What Is Letter of Credit (L/C)? Risks In The Execution of Contracts Related To L/C

With the ongoing global advancement across all spheres of societal life, the prevalence of international trade in the exchange of goods between nations is steadily growing, thereby giving rise to the imperative of addressing international payment matters.  This necessitates meeting the business demands of involved entities while ensuring the safety and security of payment operations, thereby safeguarding the interests of all parties involved in international commodity transactions.

International payment can be understood as the process of settling financial obligations between contracting parties engaged in the exchange of goods or provision of services across different countries.  Presently, various international payment methods have been implemented and are in use, including money transfers, letters of credit (L/C), book transfers, and various collection methods. Among these, the letter of credit has gained widespread usage and popularity due to its inherent reliability in mitigating the trust deficit between exporters and importers.

Now, what precisely is a letter of credit (L/C)? What risks are associated with contract performance pertaining to L/C? These are matters of great interest and concern for individuals actively involved in the international trade of goods.

Letter of Credit (L/C)

A Letter of Credit (L/C) is a letter issued by a bank at the request of the importer, committing to pay a specified amount of money within a certain timeframe to the seller (exporter) upon the presentation of valid documents as specified in the L/C.

Essentially, a Letter of Credit (L/C) is an independent transaction separate from the underlying commercial contract or other agreements that may form the basis of the L/C.  Banks are not concerned or bound by these contracts, even if the L/C refers to them.  Therefore, a bank’s commitment to payment, negotiation of payment, or the performance of any other obligations under the L/C is not dependent on any claims made by the applicant against the issuing bank or the beneficiary.

Common types of L/C:

• Revocable L/C: This type of L/C can be amended, modified, or cancelled unilaterally after it is opened.
• Irrevocable L/C: This type of L/C cannot be amended, modified, or cancelled without the agreement of all relevant parties.
• Confirmed irrevocable L/C: This type of L/C is irrevocable and is guaranteed for payment by another bank, as requested by the issuing bank.
• Transferable L/C: This type of L/C, which is irrevocable and cannot be cancelled, allows the first beneficiary to request the issuing bank to transfer the entire or a portion of the L/C amount to one or more other parties.
• There are other types of L/C, but these four are commonly used by banks.

Key contents of an L/C:

While there are different types of L/Cs, they generally include the following key contents:

• L/C number, location, and opening date.
• L/C type, typically indicating whether it is revocable or irrevocable. If this section is absent, the L/C is understood to be irrevocable.
• Names and addresses of the parties involved.
• L/C amount.
• Validity period: The period within which the bank commits to making payment to the exporter upon the presentation of documents as required by the L/C.
• L/C payment terms: Whether payment is to be made immediately or later.
• Shipment period.
• Information about the goods, including the name, quantity, weight, and price.
• Required documents: This section of the L/C is based on the documentary requirements specified by the importer in accordance with the international trade contract. It is a crucial part of the L/C because it defines the documents that confirm the exporter’s fulfillment of delivery obligations and compliance with the L/C requirements.
• Bank’s payment commitment.
• Other conditions: such as bank charges, reference to the applicable Uniform Customs and Practice for Documentary Credits (UCP), etc.

Parties involved in an L/C:

• Applicant: The buyer or importer of goods.
• Beneficiary: The seller or exporter of goods.
• Issuing bank: The bank representing the importer that can issue the credit to the importer.
• Advising bank: Typically, the bank acting as an agent for the issuing bank or the seller’s bank. Other parties that may be involved depending on the requirements of the buyer and the authorization of the issuing bank include confirming bank, negotiating bank, reimbursing bank, etc.

Conditions and procedures for opening an L/C:

To open an L/C, the importer needs to fulfill the following conditions:

• Ensure sufficient funds to pay the L/C: Typically, when opening an L/C, the importer must deposit a certain percentage of the payment as a guarantee, ranging from 0% to 100%. The amount of the deposit depends on the importer’s relationship, reputation as assessed by the bank, and the credit capacity granted to the importer by the bank.
• The L/C fund should be issued from the importer’s own capital, and the importer needs to deposit 100% of the required amount.
• In cases where the importer does not need to deposit the full 100% or is eligible for a reduced deposit, it requires approval from the bank.
• Complete the L/C application form with accurate information: The importer must provide all the necessary details in the L/C application form. It is important to cross-reference these details with the terms of the commercial contract to avoid any inconsistencies when incorporating them into the L/C.
• The required documents for opening an L/C include:
• L/C application form.
• For first-time users, a decision on the establishment of the business is required.
• Business registration license.
• Import/export registration number.
• Original copy of the international trade contract (If the contract was signed via fax, it needs to be signed and stamped on the photocopy).
• Import consignment authorization contract (if applicable).
• Commitment to perform and pay, credit contract (for loan cases), approval letter for delayed L/C issuance from the bank.
• Foreign exchange trading contract (if applicable).
• L/C opening justification prepared by the bank’s credit department and authorized by the director (for deposits below 100% of the L/C value).

Note: The mandatory documents must be provided in their original form, including payment commitment, loan contract, foreign exchange trading contract, L/C application, and L/C opening justification.

Payment process for an L/C:

• Both the buyer and seller sign a commercial contract.
• Based on the payment terms in the commercial contract, the importer (buyer) requests the bank to open an L/C.
• Based on the L/C application and related documents, the issuing bank opens the L/C and sends the L/C notification.
• The advising bank verifies and transfers the L/C to the exporter.
• The exporter delivers the goods to the importer.
• The exporter prepares the required set of documents and submits them to the advising bank.
• The advising bank verifies the documents and, if valid, makes the payment to the exporter (through the notifying bank).
• The issuing bank delivers the documents to the importer and receives the payment.

Advantages and risks of implementing contracts related to L/C:

Commercial activities between parties from different countries often lack trust and certainty regarding the other party’s commitment to fulfill their obligations.  Choosing the right payment method to safeguard one’s interests is crucial.  Currently, the Letter of Credit (L/C) payment method is widely used due to the following advantages.

• For the exporter: The exporter does not need to worry about the financial capability of the importer. Upon fulfilling the delivery obligation and providing the complete set of documents, the exporter will receive payment from the bank, regardless of whether the importer wants to pay or not.
• For the importer: The importer only needs to make payment when the goods are delivered. The importer can be confident that if the payment is made, the exporter will fulfill all the requirements stated in the L/C.
• For the bank: The bank expands international trade and earns service fees from L/C transactions.

In addition to the advantages mentioned above, there are also risks considering when entering and implementing a Letter of Credit (L/C):

• For the exporter: L/C is a demanding payment method that requires meticulous preparation and presentation of documents. If the exporter does not have a clear understanding of this payment method or fails to present the required documents that comply with the L/C’s terms or presents them late beyond the L/C’s validity period, the bank will refuse to make payment to the exporter. In such cases, the exporter will have to resolve the issue by either unloading and storing the goods, auctioning them off, or waiting for a resolution, or even having to transport the goods back to the home country. The exporter will incur expenses such as demurrage charges, warehousing fees, cargo insurance costs, etc., without knowing whether the importer agrees to accept the goods or rejects them due to discrepancies in the documents.

Additionally, there are risks from the issuing bank’s perspective: If the bank cannot ensure its ability to make payment (due to bankruptcy or insolvency), even with perfect document presentation, the payment will not be made.

• For the importer: Due to the nature of an L/C, which is independent of the underlying trade contract and not bound by it, the L/C only deals with transactions and payments based on documents. The bank pays the exporter solely based on the presented documents without verifying the actual goods. The bank only examines the external validity of the documents. If the exporter intentionally engages in fraud, they can present forged documents to the bank for payment. Consequently, there is no guarantee for the importer that the goods will match the contract in terms of quantity, type, and condition. In such cases, the importer still must fully reimburse the bank for the payment made.
• For the bank: The bank is responsible for document verification and payment, which requires scrutiny. If there are errors during the verification process, there can be adverse consequences, and the bank bears responsibility related to its role in the payment process.

The issuing bank also faces the risk of having to make payment to the beneficiary according to the L/C provisions in cases where the importer intentionally fails to make payment or lacks the ability to pay without adequately funding the required 100% reserve.

We hope that this article helps you better understand the Letter of Credit (L/C) payment method and enables you to apply it effectively in your business while avoiding risks during the process.

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