A Letter of Credit offers peace of mind and opportunities
- Rinke den Os
- 17 May 2023
- Edited 19 Aug 2022
- 8 min
- Managing and growing
When you import or export goods, there are many different factors that can leave you feeling uncertain. Will I even get my money? Will the product meet my expectations? A Letter of Credit is a powerful tool to eliminate virtually all uncertainties. Both the seller and the buyer know exactly where they stand. The main drawback, though, is that it comes with a price tag and considerable red tape. Elceco’s Marloes Wittebroek knows the costs can be intimidating for some. But she also sees clear advantages and opportunities.
There are lots of different ways to close business deals with international partners. You can prepay for goods, pay for them when they arrive in a port near you, or buy them on credit and pay when you actually receive them. Trust plays an important role in international payments. If you want full certainty, pay with a Letter of Credit (L/C) and leave nothing to chance.
What is an L/C?
“An L/C is an international payment instrument that is mainly used in countries where prepayment is not a viable option,” Marloes Wittebroek begins. Her company arranges L/Cs for Dutch and Belgian exporters.
An L/C, also known as a documentary credit, describes how delivery and payment will take place and what documents will guarantee payment. Topics commonly found in an L/C include price agreements, date of shipment, shipping documents, time of payment(s), origin of a product, quality inspection, and product details such as serial numbers of machines.
Wittebroek adds that details matter. “You have to meet the terms set out in the L/C. It is absolutely crucial, for example, that the exporter meets the shipping deadline. If you know that you will not be able to make the deadline, it is best to amend the L/C.”
Why use an L/C?
An L/C is neither the fastest nor easiest way of doing business with a foreign party, but sometimes you have little choice. In some cases, the local government will even demand payment by L/C. “This is the case in the Middle East, the Far East, and parts of Africa, and especially in countries like Algeria, Saudi Arabia, China, India, Pakistan, and Bangladesh. An L/C helps manage risk, because your customer’s bank puts a temporary hold on the amount due. This gives the exporter a lot of peace of mind, especially in politically unstable countries. At the same time, an L/C assures the importer that they will receive exactly the goods they paid for.”
L/Cs are primarily used for large transactions. “The minimum amount for an L/C is about €15,000, and most are considerably higher,” Wittebroek explains. Wittebroek’s customers ship everything from laboratory equipment, artificial turf and large machinery, to timber, raw materials in so-called big bags, and live animals such as cows. “We get to see everything that Dutch companies do particularly well. We recently worked on a shipment of massive, 30-metre gears, which was incredible to see.”
Marloes Wittebroek advises, guides and trains exporters who work with a Letter of Credit. In her first job at a trading company trading in dried milk powder L/C’s were frequently used. This was pleasant for her.
- 6 employees
I instantly found it an interesting and broad field.
How does an L/C work?
There are always 4 parties involved in an L/C: the buyer, the seller, the buyer’s bank, and the seller’s bank. Together, they make sure that the goods and the money end up exactly where they should. But how?
An L/C in 10 steps
- Buyer (importer) and seller (exporter) enter into a contract.
- The importer goes to its bank and has an L/C drawn up based on the contract. The L/C lists the documents that the exporter must produce in order to get paid.
- The importer's bank conditionally holds the amount payable to the exporter and sends the L/C to the exporter's bank.
- The exporter's bank verifies the L/C and advises the exporter or confirms the L/C.
- The exporter dispatches the goods.
- The exporter sends the documents listed in the L/C to its bank before the deadline.
- The exporter's bank checks that the documents meet the requirements of the L/C. If this is the case and the L/C is confirmed, the exporter's bank pays the amount due to the exporter.
- The exporter's bank sends the documents to the importer's bank.
- Upon approval of the documents, the importer's bank pays the amount due to the exporter's bank.
- The importer's bank hands over the documents to the importer.
The importer gets the documents from their bank in exchange for payment. The importer needs the documents to claim the goods.
Once the importer receives an L/C or a draft thereof from its bank, the exporter can check whether it can meet the conditions set. “This is the time for changes,” says Wittebroek, who knows this part of the process like the back of her hand.
“Whenever a customer comes to us with an L/C, we take a close look at it. What does it say, what are the consequences, what does the financial section say, are there clauses, are the requirements feasible. There are always things you want to change and things you have to change. Occasionally, for instance, an L/C will request 3 original versions of a Certificate of Origin (COO). That is impossible, because there can only be one original, while the other two are copies. Alternatively, the L/C may require that the COO states ‘The Netherlands’ as the country of origin, while the product was not made here.”
When working with an L/C, success depends on the details. Wittebroek cites an example: “Are you allowed to deliver the goods in batches, or do you have to ship the full order in one go? This is especially important if you run into production issues or find that you do not have a particular small part in stock. In these cases, it can be particularly useful to have the latitude to deliver whatever you have and ship the missing part by air freight later.”
Often, the final version of the transportation document is not drawn up until all the goods are fully ready to be dispatched. Wittebroek: “Only then can you be 100% sure of factors like weight or the actual departure date of the ship or plane.”
Advantages of an L/C
L/Cs are famously complicated, but Documentary Credits (D/C) also offer opportunities.
L/Cs allow you to enter new markets.
Only recently, Wittebroek came across a company selling second-hand agricultural machinery that only accepted prepayments. “They thought L/Cs were nothing but a hassle and categorically refused to give them a try. In the end, they ended up trying it once and found that it was not as bad as they had expected.” They noticed that importers do not require L/Cs to throw a spanner into the works. “And that it is just a way to facilitate business if there are no other options. I was thrilled by the result, because now that they have had one good experience, I know that more orders will follow. L/Cs allow you to enter new markets, especially in parts of Africa and the Middle East.”
Disadvantages of an L/C
L/Cs are all about staying in control, for all parties involved. All the agreements and underlying documents involved provide a lot of peace of mind, provided all the details are right and everything goes according to plan. In today’s day and age - and in the past few years - this has not been a given. With carriers faced by massive container shortages, shipping schedules no longer offer the certainty they once did. “Maritime delays have been very common recently and continue to this , (Transport Online, in Dutch)” Wittebroek admits. “Which means that L/Cs with a latest date of shipment often have to be amended.”
Wittebroek stresses that it is possible to update an L/C, “but every modification made to the final version does cost money, so drawing up a draft can be useful. That way, you can propose changes at an early stage and hammer out a final version that satisfies everyone’s needs.”
“Problems with the transport date are especially common, and although businesses will stress that they dispatched the order on the right date, what matters is that the goods are physically on a ship or in a plane on the agreed date. We also find that sellers often fail to deliver orders in one go even if they committed to doing so.”
Make sure everything is in good order
The documents provided by the exporter have to be correct down to the very last detail. “We make sure that all the t’s are crossed and all the i’s are dotted. It can be a nuisance at times, but if we come across a mistake or a questionable document, we can’t just ignore it. We can’t simply say: we saw it, but did not want to bother you.”
Sometimes, problems and mistakes can be solved with an easy solution. Wittebroek explains: “If you make a minor mistake on a document, you can easily send a corrected version right away. You always let the customer know, of course, but it does mean relinquishing control to some extent, as you become dependent on the importer. If you have a good relationship, however, the importer will simply tell their bank: ‘this document is not entirely perfect yet, but we agree’ and payment will be made.”
The costs of an L/C are a major drawback, as documentary credit is particularly expensive compared to other forms of payment. The exact costs depend on your needs and wishes and factors like the destination country. According to Drip Capital, the costs of an L/C for an exporter amount to approximately 1% of the overall value of the goods, but - the international financier adds - costs range from 0.25% to 2%. For the exact fees, visit the website of your bank.
3 questions about L/Cs
"I have never seen an L/C go unpaid, because the seller and buyer are always fully committed.”
1. What is a confirmed L/C?
With a confirmed L/C, your bank takes over the payment obligation that would usually be held by the bank abroad. Your bank will charge additional fees for a confirmed L/C and will only cooperate if all documents are 100% correct.
Wittebroek: “During the Gulf War, one of our customers had a confirmed L/C, but the borders were forced to close because of the war. Because the L/C was confirmed, the customer still got their money.”
2. What is the difference between an L/C and a documentary collection?
A documentary collection, like the L/C, involves 4 parties: the buyer, seller and a bank representing each party. The difference between the two comes down to payment. With an L/C, the importer's bank freezes the amount payable in the importer's account, which does not happen with a documentary collection. In unexpected circumstances, such as bankruptcy, the exporter would simply have to join the back of the queue and hope to get their money.
Another difference is that, with an L/C, the bank assumes the payment obligation once the documents are in order. With documentary collection, this is not the case. The importer may decide not to accept the documents, at which point your goods will already be in transit but you will not get paid.
3. Do Incoterms® matter when payment is via L/C?
Agreeing on an Incoterm® tells you whether the buyer or seller is responsible for arranging transportation, who is responsible for the shipping costs, and who bears the risk of damage to, or loss of, the goods in transit.
Various Incoterms® – the ones that make the buyer responsible for arranging transportation – do not mesh well with L/Cs: Ex Works (EXW), Free Carrier (FCA), Free Alongside Ship (FAS), and Free on Board (FOB). With these rules, the importer enters into the transportation contract, while the exporter wants to stay in control of transportation with an L/C, as it gives you grip on the goods and is ultimately the key to payment. With an L/C, the seller is always required to provide a transportation document, which you only get if you enter into the transportation contract.
L/Cs with clashing Incoterms® do occur in practice, Wittebroek says. “It happens when businesses have already made underlying agreements before opting for an L/C, for instance. They are hurdles that you have to overcome - you just have to find a way. Honestly, in all those years, we have never seen an L/C go unpaid, because the seller and buyer are always fully committed.”