top of page

International Trade Law: Letters of Credit and what to consider in this context

There are a number of risks involved in international trade transactions between buyers and sellers. Some of these risks relate to payment delays, delivery difficulties and financing issues. Letters of credit have been introduced to address this issue by involving a third party – a bank – in the transaction to mitigate credit risks for exporters.


What is a letter of credit?


A letter of credit is a written document issued by the importer's bank ("issuing bank") on behalf of the exporter. By issuing the letter of credit, the exporter is assured that the issuing bank will make a payment to the exporter for the commercial transaction conducted between both parties.


The importer is the applicant of the letter of credit, while the exporter is the beneficiary. In the case of a letter of credit, the issuing bank promises to pay the stated amount within the agreed period and upon presentation of certain documents. In doing so, it usually uses a receiving ("advising") bank – usually the exporter's house bank.


A basic principle of a letter of credit is that the issuing bank makes payment solely on the basis of the documents presented and is not obliged to physically ensure the shipment of the goods. If the documents presented comply with the terms of the letter of credit, the bank is obligated to make payment.


The beneficiary (normally the exporter) does not receive payment from the issuing bank until the letter of credit is due and all required documents are presented. Documents often required for a letter of credit are:


- ship bill of lading

- air waybill

- commercial invoice

- insurance certificate

- certificate of origin

- packing list

- goods inspection certificate


There are also special forms of the letter of credit. In the case of deferred payment letters of credit, for example, the second bank accepts the export documents that conform to the letter of credit, but no immediate payment is made. Only a payment claim of the exporter is documented, which he can assert with the bank after a defined period of time. For refinancing purposes, the exporter can apply to his bank for advance payment of the expected letter of credit amount. Another special form is, for example, the transferable letter of credit.


Procedure for letters of credit


Importers must follow a specific procedure when applying for letters of credit:


After a purchase agreement has been drawn up and signed between the importer and the exporter, the importer applies to his bank for the issuance of a letter of credit in favour of the exporter. The more clearly and unambiguously the purchase agreement is drafted, the easier it is to handle a letter of credit. It is important to check and determine at this stage which documents must (and can) be provided and in what form. The terms of the letter of credit must correspond to those of the purchase contract. Have a draft of the letter of credit sent to you in advance so that you can have it checked yourself, by your lawyer or by your house bank for any necessary changes!


The issuing bank (the importer's bank) will then draw up the letter of credit, which should comply with the terms of the purchase agreement, and send it to the exporter's bank.


The exporter and his bank should also be sure to evaluate the creditworthiness of the issuing bank. Once this has been done and the letter of credit has been reviewed – particularly with regard to its compliance with the terms of the purchase agreement – the exporter's bank approves the document and sends it to the importer.


Then the exporter manufactures and ships the goods according to the agreed schedule. A shipping company or a forwarder helps to deliver the goods.

Together with the goods, the exporter also submits documents to his bank proving compliance with the purchase agreement.


After approval, the exporter's bank sends these documents to the issuing bank.


After reviewing the documents, the issuing bank releases payment to the exporter and sends the documents to the importer, who collects the shipment.


What to consider before arranging a letter of credit


An important point for exporters is the need to submit documents in strict compliance with the terms of the letter of credit. Any failure to comply with the letter of credit may result in non-payment or delays and disputes in payment. The more clearly and unambiguously the purchase agreement is formulated, the easier it is to deal with a letter of credit. It is important to check and determine at this stage which documents must (and can) be provided and in what form.


The issuing bank should be a bank with a good standing.


Another point that must be clarified before using a letter of credit is the bearing of costs. If costs are imposed on the exporter, the cost of recovery will increase. Apart from the cost bearing, the cost-benefit ratio of a letter of credit in comparison to other options (e.g. bank guarantee) should also be considered.


Attorney trade law


Dr. Simon Harald Baier LL.M. advises on issues of international trade law, in particular on international contract drafting and letters of credit.



Recent Posts

See All

Cosmetics law - an overview

Cosmetics law is a complex legal framework that regulates the manufacture, sale, labelling and use of cosmetic products. It comprises a large number of legal provisions, regulations and guidelines at

Comments


bottom of page