How to protect your interests using a letter of credit?

Letter of credit – a good form of security in cooperation with a new contractor

Business-to-business transactions are linked to the decision to choose the appropriate security for payments. This problem appears especially in international trade when concluding first-time transactions with counterparties whose reliability cannot be confirmed, or when the political or economic situation of the counterparty’s country is unstable. In such cases, the best and safest way to secure your payment is a letter of credit.

What is a letter of credit?

A Letter of Credit is an instrument that simplifies the non-cash settlement of commercial transactions. This method of securing the transaction is beneficial for both the exporter and the importer. The exporter receives bank guarantees securing the payment for the delivery of the goods, as the bank reserves the amount on the importer’s account corresponding to the full value of the goods being the subject of the transaction. At the same time, the exporter undertakes to timely ship and deliver the documents confirming that the terms of the letter of credit have been met. Due to the costs associated with the letter of credit, this method of security is profitable for transactions above 30 thousand USD.

How to apply for a letter of credit?

A letter of credit is always opened at the importer’s request. It should be noted that the importer’s bank is not required to open a letter of credit. The bank’s decision depends on the bank’s individual assessment of the entrepreneur’s credibility, contract terms and the feasibility of the order.

The parties of the letter of credit are:
1. Principal (importer) – submits an order to open a letter of credit to his bank and provides funds to cover the payment for the exporter along with any costs and commissions due to the bank. The importer is not a direct party to the letter of credit, but has the right to demand from his bank to cover the losses resulting from the bank’s negligence or omission.
2. The importer’s bank – at the request of the ordering party, opens a letter of credit on the basis of which it undertakes to pay the exporter the funds specified in the letter of credit, provided that the exporter submits the documents indicated in the letter of credit within the prescribed period. The obligation of the bank is only to pay the amount to the exporter after he has provided the documents. The bank does not control the course of commercial transactions between entrepreneurs.
3. Exporter (beneficiary) – the letter of credit is opened for the benefit of the exporter. However, he has no obligations related to it, as the delivery of the goods results from a separate contract concluded between the exporter and the importer. The exporter receives the funds after fulfilling the terms of the letter of credit, i.e. providing the intermediary bank with the relevant documents confirming the performance of the service to the importer.
4. Depending on the terms of the letter of credit, the intermediary bank may perform the following functions:
• advising bank – notifies the exporter about the opening of the letter of credit and acts as an intermediary in correspondence between the importer’s bank and the beneficiary
• the negotiating bank – advises the letter of credit, checks the compliance of the documents and acts on behalf of the importer’s bank
• confirming bank – by agreeing to maintain the letter of credit, it assumes the same obligation as the importer’s bank.
The documents securing the letter of credit most often include:
• commercial invoice
• certificate of origin
• airline bill, bill of lading or other transport document
• certificate of insurance of the goods during transport
What are the types of letter of credit?
There are several types of alternatives, which are classified due to the method of payment or the role of an intermediary bank.

Due to the nature of the obligation of the bank issuing the letter of credit:
• Revocable letter of credit – the bank reserves the right to revoke or amend its liability without the consent of the beneficiary until the documents are recognized by the intermediary bank.
• Irrevocable letter of credit – it cannot be changed or canceled without the consent of all parties involved. The change is invalid if either party does not agree to it.
Due to the method of payment:
• Cash letter of credit (a’vista) – payment takes place immediately after the exporter presents documents.
• Letters of credit with deferred payment – the bank undertakes to pay in a deferred period (eg 30 days from the date of dispatch), provided that documents compliant with the terms of the letter of credit are presented within its validity period.
• Acceptance letter of credit – related to the deferred payment date, obliges the bank to accept fixed term deposits. After their acceptance, the obligation under the letter of credit expires and is replaced with a promissory note obligation.
• Negotiating letter of credit – the opening bank grants the intermediary bank the right to check the compliance of the documents with the letter of credit and to pay the beneficiary from the funds of the bank opening the letter of credit.
Due to the role of an intermediary bank:
• Confirmed letter of credit – to the letter of credit opened by the importer’s bank, it was added by the bank confirming the confirmation, obliging the bank confirming the letter of credit to honor or negotiate the presented documents. This form of a letter of credit is used by the exporter in the event of a lack of confidence in the bank issuing the letter of credit.
• Unconfirmed letter of credit – a type of letter of credit which is not confirmed by an intermediary bank, and only the opening bank makes the payment to the exporter.
Other types of letters of credit:
• Standby (security) letter of credit – it has the character of a bank guarantee, it obliges the beneficiary to pay the required amount if the principal fails to pay as previously agreed between the parties or fails to meet other obligations secured by the letter of credit.
• Revolving letter of credit (renewable) – applicable to successively repeated deliveries of a single item over a longer period of time.
• Back-to-back letter of credit – on the basis of a letter of credit opened by the buyer, an import letter of credit is opened to a specific beneficiary, and the proceeds from the export letter of credit secure the payments for the import letter of credit.

Applying for a letter of credit may seem complicated and difficult. However, it is worth getting interested in this form of securing your interests in cooperation with new contractors.
Author: Przemysław Chwastek