A letter of credit is a legal financial document issued by a bank or a financial institution. This document is a promise to pay if all conditions are met. As an instrument, a letter of credit is very widely used in international trade. Despite its prevalent usage, it is complicated and difficult to understand. Both the documentation and the process of the letter of credit are lengthy and in detail. A good method to understand something is through an example. Therefore, this article will discuss a full-fledged letter of credit example in detail.
So let’s understand the process step-by-step.
An Example of the Letter of Credit Process
Step-1 – Sales Agreement
Even before one opens a letter of credit, there should be a sales agreement. Therefore firstly, let’s assume that the buyer (John, i.e., importer) and the seller (Ibraham, i.e., the exporter) decide to do business together. John and Ibraham reside in different countries, and John agrees to purchase goods from the Ibraham. This gives birth to an international transaction.
John and Ibraham decide on the price, quantity, and other terms. They decide to use a letter of credit for this transaction. The question is, why would they specifically use a letter of credit when other quicker and easier modes of payment are available? There might be many reasons for this, but the most common reason is that the buyer and the seller don’t trust each other to fulfill their part of the obligation. This may be because they are working together for the first time, or the transaction is very large and entails a high amount of risk.
After that, Ibraham makes a proforma invoice and sends it to John. Proforma Invoice is a document in which all trade conditions that John and Ibraham have agreed upon are mentioned. We must note that till now, it is a simple business transaction, and the process of the letter of credit has not even started.
Step-2 – Issuing the Letter of Credit
In order to issue the letter of credit, John contacts his bank. He has to fill out the L/C instructions form and submit the proforma invoice with the form. Submission of the proforma invoice is mandatory in some and advisable in all the banks. This is because to open an L/C; the bank requires all the information about the buyer, the seller, and the terms of the transaction. All this information is available in the proforma invoice. Information includes –
- Complete name and address of the buyer and the seller
- Items purchased with their price and quantity plus total order value
- Currency denomination in which the payment must be made
- Mode of transport (by road, sea, air, etc.)
- Estimated delivery time
- Delivery instructions such as packing requirements, pre-shipment inspection, etc.
- Port of loading and port of delivery, and much more.
From the above information, the letter of credit is made. The letter of credit must have all the correct information. There cannot even be a typographical error. This is because during the instrumentation, whatever is written in the letter of credit is final, and it cannot be changed. For example – if the seller’s name is Rick Corp., but the bank makes a typo and issues the L/C in the name of Rik Corp., then the seller won’t be able to use this L/C to collect his payment.
Therefore the buyer and seller must thoroughly check the letter of credit before accepting it from the bank.
Step-3 – Shipment and Documentation
After the letter of credit is received and accepted, the Ibraham manufactures the goods and prepares them for shipment. Now is the time when Ibraham must fulfill all his obligations. These requirements are mentioned in the letter of credit, and it includes clauses such as – shipping goods at or before the delivery date, meeting all the packing requirements and other pre-shipping instructions, loading and shipping from the instructed ports, etc.
Along with the shipping procedure, a set of documents is made. These documents include:
- Packing List
- Bill of Lading
- Insurance certificate
- Inspection certificates and any others as mentioned in the letter of credit
Here Ibraham’s obligation is to make sure that he fulfills his side of the commitment as per the letter of credit. The buyer’s bank will only pay if he satisfies all the terms of the letter of credit. For example, if the port of loading mentioned in the letter of credit is Port of Los Angeles, but the seller sent the goods from Port of Long Beach (sister port to Port of Los Angeles), he will not be paid. Even if John has agreed with this new arrangement, the bank won’t pay Ibraham as it is not as per the letter of credit. If the Ibraham needs any changes, he has to request John to amend the letter of credit. Only then he will be paid. Amendment can be a costly and lengthy process and should be avoided.
Step-4 – Document Submission and Payment
In the final step, the Ibraham submits the set of documents to his bank. He has to submit all the documents as per the L/C requirement. Even one single document is missing, then the seller will be heavily fined or, worse, won’t be paid at all. Most of the time, the letter of credit demands multiple sets of documents. As many as six sets can be demanded, and the seller has to oblige.
After the seller submits the documents to his bank, the seller’s bank checks the documents thoroughly. If found acceptable, the seller’s bank will pass on the documents to the buyer’s bank. The buyer’s bank does its own due diligence and checks the documents, and if found okay they will make the payment to the seller via the seller’s bank. The bank will send the payment after deducting its fees and applicable fines.
On the other end, the buyer receives the documents from his own bank and gets the goods released from the shipping company. The buyer then fulfills his monetary obligation to his bank.
Adjustment for other Types of Letters of Credit
It is important to note that this is an example of the most basic form of a letter of credit, i.e. commercial letter of credit. L/C’s come in many types with many clauses, which is the plain vanilla process. The terms of an L/C can be altered as the type of L/C changes. For example – In the red clause letter of credit, the seller can receive an advance payment on the order, or a revolving letter of credit can include multiple shipments under one L/C. Therefore as the type changes, the process changes as well. However, the principles of the letter of credit remain the same. It is a document-based system, and whatever is mentioned in the letter of credit must be fulfilled.
Continue reading about other Types of Letters of Credit.