Letters of Credit - Why Use Them?

Reading this article will make you a semi expert on the subject. For more information you can see my book Letters of Credit and Documentary Collections which can be found on line. Also see my other articles on Letters of Credit on Associated Content. This information is based on my 30 years of experience in international business operations.

If you read my article on Letters of Credit one can see how complicated and costly they can be. In addition Documentary Collections, such as documents against payment, are also cumbersome but easier than a Letter of Credit. One mistake that people and companies is they assume a Letter of Credit is an agreement or contract. This is why big company accounting departments who have so called bean counters usually have a lot of clout. The accounting people push the sales management too always demand a Letter of Credit when doing international sale. They think a Letter of Credit is a sure method to be paid. This type of thinking is wrong as you will see below.

This is the definition provided by globaledge.msu.edu/resourcedesk/glossary.asp: " A letter issued by an importer's bank guaranteeing payment upon presentation of specified trade documents (invoice, bill of lading, inspection and insurance certificates, etc.)."

The problem comes in when there are discrepancies or disagreements in the documents. If the bank or customer claims a problem then payment will not be made in a timely manner or maybe not at all. The possibility of nonpayment is however very slim.

The Letter of Credit is not an agreement or an official contract. The Letter of Credit is made from the official sales contract or agreement that your customer and sales person signed. The Letter of Credit is only a means to transfer proof of goods being shipped and a means to transfer funds for payment. It is a third party watch dog so to speak, with no power to enforce any contract let alone adherence to the Letter of Credit.

The Banks advise you they are not responsible in any manner for nonpayment. A Confirmed Letter of Credit however once accepted by the issuing and advising bank does promise payment. So a Confirmed Letter of Credit is the only safe method to use if you have any doubts about your customers ability to pay.

If you are doing business with a large famous international company why do you need to use a Letter of Credit? Letters of Credit are now outdated with international trade occurring everyday and many multinational companies located all over the world, Letters of Credit have become a cumbersome time consuming task. Companies have developed trust in each other and consider it very important to honor contracts or purchase agreements. Most international business should done by Documents against Payment, Documents against Acceptance, or Net 30 Day payment terms. However one will find that most companies want 60 day payment terms or more in some cases.

Net 30 Days

One can also use Net 30 day terms, just as we do in the United States with a customer. The Net 30 day term is the best method to use if there is a good, trusting relationship. You also need to take into account who the customer is and what the size of their company is. For example, most companies would have no problem giving Panasonic Net 30 or even Net 60 day payment terms. They are a huge international company that can be trusted to pay their invoices on time. Most companies overseas prefer sixty-day payment terms.

The steps to use Net 30 day terms for customers overseas are very easy. It is very similar to doing business in the United States, but you receive payment by wire transfer directly to your bank from the customer's bank overseas instead of a check.

1. The customer sends you an inquiry to purchase a certain material. 2. You send them back a formal quote which contains the payment terms, shipping terms, conditions, item description, specification, and any other information such as an MSDS (material safety data sheet). 3. The customer sends you a purchase order that shows all your terms and conditions and material description. 4. Upon receiving the purchase order, you send a confirmation to the customer that it was received and provide them with an estimated ship date. 5. When goods are ready to ship, notify your shipper to pick up the goods and provide you with an original bill of lading once the goods are on board. 6. E-mail your customer a copy of all the documents, and be sure to put your bank address and SWIFT code with your account number on the invoice. This is to assure you receive payment. The following example should be on your invoice:

REMIT PAYMENT TO: This example is Key Bank

Key Bank

127 Public Sq.

Cleveland, Ohio 44144 USA

ABA Routing No. 041 001 000

SWIFT: KEYBUS39

Account No.: 366000

Account Name: Kia, Inc.

This address tells the overseas bank exactly how and where to submit payment. It takes about two to three days to receive the funds in your account from the date the customer's bank remits payment. 7. Send your customer the original documents by UPS or express mail. These documents allow the customer to obtain his goods from the shipping company and the customs broker in his country. They show he has Net 30 days to make payment.

8. Now you just wait for payment from your customer and hope he pays on time. There is nothing that can make the customer pay on time, so usually they pay late by up to fifteen days. You really need to trust your customer.

This is a direct sale to your customer, and the bank's only job in this transaction is to transfer funds to your account. If the customer does not pay you, your bank can be of no help in the collection. You will have to either phone or visit the customer to obtain payment if necessary. This is why it is important to know if your customer is a large stable company.

The following documents are submitted for Net 30 Day payment.

1. Customer purchase order

2. Air waybill or bill of lading

3. Commercial invoice

4. Packing list

It may also be necessary to send certifications on any metal or chemicals that are shipped. A bank draft or draft is not necessary with Net 30 day transactions. To check if payment is received, it is necessary to phone your bank, and they will also send you a copy of the wire transfer payment.

Payment in Advance of Shipment

The very best method to use for an overseas sale is to require payment in advance of the shipment or prepaid. In this case, the customer pays before the goods are shipped. This system is used for small orders of less than $1,000 or when the customer is a big risk in your opinion. Steps for payment in advance of shipment are:

a. Customer sends an inquiry.

b. Your company quotes a price, terms, and conditions which are payment in advance. In this case, it is normal practice for you to pay the freight and include the freight charge in the material cost. Since it is your shipper, use a CIF term which covers insurance so if something happens to the shipment, you are protected.

c. The customer sends you a purchase order, and you return to him a pro forma invoice. A pro forma invoice is used by the customer in many countries as proof to provide their bank that they need to transfer funds outside of the country for payment of goods to be shipped. Be sure to have your banking information on the pro forma.

d. The customer remits payment to your account.

e. Once payment is received, you must ship the goods as stated in the pro forma invoice. However, you now make a commercial invoice which is stamped "paid." Advise your customer the shipping information, and e-mail them the new invoice and packing list as well as the bill of lading. You must also send the original copies by UPS or FedEx.

So why use Letters of Credit for trusted customers? There is no reason. If the customer is new and cannot be trusted then use payment in advance until he can be given a credit line by showing he can pay. Letters of Credit are very costly and time consuming. In effect they slow down the international sale process. The writer will agree that sometimes a Confirmed Letter of Credit maybe good to use but without the confirmation a Letter of Credit is just a piece of paper. Once a Bank told me that a Chinese Letter of Credit is not worth the paper it is written on. Any contract is only as good as the people signing the agreement and the company standing behind the agreement.

Coming next Letters of Credit and Sight Drafts or Bills of Exchange.

References: www.aesdirect.gov, www.sba.gov, www.ffiec.gov