Chuck LEAN Business Consultant
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Have you ever used a Letter of Credit in your international transactions?
n the world of buying and selling, which encompasses just about any kind of commerce, a letter of credit is an important financial tool. Specifically, a letter of credit is a letter from a bank guaranteeing a seller will receive payment from the buyer in the correct amount and on time. The reason a letter of credit is so important is that if the buyer is unable to pay, the bank has to cover the full amount of the purchase.
When I worked for The SchwinnBicycle Company, I used a Letter of Credit to purchase bicycle parts overseas.
What is your experience with a Letter of Credit?
Which Parties Are Involved in Letters of Credit?
There are often a few groups involved in any deal with a letter of credit, depending on the kind of deal you’re working on. Indeed, there can be up eight or more distinct groups involved in a letter of credit transaction, but they usually are:
The Applicant: "The applicant is the buyer in a deal that involves a letter of credit," says Fundera's O'Connor.
The beneficiary: This is the seller in the letter of credit transaction.
The issuing bank: This is the bank, often in a foreign country, that reviews the applicant's credentials and holds onto the money involved in the letter of credit.
The negotiating bank: The negotiating bank handles the ins and outs of actually getting the seller paid, and works on the beneficiary’s side of the transaction as a go-between.
The intermediary: Intermediaries usually connect applicants and beneficiaries to help them strike a deal, and can facilitate the creation of a letter of credit to make it all go smoothly. The intermediary can be an employee of the issuing or negotiating bank, or another party.
The freight forwarder: If the purchase involves a large amount of goods or large-sized goods, such as vehicles or factory or farm equipment, a freight forwarder ensures that shipping goes smoothly by attaching postage, if need, or ensuring that any export, import, or other fees are paid.
The shipper: As with any transaction involving a delivery, the shipper delivers the goods.
Legal counsel: As is often the case, lawyers enter the fray in complicated transactions. Usually this is for the good: to cover all bases and ensure all legal requirements from foreign countries are met. But lawyers may also be needed to help handle any disputes over the transaction should they arise.
What Is a Letter of Credit in the Export/Import Business?
An export/import letter of credit is issued by the importer’s bank on behalf of the importer with the exporter being the beneficiary. A letter of credit is guaranteed by the importer’s or buyer’s bank that the payment will be given to the exporter or seller. As eFinanceManagement, a business information website, explains:
The biggest advantage of import letter of credit export/import is that it minimizes risk, especially when a seller is dealing with an overseas client. "The exporter has to submit valid documents as proof of shipment of agreed upon goods before the payment can be made. The terms and conditions under import letter of credit cannot be changed unless all the parties agree, so it’s legally binding," says eFinanceManagement.
The disadvantage of a letter of credit export/import is that the issuing bank is required to pay the exporter as and when he presents the documents covered in terms and conditions of the import letter of credit. There is a real risk that the goods may have been damaged or arrived in unsatisfactory condition. This can put the guaranteeing bank on the hook for payment.
What Is a Letter of Credit With an Example?
Export.gov, a website operated by the U.S. Department of Commerce to assist U.S. businesses plan their international sales strategies in the global marketplace, explains that letters of credit are "one of the most versatile and secure instruments available to international traders." A letter of credit represents a commitment by a bank on behalf of the importer (foreign buyer) that payment will be made to the beneficiary (exporter), provided the terms and conditions stated in the letter of credit have been met, as evidenced by the presentation of specified documents, Export.gov notes. A letter of credit issued by a foreign bank is sometimes confirmed by a U.S. bank.
The Tennessee Valley Authority, a corporate agency of the United States that provides electricity for business customers and local power companies, gives this example of a letter of credit: