Ishha Nagrath Ishita Gupta Manish Kalra Manish Sharma

A major barrier to international trade activities is the issue of trust. Even when importers and exporters are known to each other, there is a high degree of risk associated with international trade transactions, i.e., exporters want to be sure theyll be paid and importers want to be sure they receive the full value of an order. Discuss the reasons letters of credit and the various forms of a draft help both importers and exporters overcome this challenge. Under what conditions might each instrument be preferred?

Methods of Payment
Cash in Advance
Letters of Credit Documentary Collection Open Account
Risk mitigation:

Export Credit Insurance Standby L/Cs

Cash in Advance
Importer pays Exporter prior to shipment
Exporter has no risk of non-payment or non-acceptance Importer has risk that exporter will not ship the goods as

ordered Used occasionally for small amounts, new customers, onetime sales

Documentary Collections
Exporter routes documents through banking channels, where they are held for payment or acceptance
Importer pays Exporter prior to shipment
Exporter has no risk of non-payment or non-acceptance Importer has risk that exporter will not ship the goods as ordered Used occasionally for small amounts, new customers, one-time sales
Less costly than a L/C and avoids tying up Importers line of credit Average of 2 - 4 weeks for exporter to collect on a sight draft Consignment Issues Used for lower risk customers

Risks in Documentary Collections

For the Exporter If it is a sight draft, the exporter will reduce the risk of non-payment but will not eliminate it totally since the importer may not be in a position to pay for the goods or may not be able to procure sufficient foreign exchange to make the payment. In this case the exporter may be forced to either call back the goods or negotiate sale to some other interested party, which may be at a reduced rate. In the case of term draft, the risk to the exporter is higher since the foreign buyer will take possession of the goods and may not pay at due date, forcing therefore the exporter to try and collect payment from the foreign buyer in the foreign buyer's home country. For the Importer The importer faces the risk of paying for goods of sub-standard quality or even with shortages. In such a circumstance, it would take some time to get refunds from the exporter. It could also happen that the exporter refuses to make refunds, leading the importer to lengthy legal proceedings.

Open Account
Exporter ships goods and bills the importer for payment at sight or at a future date

Importer has use of funds, no product risk Exporter has risk of non-payment Risk can be shifted through credit insurance, standby L/Cs Used for well-established customers with good credit

Letter of Credit

What is a letter of credit?

An arrangement, however named or described, whereby a bank(the issuing bank)acting at the request and on the instructions of a customer(applicant) on its own behalf :
(a)Is to make payment to or to the order of a third party (the beneficiary) or to accept bills of exchange(drafts)drawn by the beneficiary Or (b) Authorizes another bank to effect such payments or to accept and pay such bills of exchange(drafts) Or ( c) Authorizes another bank to negotiate against stipulated documents provided that the terms are complied with

Salient features of a Letter of Credit :

Based on a sale contract/agreement between buyer & seller
An instrument of settling payments An undertaking by the bank On behalf of the buyer

To make payment to the seller

On presentation of specified documents Within the time limits Upon compliance of terms & conditions

Example :
Opening of LC X, a resident of New York agrees to buy ready made garments from Y, a resident of Bangalore. Accordingly an agreement is entered into between them as to the price, delivery time, trade terms, port of shipment, destination etc., In order to secure himself Y insists on opening of a LC in his favors. X will approach his banker viz. Bank of America New York to open a LC. Based on the agreement already entered into X conveys the relative details to be incorporated in the LC, documents to be called for, the last date for shipment etc., Bank of America, in turn opens its LC and sends it to its correspondent bank in India to be passed to Y, say SBI, Bangalore after ensuring its authenticity. SBI passes on the LC thus opened to Y.

Negotiation of Documents/payment to the beneficiary

Y after completing shipment prepares various documents as

listed out in the LC submits them to his banker say ICICI Bank and the latter sends those documents to Bank of America New York. Upon scrutiny if Bank of America finds that documents are presented as stipulated in the LC will pay ICICI Bank.

Need for letter of credit:

In matters of international trade, International Chamber of Commerce Uniform Customs and Practice for Documentary Credits applies

(UCP 600 being the latest version). This ensures both sides will get their share of remunerations while protocols are followed. They are also used in the land development process to ensure that approved public facilities (streets, sidewalks, storm water ponds, etc.) will be built. To qualify for a letter of credit you almost always need to qualify for traditional bank financing. This means companies willing to enter into a LOC will have considerable experience working with big financial ventures in a structured banking format. The bank pays the shipper within a time they set. So the shipper gets paid, regardless of what arrives at destination, in whatever condition it is in, however early or late it is, on whatever conveyance, flying whatever flag it arrived on regardless of whatever the paperwork shows.

LOC vs Draft:
One of the primary peculiarities of the documentary credit is that the

payment obligation is abstract and independent from the underlying contract of sale or any other contract in the transaction. Thus the banks obligation is defined by the terms of the credit alone, and the sale contract is irrelevant. If you cannot qualify for a letter of credit, your best business financing alternative is to secure trade financing use purchase order financing. Consider other forms of payments such as:
C.O.D. payment prior to sending anything anywhere is the best

method for guaranteeing payment. It means no cost or worries about moving anything until payment is received, but the consignee is given no assurance that the shipment will be sent after you do receive payment.

 If you trust the consignee to pay you, but still feel uneasy, you should

consider sending the shipment on a Collection basis on C&F or CIF terms of sale through the forwarders' agent. The agent must hold the shipment at destination until payment for the value of the cargo (indicated by your commercial invoice) is received from the consignee. The drawback is that the agent will charge the consignee a collection fee, and the consignee can refuse the freight leaving the shipper no option but to return it at greater cost to themselves, or source another company nearby who requires their product. To simplify a Sight Draft, this includes Banks and couriers in the above situation at additional cost. It does mean the forwarders agent is not required, the collection fee they generate is not applicable (but the banks fees and courier costs could well make up for this, and are payable by the shipper rather than the consignee), but the bank is also likely to send you back the money swiftly, where a forwarders agent may not.

 The closest thing to guaranteed payment and guaranteed

delivery is sending it on an Irrevocable Confirmed Documentary Letter of Credit with Inco terms showing CIF (freight and insurance is prepaid by the shipper up to arrival destination port) asking for a certificate from Cotecna, Lloyds, SGS, or some other Independent authority certifying the commodity. While costly to the shipper, and time consuming compared to a standard shipment, the benefit is that the consignee is assured a good product will be shipped, the freight is insured, the shipper is assured payment close to the value required (less bank fees and the costs for shipping, etc.) and the title to the goods remains with the shipper all the way up to destination port.

Process

How Does the Letter of Credit Process Work?

The seller (known in the Letter of Credit as the "Beneficiary")

advises the buyer (known in the Letter of Credit as the "Applicant") that the purchase order is acceptable. The Beneficiary also sends the Applicant a copy of their "Letter of Credit Guidelines" to ensure that the credit is opened properly and will not require any costly amendments. A Letter of Credit Application is completed by the Applicant and is submitted to their Bank
The Letter of Credit is issued and sent by the Opening Bank to an

Advising Bank in the country of the Beneficiary.

 The Beneficiary must carefully review the requirements of

the Letter of Credit to ensure it has been issued per the agreed terms. The Beneficiary should make sure that he can comply with all stipulations, such as shipping terms, documentary requirements, shipping and/or expiration dates and packing and marking conditions. If the Letter of Credit has terms that are not as per the agreement, the Beneficiary should request an amendment to the Letter of Credit. This request is made directly to the Applicant, who then instructs the Opening Bank to amend the Letter of Credit.

 Once the Letter of Credit is in order and the shipment is

ready for export, the Beneficiary ships the goods. The seller can now begin preparation of documentation required under the Letter of Credit terms. After goods are shipped, the transport document is acquired by the beneficiary are presented to the Negotiating Bank. The Negotiating Bank may or may not be the Advising Bank Scrutiny of documents by Negotiating Bank Pay the Beneficiary, or forward the documents to the Opening Bank for payment, depending on the terms of the Letter of Credit.

Types of LCs :
Revocable Irrevocable Confirmed Unconfirmed

Types of Letters of Credit - 1 A letter of credit may be of two forms: Revocable or Irrevocable Revocable L/C This is one that permits amendments or cancellations any time by the issuing bank. This means that the exporter can not count on the terms indicated on the initial document until such a time as he is paid. This form is rarely in use in modern day trade transactions. Irrevocable L/C Such a letter of credit cannot be changed unless both buyer and seller agree to make changes. Usually an L/C is regarded as irrevocable unless otherwise specified. Therefore, in effect, all the parties to the letter of credit transaction, i.e. the issuing bank, the seller and the buyer, must agree to any amendment to or cancellation of the letter of credit. Irrevocable letters of credit are attractive to both the seller and the buyer because of the high degree of involvement and commitment by the bank(s). By the 1993 revision of the UCP, credits are deemed irrevocable, unless there is an indication to the contrary.

Types of Letters of Credit - 2 A letter of credit may be of two forms: Confirmed or Unconfirmed. Confirmed L/C If the exporter is uncomfortable with the credit risk of the issuing bank or if the country where the issuing bank is situated is less developed or politically unstable, then as an extra measure, the exporter can request that the L/C to be confirmed. This would add further comfort to the transaction; an exporter may request that the L/C be confirmed. This is generally by a first class international bank, typically the advising bank (now the Confirming Bank). This bank now takes the responsibility of making payments if no remittance is received from the issuing bank on due date. Unconfirmed L/C In contrast, an unconfirmed credit does not require the advising bank to add its own payment undertaking. It therefore leaves the liability seller with the issuing bank. The advising bank is merely as a channel of transmission of documents and payment.

Financing Importers through Letters of Credit

While the L/C can be used as a payment mechanism, it can also be

used to provide financing to the applicant (importer). Deferred and Acceptance credits (i.e. term credits) are considered to be financing instruments for the importer/buyer. Both payment structures provide the importer/buyer the time opportunity to sell the goods and pay the amount due with the proceeds. Under the Deferred Payment structure payment is made to the seller at a specified future date, for example 60 days after presentation of the documents or after the date of shipment (i.e. the date of the bill of lading). Under the Acceptance structure the exporter is required to draw a draft (bill of exchange) either on the issuing or confirming bank. The draft is accepted by the bank for payment at a negotiated future fixed date. This gives the importer the potential time needed to sell the product and pay off the Acceptance at due date. For example, payment date under an acceptance credit may be at sight or after 90 days from presentation of the documents or from the shipment of goods.

Benefits of Letters of Credit

To the Exporter: Payment protection Reliance on issuing banks credit rather than buyers Rapid, local source of repayment, if payable at a U.S. bank To the Importer: Documentary evidence that the ordered goods have been shipped on time Assurance that necessary clearance documents will be provided Payment deferred until goods are shipped and documents presented (use of funds)

Examples
For simplicity sake lets imagine that your company imports radios from a Korean manufacturer called Seoul Manufacturing, which banks at First Seoul Bank. Your company currently banks at First American Bank
For the purpose of this example these will be the roles that the parties will play

in the letter of credit transaction:

Your company : applicant Seoul Manufacturing : beneficiary First American Bank : Issuing Bank

First Seoul Bank : Advising Bank

 You want to buy $50,000 worth of radios from Seoul Manufacturing, which agrees to sell the merchandise and gives you 60 days to pay it with the condition that you provide them with a 90 days letter of credit for the full amount. The steps to get the LC would be as follows: 1)You go to First American Bank and request a $50,000 letter of credit with Seoul Manufacturing as a beneficiary. 2)The bank goes through its underwriting process. Although the bank is not advancing money, they are extending credit on your behalf and are taking on a contingent liability. If your company qualifies from a credit standpoint the LC is issued. 3)Even if your company does not qualify for credit, you can still get an LC if you are willing to put cash collateral CD secured letters of credit are very common for small business . 4)The bank sends a copy of the letter of credit to First Seoul Bank, which lets the vendor knows and the merchandise is shipped.

Case Study
Asian Buyer from an Irish Exporting company convinced

the Exporter to sell to them on an open account terms. The Asian Buyer obtained 60 days credit, which was to be calculated from the date of the invoice. The value of the order was USD 100, 000 and the goods were dispatched and invoiced by the Irish Exporter on the 15th April 2006. The payment from Asia was due on 14th June 2006. The payment eventually arrived on 21st August 2006, over two months late. The delay in payment cost the Exporter USD 1700 as it resulted in his account being overdrawn by this amount for 68 days at 9% per annum.

Letter of Credit too expensive ??

The Irish Exporter could have insisted on receiving a confirmed Letter of Credit through Allied Irish Bank. The following costs would have applied at that time:

Confirmation Fee

USD USD USD

$250 $250 $150

Acceptance Commission (@ 1.5% pa for 60 days)

Negotiation / Payment Fee

Out of Pocket Expenses (estimate)

Total Letter of Credit Cost

USD
USD

$60
$710

Interest Cost as a result of late payment

USD

($1700)

Benefit of using Letter of Credit

USD

$990

Benefits for the Exporter

A guaranty of payment on the due date from Allied Irish

Banks. (Provided the terms and conditions of the Letter of Credit were complied with). No risk of non-payment as a result of problems with the buyer or the Asian economy. A definite date for the receipt of funds. The opportunity to receive the payment in advance of the due date.

Conclusion
This case has not accounted for the costs the Irish Exporter

incurred in chasing the debt with the Asian buyer. In addition if the Exporter had sold his foreign currency receivable on a forward basis to his bank for the original due date, they may have incurred a further cost in cancelling or rearranging the forward contract. Letters of Credit although looks expensive as the costs are very visible but they do provide real and tangible benefits to the companies. In this case, the Irish exporter only lost USD 1700. Of course if the Asian buyer had not paid at all they would have lost the whole USD 100,000.