Letter of Credit – Things to Look Out For

By Bryan Boo

International business and trade is not uncommon in our seemingly borderless world. Goods can be delivered across countries in a matter of days and payments can be transferred almost instantaneously.

If you do have an international business partner, you may have come across the term “Letter of Credit“. In fact, some companies insist on a Letter of Credit for their commercial dealings.

What is a “Letter of Credit”

A Letter of Credit is a negotiable instrument given by the issuer of the Letter of Credit (usually a bank) to the vendor. It is essentially a written undertaking by the issuer of the Letter of Credit to make payment of a certain amount to the vendor (or the vendor’s bank, as the case may be) upon the fulfilment of certain criteria and/or requirements.

With the Letter of Credit, the vendor can be assured that the payment will be made to the vendor so long as the terms of the Letter of Credit is fulfilled.

Documents, documents, documents

It must be noted that when it comes to the disbursement of monies pursuant to the Letter of Credit, the issuer of the Letter of Credit is usually only concerned with the documents furnished. This means that the issuer of the Letter of Credit only needs to review the document furnished to determine if the vendor has indeed fulfilled its obligation.

This means that when negotiating and/or finalising the terms of the Letter of Credit, both the buyer and the vendor has to ensure that the specific clauses that protect their individual interests are incorporated into the Letter of Credit. For example, if the buyer wants to ensure that the quality of goods received from the vendor is at least of a certain quality, the buyer may incorporate a clause that includes an inspection certificate as part of the documents to be furnished for the processing of payment.

Caution

A Letter of Credit is a very intricate document. As such, the terms of the Letter of Credit should be carefully reviewed. Some of the things that should be considered are as follows:

  1. Ensure that you know all of the documents will be required. As the vendor, you would be required to furnish all the documents listed before payment can be processed. As the buyer, ensure that the documents listed sufficiently protect your interests.
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  2. A Letter of Credit usually has an expiry date. Therefore, it is of the utmost importance to understand the time frame and deadlines laid out in the Letter of Credit and determine if such a time frame is reasonable for the fulfilment of your obligations.
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  3. In view that a Letter of Credit has an expiry date and may contain clauses that specify a certain time frame, a vendor would have to know how quickly the service providers employed (e.g. the shippers, freight, etc.) can furnish the vendor with the necessary documents.
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  4. All documents that the vendor is required to furnish under the Letter of Credit should be verified and carefully to ensure that the documents are exactly what is requested for (e.g. if the Letter of Credit stipulates that the original copy of the document is to be provided, then the original copy of that document should be furnished). This includes checking the individual document itself as typographical errors or common substitutions may be a problem in the processing of the payment.
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  5. The vendor should also know the different parties involved. Typically, the vendor will furnish the documents to the vendor’s bank, who would, in turn, forward the same to the buyer’s bank for processing. Thereafter, if everything is in order, the buyer’s bank will disburse the payments. However, there may be instances in which more parties are involved in the chain (e.g. apart from the vendor’s bank and the buyer’s bank, there may be an advising bank, negotiating bank or confirming bank involved). The more parties that are involved, the more time that would be required for the documents to be forwarded and/or processed before payment can be disbursed.

The list above is not exhaustive and it is really dependant on the specific transaction and purpose of the Letter of Credit.

Conclusion

It must be pointed out that while Letters of Credit are usually used in international transactions, although uncommon, it may also be used in domestic transactions. Nonetheless, the use of Letters of Credit has become an important aspect of international trade, particularly due to the nature of international dealings.

There are many different types of Letters of Credit (such as, inter alia, a Standby Letter of Credit, Letter of Credit at Sight, Revolving Letter of Credit and Confirmed Letter of Credit). Some might be revocable and transferrable, some might not.

In any case, whichever type of Letter of Credit is used, it is important to carefully peruse the Letter of Credit. It would be dangerous to just agree to a Letter of Credit without understanding its clauses. Parties should negotiate and discuss the individual clauses that each party wishes to incorporate into the Letter of Credit, including the deadlines and expiry date, to ensure that not only the interests of both parties are well protected but also that the obligations of the parties can be fulfilled within the stipulated deadlines.