credit and any amendmend without any obligation to
honor.
Confirming Bank Confirming bank is the bank that adds its confirmation to a credit upon the issuing bank's
authorization or request. Confirming bank may or may not add its confirmation to a letter of credit.
This decision is up to confirming bank only. However, once it adds its confirmation to the credit
confirming is irrevocably bound to honor or negotiate as of the time it adds its confirmation to the
credit. Even if the issuing bank fails to honor, confirming bank must pay to the beneficiary.
Reimbursing Bank Reimbursing Bank shall mean the bank instructed and/or authorized to provide reimbursement
pursuant to a reimbursement authorization issued by the issuing bank.
Risks in Letters of Credit
What are the risks in a letter of credit transaction? Risks in letters of Credit
Although letters of credit are a balanced payment method in terms of risk issues for both exporters
and importers, each letters of credit party bears some amount of risk. As we have explained before
letters of credit transactions are handled by banks. This responsibility makes the banks one of the
parties that bears risks in a letter of credit transaction.
What are the risks of the letters of credit which are payable with 90% at sight and 10% usance after consignee accepts the quality of goods?
Risks in letters of credit can be discussed under four groups; general risks in letters of credit, risks to
the applicant, risks to the beneficiary and risks to the banks.
General Risks in Letters of Credit:
Country Risk: (Political Risk)
The first risk factor that can be mentioned in the general risks group is the country risk or the
political risk. Let us assume that we are an exporter located in a country X and we have a customer
from the country Y. Our customer, which is from the country Y, opened a L/C in favor of us. We
have checked the L/C conditions and they seem workable. We have produced and shipped the
order as per the L/C and transmit the required documents to the issuing bank before the expiry
date. The issuing bank found our presentation complying and informed us that they will be
honoring our payment claim at the maturity date. However, before the maturity date due Country Y
has changed its export regime, which makes it impossible for the issuing bank to honor our
presentation. This illustrative is a good example of a country risks. Other examples of country risks
are mass riots, civil war, boycott, sovereign risk and transfer risk.
Fraud Risk:
As we have described before all conditions stated in a letter of credit must be connected to a
document, otherwise banks will disregard such a condition. In addition, banks deal with only
documents but not goods, services or performance to which the documents may relate. This
feature of the letters of credit is the source of the fraud risk at the same time. As an example, a
beneficiary of a certain letter of credit transaction can prepare fake documents, which looks
complying on their face, to make the presentation to the issuing bank. As the documents are
complying on their face, the issuing bank may honor the presentation and in this case, the applicant
must pay to the issuing bank for the goods it will never be receiving. Beneficiaries of L/Cs bear also
fraud risks. This happens if an applicant issues a counterfeit letter of credit. In this case, the
beneficiary never receives its payment for the goods it has shipped.
Risks to the Applicant:
In a letter of credit transaction, main risk factors for the applicants are non-delivery, goods received
with inferior quality, exchange rate risk and the issuing bank's bankruptcy risk.
Risks to the Beneficiary:
In a letter of credit transaction, main risk factors for the beneficiaries are unable to comply with
letter of credit conditions, counterfeit L/C, issuing bank's failure risk and issuing bank's country risk.
Risks to the Banks:
Every bank in a L/C transaction bears risks more or less. The risk amount increases as responsibility
of the bank increases.
Basic Letter of Credit Transaction
How letters of credit work in international trade? Commercial letter of credit transaction in simple language.
Understanding Letter of Credit Transaction
On this page I will try to explain you letter of credit process in a very simple way. After reading this
article you should understand the working mechanism of letter of credit payment in general terms.
1. The starting point of the letter of credit process is the agreement upon the sales terms between
the exporter and the importer. Then they sign a sales contract. It is important to stress here that
letters of credit are not a sales contract. Actually, letters of credit are independent structures from
the sale or other contract on which they may be based. Therefore, it should be kept in mind that a
good sales contract protects the party, which behaves in goodwill against various kinds of risks.
2. After the sales contract has been signed, the importer (applicant) applies for its bank to issue a
letter of credit. The letter of credit application must be in accordance with the terms of the sales
agreement.
3. If the importer and its bank reach an agreement together on the working conditions the
importer's bank (issuing bank) issues its letter of credit. In case the issuing bank and the exporter
(beneficiary) are located at different countries, the issuing bank may use another bank's services
(advising bank) to advise the credit to the beneficiary.
4. The advising bank advises the letter of credit to the beneficiary without any undertaking to honor
or negotiate. The advising bank has two responsibilities against to the beneficiary. Advising bank's
first responsibility is satisfy itself as to the apparent authenticity of the credit and its second
responsibility is to make sure that the advice accurately reflects the terms and conditions of the
credit received.
5. The beneficiary should check the conditions of the credit as soon as it is received from the
advising bank. If some disparities have been detected beneficiary should inform the applicant about
these points and demand an amendment. If letter of credit conditions seem reasonable to the
beneficiary then beneficiary starts producing the goods in order to make the shipment on or before
the latest shipment date stated in the L/C. The beneficiary ships the order according to the terms
and conditions stated in the credit.
6. When the goods are loaded, the exporter collects the documents, which are requested by the
credit and forwards them to the advising bank.
7. The advising bank posts the documents to the issuing bank on behalf of the beneficiary.
8&9. The issuing bank checks the documents according to the terms and conditions of the credit. In
addition, the governing rules, which are mostly latest version of the UCP are taken into account. If
the documents are found complying after the examination the issuing bank honors the payment
claim.
10. The documents transmit to the applicant. The applicant uses these documents to clear the
goods from the customs.
Availability of Letters of Credit A credit must state whether it is available by sight payment, deferred payment, acceptance or negotiation. (UCP 600 - Article 6- b)
What does availability mean in a letter of credit transaction?
In documentary credit terminology, availability refers to the availability of the documents in
exchange for the payment of the amount stated in the letter of credit. UCP 600 defines four
availability options ;
Sight Payment : Sight payment refers to the payment which is made as soon as the complying
presentation is seen by the issuing bank or the bank nominated in the letter of credit. The
nominated bank fulfills its payment obligation with recourse basis. Nominated bank can demand
the amount paid to the beneficiary back in case of documents are found noncomplying by the
issuing bank. Nominated bank's payment obligation is not strict as the issuing or the confirming
bank's payment obligation. UCP 600 states that a nominated bank is not obligated to accept the
nomination directed to itself unless nominated bank inform its acceptance of nomination expressly
to the beneficiary. Even in this situation UCP 600 assumes non payment by the nominated bank and
describe the roles of the issuing and confirming banks.
Deferred Payment : Deferred payment refers to the payment which is made after a period of time
that is specified also in the letter of credit. The payment period is usually determined as specific
number of days after the date of presentation or the date of the transport document. Bill of
exchange or draft is not required under deferred payment.
Acceptance : Acceptance refers to acceptance of a bill of exchange which is drawn on the bank
mentioned in the letter of credit to be presented with the other required documents and payment
at the maturity.
Negotiation : Let us check the definition of the negotiation from the UCP 600 in order to
understand the term more clearly.
Negotiation means the purchase by the nominated bank of drafts (drawn on a bank other than the
nominated bank) and/or documents under a complying presentation, by advancing or agreeing to
advance funds to the beneficiary on or before the banking day on which reimbursement is due to the
nominated bank. (UCP 600 - Article 2)
As can be seen from the above definition any letter of credit which is available by negotiation could
be issued in a way so that a draft may or may not be required. Also the payment of the letter of
credit may or may not be at sight. If the nominated bank advance or agreeing to advance funds to
the beneficiary before it receives reimbursement from the issuing bank the negotiation condition is
fulfilled. This can happen in two ways. First possibility is, in a letter of credit which is available by
sight payment when the nominated bank reimburse the beneficiary before it receives funds from
the issuing bank. Second possibility occurs when a letter of credit is available by negotiation
requesting presentation of a time draft, while the nominated bank reimburses the beneficiary
before the maturity date of the bill of exchange. (How does a negotiable letter of credit work?)
When issuing a documentary credit via swift message banks show the availability of a documentary
credit in Field 41a.
MT 700 Issue of a Documentary Credit
Field 41a: Available With ... By ...
BY ACCEPTANCE
BY DEF PAYMENT
BY MIXED PYMT
BY NEGOTIATION
BY PAYMENT
Payment means payment at sight. Mixed payment is not directly covered under UCP 600.
Confirmation and Confirmed Letter of Credit
What is confirmation in a letter of credit transaction? What are the benefits of a
confirmed lc?
Confirmation is a security tool for the exporters. Confirmation eliminates country risk and
insolvensy risk of the issuing bank.
How to add confirmation to a letter of credit? How to add confirmation to a letter of credit?
Confirmation gives additional payment guarantee to the exporters. On this page you can
find letter of credit confirmation process which is explained with the help of a graphic
illustration.
Figure 1 : Step by step explanation of letter of credit confirmation process.
Step 1 - Sale Contract: Exporter and Importer sign a sale contract. They choose letter of
credit as a payment method.
Step 2 - Confirmation Request on Sale Contract: On the sale contract exporter demand
from the importer that the letter of credit must be confirmed. Exporters may want the
credit to be confirmed by a bank which is acceptable for them. In order to make sure that
the credit would not be confirmed by another bank which is not suitable for the exporter,
exporters should indicate this on the sale contract with a wording similar stated bellows:
"The documentary letter of credit should be issued in a way so that it can be confirmed by a
bank acceptable to the exporter".
Step 3 - Letter of Credit Application: Importer applies to his bank to open the letter of
credit.
Step 4 - Letter of Credit Issuance: Issuing bank issues the letter of credit. The letter of credit
must include "May Add" or "Confirm" codes in field "Field 49: Confirmation Instructions".
Step 5 - Confirmation: Advising bank or another bank that the beneficiary wants to have the
letter of credit confirmed discuss the terms and conditions of the confirmation. If both
parties agree on the confirmation conditions than the letter of credit will be confirmed.
Confirming bank should inform to the beneficiary that it has included its confirmation to the
letter of credit.
5 Things You Should Never Do When Working with a Letter of Credit for the First Time :
Do you know the most biggest mistakes that exporters do when working with a letter of credit for
the first time?
5 Things You Should Never Do When Working with a Letter of Credit for the First Time, titled article
is written by Ozgur Eker. You can find important failure points for unexperienced exporters.
Most of the times letter of credit is not the first payment option for exporters and
importers. Exporters and importers tend to choose other payment options such as cash
against document, advance payment or mixed payments over letters of credit. But as
situation dictates foreign traders have to use letter of credit in international trade
transactions. On this article I would like to explain 5 most costly mistakes that exporters
repeatedly make in their lc operations.
Most costly mistake 1 : Doing a business with an importer to whom you have no real
information...
Business is not a virtual thing. You should have a real knowledge about your counter party
before starting to do any kind of transaction. I have seen a lot of exporters who tried to
finish a transaction without having a decent information about their buyers by just trusting
a letter of credit. Letter of credit does not protect you against any immoral buyer.
Please answer below questions to understand how much you know about your buyer.
Table 1 : Customer questionnaire
How much do you know about your buyer?Did I find this customer from a trade exhibition or a customer visit? Yes NoDoes my customer have any proven business relationship in my sector? Yes NoDoes my customer visit me before the business was initiated? Yes NoIs there any positive feedback that I have gathered about my customer? Yes NoDoes transaction doable in regards to my buyer's perpective? Yes No
If you can not answer "yes" to all of these questions immediately, than you should be
starting to re-think about the whole business. If you answered more than 1 question
negatively, than you should be very careful about the trade transaction in terms of risk
issues.
Most costly mistake 2 : entering business offers which are too good to be true...
In most cases scammers seduce exporters with unbelievable proposals. They do not bargain for
the prices, they order big quantities, they promise to pay "at sight" not "usance" terms. As a
buyer if you do not intend to pay anything than sky would be the limit for you. You can propose
whatever you think would be necessary to seal the deal. These proposals can be sum up as "too
good to be true" type business offers. If you meet a buyer one day who is promising very
favorable conditions to you, please keep in mind that you might be loosing money at the end.
Most costly mistake 3 : underestimating risk factors associated with the transaction
Businesses turn around on risk and profit axis, more you take risks, more you can get profit. But
some exporters lost their common sense and take too much risks to make more profit in a short
perod of time. This behavior associated with an extreme risk taking behavior. However
normally you have to understand your risks very well before signing any contract with your
buyer. Than you should take preventive steps to reduce each risk level to acceptable degrees. If
you would like to learn more about risk factors in a letter of credit transaction please follow this
link.
Most costly mistake 4 : "I can do it in my way" perception...
Letters of credit are different than other payment methods in international trade in terms of
flexibility. Banks play a key role on lc transactions. Letter of credit rules are strictly followed
by banks. As a result you have to prepare required documents as per credit terms,
latest letter of credit rules and standard banking practices. Otherwise you can not get your
payment under a letter of credit.
Most costly mistake 5 : lack of knowledge...
As I have mentioned above letter of credit transactions are governed by one of the most
complicated rules of whole international trade practices. In order to complete a letter of
transaction without experiencing a negative result, you need to understand how logistics,
finance and governmental procedures work very well. Also you need to be very careful
when reading the credit terms and conditions. You have to note down every detail and
clarify each point that can not be understood openly. Do not be shy asking questions to
issuing bank or confirming bank to comprehend the credit.
Summary :
1. Learn who your buyer is. Try to get references of your buyer from your sector. If needed
make a financial investigation.
2. Be careful about too good business opportunities. Be aware of scammers.
3. Understand risk factors associated with your transaction
4. Accept the fact that letter of credit is not flexible in terms of regulations.
5. Learn the rules. Read the credit well. Eliminate all gray areas.
Confirmed L/C at Sight
Understanding the benefits of confirmed lc at sight.
What are the benefits of at sight confirmed letter of credit?
At sight payment is one of the payment terms in a letter of credit transaction. Also confirmation
means "a definite undertaking of the confirming bank , in addition to that of the issuing bank, to
honour or negotiate a complying presentation" according to latest UCP rules.
UCP 600 defines four availability options ; A credit must state whether it is available by sight
payment, deferred payment, acceptance or negotiation (UCP 600 - Article 6- b). At sight payment is
one of the payment terms in a letter of credit transaction. Also confirmation means "a definite
undertaking of the confirming bank , in addition to that of the issuing bank, to honour or negotiate
a complying presentation" according to latest UCP rules. On this page I would like to write about
pros and cons of confirmation when letter of credit is available with sight payment (l/c at sight)
Let us start by asking ourself a very simple question. Why sellers pay additional money to have their
L/Cs confirmed? The first reason is that sellers would like to eliminate default risk of the issuing
bank. Second reason is that they would like to receive their payment sooner by removing the
issuing bank out of the equation.
Most of the small companies work with limited capital volume and they rely on their suppliers
credit terms such as 30 days after bill of lading date. Which means that a seller have to pay to its
supplier 30 days after he ships the goods. This relatively short time could create problems in terms
of cash flow, when we take into account document examination period of 5 working day that each
bank has to examine the documents under a letter of credit presentation.
Confirmation would be a great solution for this problem. Under unconfirmed letters of credit
nominated banks in most cases send documents to issuing banks and wait reimbursement.
Nominated banks pay to the sellers only after they have been reimbursed by the issuing banks. This
is a relatively long period of time and could exceed 30 days time allowance that sellers have to pay
to their suppliers.
Nomimated banks keep sending documents to issuing banks and wait for reimbursement even
under confirmed letters of credit. Unfortunately confirmation couldn't eliminate the wait for
reimbursement! Confirming banks should pay against credits they confirmed without receiving
reimbursement. But in practice they pay without waiting reimbursement only when they have
determined that the issuing bank defaulted. Further, confirming banks unable to tell us how long it
might take to determine that the issuing bank had defaulted! This is another example where
theory does not match the practice. UCP 600 sub-Article 8(a) clear enough. I will qoute related
articles from UCP 600 belows,
Article 8 - Confirming Bank Undertaking
a. Provided that the stipulated documents are presented to the confirming bank or to any other
nominated bank and that they constitute a complying presentation, the confirming bank must:
i. honour, if the credit is available by
a. sight payment, deferred payment or acceptance with the confirming bank; ..."
I am asking now a simple question to banks, if you do not honour your confirmation as per UCP
rules why are you adding your confirmation to lcs and charging confirmation cost to sellers?
What is Field 49: Confirmation Instructions?Field 49: Confirmation Instructions is a field in MT 700 swift message type that contains confirmation instructions for the Receiver.
Field 49: Confirmation Instructions :
This field contains confirmation instructions for the Receiver.
According to current letter of credit rules confirmation means a definite undertaking of the
confirming bank, in addition to that of the issuing bank, to honour or negotiate a complying
presentation.
According to current letter of credit rules confirming bank means the bank that adds its
confirmation to a credit upon the issuing bank's authorization or request. As a result banks
can not add their confirmations to the letter of credit without having a confirmation request
by the issuing banks.
According to current letter of credit rules a confirming bank is irrevocably bound to honour
or negotiate as of the time it adds its confirmation to the credit.
Sample Field 49: Confirmation Instructions
MT 700
Field 49: Confirmation Instructions :
DEFINITION
This field contains confirmation instructions for the Receiver.
CODES
One of the following codes must be used.
CONFIRM The Receiver is requested to confirm the credit.
MAY ADD The Receiver may add its confirmation to the credit.
WITHOUT The Receiver is not requested to confirm the credit.
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Field 49: Confirmation Instructions :
This field contains confirmation instructions for the Receiver.
According to current letter of credit rules confirmation means a definite undertaking of the
confirming bank, in addition to that of the issuing bank, to honour or negotiate a complying
presentation.
According to current letter of credit rules confirming bank means the bank that adds its
confirmation to a credit upon the issuing bank's authorization or request. As a result banks
can not add their confirmations to the letter of credit without having a confirmation request
by the issuing banks.
According to current letter of credit rules a confirming bank is irrevocably bound to honour
or negotiate as of the time it adds its confirmation to the credit.
Sample Field 49: Confirmation Instructions
MT 700
Field 49: Confirmation Instructions :
DEFINITION
This field contains confirmation instructions for the Receiver.
CODES
One of the following codes must be used.
CONFIRM The Receiver is requested to confirm the credit.
MAY ADD The Receiver may add its confirmation to the credit.
WITHOUT The Receiver is not requested to confirm the credit.
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Confirmation fees
Confirmation Fee
What is confirmaton fee?
Confirmation fee can be defined as charges collected by the confirming banks against the risks they
will be having to posses by confirming the letters of credit. As I have explained below confirming
banks undertake two main risk factors with the confirmation: default risk of the issuing bank
and political risk of the issuing bank’s country.
Confirmation of a letter of credit is defined as an undertaking from a bank in addition to the
undertaking provided to the beneficiary by the issuing bank. Beneficiary would like to eliminate the
default risk of the issuing bank as well as political risk by having the letter of credit confirmed to a
bank which is located within the same country.
Confirming banks could only honour or negotiate a complying presentation. As a
result beneficiaries have to present complying documents in order to obtain funds under letters of
credit from either the issuing bank or the confirming bank. For this reason complying presentation
is the key for the payment for both confirmed letters of credit and unconfirmed letters of credit.
Confirming banks take the default risk of the issuing bank as well as non-payment risk of the letter
of credit originated from the political risk of the issuing bank’s country over themselves from the
moment they have added their confirmation to the letters of credit. Even if a confirming bank could
not receive any reimbursement from the issuing bank he has to make payment to the beneficiary
against a complying presentation under the letter of credit which he has confirmed.
You might be wondering why a confirming bank would take such risks and confirm a letter of credit.
The correct answer is very simple and straight forward; to make more profit.
Examples of Confirmation Fees:
Confirmation Fee Format 1: Exporters First Help Bank of New York confirms this credit and hereby
undertakes to honor all drafts and documents presented in strict compliance with the credit terms.
Our confirmation charges USD3.120,48.
Confirmation Fee Format 2: We shall charge our confirmation commission of 4,000000 PCT p.a.,
min. EUR200.00 p.q.
p.a. : per annum (12 months or 360 days)
p.q. : per quarter (3 months)
Who should pay confirmation fees?
According to letter of credit rules all fees and charges related to credits should be paid by the
applicants. But we have learned long ago that this perfect world indication is not valid under real
life situations. In most cases applicants pay only letter of credit issuance charges and let the banks
collect all the remaining fees from the beneficiaries. As a result confirmation fees will be paid by the
beneficiaries in most cases.
What happens if court stops payment of an irrevocable, confirmed letter of credit which is payable 90 days after sight due to low quality of goods?
What happens if court stops payment of an irrevocable, confirmed letter of credit which
is payable 90 days after sight due to low quality of goods?
In many countries letter of credit applicants able to prevent payment by obtaining court orders
forcing issuing banks from paying demands under their letters of credit on the grounds of low
quality goods shipment or fraud. Often courts issue a temporary or preliminary injunction. On this
case scenario we demonstrate a court order that stops payment of an irrevocable confirmed
deferred payment letter of credit.
Saudi Arabian steel importer and South Korean steel supplier signed a sales contract
A multinational company's Saudi Arabia branch signed a sales contract with a South Korean steel
supplier. The product being traded was Cold Rolled Steel Sheets. Sales contract amount was
9.700.000,00 USD and quantity of goods was 10.000mtons.
Importer company which is the beneficiary under the letter of credit transaction is Strong Saudi
Steel Import Co. Ltd and exporting company which is the applicant under the letter of credit
transaction is Korean Shining Steel Exporter Ltd.
Letter of credit issued by a commercial bank in Saudi Arabia
A Saudi Arabian commercial bank issued the letter of credit which is available by a deferred
payment payable 90 days after sight. Letter of credit is subject to UCP 600 and it is irrevocable.
Letter of credit is available with a South Korean national commercial bank. Also issuing bank
requested from the nominated bank to confirm the credit.
You can find important details of the letter of credit on below MT 700 swift message summary.
MT 700 Swift Message Summary
----------------------- Message Header ---------------------------------Swift OUTPUT FIN 700 Issue of a Documentary CreditSender : ARABBANKSKSA SAUDI ARABIAN BANK (COMMERCIAL BRANCH) JEDDAH KSA
Receiver : TRADEBANKXXX SOUTH KOREAN TRADE BANK (ALL SOUTH KOREAN OFFICES) SEOUL KR
40E: Applicable Rules
UCP LATEST VERSION
31D: Date and Place of Expiry
130106-SOUTH KOREA
50: Applicant
STRONG SAUDI STEEL IMPORT CO. LTD.
P.O. BOX 30000, JEDDAH
KINGDOM OF SAUDI ARABIA
59: Beneficiary - Name & Address
KOREAN SHINING STEEL EXPORTER LTD
(FULL BENEFS. NAME AND ADDRESS UNDER FIELD 47A ITEM NO.2)
32B: Currency Code, Amount
Currency : USD (US DOLLAR)
Amount : #9.700.000,00#
39B: Maximum Credit Amount
NOT EXCEEDING
41A: Available With...By... - BIC
TRADEBANKXXX
BY DEF PAYMENT
42P: Deferred Payment Details
90 DAYS AFTER SIGHT
49: Confirmation Instructions
CONFIRM
Letter of credit confirmed by South Korean Bank
South Korean bank, which was initially the nominated bank, confirmed the letter of credit as per
instructions received from the issuing bank. Once South Korean bank confirmed the letter of credit,
it became the confirming bank.
Under UCP 600 rules confirming banks have to honor complying presentations. Confirming banks
can also discount letters of credit upon exporters’ demand.
Complying presentation
After having the letter of credit confirmed, exporter arranged the shipment and made the
presentation to the South Korean Bank which is not only the nominated bank but also the
confirming bank.
Confirming bank checked the documents and found them complying. Confirming bank determined
that the documents have been presented was free of errors. Confirming bank sent the documents
to the issuing bank.
The issuing bank also confirmed, by an authenticated swift message that, the acceptance of
documents and the remittance of funds with a value maturity date.
As it was mentioned earlier, the letter of credit is payable with a deferred payment which is 90 days
after sight. The exporter applied to the confirming bank to discount the credit in order to get the
payment in advance of the maturity date of the credit.
Letter of credit discounted by South Korean confirming bank
Confirming bank and the exporter agreed on the terms and conditions of the letter of credit
discount and confirming bank negotiated the credit without recourse basis. The confirming bank
purchased the deferred payment undertaking resulting from documents presented in full
conformity with the terms and conditions of the letter of credit and effected payment to the
beneficiary.
One week before the maturity date, the issuing bank informed the confirming that the letter of
credit payment has been stopped by the court order. In this regards the issuing bank sent two
subsequent authenticated SWIFT messages to the confirming bank as follows:
MT 799 Swift Message Summary
On 18.February.2013, the following swift message was sent by confirming bank to the issuing bank,
which explained the objections of the confirming bank to the court order and the issuing bank's
standing.
"Please kindly be informed that we would like to draw your attention to the following facts:
1.The Court Order dd. 15.February.2013 of the Court of First Instance is addressed to your bank, in
order to proceed with the suspension of payment according to the instructions of applicant of L/C.
This court order forbids your payment to be effected to the beneficiary.
2.According to Art. 7c of the UCP 600 of ICC
a) your bank is obliged to reimburse the nominated bank, i.e. confirming bank, at maturity
b) your undertaking to reimburse us is independent of your undertaking to the beneficiary
3. According to Art. 12b of the UCP 600, you authorized us to prepay or purchase a deferred
payment undertaking incurred by us
4. As you are aware we prepaid the deferred payment undertaking to the beneficiary.
As a matter of fact we, confirming bank, are the owner of the receivables and entitled to receive the
counter-value without any further delay. Summarizing the above, we regard you as a highly
reputable bank with an excellent standing and experience in the international business, including
documentary credits, and thus anticipate your assistance in solving the pending problem by
appealing against the court order and to immediately remit funds in favour of our bank."
Issuing bank remained unanswered confirming bank's swift messages.
The confirming bank believed that the issuing bank is obliged to honour the nominated bank's
reimbursement claim immediately upon maturity, even if a court order issued against the issuing
bank prohibits payment to the beneficiary. As the issuing bank remained silence the confirming
bank applied to the ICC banking commission for an opinion.
Conclusion:
ICC banking commission states that local law will prevail over the letter of credit transaction. As a
result banks must act according to court orders.
However, the credit was subject to UCP 600 and apparently contained no exclusion to the rule
appearing in sub-article 12 (b). Due to the content of sub-article 12 (b) and sub-article 7 (c), the
issuing bank should seek to resist such an injunction in order to preserve the integrity of its credit
and the UCP. It must be expected that the issuing bank will seek to have the injunction removed by
referring the court to the appropriate articles of UCP 600 and the terms and conditions of the
credit. The issuing bank would also be well advised to inform its applicant(s) of the content and
effect of sub-article 12 (b) for this and any future transactions. It is the responsibility of the
applicant to cover any issues concerning quality of goods in the documents called for and the data
content required to appear on those documents, and not to seek redress that affects the right of a
nominated bank to receive reimbursement in respect of a complying presentation.
This case study created by the author based on the informations gathered from ICC Opinion R629 / TA672rev.
Author:
Ozgur Eker is an independent trade finance consultant based in Izmir, Turkey. He has been 10+ years
of experience in international trade finance field. He is also the founder of letterofcredit.biz.
As we have discussed earlier there are some risk factors exist for each party in a letter of credit
transaction. When we look at the risk issue from the beneficiaries' perspective, we will observe two
main risk factors that beneficiaries must bear ; the country and the insolvency risk of the issuing
bank. Confirmation can be seen as a security mechanism which works in favour of the beneficiaries
that eliminates these two risk factors.
Let us look at the definitions of confirmation and confirming bank from the UCP 600 ;
"Confirmation means a definite undertaking of the confirming bank , in addition to that of the
issuing bank, to honour or negotiate a complying presentation."
"Confirming bank means the bank that adds its confirmation to a credit upon the issuing bank's
authorization or request."
As can be seen on the above definitions confirming bank adds its undertaking to the letter of credit
in addition to that of the issuing bank. In this way beneficiaries receive a second payment guarantee
from another bank. Insolvency risk of the issuing bank is eliminated by addition of this second
payment guarantee to the letter of credit.
Mostly confirming banks and the beneficiaries are located in the same country and when this is the
case the country risk of the issuing bank is eliminated as a bank which locates in the same country
with the beneficiary adds its undertaking to the letter of credit in addition to that of the issuing
bank.
Confirmed Letter of Credit After discussing the benefits of the confirmation in a letter of credit transaction, let us examine the
points that need to be take into consideration regarding the confirmed letters of credit.
Only irrevocable letters of credit can be confirmed.
During the issuance phase of a letter of credit, the issuing bank should "authorize or
request" the potential confirming bank to add its confirmation to the letter of credit.
No bank can be forced to add its confirmation to any letter of credit.
If a bank is authorized or requested by the issuing bank to confirm a credit but is not
prepared to do so, it must inform the issuing bank without delay and may advise the credit
without confirmation. (UCP 600 article 8 ii-d)
Confirming a letter of credit does not mean that confirming bank is obligated to confirm any
subsequent amendment or amendments.
A confirming bank is irrevocably bound to honour or negotiate as of the time it adds its
confirmation to the letter of credit. (UCP 600 article 8 ii-b )
Letter of Credit FeesHow to deal with high banking commissions under letters of credit as an exporter?
Who pays letters of credit fees? Letters of credit have certain advantages as an international payment method. If you have enough knowledge and expertise on letters of credit field then you can use them wisely to get paid where no other payment method works. No matter how many advantages letters of credit have they have one big disadvantage. They are expensive.
As a result you should understand your costs before finalizing a letter of credit deal.
Why letters of credit are expensive comparing to other payment methods?
Banks play a key role in letters of credit transactions. This is the main reason why letters of credit
are so expensive comparing to other payment methods. Issuing banks open letters of credit for
the account of applicants and in favor of the beneficiaries. Issuing banks have to bear certain
amount of risks when they open letters of credit. They also let the applicants benefited from their
credit worthiness. As a commercial institution issuing banks provide these services only for one
reason. To earn more money, to make more profit. Similarly confirming banks collect fees from
the letter of credit parties for the same reason. When confirming a letter of credit confirming
banks may have to bear substantial amount of non-payment risk. As a result confirmation fees can
sometimes climb to high values. As we have learnt that in a typical letter of credit transaction there
are other banks may exist in addition to issuing bank and confirming bank such as advising
bank, nominated bank, reimbursing bank. Every additional bank means additional fees and
additional cost for either applicants or beneficiaries.
Who should pay bank charges in a letter of credit transaction?
We can answer this question by either looking at the rules or by looking at the real life situations
because what rules say is not what is really happening on practice.
UCP 600's article related to charges of letters of credit is article 37 c: "A bank instructing
another bank to perform services is liable for any commissions, fees, costs or expenses
("charges") incurred by that bank in connection with its instructions. If a credit states that
charges are for the account of the beneficiary and charges cannot be collected or deducted
from proceeds, the issuing bank remains liable for payment of charges."
In real life situations applicant pay only issuing bank's charges and remaining bank charges
will be paid by the beneficiary unless beneficiary is very strong against applicant. We need
to look at field "71B: Charges" in a letter of credit text issued by swift format to understand
how bank charges will be paid by letter of credit parties.
Samples :
o Issuing bank charges will be paid by applicant and all other cherges will be paid by
beneficiary : Field "71B: Charges : ALL BANKING CHARGES OUTSIDE BRAZIL ARE FOR
BENEFICIARY'S ACCOUNT." This letter of credit issued by a Brazilian bank.
o Field "71B : Charges and Fees: OTHER THAN THE ISSUING BANKS ARE FOR THE ACCOUNT OF
THE BENEFICIARY. ISSUING BANK’S CHARGES ARE FOR THE ACCOUNT OF THE APPLICANT."
Discrepancies : Biggest trouble for everyone in lc business
What does discrepancy mean in a letter of credit payment? How can discrepancy be defined
under a letter of credit transaction?
Perhaps discrepancies is one of the most complicated and "blurred" field in all letters of credit
terminology. One bank finds multiple discrepancies on a document yet the same document found to
be complying by another bank. But how?
Transport Document Discrepancies
Multimodal Bill of Lading Discrepancies
Marine Bill of Lading Discrepancies
Non Negotiable Sea Waybill Discrepancies
Charter Party Bill of Lading Discrepancies
Road Transport Document Discrepancies
Air Transport Document Discrepancies
Rail Transport Document Discrepancies
Commercial Document Discrepancies
Commercial Invoice Discrepancies
Packing List Discrepancies
Weight List Discrepancies
Inspection Certificate
Certificate of Analysis
Pre-Export Verification of Conformity (PVoC) Certificate
Official Document Discrepancies
Certificate of Origin Discrepancies
Health Certificate
Consular Invoice, Legalized Invoice
Insurance Document Discrepancies
Insurance Policy Discrepancies
Almost all of the ICC opinions issued so far are related to complaints about "alleged discrepancies".
What we can see from the results of the ICC opinions is that ICC Banking Committee does not agree
with banks in most cases.
Definition : or lack of definition :
How can we define a discrepancy in a letter of credit transaction. Seriously is there any reference to
the definition of a discrepancy in the letter of credit rules? Is it too simple to be forgotten? Or too
complicated to define? What is the definition of a discrepancy according the UCP 600 rules?
Inconsistency in Application :
Discrepancies can change from country to country, bank to bank, document checker to document
checker. Let me give you a real life example here. Couple of years ago we have presented
documents to the confirming bank under a set of letters of credit consists of 10-15 pcs of
independent letters of credit. All of these small amount independent letters of credit have the same
text and having the same conditions. Description of goods, port of loading, port of discharge,
additional conditions all were the same. Just latest date of shipment and expiry date were changing
form one lc to another. First 3 presentations found to be complying by the confirming bank. But on
the 4th document set we received a swift message "MT 734 Advice of a Refusal" indicating a
discrepancy on the certificate of origin. Lessons learned. Discrepancies can change from country to
country, bank to bank, document checker to document checker and presentation to presentation.
and here is the results :
According to ICC Trade Finance Surveys on average %70 of letter of credit presentations found to be
discrepant on first presentation. This is a very frustrating result. Everyone in letter of credit business
should understand huge negative effects of such a high volume of discrepant presentations.
Why banks find too much discrepancies on the documents :
Letter of credit rules are often find to be very complicated and hard to understand by
exporters and importers.
Most of the small and medium scale export and import companies do not have enough
resources to hire a letter of credit specialist in their organizations.
Exporters and importers do give enough respect to letter of credit rules and standard
banking practices. exporters and importers think that they can handle letters of credit with
ease on their way. but the fact is different. Letters of credit have very strict rules to follow.
Exporters do not allocate enough time to understand the letter of credit text before starting
to production and shipment.
Banks open over detailed letters of credit. Sometimes we see that banks demand almost
impossible conditions from the beneficiaries on their letters of credit texts.
Banks issue foggy (not clear) letters of credit.
Banks examine documents too strictly.
What can be done to prevent discrepant presentations :
Pre - Document Preparation Stage :
Please keep in mind that whatever you do to prevent a possible discrepant presentation, it
is highly likely that you will be facing a discrepancy one of the documents you have
submitted. So it would be very wise for you to keep your relations close with your customer.
Before entering a letter of credit transaction you need to learn the letter of credit rules very
well. You should buy one original copy of current letter of credit rule book, UCP 600. Please
follow this link how to find a copy of UCP 600 online.
Before entering a letter of credit transaction you also need to be familiarized with the
International Standard Banking Practices. In order to do that you should buy one original
copy of current International Standard Banking Practices book. Please follow this link to
learn more about International Standard Banking Practices.
You should starting to study letter of credit text as early as you can. As one of the letter of
credit guru indicated "you can not solve lc problems at the presentation stage." The earlier
you start to work on the letter of credit text the better it would be.
Demand a letter of credit draft from your buyer before having the original letter of credit
issued. Work on this letter of credit draft carefully.
Check required documents field one by one. Make sure that you can supply all the required
documents as requested by the letter of credit.
Check additional conditions field one by one. Make sure that conditions stated in this field is
not going to create any problem for you on the presentation stage.
If you find a condition or clause that you can not comply with get in touch with your buyer
to amend the letter of credit.
If you can not understand a condition or sentence on the letter of credit text then you
should get in touch with the issuing bank for clarification.
Document Preparation Stage :
Complete the documents as requested by the credit. Make sure that you also take into
account the letter of credit rules and international standard banking practices when
preparing the documents.
Make sure that signatures, authentication are made by requested persons or institutions.
Make sure that you will be presented all required documents without any absence.
Make sure that you presented correct number of originals and copies as requested by the
credit.
Make sure that the dates on the documents are in accordance with the dates mentioned on
the credit. For example you would not be making either a late shipment or a late
presentation.
Make sure that you will collect all requested documents by credit as soon as you make the
shipment. Once you collect all documents you need to make the presentation without
losing time.
After Presentation Stage :
Follow the situation of the documents day by day with the advising bank. Give necessary
information to your buyer. And stay in alert mode until you received your payment.
