If your business exports or imports goods, you either have used or someday will use a letter of credit during a transaction. Businesses often use letters of credit to facilitate or guarantee payment in domestic and international transactions. Here are some things you need to know to understand letters of credit.
International Letters of Credit
International letters of credit are much more common than domestic standby letters of credit and require more detail and understanding of the processes than do domestic letters of credit. International letters of credit are often called “commercial letters of credit.” For international trade, the commercial letter of credit is the primary mechanism for payment. The International Chamber of Commerce publishes rules and regulations governing use of commercial letters of credit, while the United States Uniform Commercial Code provides rules governing domestic letters of credit.
In international trade, the most commonly used type of letter of credit is called a documentary irrevocable commercial letter of credit. These letters cannot be revoked or changed without the agreement of all parties.
Documentary irrevocable letters of credit are contractual agreements between two banks and two parties conducting commerce. The buyer of goods is called the applicant in the letter of credit. The seller is called the beneficiary. A bank that acts on behalf of the buyer is called an issuing bank, while the bank acting on behalf of the seller is called an advising or confirming bank.
The commercial letter of credit document provides in detail the evidence the beneficiary must present to the issuing bank for money to be transferred from the issuing bank to the advising bank to complete the transaction. Examples of documentation include an invoice for the goods delivered, a bill of lading showing the goods have been delivered, and third-party verification of quality and quantity of goods sold. Many more examples of documents could be required depending on the kind of goods being shipped.
Once the letter of credit is in place, the seller ships goods to the buyer in accordance with all instructions in the document. Once the buyer receives the goods, the seller presents all the documents required in the letter of credit to the confirming bank. The advising bank reviews all the documentation for completeness and compliance with the letter of credit contract. Once the confirming bank certifies that all conditions have been met, funds are transferred to the advising bank on behalf of the beneficiary.
Domestic Letters of Credit
Domestic letters of credit are often called “standby letters of credit.” They are less complicated than their international counterparts. Standby letters of credit are most often used to strengthen the creditworthiness of the buyer. When a buyer of goods has opened a standby letter of credit, the supplier provides more liberal payment terms than cash on delivery. The supplier’s terms govern the standby letter of credit. Ideally, once the goods have been received, the buyer pays according to the terms, and the standby letter of credit is not drawn on. A standby letter of credit is only drawn on when the buyer does not pay within agreed upon terms.
Both commercial and standby letters of credit reduce credit risk and provide a uniform mechanism to conduct orderly commerce. Both use rules promulgated by recognized authorities and use third-party banks to administer them. Commercial letters of credit are especially important in foreign trade, while standby letters of credit provide sellers of goods a stronger guarantee they will be paid.
Sam Thacker is a partner in Austin, Texas–based Business Finance Solutions.