Export Letters of Credit

The letter of credit is a highly standardized instrument which has evolved over many years into a reliable method of effecting payment for commercial transactions throughout the world. To ensure a seamless transaction when relying on an export letter of credit for payment, it is important to understand the responsibilities of the parties.

Elements of the Letter of Credit
Every letter of credit should be scrutinized as soon as it is received. Special attention should be paid to the following key elements:

• Key dates. These include the latest date for shipment, the number of days for presentation of documents, payment (in the case of deferred payment or time letters of credit), shipping frequency (in the case of a multiple shipment letter of credit), and the expiration date. These dates should be realistic and acceptable.
• Amount.  A letter of credit which says “about $X” means the exporter may draw 10% more or less. If the merchandise description calls for “about X” amount of product, then the exporter may ship 10% more or less.
• Documentary requirements. Documents should be obtainable in time to meet the latest date for presentation. Special consideration must be given requirements for consularized invoices, inspection certificates and evidence of prior notification.
• Negotiability. The letter of credit can be freely negotiable or restricted to the counters of a named bank.

The Flow of Goods & Documents
Understanding the flow of goods and documents is essential for the exporter to properly plan and schedule shipments. It is important to remember that banks deal only in documents. The merchandise flows directly from the seller/exporter to the buyer. The following steps outline the process:

1. The buyer completes an application for a commercial letter of credit and submits it to his bank (see figure 1 below).

2. The bank issues a letter of credit in accordance with the buyer’s application and transmits it to a US bank (see figure 2 below), usually to a correspondent domiciled in the city or state of the beneficiary (seller), or any other bank unless the buyer names an advising bank. This can be an important consideration because most exporters prefer to work with a bank they know. In that case, the exporter should specifically request that all letters of credit be advised through a named bank.

3. INTRUST, as advising bank, receives the letter of credit, authenticates it, and sends it to the exporter, along with a transmittal letter which usually contains additional information, such as whether or not the credit has been confirmed (see figure 3 below). If the letter of credit is restricted to the counters of another bank for negotiation, this would be noted so that delays in presentation can be avoided. If any other unusual conditions, such as an abbreviated expiration period or latest date for shipment, are discovered, they will be noted.

4. The exporter examines the letter of credit to determine if he can comply with its terms. If he cannot, he should contact the buyer immediately to arrange for an amendment. If the letter of credit is found to be acceptable, a copy of it should be sent to the freight forwarder, if applicable, and appropriate ticklers should be set so that important dates are not missed.
5. After the merchandise is shipped, the exporter and/or the freight forwarder prepares and assembles all required documentation for presentation. INTRUST examines the documents and, if found to be in order, forwards them on to the issuing bank and simultaneously initiates the payment process (see figure 4 below). If the documents contain discrepancies or some condition has not been met, they will be noted and the exporter will be notified. If the defect can be cured, the exporter can submit replacement documents. If not, then the bank will request approval to pay and to forward the documents to the issuing bank.

Financing Features
In addition to serving as a vehicle for payment, a letter of credit can serve as a financing instrument if the seller and issuing bank agree to the arrangement. It is usually in the exporter’s best interest to be paid at sight, but when competition necessitates an alternative, it is important to understand the implications and the costs associated with each option. The most common methods are described as follows:

• Deferred payment. With this arrangement payment is not required until a specified number of days after shipment of the merchandise. The buyer will have access to the documents so that the goods can be claimed from the carrier, but payment is deferred until a stipulated future date.  Payment is assured, however, by the undertaking of the issuing bank (and the confirming bank where applicable) as a direct obligation when documents are accepted at the time of presentation. A time draft is not presented so there would be no acceptance nor discount fees to pay. The buyer will likely pay a usance fee to the issuing bank.
• Time drafts. As with a deferred payment letter of credit, the buyer would be able to obtain the goods without making immediate payment as long as the letter of credit stipulates that the draft be drawn at a specified number of days after sight or after shipment . The bank on which the draft is drawn accepts the draft, thereby creating a banker’s acceptance, and undertakes to pay the draft at its maturity. The exporter then has the option of holding the draft to its maturity and collecting the face value, or discounting the draft before it matures. Discount rates are usually more favorable than other rates at which the exporter might borrow, so financing receivables with this instrument is an attractive option, especially in a high interest rate environment. If the exporter does not wish to carry the receivable nor bear the expense of discounting the banker’s acceptance, the buyer may pay these costs through an adjustment in the price of the goods or through the letter of credit. The letter of credit would then stipulate that all acceptance and discount fees are for the account of the applicant.
• Transferable letters of credit. If it becomes desirable or necessary to use the buyer’s credit to finance the purchase of the goods covered by the letter of credit, a portion or all of the value of the letter of credit can be transferred to another person or company if the letter of credit explicitly states that it is transferable. In this case, the exporter would prepare a transfer request form and submit it along with the original letter of credit and amendments, if any, to the advising bank. The advising bank will then irrevocably transfer the credit or a portion thereof to the named transferee. Please note that the guidelines for transferable credits are very strict. For more information, contact our trade finance staff.

Managing Risk
An exporter who stipulates a letter of credit in the terms of sale to a foreign buyer mitigates his commercial credit risk by substituting the issuing bank’s creditworthiness for that of the buyer. Commercial risk, however, is not the only kind of exposure which must be managed. Inherent in a foreign sale are the risks associated with the country in which the bank is domiciled. Political, social and economic upheavals are examples. In many countries, however, the risk is acceptably low.

If the exporter decides that the risk is too great, then he should request that the letter of credit be confirmed by a US bank. In this case, the confirming bank adds its undertaking to honor conforming documents upon presentation. This effectively mitigates the country risk, but at a cost that can range from 0.25% to 2% or more of the letter of credit amount per annum. Some exporters require every foreign sale to be secured by a confirmed letter of credit. Others, to reconcile the costs of such assurances, require confirmation only when they decide the risk is too great or is unknown. Guidance in these matters is available from the International Banking department of INTRUST.



Controlling Export Finance Costs
Banks which process letters of credit do so for a fee. Overhead and the costs of managing the credit risks associated with confirmation and banker's acceptances must be covered. International banking operations require a substantial investment in technology and expertise, and document examination is labor-intensive.

While most banks will avow that the return is not commensurate with the risk, the costs to the exporter can be significant. Several steps can be taken to control the expenses related to export finance, and where elimination or reduction is not a possibility, simple awareness of these matters will enable the wary exporter to adjust his margins. Some suggestions are listed below:

• Construct a credit policy that factors in some cash management concerns. A customer who is creditworthy may be kept on letter of credit terms simply because he is foreign. Perhaps this restriction can be relaxed for certain countries.
• Select an advising/negotiating bank of your choice. Letters of credit that are advised and negotiated by just any bank may represent a costly kind of laissez faire for the exporter. They should be directed to a bank whose pricing is more competitive. Taking a proactive role in deciding which bank will process the exporter's letters of credit can also result in a more satisfactory experience when questions or problems arise. In addition, some international bankers are more accessible and more broadly experienced than others.
• Watch out for delays in processing documents before they are presented. The daily cost of funds should be a matter of concern for everyone.
• Restrict the minimum amount for which a letter of credit will be accepted. Minimum fees can substantially decrease the gross profit margin of small orders.

Other cost saving measures can be uncovered through an analysis of the exporter’s operation. The International Banking staff of INTRUST can assist with this process.

An exporter who receives a letter of credit from the bank of a foreign buyer does not need to make any special arrangements to initiate the action, but he is well advised to stipulate which terms and conditions are acceptable before the buyer expends the effort and expense of applying for a letter of credit. Normally, these matters are covered in the merchandise contract which sets forth the terms of sale, but some details can cause expense and delay if they are not addressed before the letter of credit is issued.

For this reason, INTRUST has developed a worksheet (see figure 5 below) which lists most of the features of a letter of credit. This worksheet can be used as guide to design one that best fits the needs of the exporter and his customers.