Small Business Questions & Answers


Filed under Start Up

Ask About Letters of Credit

by Bothered in Boise | May 25, 2012

Subject :International

Dear Toolkit,

I recently decided to order a large quantity of small toys which I intend to use as giveaways with the kids' meals at my several snack shops. I discovered that it would be much cheaper to order these in volume directly from a manufacturer in Taiwan rather than buying them from a local supplier.

But—there's always a but—when I went to finalize the deal, their rep told me I'd need a "letter of credit" to complete the purchase. What in the world is that all about?

Bothered in Boise

Dear Bothered in Boise,

Inasmuch as you're a rank rookie in the import/export game, I'd strongly recommend that you hire an experienced customs broker to grease the foreign trade tracks for you, at least on your maiden voyage into global commerce. But even if you follow my advice and retain a pro, it will be useful for you to know as much as possible about the letter of credit as a financial instrument. So I'll give you my lecture on this dry but important tool of international trade.

A letter of credit (LC) is simply a guarantee of payment upon proof that contract terms between a buyer and seller have been completed. LCs are just fancy, two-way IOUs often used to facilitate international credit purchases such as the one you describe.

You, the buyer, go to your bank and request a letter of credit, which they will grant you—but only if you have an adequate line of credit established with them, of course. On your behalf (and for a fee), your bank promises (via the LC) to pay the purchase price to a seller (or his appointed bank) if stipulated and highly detailed conditions are met.

These conditions might include any or all of the following:

  • complete, on-board, ocean bills of lading
  • commercial invoice, original, six copies
  • packing slip, original, six copies
  • insurance certificates
  • inspection certificates
  • strict date limitations
  • amounts, precise name, and address of the beneficiary (seller)
  • references to mode of transport
  • and dozens of other conditions covered by the "Rules"

The "Rules" were drafted by the International Chamber of Commerce (ICC) in 1933 and revised as recently as 1993. They govern a standard letter of credit format accepted internationally and fondly known as the "Uniform Customs and Practice for Commercial Documentary Credits (UCP)."

The buyer's bank works as a kind of transfer agent, usually with the seller's bank, to exchange the purchase price for title or claim to goods. The parties thereby use their banks as intermediaries or middlemen to limit the risks of doing business with foreign trading partners. These risks include foreign currency exchange rate fluctuations as well as frequent shipping delays and the multitude of perils inherent in international trade.

Letters of credit are available in a variety of forms (for example, confirmed irrevocable letters of credit, confirmed letters of credit, acceptance letters of credit, or back-to-back letters of credit) with differing degrees of bank commitment. Generally you will only be dealing with irrevocable LCs.

In your case, as the importer, you need to be assured that the proper goods will be delivered to you intact, on a date certain, in good condition and at the agreed upon cost. The seller (exporter) needs to know that when he complies with all the terms you've set forth in the letter of credit, he'll be paid the amount due in a timely manner. And everything must be thoroughly documented at both ends.

Keep in mind that banks deal with documents, not goods, and if the documents are incorrect—even if the goods arrive as promised—the letter of credit can be worthless if any party to the agreement has goofed up the paperwork. And the flip side is that the paperwork can be perfection personified and the LC therefore honored—but the wrong goods might be delivered. That's why you need to have an inspector certify that what you ordered is what was shipped and that it arrived in good shape.

The key point to remember about LCs is the need for precision. Attention to detail and nit-picking legalese are mandatory. If an error is made or adjustments are needed subsequent to the issuance of an LC, amendments can be made to accommodate all parties to the transaction. But banks will follow these instruments to the (literal) letter, so you need to be as concise and accurate as possible when specifying terms.

The devil, as usual, is in the details, but the security an LC provides to both buyer and seller is well worth the effort involved. Good luck with your adventure in importing.