Overseas markets represent a huge potential opportunity for many U.S. businesses to grow and expand in the face of a sluggish domestic economy.
But doing business with foreign customers means facing challenges that aren’t present with clients in the United States. One of the biggest is the payment uncertainty that accompanies dealing with customers who may be thousands of miles away.
Fortunately there’s a tool available to help mitigate this uncertainty and facilitate a smooth overseas payment transaction: the letter of credit.
Helping Ensure Payment
With a letter of credit (or LC), a bank substitutes its creditworthiness for a business’s to ensure overseas trading partners that they will be paid as long as they abide by the terms and conditions set forth in the LC. If you’re exporting goods or services, a commercial LC assures that you’ll be paid once the goods or services have been delivered according to the terms agreed upon by both parties.
Export LCs are issued for goods and services you sell to an overseas customer while import LCs are issued for goods and services you buy from an overseas vendor.
Another kind of letter of credit, the standby LC, is similar to a performance bond because it’s used to ensure performance in a transaction. For example, if your overseas customer defaults on a payment to you, the standby LC can be used to document proof of your loss consistent with the terms set forth in the letter and to secure payment from the bank that issued the LC.
When a U.S. business sells goods or services to an overseas customer, the overseas customer’s bank will issue an LC on behalf of the U.S. business (the beneficiary), committing to honor the payment as long as the conditions spelled out in the letter are met. For example, the letter might require that goods be delivered to a particular overseas shipyard in a certain type of container on a specified date.
Once the goods are received according to the terms, documentation (usually a commercial invoice, bill of lading, and documents proving the shipment was insured against loss or damage in transit) is provided to the seller’s bank. At this point, the letter must be paid, even if the goods are damaged or lost subsequent to their arrival in satisfactory condition. In this way the LC protects the seller should the goods be damaged or lost after they’ve arrived and the buyer claims they either didn’t arrive or were damaged after arrival.
Most letters of credit are irrevocable, which means they can’t be amended or canceled after the date of issue without agreement from all parties. Banks usually issue LCs only on behalf of customers whom they’re confident will fulfill their obligation — either to pay or to meet the terms of shipping and delivery. Typically an importer will need to have enough money on deposit (or a large enough line of credit) with the bank to cover the amount of the LC.
Additional Steps to Take
While LCs help mitigate much of the risk involved in doing business with overseas customers, you should take the following steps as well.
- Carefully review all the requirements set forth in the LC and make sure you understand all the documents that are needed.
- Make sure you can obtain all the documents stipulated by the LC. Also find out how long it will take you to get them from your shippers and other service providers.
- Clarify whether there are any time limits specified by the LC for receipt of documents and if these limits are realistic for you.
- Ensure that the documents specified and required in the LC exactly match those on the LC application.