Letter of Credit (L/C)
A foreign merchant entrusts a bank to issue a written document that promises to pay conditionally in accordance with the agreed matters in the contract. The document specifies the requirements of the transaction, such as the commodity, quantity, quality, and delivery time, and specifies the types and production requirements of the required documents. The exporter prepares the goods according to the letter of credit, and then prepares and collects a full set of documents, and delivers them to the bank within the specified time limit. The bank will pay the payment after reviewing them.
Using a letter of credit to pay for goods is a guarantee for both buyers and sellers, and it is also the way for banks to bear the greatest responsibility, so the bank charges the highest handling fee, which increases the transaction costs of both buyers and sellers. Therefore, for business partners who have cooperated for many years and trust each other, or transactions with low value of goods, letters of credit are generally not preferred. But in most cases, letters of credit are very popular. In addition to effectively avoiding breach of contract, they can also solve the common problem of advance payment – with letters of credit as a guarantee, exporters do not have to insist on requiring foreign merchants to pay advance payments as collateral, which reduces the burden on foreign merchants. If exporters need funds to prepare goods, they can completely finance by means of mortgage loans from banks with letters of credit. Of course, you can also collect part of the advance payment by T/T and pay the rest by letter of credit. It all depends on the negotiation between the two parties. It is very flexible.
When banks operate letters of credit, they rely on the full set of foreign trade documents delivered by the exporter as the basis for whether to fulfill the contract and deliver the goods, that is, “look at the documents but not the goods”. Therefore, they have very high requirements for the completeness of foreign trade documents and the accuracy and completeness of the contents, even down to the textual expression in the documents. The full set of documents must fully comply with the requirements of the letter of credit before they will be accepted by the bank and the payment obligation will be fulfilled. Any error, even spelling errors in words and punctuation marks, can theoretically be judged by the bank as a discrepancy – a place that does not meet the requirements of the letter of credit.
When a discrepancy occurs, the letter of credit becomes invalid and the bank no longer guarantees payment. At this time, the bank will consult the foreign merchant. If the foreign merchant does not mind and is willing to pay, the bank will continue to perform – at this time it becomes similar to the effectiveness of D/P, so some tricky foreign merchants often take the opportunity to blackmail and demand deductions. Note that even if the foreign merchant agrees to pay in full at this time, the bank will impose a “discrepancy” penalty, generally around US$50 or more. This is entirely a unilateral act of the bank and will be stated in advance in the letter of credit.
The letter of credit is highly professional and is issued in English, which places high demands on the document level of foreign trade salesmen. People who are not familiar with foreign trade knowledge and letter of credit knowledge find it difficult to understand the meaning of the terms. In practical experience, some illegal foreign merchants often take advantage of this and deliberately set trap clauses in the letter of credit, or deliberately find faults, which makes it easy for exporters to have discrepancies, and then use the fait accompli of the goods having arrived at the foreign port to threaten them to achieve the purpose of selling at a low price. Therefore, the letter of credit can sometimes be a double-edged sword. If used well, it can guarantee collection, but if used poorly, it will increase risks.
However, since July 2007, the international community has made new adjustments to the operation of letters of credit, striving to be fair and reasonable and to avoid intentional fraud in letters of credit as much as possible. For example, some text errors that do not affect the validity of documents are no longer demanding. However, after all, banking rules in different countries are slightly different, and disputes over “discrepancies” are also quite tricky. Therefore, as exporters, we still need to thoroughly understand the principles of letters of credit, be familiar with the terms, understand common traps and tricks, and avoid “discrepancies” in order to avoid risks and collect money smoothly.