Buying by Letter of Credit

A letter of credit (LC) is a financial obligation undertaken by a bank on behalf of a buyer. This article describes how letters of credit work.

Irrevocable Letters of Credit (LC)

A written guarantee confirming payment between a buyer's bank and a seller's bank describes an irrevocable letter of credit. The guarantee is subject to the seller providing full documentary evidence of compliance with the buyer's conditions that will be included in the letter of credit

Implications of Documentary Credits

There is an important distinction therefore between buying by letter and credit and buying on open credit.

Instead of inspection of goods on arrival confirming compliance with the individual conditions of buyer's order, documents issued by third parties such as the shipping company or an insurer substitute for this. Provided that these documents are perceived to be in order, the bank's guarantee of payment becomes irrevocable.

If on arrival the goods turn out not to be of the specification ordered or worse, the only recourse your business has is directly with the seller, you cannot stop the bank from paying: The merchandise is strictly your problem.

The Bill of Lading (BL)

The original on board bill of lading is the key document of title, issued by the office of the ship's master once the goods have been loaded. You cannot access the goods without the original bill of lading. Note "orginal" - a copy is not acceptable.

In the case of a letter of credit a latest "shipment by" clause must always be included. The shipment date is deemed to be the date of the bill of lading. If the goods have been loaded by the date you have specified but an event subsequently occurs while in transit to cause delay or loss, that will be a matter for your business and its insurers; not the seller

Certificate of Origin

Every import transaction must be accompanied by a certificate of origin. This enables customs to establish the rates of import duty, if any that need to be applied.

Exemptions to import duty must be reflected in the form of the certificate of origin. A typical example of exemption is trade between members of the EU (and Turkey) which will require an ATR 1 declaration to confirm that the goods are in free circulation within the EU and therefore duty free. Similar arrangements are in force for members of NAFTA.

Preferential certificates of origin will also be called for  where certain imports are subject to favourable rates of duty in your country resulting from “most favoured nation” status.

Invoices and Packing Lists

Invoices listing quantities and prices and packing lists (which should not show prices) will be included in the documents called for in your letter of credit. Errors or omission represent grounds for rejecting the letter of credit. Copies of all documents are made available to customs once the consignment arrives at your home port to assist in efficient customs clearances ao errors and omissions here will result in considerable delays if the consignment is to be inspected.

Packing lists should detail  the ID markings carried on each export carton, their dimensions and weights. This information is important for the importer to be able to allocate the shipment to its warehouse location once the consignment has been inspected. Customs also refer to this when confirming that the goods correspond with their description.

If goods are to be shipped to your business under CIF terms (prices include cost, insurance and freight) a copy of the insurance policy will have to be included with the submitted documents. Note "policy" - a cover note is not acceptable.

Certificate of Inspection

Your business can specify other documents in support of a letter of credit. One such is a certificate of inspection.

Most serious exporters will provide such certificates as a matter of course but you should always be aware as to who will be undertaking the inspection beforehand to satisfy yourself that they are acceptable. The inspection must confirm that the shipment was checked by the nominated inspector  and that it corresponds exactly with what has been specified in the letter of credit.

Certification - Consumer Safety Laws

One important but often overlooked consideration is that any merchandise, regardless of from where or how you buy it conforms to your national product safety standards.

A certificate confirming this can and should be one of the supporting documents to be called for in a letter of credit. Not anybody can issue a valid certificate and you are recommended to follow the link below to the important FAQ on Consumer Safety Law for more on this. The importer is liable for any breach.

Insuring Letters of Credit

Even if you are buying under CIF terms the business should be covered by your own local insurance.

This is because once the goods are shipped and the seller has discharged all of their obligations under the letter of credit they are entitled to payment. The consignment could still be at risk however, despite insurance under CIF being included in the price.

For example if following shipment an unforseen event occurs which results in the goods being delayed or lost altogether, it will not just be the value attached to the letter of credit that is lost; your anticipated profits and cash flow from the deal will be lost too. CIF terms do not cover this so you should always insure the business against such consequential losses or business interruption as well as duplicating the cover for the value of the letter of credit.

Any goods in transit insurance policy, whether or not subject to a letter of credit should definitely include such cover against losses arising from piracy.

Financing Letters of Credit

Importing directly by letter of credit can yield considerable improvements in profit margins and ultimately cash flow but initially at least the cash flow costs can be high. This is because your bank is likely to charge your business account for the full value of a letter of credit at the time it is issued.

Figurewizard.com - a free site calculates forecasts enabling you to plan the levels of increased financing, through either bank loans or factoring / invoice discounting that may be needed to cover the cost of imports by letter of credit. It will also forecast the benefits of increased profitability from better gross profit margins and cash flows arising from this over time.

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