How a Letter of Credit Works
Protection for Payments
A letter of credit is a document from a bank that guarantees payment. There are several types of letters of credit, and they provide security when buying and selling.
- Seller protection: If a buyer fails to pay a seller, the bank that issued a letter of credit will pay the seller if the seller meets all of the requirements in the letter. This provides security when the buyer and seller are in different countries.
- Buyer protection: Letters of credit can also protect buyers. If you pay somebody to provide a product or service and they fail to deliver, you might be able to get paid using a standby letter of credit. That payment can be a penalty to the company that was unable to perform, and it’s similar to a refund, allowing you to pay somebody else to provide the product or service needed.
If you're familiar with escrow services, the concept is similar: Banks act as "disinterested" third parties (they don't take anybody's side), and they release funds only after certain conditions are met. Letters of credit are common in international trade, but they are also used in domestic transactions like construction projects.
- A letter of credit provides protection for sellers (or buyers).
- Banks issue letters of credit when a business “applies” for one and has the assets or credit to get approved.
- Letters of credit are complicated, and it’s easy to make an expensive mistake when using one.
- A manufacturer gets an order from a new customer overseas. The manufacturer has no way of knowing if this customer can (or will) pay for the goods after they’re produced and shipped.
- To manage risk, the seller uses an agreement requiring the buyer to pay with a letter of credit as soon as shipment is made.
- To move forward, the buyer needs to apply for a letter of credit at a local bank. The buyer may need to have funds on hand at that bank or get approval for financing from the bank.
- The bank will only release funds to the seller after the seller proves that the shipment happened. To do so, the seller typically provides documents showing how goods were shipped (with details like the exact dates, destination, and contents). In some ways, the buyer also enjoys protection under a letter of credit: Buyers might prefer to pay a bank with a big legal department than send the money directly to an unknown seller.
- If the buyer is concerned about a dishonest seller, there are additional options available for the buyer’s protection. For example, somebody can inspect the shipment before the payment is released.
The concept of a letter of credit can be complicated. The easiest way to get a handle on things is to see a visual step-by-step example.
The Money Behind a Letter of Credit
A bank promises to pay on behalf of a customer, but where does the money come from?
The bank will only issue a letter of credit if the bank is confident that the buyer will pay. Some buyers have to pay the bank up front or allow the bank to freeze funds held at the bank. Others use a line of credit with the bank, effectively getting a loan from the bank.
Sellers must trust that the bank issuing the letter of credit is legitimate and that the bank will pay as agreed. If sellers have any doubts, they can use a "confirmed" letter of credit, which means that another (presumably more trustworthy) bank will guarantee payment.
Sellers typically get letters of credit confirmed by banks in their home country.
When Does Payment Happen?
A beneficiary only gets paid after performing specific actions and meeting the requirements spelled out in a letter of credit.
For international trade, the seller may have to deliver merchandise to a shipyard to satisfy the requirements of the letter of credit. Once the merchandise is delivered, the seller receives documentation proving that he made delivery, and the documents are forwarded to the bank. In many cases, the letter of credit now must be paid—even if something happens to the shipment. If a crane falls on the merchandise or the ship sinks, it's not necessarily the seller's problem.
Documents matter: To approve payment on a letter of credit, banks simply review documents proving that a seller performed any required actions.
The bank is not concerned with the quality of goods or other items that may be important to the buyer and seller. That doesn't necessarily mean that sellers can send a shipment of junk: Buyers can insist on as part of the deal, which allows somebody to review the shipment and ensure that everything is acceptable.
For a “performance” transaction, a beneficiary (the buyer, or whoever will receive the payment) might have to prove that somebody failed to do something. For example, a city might hire a contractor to complete a building project. If the project is not completed on time (and a standby letter of credit is used), the city can show the bank that the contractor did not meet his obligations. As a result, the bank will pay the city. That payment compensates the city and makes it easier to hire an alternative contractor to finish the work.
What Can Go Wrong?
Letters of credit make it possible to reduce risk while continuing to do business. They are important and helpful tools, but they only work when you get all of the details right. A minor mistake or delay can wipe out all of the benefits of a letter of credit.
If you rely on a letter of credit to receive payment, make sure you:
- Carefully review all requirements for the letter of credit before agreeing to any deal.
- Understand all of the documents required. If you don’t know what something is, ask your bank.
- Will truly be able to get all of the necessary documents for the letter of credit.
- Understand the time limits associated with the letter of credit, and whether or not they are reasonable.
- Know how quickly your service providers (shippers, etc.) will produce documents for you.
- Can get the documents to the bank on time.
- Make sure all documents required by the letter of credit match the letter of credit application exactly. Even typographical errors or common substitutions can cause problems.
Importers and exporters regularly use letters of credit to protect themselves. Working with an overseas buyer can be risky because you don't really know who you're working with. A buyer may be honest and have good intentions, but business troubles or political unrest can delay payment or put a buyer out of business.
In addition, communication is difficult across thousands of miles, different time zones, and different languages. A letter of credit spells out the details so that everybody is on the same page. Instead of assuming that things will work a certain way, everybody agrees on the process up front.
Letter of Credit Lingo
To better understand letters of credit, it helps to know the terminology.
Applicant: The party who requests the letter of credit. This is the person or company that will pay the beneficiary. The applicant is typically (but not always) an importer or buyer who uses the letter of credit to make a purchase.
Beneficiary: The party who receives payment. This is usually a seller or exporter who has requested that the applicant use a letter of credit (because the beneficiary wants more security).
Issuing bank: The bank that creates or issues the letter of credit at the applicant’s request. It is typically a bank where the applicant already does business (in the applicant’s home country, where the applicant has an account or a line of credit).
Negotiating bank: The bank that works with the beneficiary. This bank is generally located in the beneficiary’s home country, and may be a bank where the beneficiary already conducts business. The beneficiary will submit documents to the negotiating bank, and the negotiating bank acts as a liaison between the beneficiary and other banks involved.
Confirming bank: A bank that “guarantees” payment to the beneficiary as long as the requirements in the letter of credit are met. The issuing bank already guarantees payment, but the beneficiary may prefer a guarantee from a bank in her home country (with which she is more familiar). This may be the same bank as the negotiating bank.
Advising bank: The bank that receives the letter of credit from the issuing bank and notifies the beneficiary that the letter is available. This bank is also known as the notifying bank, and may be the same bank as the negotiating bank and the confirming bank.
Intermediary: A company that connects buyers and sellers, and which sometimes uses letters of credit to facilitate transactions. Intermediaries often use back-to-back letters of credit (or transferable letters of credit).
Freight forwarder: A company that assists with international shipping. Freight forwarders often provide the documents exporters need to provide in order to get paid.
Shipper: The company that transports goods from place to place.
Legal counsel: A firm that advises applicants and beneficiaries on how to use letters of credit. It’s essential to get help from an expert who is familiar with these transactions.
Getting a Letter of Credit
To get a letter of credit, contact your bank. You'll most likely need to work with an international trade department or commercial division. Not every institution offers letters of credit, but small banks and credit unions can often refer you to somebody who can accommodate your needs.