What is a Letter of Credit?
Sunday, August 10 2008 17:15
The Letter of Credit is a document that is issued by a bank per instructions by the buyer of the goods. This document authorizes the seller to draw a specified sum of money under specified terms, usually the receipt by the bank of certain documents within a given time. The foreign buyer applies for issuance of a letter of credit from the buyer's bank to the exporter's bank and is therefore called the applicant; the exporter is called the beneficiary.
Payment under a documentary letter of credit is based on documents, not on the terms of the sale or the physical condition of the goods. The letter of credit specifies the documents required by the exporter, such as an ocean bill of lading, consular invoice, draft and an insurance policy. Before the payment, the bank responsible for payment verifies that the proper documents conform to the letter of credit requirements.
U.S. exporters may want to confirm the letter of credit issued by the foreign bank if they are unfamiliar with the bank or are concerned about the political and economic risk associated with that country. A letter of credit may either be irrevocable, thus unable to be changed unless both parties agree, or revocable where either party may unilaterally make changes. This later form is inadvisable, as it carried many risks for the exporter.
A change made to the letter of credit after it has been issued is called an amendment. Banks charge fees for this service. It should be specified in the amendment who will pay these charges
to the bank. It is important to get the letter of credit right the first time because of the cost in money and time.
Typical steps include:
After the exporter and buyer agree on the terms of sale, the buyer makes arrangements with his/her bank to open a letter of credit (LC) that specifies what documents are needed for payment (the buyer determines which documents are required).
The buyer's bank issues the irrevocable LC that includes the instructions to the seller concerning documentation requirements.
The buyer's bank sends the LC to a selected U.S. bank requesting confirmation (exporter may request particular bank).
The U.S. bank prepares a letter of confirmation and forwards it to the exporter along with the LC.
After examining the conditions of the LC, the freight forwarder is contacted to confirm the shipping date.
The exporter arranges with the freight forwarder to deliver the goods to the appropriate vessel port or airport.
The freight forwarder completes the necessary paperwork after the goods are loaded.
The exporter or freight forwarder presents the documents to the U.S. bank, showing full compliance with the terms of the LC.
After the U.S. bank reviews the LC, it is then sent to the buyer's bank for review and is then transferred to the buyer.
The buyer uses the documents to claim the commodity.
A draft, which accompanies the letter of credit, is paid by the buyer's bank at the time specified or, if a time draft, may be discounted at the exporter's bank at an earlier date.Source: export.gov