Documentary Risk in Commodity Trade Part 3

The Letter of Credit

The purpose of a letter of credit is for the issuing bank to substitute for the credit-worthiness of the buyer. As defined earlier, a letter of credit assures the seller that payment will be made against the merchandise shipped, on condition that the documents presented are in compliance with the letter of credit terms. The seller is thus protected from buyer credit risks as the issuing bank is providing a guarantee of payment.

Unless otherwise specified the letter of credit is considered to be irrevocable, that is: it cannot be changed unless both the buyer and the seller agree to make changes. It is not advisable to use a revocable letter of credit.

An irrevocable and confirmed letter of credit gives the strongest guarantees, and thus is more expensive than a simple irrevocable letter of credit. An (irrevocable) confirmed letter of credit is basically used when the parties are dealing for the first time with each other, or when the seller is not sure about the credit-worthiness of the buyer’s bank (or sometimes may not even be sure about the situation of the buyer) and also because there may be concern about the political or economic risks in the country where the bank is situated (confirmation in that case is applied to cover political risks even if the bank issuing the letter of credit is a first-class bank). As many banks in developing countries have insufficient capital, their ability to guarantee letters of credit is sometimes doubtful. Therefore, in order to have an additional source of security, confirmation of a letter of credit is sometimes required and can be obtained from local financial institutions or international banks; but still, many banks are unwilling to assume these risks. Some banks may refuse to confirm letters of credit issued by banks in countries with high political risks; however, there are banks which can provide such confirmation through the specific lines of credit they have in place for a particular country (usually limits are very low and fees could be very high).

It should be remembered that, in a letter of credit transaction, conforming documents imply payment. What is and what is not a discrepancy is determined by the UCP articles, and the terms of the letter of credit. Discrepancies are also discerned through practice and experience. Lack of training and improper understanding of letters of credit administration can lead to problems and rejection. Training is a key component in achieving greater efficiency in completing letters of credit properly. Accuracy in properly completing a letter of credit is a vital requirement to avoid problems and corrections, thus saving time and money (improving cash flow and enhancing profitability). Checking procedures need to be carried out at a very early stage of the transaction.

When checking documents, the issuing bank will check the documents against the terms and conditions of the letter of credit. If any discrepancy is noted, the buyer will be notified as soon as possible and will be given the opportunity to decide whether or not to accept the documents despite the discrepancies. If the documents are accepted by the buyer, the issuing bank will then notify the seller’s bank that the letter of credit will be honored despite the discrepancies. On the other hand, if the documents are rejected, then the issuing bank will issue a notice of rejection to the seller’s bank within seven banking days from the date the issuing bank received the documents.

The letter of credit should indicate that it will be covered by the principles of the UCP. It may also be important to specify that transaction and arbitration are covered by the United Nations Convention on Contracts for the International Sale of Goods, commonly referred to as the Vienna Convention.

The standard forms of contract are aimed at facilitating trade; generally speaking, they cover the basis of quality grading, delivery terms, provide protection, advice with regards to insurance and to appropriate payment, and include an arbitration clause and provisions in case of default. These standard forms of contract generally meet the requirements of trade and their terms and conditions reflect customary trade practices. They are not imposed by the associations which provide them. Contracting parties usually select in full or in part one of these contracts as the basis of their sales agreement. It is always recommended to use these types of contract since they have the advantage of helping to reduce risks and discrepancies.

Please take note that if the seller, after shipping the goods, has problems in getting paid under the letter of credit, it is important then for him to be vigilant in checking on the status of the goods he has shipped; make sure about the condition of the goods (where they are located, whether they are properly stocked,..) and most importantly make sure that the goods are properly insured. In case of dispute, the seller can sell his merchandise to a different party, provided that the goods are still in good condition. If he is paid less than what he was supposed to receive from the first buyer, he can then claim the difference through arbitration, provided that the buyer has breached the contract without apparent justification.

The Two Fundamental Principles of Letters Of Credit
The Autonomy of the Letter of Credit
According to this principle, the letter of credit is disassociated from the actual sales and other contracts and, thus, is not affected by any problems and disputes related to the contracts or dissatisfactions between the exporter and buyer. The main and only agreement that is arranged between the exporter and the bank is the letter of credit. Under a letter of credit, the bank is only concerned with one problem: to check whether the documents presented by the buyer comply with those specified in the letter of credit. Because of the autonomy of a letter of credit, the buyer’s bank is therefore absolutely bound to honor the letter of credit by paying the exporter upon presentation of proper documents, notwithstanding any dissatisfaction from the buyer in relation to the sales contract or any dispute between the buyer and seller. The buyer’s protest about the export cannot suspend payment of the letter of credit. This was the case with one exporter’s bank. It successfully sued a buyer’s bank for dishonoring drafts against a letter of credit because of complaints about the quality of the exported goods. The only case where a bank may refuse payment is in case of fraud or forgery in the transaction, referred to as fraud exception.
The Doctrine of Strict Compliance
According to this principle, the exporter must respect the written terms “to the letter” of the letter of credit. If any discrepancy or inconstancy occurs between the documents presented by the exporter and what is actually specified in the letter of credit, the bank can refuse payment. Therefore, with a letter of credit, the buyer has the protection of the bank strictly controlling the documents, and the seller has the protection of getting paid if all documents comply with the letter of credit. But the problem is how strict compliance should be. Some courts insist upon literal compliance, so that a misspelled name or typographical errors may be a divergence to refuse payment. Others accept payment upon substantial compliance with documentary requirements. However, one should keep in mind that the bank may insist on strict compliance with all the requirements of the letter of credit, and therefore the beneficiary must be able to provide prompt documentation. As the seller has very limited defense to protect himself, he should check with his bank whenever he has any doubts in interpreting unclear items in the letter of credit.
Types of Letters of Credit
Revocable Letters of Credit
The term “revocable” means that the letter of credit can be modified or cancelled by the buyer or his bank at any time without prior notice to the seller. It offers no guarantee of payment. Therefore, because it offers little security, revocable letters of credit are rarely acceptable by sellers or used in international trade.
Irrevocable Letters of Credit
Under this type of credit the buyer's bank has made an irrevocable commitment to pay the seller, on his proof of compliance with the stipulated conditions of the letter of credit, and this cannot be changed or cancelled by the bank without permission of the exporter. It offers a guarantee of payment. Therefore, because of the security it offers, irrevocable letters of credit are widely used in international trade. They are more expensive since the issuing bank is guaranteeing the credit.
Confirmed Letters of Credit
This term means that the credit is not only backed by the issuing bank, but that payment is also guaranteed by the confirming bank (which may be the advising/notifying bank). Thus the confirming bank is adding its guarantee to pay the seller in case the issuing bank fails to make payment. If a seller is unfamiliar with the buyer’s bank (or even the buyer) which issues the letter of credit, or if he is trading in a high risk area, he may then insist on an irrevocable confirmed letter of credit. A confirmation on a letter of credit adds costs because the confirming bank has added liability.
Unconfirmed Letters of Credit
This means that the issuing bank is the only party responsible for payment to the supplier. The seller’s bank does not add its guarantee of payment and is obliged to pay only after the payment from the issuing bank is received. In case of difficulties the exporter must look to the issuing bank for payment. The most desirable type of credit is the "Irrevocable Confirmed Letter of Credit", but this is not always available.
Revolving Letters of Credit
A revolving letter of credit covers multiple or continuous shipments of merchandise. It is a commitment on the part of the issuing bank to make the letters of credit available in the original amount whenever it has been used or drawn down, usually under the same terms and without the issuance of another letters of credit. Revolving letters of credits enable sellers to rely on ongoing sources of short-term financing. But while they avoid the fixed costs of entering each time into a new short-term financing transaction, revolving credits cannot replace longer-term financing. The number of times the letters of credit can be utilized and the period of validity is specified in the letters of credit. A revolving letter of credit can be either cumulative or noncumulative; cumulative means that the unused sums in the letters of credit can be added to the next installment, whereas noncumulative means that partial amounts not used in time expire.
Back-to-Back Letters of Credit
Back-to-back letters of credit can be used by trading companies which arrange transactions for the sale of goods between two other parties, or by processing companies. They enable the trading company to use a first letters of credit, issued in his favor by the buyer, as collateral for his issuance of a second letters of credit in favor of the supplier. Thus a new letters of credit is opened on the basis of an already existing one.
Transferable Letters of Credit
Transferable letters of credit are an alternative to back-to-back letters of credit as a method of facilitating transactions arranged by a trading company. The first beneficiary (the trading company) instructs the advising bank to advise the letter of credit (i.e. to transfer all or part of the proceeds of the letter of credit) to the second beneficiary (the ultimate exporter).
Red-Clause Letters of Credit
Red-clause letters of credit enable an exporter to obtain pre-shipment finance (which is a percentage of the letter of credit amount) from the buyer through the opening bank and against the advising bank’s guarantee of reimbursement, either (i) against a simple written statement of purpose (clean red clause) or (ii) against his undertaking to provide certain specified documents.
Green-clause Letters of Credit
Green-clause letters of credit serve the same purpose as red-clause letters of credit but differ in that the exporter can only obtain advance payments against production of warehouse receipts (and/or related documents) evidencing that the goods are held to the order of the buyer/opening bank/advising bank until the required documents are received. In this respect, green-clause letters of credit are very similar to inventory financing, although most of the comments made about red-clause letters of credit also apply here.
Payment under Documentary Credit
Sight Payment
Payment is made to the seller by the issuing or confirming bank immediately upon presentation and examination of the documents (the documents may or may not include a bill of lading).
Deferred Payment
Payment is made to the seller at a specified future date, for example 60 days after presentation of the documents or after the date of shipment (i.e. the date of the bill of lading).
Acceptance
This type of credit requires the exporter to draw a usance draft (bill of exchange) either on the issuing or confirming bank. The draft is accepted by the bank for payment to be made at a future fixed date. For example, payment date under an acceptance credit may be after 90 days from presentation of the documents or from the shipment of goods.
Negotiation
A credit payable at sight or at usance can be negotiated, either with a freely chosen bank or a bank that is specifically nominated by the issuing bank. Under negotiation, three payment options may occur:

• The negotiating bank would pay the beneficiary only when it receives payment from the issuing bank. The seller would present the documents to the advising bank for payment. The negotiating bank would in turn forward the documents to the issuing bank claiming payment and would pay the seller on receipt of payment by the issuing bank. Payment is made by the issuing bank on receipt of proper documents.
• The negotiating bank would negotiate the documents by “giving value” to the documents, and paying the beneficiary the value of the documents less a charge (i.e. discounting the documents), while awaiting reimbursement from the issuing bank. When the negotiating bank “gives value” to the documents, it does not receive immediate payment itself, therefore it will deduct interest to cover the period between paying and receiving payment from the issuing bank. The bank may agree to advance payment without recourse which means that the bank will not have the right to get reimbursement from the beneficiary, if payment is not received from the issuing bank as expected. In that case the negotiating bank is advancing the payment at its own risk.
• The negotiating bank would offer to give value if it is prepared to accept the payment risk of the issuing bank. The bank may agree to advance payment with recourse to the seller for reimbursement.

Guidelines for the Seller

• The seller should carefully assess the credit-worthiness of the buyer, the buyer’s bank, and the risk in the buyer’s country. Normally, it is the seller’s bank which should assist the seller in the inquiry. Financial strength of the bank issuing the letter of credit must be examined, and if necessary a credit may have to be confirmed (for instance if a smaller bank is involved in the transaction, depending on the country of origin, the credit may have to be confirmed by a large bank).
• The seller should carefully review the letter of credit to make sure that all the details and conditions stipulated can be met (type of credit, schedules of shipment, expiry date, quality and quantity of goods, packaging and documentation). Documentary credit is a separate transaction from the underlying sales contract. It is usually during the negotiation stage of the sales contract that the responsibilities of both the seller and buyer are defined and most of the terms and conditions of the documentary credit are agreed upon. Therefore, it is very important for the seller to be fully aware of all terms and conditions that need to be fulfilled before the application for a letter of credit is made. It is the seller’s responsibility to examine the letter of credit thoroughly to assure its workability (he may get the assistance of a forwarder).
• All aspects of the letter of credit must conform with the terms agreed upon and should match the terms and conditions of the sales contract, the amount to be paid, transport means, etc. (including seller’s name and address which should match the name on the invoices, packaging list, and other shipping documents as well). Therefore, it is more convenient for the buyer to receive a completed copy of the letter of credit application before the buyer submits it to his bank, to make sure that all terms and conditions can be met. Sometimes it is recommended to give a general description of the merchandise in order to avoid discrepancies.
• If any of the terms or conditions of the credit need to be modified, the seller should get in touch with the buyer as soon as possible so that the buyer can instruct the issuing bank to make the necessary amendments. For example, if an extended period is required in relation to credit expiration or shipment dates, the seller should request his buyer to arrange for the required extensions immediately. The credit expiration and shipment dates should be considered and decided upon if shipment can be made and documents presented for payment before the specified dates.
• The seller should have a correct amount of drawings specified in the letter of credit (usually an optimum amount is stated), banks pay only the amount specified in a letter of credit, even if higher charges for shipping, insurance or other factors are advanced. If the word “approximately”, “about” or “circa” is used, a variance (usually a variance of plus/minus 10%) is permitted. If the seller is making a CIF shipment under a sales contract, he should be aware of the amount of the credit and whether the credit covers sufficiently the payment for the merchandise, plus all shipping, insurance and freight charges.
• If the letter of credit is denominated in a foreign currency, the seller should consider a foreign exchange contract to cover currency risks.
• The seller should be aware of the importance of dates and schedule. Tight timing and schedule lead to problems, it does not really mean that it will accelerate shipment and deliveries. On the other hand, it is not appropriate to ask buyers for expiration dates far beyond what is reasonably needed, as it ties up the buyer's credit lines or cash collateral at his bank. As a seller, one should consider the following issues regarding latest ship dates:

• Consider the time it takes to manufacture/produce (if required) and move the product from an inland origin point to the port or airport of departure. The method of carriage, usually truck or rail, is a factor as are weather and time of year.
• Perishables generally are given priority over nonperishables in airfreight shipments. In other words, there is a risk of delay if the exporter wishes to airfreight non-perishables.
• High value ocean container cargoes can be given priority, by shippers, over low value ocean container cargoes.
• For a given shipping location, air and especially ocean freight services have different departure frequencies to different destinations. From a given location, there may be air service daily, and ocean service weekly. Allow enough time to miss a flight or sailing. The more remote the destination, the less frequent the departures.
• Air and ocean carriers often require the freight to be in their possession several days in advance of the departure date to allow time for loading. This "cut off" date is critical in ocean shipments. Also, it is important that the seller arrange specific bookings for ocean freight in advance and have written booking confirmations.
• The seller has to make sure that the freight forwarder has seen a copy of the letter of credit and is committed to meeting the shipping requirements of the credit, and preparing the Bills of Lading and other documents in a timely fashion, in strict conformance with the letter of credit. It should be noted that in some cases, buyers would intentionally embroider the truth and would require documents that are difficult to obtain. In that case one should take into consideration the delays in providing those documents.

• The seller should be familiar with foreign exchange limitations in the buyer’s country; otherwise payment procedures could be hindered.
• As a seller, one should always insist that the payment documents on any letter of credit are negotiated and reviewed in his own country. The seller should not accept letters of credit which require that documents be sent abroad for negotiation.
• The seller should always request that the letter of credit specify whether partial shipments and transshipment is allowed in order to avoid unexpected problems. In case partial shipment is allowed, the validity of the letter of credit will not be affected even if a problem arises in meeting the delivery date.
• It is important for the seller to make a delivery obligation dependent on the receipt of the letter of credit in “good order”, (i.e. the seller does not have the obligation to deliver the goods if the letter of credit does not contain all the elements that have been agreed upon). This condition should be specified in the letter of credit.
• The last point in this brief overview is in relation to confirmation; it is recommended that the exporter always ask the buyer which bank he will be dealing with to open a letter of credit. The exporter should then ask his bank (advising bank) whether they will accept to confirm a letter of credit from the specified opening bank with the specified amount. If the bank approves, the exporter should instruct the buyer to have the letter of credit advised and confirmed through the seller’s bank. If the seller’s bank refuses to confirm the letter of credit, the seller may obtain confirmation from another bank (the buyer’s correspondent bank in the exporter’s home country, for example). However, it is more convenient to involve only two banks whenever possible.

Guidelines for the Buyer

• Before opening a letter of credit, the buyer should come to an agreement with the seller on all aspects of quantity and quality of goods to be sent, schedules of shipment, payment procedures, and documents to be supplied. As with the seller, it is very important for the buyer to be fully aware of all terms and conditions that need to be fulfilled before the application for the letter of credit is made.
• When dealing with letters of credit, the buyer should take into consideration the standard payment methods in the country of the seller.
• When setting the dates in the letter of credit, the buyer should define a tight but reasonable shipping schedule. If dates are improperly set, this will lead to amendments to the letter of credit leading to additional costs, or simply to non-shipment.
• The buyer should be prepared to amend or renegotiate terms of the letter of credit with the seller. Amendments are a common procedure in international trade.
• In order to eliminate foreign exchange risk, the buyer may cover himself by using the futures/forward markets.
• The letter of credit validity should give the seller enough time to produce and ship the goods. With the expiry date and the latest shipping date, the buyer should give the seller ample time to present documents to the bank. For instance, several countries, particularly those in the Middle East, require that documents be "legalized". This requires that some of the documents be sent to the destination country's consulate, in the country of origin, for a stamp before presentation. This is a routine procedure, but it adds a few days or more to the time needed for presentation.
• As a general rule, the commercial contract should clearly specify the party responsible for appointing the confirming bank and the party who will pay for the confirmation. Therefore, the buyer should agree in advance that the confirming bank may be chosen by the seller. Most commonly, it is the buyer who bears the cost of confirmation. However, if the buyer is a small company, it is reasonable for the seller to bear the security of confirmation and its costs. This can be stated in the letter of credit.