A Letter of Credit (LC) is a letter issued by a bank guaranteeing a buyer’s payment will be sent to the seller on time and for the correct amount. Letters of credit are useful when conducting international business especially due to the distance, differing laws, language and unfamiliarity of your business partner. A Letter of Credit can safeguard you against outstanding invoices as the issuing bank is required to pay the full or outstanding balance should the buyer not be able to.

Who is protected by a Letter of Credit?

A Letter of Credit can provide protection to both sellers and buyers:

  • Sellers – as long as all the requirements outlined in the letter are met, the seller will receive their payment.
  • Buyers – if sellers fail to deliver their goods or services, a buyer will receive a ‘refund’ from the bank so they are able to purchase the goods again from another supplier.

Types of Letters of Credit

There are 5 types of Letters of Credit. These are:

  1. Commercial – payment will be made directly from the bank to the seller once the product or service has been delivered and a delivery note is received by the bank.
  2. Standby – payment will only be made by the bank if the buyer defaults or is unable to pay.
  3. Revolving – multiple amounts can be drawn from the Letter of Credit, up to a specified amount and within a specific time.
  4. Confirmed – the Letter of Credit is confirmed by a different bank to the issuing one. This is normally the sellers bank and they will ensure the payment is made if both the buyer and issuing bank default. For international arrangements, this is usually requested and highly recommended.
  5. Travelers – issuing banks will honour withdrawals made at certain foreign banks.

What is the cost for a Letter of Credit?

Overseen by the International Chamber of Commerce Uniform Customs and Practice for Documentary Credits, banks will charge a fee for the service, normally a % of the overall amount documented in the letter. Banks may also require other securities such as cash before issuing the letter.

When does the bank make the payment?

Once all the requirements outlined and agreed in the Letter of Credit have been performed, and proof has been provided, the bank will issue the payment. It is important to note however, that banks are not interested in any other aspect of the sale other than the delivery of the good or services. Once a delivery note is received, the bank will immediately make the payment, even if the goods haven’t been received at that point. Banks are not concerned with the quality of the product.

For Buyers, it is recommended to include an inspection certificate as a requirement of the letter to protect against this.

7 important things to know about a Letter of Credit

  1. Letters of Credit only work if all the details are correct. If there is anything different, even with regards to the spelling or naming of a document, the letter becomes invalid.
  2. Understand all the requirements of the letter. If you’re unsure, ask the bank to clarify.
  3. Review all requirements of the letter before agreeing and be 100% certain you can obtain all the documents outlined within it.
  4. Do you understand and agree the time limits set out in the letter? Are they achievable?
  5. Find out how quickly your service providers e.g. delivery company, can send you the necessary documents for proof.
  6. Can you deliver all the required documents to the bank on time?
  7. Ensure all necessary documents exactly match the ones stated in the Letter of Credit. Any anomalies or differences, even spelling mistakes, will void the letter.

Do you want to know more about a Letter of Credit? Get in touch with us today. We will be happy to help you.