Posted on Sep 14, 2006 at 05:45
Discussion: Important details about L/C's (Letter of Credit)
1. What is a Letter of Credit?
A letter of credit is a letter from a bank guaranteeing that a buyer's payment to a seller will be received on time and for the correct amount. In the event that the buyer is unable to make payment on the purchase, the bank is required to cover the full or remaining amount of the purchase. A letter of credit is often abbreviated as LOC or LC, and is also referred to as a documentary credit. The parties to a letter of credit are usually an applicant who wants to send money, a beneficiary who will receive the money, the issuing bank and the advising bank.
Letters of credit are often used for international transactions to ensure that payment will be received. They have become an important aspect of international trade, due to differing laws in each country and the difficulty of knowing each party personally. The bank also acts on behalf of the buyer, or holder of the letter of credit, by ensuring that the supplier will not be paid until the bank receives confirmation that the goods have been shipped.
A letter of credit is often confused with a bank guarantee, which is similar in many ways but not the same thing. The main difference is the bank's position relative to the buyer and seller of a good or service in the event of the buyer's default of payment. With a letter of credit, a seller may request that a buyer provide them with a letter obtained from a bank which substitutes the bank's credit for their client's.
In the event of the borrower defaulting, the seller can go to the buyer's bank for the payment. Instead of the risk that the buyer will not pay, the seller only faces the risk that the bank will be unable to pay, which is unlikely. This means that if the applicant obtaining the letter of credit fails to perform his or her obligations, the bank must pay. The letter of credit can also be the source of payment for a transaction, meaning that an exporter will get paid by redeeming the letter of credit. A letter of credit is less risky for the merchant, but even riskier for a bank.
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2. All letters of credit contain these elements:
- a payment undertaking given by the bank (issuing bank)
- on behalf of the buyer (applicant)
- to pay a seller (beneficiary)
- a given amount of money
- on presentation of specified documents representing the supply of goods
- within specific time limits
- these documents conforming to terms and conditions set out in the letter of credit
- documents to be presented at a specified place.
Put simply, the issuing bank's role is twofold:
to guarantee to the seller that if compliant documents are presented, the bank will pay the seller the amount due. This offers security to the seller - the bank says in effect "We will pay you if you present documents (xxxxxx)"
to examine the documents, and only pay if these comply with the terms and conditions set out in the letter of credit. This protects the buyer's interests - the bank says "We will only pay your supplier on your behalf if they present documents (xxxxxx) that you have asked for"
IMPORTANT:
Typically the documents requested will include a commercial invoice, a transport document such as a bill of lading or airway bill, an insurance document; but there are many others.
* Letters of credit deal in documents, not goods.
~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~
3. The stages of the letter of credit
Buyer and seller agree terms, including means of transport, period of credit offered (if any), latest date of shipment, Incoterm to be used
Buyer applies to bank for issue of letter of credit. Bank will evaluate buyer's credit standing, and may require cash cover and/or reduction of other lending limits
Issuing bank issues L/C, sending it to the Advising bank by airmail or (more commonly) electronic means such as telex or SWIFT
Advising bank establishes authenticity of the letter of credit using signature books or test codes, then informs seller (beneficiary). Advising bank MAY confirm L/C, i.e. add its own payment undertaking
Seller should now check that L/C matches commercial agreement, and that all its terms and conditions can be satisfied, (e.g. all documents can be obtained in good time.) If there is anything that may cause a problem, an AMENDMENT must be requested.
Seller ships the goods, then assembles the documents called for the L/C (invoice, transport document etc.) Before presenting the documents to the bank, the seller should check them for discrepancies with the L/C, and correct the documents where necessary.
The documents are presented to a bank, often the Advising bank. The Advising bank checks the documents against the L/C. If the documents are compliant, the bank pays the seller and forwards the documents to the Issuing bank
The Issuing bank now checks the documents itself. If they are in order (and it is a sight L/C), it reimburses the seller's bank immediately.
The Issuing bank debits the buyer and releases the documents (including transport document), so that the buyer can claim the goods from the carrier.
NOTE: if your L/C contains errors and your supplier tells you to amend (amend cost money to you), try to convince them to amend before date of shipment JUST IN CASE YOU HAVE TO MAKE NEW CHANGES IN THE FUTURE LIKE DELIVERY PORT ETC. This is to avoid paying to the bank for amendments several times.
For now I can say, L/C is the most secure way to deal in China.
* Guys, please add your comments so we can give conclussion about several points. Regards.
A letter of credit is a letter from a bank guaranteeing that a buyer's payment to a seller will be received on time and for the correct amount. In the event that the buyer is unable to make payment on the purchase, the bank is required to cover the full or remaining amount of the purchase. A letter of credit is often abbreviated as LOC or LC, and is also referred to as a documentary credit. The parties to a letter of credit are usually an applicant who wants to send money, a beneficiary who will receive the money, the issuing bank and the advising bank.
Letters of credit are often used for international transactions to ensure that payment will be received. They have become an important aspect of international trade, due to differing laws in each country and the difficulty of knowing each party personally. The bank also acts on behalf of the buyer, or holder of the letter of credit, by ensuring that the supplier will not be paid until the bank receives confirmation that the goods have been shipped.
A letter of credit is often confused with a bank guarantee, which is similar in many ways but not the same thing. The main difference is the bank's position relative to the buyer and seller of a good or service in the event of the buyer's default of payment. With a letter of credit, a seller may request that a buyer provide them with a letter obtained from a bank which substitutes the bank's credit for their client's.
In the event of the borrower defaulting, the seller can go to the buyer's bank for the payment. Instead of the risk that the buyer will not pay, the seller only faces the risk that the bank will be unable to pay, which is unlikely. This means that if the applicant obtaining the letter of credit fails to perform his or her obligations, the bank must pay. The letter of credit can also be the source of payment for a transaction, meaning that an exporter will get paid by redeeming the letter of credit. A letter of credit is less risky for the merchant, but even riskier for a bank.
~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~
2. All letters of credit contain these elements:
- a payment undertaking given by the bank (issuing bank)
- on behalf of the buyer (applicant)
- to pay a seller (beneficiary)
- a given amount of money
- on presentation of specified documents representing the supply of goods
- within specific time limits
- these documents conforming to terms and conditions set out in the letter of credit
- documents to be presented at a specified place.
Put simply, the issuing bank's role is twofold:
to guarantee to the seller that if compliant documents are presented, the bank will pay the seller the amount due. This offers security to the seller - the bank says in effect "We will pay you if you present documents (xxxxxx)"
to examine the documents, and only pay if these comply with the terms and conditions set out in the letter of credit. This protects the buyer's interests - the bank says "We will only pay your supplier on your behalf if they present documents (xxxxxx) that you have asked for"
IMPORTANT:
Typically the documents requested will include a commercial invoice, a transport document such as a bill of lading or airway bill, an insurance document; but there are many others.
* Letters of credit deal in documents, not goods.
~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~
3. The stages of the letter of credit
Buyer and seller agree terms, including means of transport, period of credit offered (if any), latest date of shipment, Incoterm to be used
Buyer applies to bank for issue of letter of credit. Bank will evaluate buyer's credit standing, and may require cash cover and/or reduction of other lending limits
Issuing bank issues L/C, sending it to the Advising bank by airmail or (more commonly) electronic means such as telex or SWIFT
Advising bank establishes authenticity of the letter of credit using signature books or test codes, then informs seller (beneficiary). Advising bank MAY confirm L/C, i.e. add its own payment undertaking
Seller should now check that L/C matches commercial agreement, and that all its terms and conditions can be satisfied, (e.g. all documents can be obtained in good time.) If there is anything that may cause a problem, an AMENDMENT must be requested.
Seller ships the goods, then assembles the documents called for the L/C (invoice, transport document etc.) Before presenting the documents to the bank, the seller should check them for discrepancies with the L/C, and correct the documents where necessary.
The documents are presented to a bank, often the Advising bank. The Advising bank checks the documents against the L/C. If the documents are compliant, the bank pays the seller and forwards the documents to the Issuing bank
The Issuing bank now checks the documents itself. If they are in order (and it is a sight L/C), it reimburses the seller's bank immediately.
The Issuing bank debits the buyer and releases the documents (including transport document), so that the buyer can claim the goods from the carrier.
NOTE: if your L/C contains errors and your supplier tells you to amend (amend cost money to you), try to convince them to amend before date of shipment JUST IN CASE YOU HAVE TO MAKE NEW CHANGES IN THE FUTURE LIKE DELIVERY PORT ETC. This is to avoid paying to the bank for amendments several times.
For now I can say, L/C is the most secure way to deal in China.
* Guys, please add your comments so we can give conclussion about several points. Regards.
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