Letter of Credit

Many a USA based small business has received a request to sell their products to a foreign company. Often they are reluctant to do so because they are afraid of not getting paid. To mitigate the risk they invariably ask the buyer to pay up front. But, with a Letter of Credit you can change the rules.

There is a better way.

Better than getting paid up front? Well in a sense yes.

A buyer paying up front is tying up capital and may purchase less or seek a seller offering payment terms (like Net 30). But you can prevent this by offering to sell your goods and allowing the buyer to supply a letter of credit for the transaction.

The way it works is thus:

  1. The buyer asks their bank to issue a letter of credit (a commitment to pay on their customer’s behalf) with the seller as beneficiary. 
  2. The issuing bank issues the letter of credit electronically to the seller’s bank. 
  3. The seller then ships the goods to the customer, and sends a copy of the shipping documents to their bank. 
  4. The buyer’s bank forwards the shipping docs (which are legal title to the goods) to the buyer’s bank. 
  5. Once received, the buyer’s bank notifies the buyer and makes payment on their behalf to the seller’s bank (electronically or by wire) and delivers the documents to the buyer so they can pick up the goods when they arrive. 

Most often, the documents arrive well ahead of the product and the seller has been paid before the goods have been received by the buyer. The banks act as intermediaries, collecting documents and payments on behalf of their customers. 

What Does a Letter of Credit Do For Us?

This guarantees payment to the seller, and guarantees product is on the way for the buyer. Both sides are protected. The buyer cannot refuse the shipment once it arrives, meaning payment will be made regardless of whether the buyer still wants the goods. There are ways to guarantee the goods are as stated – through pre-shipment inspections for example.

Fees for issuing and negotiating (the term given to processing a letter of credit for payment) are very low – normally a few hundred dollars – making it a cost effective way of doing business.

OK. Tell Me More!

If a letter of credit is payable upon receipt of the documents it is called a “sight draft” because it is payable upon sight of the documents. If it is payable over time, it is called a “time draft”. The tenor (length of time) of a time draft is typically 30 – 120 days, but can be shorter or longer.

The beauty of a time draft is that it allows the seller to give credit terms to their customer while still being guaranteed payment. This is advantageous to both parties. 

Give Me An Example

Let’s say a USA exporter of Californian wine to England grants credit terms to the buyer of 120 days from date of shipment. The buyer may have sold the wine to a distributor and been paid before they even have to make payment to the USA exporter. 

The exporter can take the letter of credit their customer issued in their favor, once the shipping documents are issued, to their American trade bank and asked to be immediately paid. This is called “discounting the draft”. If all seems in order, the exporter’s bank will give the exporter a percentage of the money due and charge a fee plus a nominal interest rate. The rate will be far lower than the interest charged on a line of credit. It is usually pegged to the Libor rate for the length of the letter of credit. 

When the letter of credit is paid by the original buyer, the bank pays itself the principal due and passes the rest to the exporter. The exporter has received the vast majority of what they are owed (often 90-98%) well before they letter of credit is due to pay out, and the seller has sold the goods and has plenty of time to pay. This encourages the buyer to purchase more than normal, and improves the seller’s cash flow without resorting to a line of credit. 

What Problems Can I Have?

There are two big caveats. The shipping documents issued to the bank must match those received with the shipment exactly. Exactly means exactly. Any discrepancy will have to be reconciled before the letter of credit will be paid, and the bank will charge a fee for each discrepancy. 

The second caveat is that it must be a reliable bank issuing the letter of credit. Each bank will have a credit rating that will be used to determine if they are reliably able to pay on their letters of credit. 

Many small banks are perfectly credit worthy when it comes to letters of credit, but some in certain countries may not be. When in doubt ask your banker. Reputable banks here in the USA will confirm (guarantee) payment on a letter of credit issued by foreign banks. It is often unnecessary and an unneeded expense though. But if the sale is so big that failure to pay might jeopardize the seller’s ability to remain in business, confirmation of a letter of credit would be prudent. 

Next time we will discuss Standby Letters of Credit, and Documentary Collections.

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Wesley John

Wesley John is a partner at Fair Winds Strategies. He has been involved in banking for over 15 years, first at Fleet Bank and later at HSBC as a Vice President and Senior Relationship Manager. He is currently the President of the Cornell Cooperative Extension of Albany County, and also CEO and Owner of Macklin & Co., a premium manufacturer of cutlery. John received his MBA and his bachelor’s degree from SUNY Albany.
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