Letter of Credit offers security and opportunities abroad

If you import or export goods, various factors cause uncertainty. Will I get my money? Is the product as agreed? With a Letter of Credit you remove practically all uncertainties: buyer and seller know exactly where they stand. However, there is a considerable administrative job and a price tag. That scares off, says Marloes Wittebroek of Elceco, but she also sees advantages and opportunities.

You can close business deals with international partners in many different ways. You arrange the payment in advance, or when the goods are in the port or arrive at the agreed destination. Trust plays a major role in international payments. If you want absolute certainty, you can arrange payment with a Letter of Credit (L/C). This way you leave nothing to chance. This article covers these topics:

“An L/C is a payment instrument for international trade. Especially for countries where working with payment in advance is not an obvious choice,” says Marloes Wittebroek. With her company Elceco, she provides L/Cs for Dutch and Belgian exporters.

The L/C, also known as documentary credit, describes how delivery and payment takes place and which documents guarantee payment. Subjects that often occur in an L/C are: price agreements, date of shipment, transport documents, time of payment(s), the origin of a product, quality inspection and product details such as serial numbers of machines.

Details are important, confirms Wittebroek. “You must comply with the conditions stated in the L/C. For example, it is very important that you, as an exporter, meet the final shipping date. If that is not possible, it is advisable to adjust the L/C.”

An L/C is not the fastest or easiest way of doing business with a foreign party, but sometimes you have little choice. For example, because the government demands payment by L/C from your business partner. “For example, in the Middle East, the Far East and parts of Africa. Especially in countries such as Algeria, Saudi Arabia, China, India, Pakistan and Bangladesh. That is also part of the risk coverage. Because your customer’s bank reserves the order amount due on his bank account. As an exporter, this gives you a great deal of certainty. Especially in countries where it is politically unstable or somewhat unsettled. On the other hand, the importer has the certainty that the right goods are on their way to him.”

You often use an L/C for larger transactions. “It is usually at least 15,000 euros. And then you are on the low side, because we often see them for much higher amounts,” says Wittebroek. For example, with its customers it concerns shipments with laboratory equipment, artificial grass, large machines, wood, raw materials in so-called big bags and live animals such as cows. “Everything that the Netherlands is good at passes by: the manufacturing industry, such as huge gears with a diameter of 30 metres. I always find that super cool.”

There are four parties involved in an L/C: buyer, seller, the buyer’s bank and the seller’s bank. Together they ensure that the goods and money reach the right destination. But how?

An L/C in ten steps

1. Buyer (importer) and seller (exporter) enter into a contract.
2. The importer goes to his bank and has an L/C drawn up. This is done on the basis of the contract. The L/C contains a list of documents that the exporter must submit in order to receive payment.
3. Under certain conditions, the importer’s bank reserves the amount intended for the exporter and sends the L/C to the exporter’s bank.
4. The exporter’s bank checks the L/C and advises the exporter or confirms the L/C.
5. The exporter puts the goods on transport.
6. The exporter sends the requested documents from the L/C to his bank within the agreed term.
7. The exporter’s bank checks whether the documents meet the requirements of the L/C. If this is the case and it concerns a confirmed L/C, the exporter’s bank will pay the order amount due to the exporter.
8. The exporter’s bank sends the documents to the importer’s bank.
9. If the documents are approved, the importer’s bank pays the amount due to the exporter’s bank.
10. The importer’s bank hands over the documents to the importer.

The importer receives the documents from his bank in exchange for payment. The documents are necessary to receive the goods.
As soon as the importer receives a (draft) L/C from his bank, an exporter can check whether he can meet the conditions set. “Now is the time for changes,” says Wittebroek, who is experienced in this part of the process.

“When a customer comes to us with an L/C, we take a critical look: what does it say, what are the consequences, what does the financial section look like, are there clauses, are the requirements feasible. There are always things you want to adjust. And things you need to adjust. For example, with a Certificate of Origin (C VO). Sometimes three original copies are requested. That is not possible. There is only one original, the other two are copies. Or it says in the L/C that ‘The Netherlands’ must be stated as the country of origin on the CVO, while the product was not made here.”

Details

The success of your sale via an L/C lies largely in the details of the agreements you make. Wittebroek gives an example: “Can you deliver in parts, or must everything be delivered in one go? This is important if you have a problem in your production. Or if you don’t have a small part in stock. In such a situation it is nice if you can deliver without hassle. Apart from the L/C, you then send the relevant part by air freight later.”

The final version of the transport document can often only be drawn up when the goods are fully ready for transport. Wittebroek: “Only then are you 100% sure of things like weight, or the actual time of departure of the boat or plane.”

The L/C is known to be complicated. But the documentary credit also offers opportunities.

You can tap into new markets with the L/C.

Wittebroek last saw this at a company that sells second-hand agricultural machinery and only delivers on payment in advance. “They found working with L/Cs a hassle. “We’re not going to do that,” they said. In the end, they tried it once and noticed that it wasn’t too bad.” They realized that the choice for an L/C by the importer was not made to interfere. “And that it is simply the way from the other country to be able to do business. I like that. Because once they cross that threshold, the follow-up orders will come. You can tap into new markets with the L/C. Especially in parts of Africa and the Middle East.”

An L/C is all about maintaining control, for all parties involved. Good agreements and underlying documents provide a lot of certainty. But then everything has to be right and go according to plan. And that is currently, and in recent years, not self-evident. Due to the shortage of containers, shipping schedules no longer offer guarantees. “There is a lot of delay in maritime transport, that situation is still not over,” says Wittebroek. “L/Cs that include a ‘latest date of shipment’ must be adjusted regularly.”

Adjustments are possible, Wittebroek emphasizes. “But every adjustment to the final version costs money. That is why it is nice to start with a concept L/C. Then you can propose adjustments at an early stage so that the final version does not cause any surprises.”

“We regularly encounter errors with the transport date. ‘It left us on the agreed date,’ entrepreneurs say. But what matters is that the items are on the ship or in an airplane on the agreed date. What we also see is that a delivery does not succeed in one go, even though that has been agreed.”

All letters and numbers must be correct

In the documents that the exporter must provide, all letters and numbers must be correct. “We fall over every point and comma. Sometimes that’s annoying, but if we see something that’s wrong or questionable, we can’t ignore it. We cannot say afterwards: we had seen it, but we did not want to bring anything up again.”

Sometimes a simple solution is obvious to solve problems and errors. Wittebroek illustrates: “If you make a small mistake on a document, for example, you can easily send an improved version. Of course you inform your customer in advance. You do lose your grip with that; you become dependent on the importer. But, if you have a good mutual relationship, then the importer says to his bank: ‘joh, there is a small difference on this document, but we agree’, and then the payment takes place.

Cost plate

Another disadvantage of the L/C is the cost. This is because documentary credit is expensive compared to other forms of payment. The exact costs depend on your wishes and, for example, the country of destination. According to Drip Capital, the costs for an exporter amount to an average of 1% of the value of the goods. But, the international financier adds, the costs range from 0.25% to 2%. You can always find the costs at your own bank on its website.

1. What is a confirmed L/C?

With a confirmed L/C, your bank takes over the payment obligation that normally rests on the bank abroad. Your bank charges additional costs for a confirmed L/C and only cooperates if all documents are 100% correct.

Wittebroek: “At the time of the Gulf War, one of our customers had a confirmed L/C. Because of the war, the borders were closed at one point. Because the L/C was confirmed, the customer simply received his money.”

2. What is the difference between L/C and documentary collection?

Just as with the L/C, documentary collection involves four parties: buyer, seller and a bank belonging to both entrepreneurs. The difference is in the payment. With the L/C, the importer’s bank freezes the required amount of money in the importer’s account. This does not happen with a documentary collection. In unexpected circumstances, for example in the event of a bankruptcy, as an exporter you join the back of the queue for your money.

Another difference is that a bank assumes the payment obligation with an L/C as soon as the documents are in order. This is not the case with a documentary collection. The importer may decide not to accept the documents, with the result that your goods are already on their way and you will not get paid.

3. Does it matter which Incoterms® I agree on if the payment is via L/C?

By agreeing on an Incoterm® you know who of the two (buyer or seller) is responsible for arranging the transport, who is responsible for the costs associated with the transport and who bears the risk of damage to or loss of the goods during this transport.

Different Incoterms® do not go well with the L/C. This concerns Incoterms® whereby the buyer is responsible for the main transport: Ex Works (EXW), Free Carrier (FCA), Free Alongside Ship (FAS) and Free on Board (FOB). In this case, the importer concludes the transport agreement, while with an L/C as an exporter you want to have the transport in your own hands. It gives you a grip on the goods and is ultimately the key to payment. The L/C always prescribes that you, as the seller, must submit a transport document. And you will receive that document when you enter into the contract of carriage.

L/Cs with conflicting Incoterms® do occur in practice, says Wittebroek. “If the entrepreneurs have already made agreements. Those bears on the road are sometimes there anyway and then you have to see how you maneuver through them. I have to be honest, in all those years we have never experienced an unpaid L/C. Both buyer and seller really want to do business.”