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Letter of Credit

What is Letter of Credit:

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.

Key points:

  • 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.

Example:

  1. 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.
  2. To manage risk, the seller uses an agreement requiring the buyer to pay with a letter of credit as soon as shipment is made.
  3. 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.
  4. 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.
  5. 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 an inspection certificate 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.

International Trade:

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 Terminology

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.

Letter of Credit Types

Letters of credit come in various forms. Some are for international trade, and some serve more local purposes. Learning about different types of letters of credit can help you choose which one to use and understand what you’re working with.

Commercial Letter of Credit:

This is a standard letter of credit that’s commonly used in international trade, and may also be referred to as a documentary credit. Letters of credit provide security to buyers and sellers: The bank guarantees payment as long as documents are produced by the seller (assuming those documents meet the requirements listed in the letter of credit).

Standby Letter of Credit:

This type of letter of credit is different: It provides payment if something fails to happen. Instead of facilitating a transaction, a standby letter of credit provides compensation when something goes wrong. Standby letters of credit are very similar to commercial letters of credit, but they are only payable when the payee (or “beneficiary”) proves that they didn’t get what was promised. Standby letters of credit can be used to ensure that you’ll get paid, and they can be used to ensure that services will be performed satisfactorily.

Confirmed (And Unconfirmed) Letters of Credit:

When a letter of credit is confirmed, another bank (presumably one that the beneficiary trusts) guarantees that payment will be made. Exporters might not trust a bank that issues a letter of credit on behalf of a buyer (because the exporter is not familiar with that bank, for example, and is not sure if payment will ever arrive), so they might require that a bank in their home country confirm the letter. If the issuing bank fails to pay – and the exporter is able to meet all of the requirements of the letter of credit – the confirming bank will have to pay the exporter (and try to collect from the issuing bank later).

Back to Back Letters of Credit:

A back to back letter of credit allows intermediaries to connect buyers and sellers. Two letters of credit are used so that each party gets paid individually: An intermediary gets paid by the buyer, and a supplier gets paid by the intermediary. The final buyer and the intermediary use a “master” letter of credit, and the intermediary and supplier use a letter of credit based on the master letter.

Revolving Letters of Credit:

A revolving letter of credit can be used for multiple payments. If a buyer and seller expect to do business continually, they may prefer not to obtain a new letter of credit for every transaction (or for every step in a series of transactions). This type of letter of credit allows businesses to use a single letter of credit for numerous transactions until the letter expires (typically up to one year).

Sight Letter of Credit:

Payment under a sight letter of credit occurs as soon as the beneficiary submits acceptable documents to the appropriate bank. The bank has a few days to review the documents and ensure that they meet the requirements in the letter of credit. If the documents are compliant, payment is made immediately.

Deferred Payment Letter of Credit:

With this type of letter of credit, payment does not happen immediately after the documents are accepted. Some agreed-to period of time passes before the seller receives cash. A deferred payment letter of credit is obviously a better deal for buyers than for sellers. These are also known as term or usance letters of credit.

Red Clause Letter of Credit:

With a red clause, the beneficiary has access to cash up front. The buyer allows for an unsecured loan to be issued as part of the letter of credit, which is essentially an advance on the rest of the payment. The seller or beneficiary can then use the money to buy, manufacture, or ship goods to the buyer.

Irrevocable Letter of Credit:

An irrevocable letter of credit is a letter of credit that cannot be changed without authorization from all parties involved. Almost all letters of credit now are irrevocable, because revocable letters of credit simply do not provide the security that most beneficiaries want.

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Bank Guarantee

A bank guarantee refers to a promise provided by a bank or any other financial institution that if a certain borrower fails to pay a loan, then the bank or the financial institution will take care of the losses. The bank will assure the original creditor through this bank guarantee that if the borrower does not meet his or her liabilities, then the bank will take care of them.

A bank guarantee is a contract between 3 different parties and they include:

  • The applicant (the party that requests a bank guarantee from the bank and borrows from a creditor)
  • The beneficiary (the party that receives a partial guarantee)
  • The bank (the party that agrees to sign and assures payment in case the applicant fails to repay the loan)

Bank guarantees are very commonly utilised among business entities. With the help of a bank guarantee, the debtor or borrower or customer will be able to purchase equipment, machinery, raw materials, acquire additional funds, etc. for commercial purposes. Bank guarantees help businesses as creditors will get a proper reassurance that the loan amount will be repaid by the bank if the business is unable to repay the loan entirely on time.

When a bank signs a bank guarantee, it promises to pay any amount according to the request made by the borrower. Hence, signing a bank guarantee implies a high risk for banks.

Process of Bank Guarantee

For understanding the Process of Bank Guarantee:

First, an applicant will ask for a loan from a beneficiary or creditor.

While applying for the loan, these 2 parties will agree that a bank guarantee is necessary.

Then, the applicant will request a bank to provide a bank guarantee for the loan taken from the creditor. The bank guarantee will be taken on behalf of the creditor.

The bank will now offer the bank guarantee to the applicant and send a financial instruction to an advising bank.

Kinds of Bank Guarantee

You can see the different types of Bank Guarantee at below:

Deferred payment guarantee: This refers to a bank guarantee or a payment guarantee that is offered to the exporter for a deferred period or for a certain time period. When a buyer purchases capital goods or machinery, the seller will give credit to the buyer when the buyer’s bank gives a guarantee that it will pay the unsettled dues of the buyer to the seller. Under this type of guarantee, payment will be made in installments by the bank for failure in supplying raw materials, machinery or equipment.

Financial guarantee: A financial bank guarantee assures that money will be repaid if the party does not complete a particular project or operation entirely. According to the financial guarantee agreement, when there is a delay in the completion of the project, the bank will make the payment.

Advance payment guarantee: Under this kind of guarantee, an advance payment will be made to the seller. There will also be a guarantee that if the seller fails to deliver the service or product accurately or promptly, the buyer will receive a refund of the payment.

Foreign bank guarantee: A foreign bank guarantee is provided by a bank on behalf of a borrower. This will be offered on behalf of the foreign beneficiary or creditor.

Performance guarantee: Under a performance guarantee, compensation of money will be made by the bank when there is any delay in delivering the performance or operation. Payment will have to be made even if the service is delivered inadequately.

Bid bond guarantee: Under this type of guarantee, there will be a supply bidding procedure. This will be conducted by the contractor for the owner of an infrastructure or industrial project or any kind of operation. The contractor of the project will guarantee that the best bidder or the highest bidder will have the capability and authority to implement a project as per his or her preferences. The bid bond will be given to the owner of the project as a proof of guarantee and the bond will imply that the project will have to be devised according to the bid contract.

Comparision Between Bank Guarantee and Letter of Credit

Many times, people get confused between bank guarantee and a letter of credit. However, one should understand that both are pretty different.

A bank guarantee refers to a commercial or financial instrument that is provided by a bank, where the bank assures or guarantees a beneficiary that it will make the payment to the bank in case the actual customer fails to meet his or her obligations. The bank will pay on behalf of the customer who requests for a bank guarantee.

On the other hand, a letter of credit refers to a promise or commitment in writing made by a bank or any other financial institution or corporation to a particular seller that payment will be made to the seller if the seller completes performing whatever is mentioned in the letter of credit. For the bank to make the payment on behalf of the original buyer, there should be a documentary proof that the seller has completed the transaction accurately by delivering the right product or service on time. The seller will get a guarantee from the bank that the seller will definitely pay the amount on behalf of the original buyer once the obligations are fulfilled.

Under a bank guarantee, if the buyer is unable to make the payment to the seller or creditor, then the bank pays the fixed amount to the seller as the obligations of the contract are not met. On the other hand, under a letter of credit, the bank makes the payment to the seller once he or she delivers. This is because the seller has completed fulfilling the required obligations.

Bank guarantees are competitively priced in nature generally. They are usually valid for a long period. The tenure of a bank guarantee is usually high. Moreover, bank guarantees are commonly accepted in almost all countries. Bank guarantees are available in Indian Rupee as well as currencies of other nations. Hence, they are very helpful for global transactions with parties in different foreign countries.

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Standby Letter of Credit

A Standby Letter of Credit (SBLC / SLOC) is a guarantee that is made by a bank on behalf of a client, which ensures payment will be made even if their client cannot fulfill the payment. It is a payment of last resort from the bank, and ideally, is never meant to be used.

How can a contractual SBLC be used?

An SBLC is frequently used as a safety mechanism for the beneficiary, in an attempt to hedge out risks associated with the trade. Simplistically, it is a guarantee of payment which will be issued by a bank on the behalf of a client. It is also perceived as a “payment of last resort” due to the circumstances under which it is called upon. The SBLC prevents contracts going unfulfilled if a business declares bankruptcy or cannot otherwise meet financial obligations.

Furthermore, the presence of an SBLC is usually seen as a sign of good faith as it provides proof of the buyer’s credit quality and the ability to make payment. In order to set this up, a short underwriting duty is performed to ensure the credit quality of the party that is looking for a letter of credit. Once this has been performed, a notification is then sent to the bank of the party who requested the Letter of Credit (typically the seller).

In the case of a default, the counter-party may have part of the finance paid back by the issuing bank under an SBLC. Standby Letter of Credit’s are used to promote confidence in companies because of this.

How can you apply for a Standby Letter of Credit?

There are many aspects that a bank will take into consideration when applying for a Standby Letter of Credit, however, the main part will be whether the amount that is being guaranteed can be repaid. Essentially, it is an insurance mechanism to the company that is being contracted with.

As it is insurance, there may be collateral that is needed in order to protect the bank in a default scenario – this may be with cash or assets such as property. The level of collateral required by the bank and by the size of the SBLC will largely depend on the risk involved, and the strength of the business.

Other Application steps

There are other standard due diligence questions asked, as well as information requests regarding assets of the business and even possibly the owners. Upon receipt and review of the documentation, the bank will typically provide a letter to the business owner. Once the letter has been provided, a fee is then payable by the business owner for each yeah that the Standby Letter of Credit remains outstanding.

What are the fees for Standby Letters of Credit?

It is standard for a fee to be on the SBLC value. In the event that the business meets the contractual obligations prior to the due date, it is possible for an SBLC to be ended with no further charges.

What is the difference between SBLCs and LCs?

A Standby Letter of Credit is different from a Letter of Credit. An SBLC is paid when called on after conditions have not been fulfilled. However, a Letter of Credit is the guarantee of payment when certain specifications are met and documents received from the selling party.

Letters of credit promote trust in a transaction, due to the nature of international dealings, distance, knowledge of another party and legal differences.

How do SBLCs work in Cross-Border trade?

Where goods are sold to a counter-party in another country, they may have used an SBLC to ensure their seller will be paid. In the event that there is non-payment, the seller will present the SBLC to the buyer’s bank so that payment is received.

A performance SBLC makes sure that the criteria surrounding the trade such as suitability and quality of goods are met.

We sometimes see SBLCs in construction contracts as the build must fulfill many quality and time specifications. In the event that the contractor does not fulfill these specifications then there is no need to prove loss or have long protracted negotiations; the SBLC is provided to the bank and payment is then received.