The Documentary Letter of Credit, abbreviated L/C, is a written undertaking of a bank made at the request of a buyer, to honor drafts or other demands for payment (presented by the Seller) upon compliance with the conditions specified in the L/C. Beneficiary of the L/C is the Seller!
Essentially, Letter of Credit is a declaration by a bank that it will make certain payments on behalf of the Buyer (you) under specified conditions!
Let’s say, you are in Bombay, India and you want to buy 100 dining room tables. The manufacturer/seller informs you that the order will take two months to complete and nearly three months to deliver to the United States and that he wants to be paid only by an Irrevocable Letter of Credit issued in his favor. He stipulates that he wants you to set up the Letter of Credit with an expiration date three months from the day of your order.
You will need to contact your bank and ask them to issue the Irrevocable Letter of Credit as the Seller specified.
Your bank in the United States will issue such a L/C per your instructions, to contain a set of conditions you specify, but will do so only once you give them the funds, say $25,000, a sum the Seller indicated / you agreed to pay the Seller as purchase price.
In other words, your bank will not enter into a contractual obligation with the Seller’s bank – and L/C is in essence a contractual agreement between the Seller’s and Buyer’s banks – unless your bank will either collect the money from you up front or puts a lock on it in your account.
For that simple reason, it’s best that you will keep an account in a bank that does import/export financing as oppose to having to give up the funds for the entire course of the contract – until your order arrives and your bank will have to pay the draft.
In such a case, the best solution for you is to open a special CD account in your bank where your money will at least keep earning interest all the while your bank has got a hold on it as oppose to parting from your money and having your bank use it any which way they may and you earn no interest until your bank needs to disburse the funds to Seller’s bank.
Letter of Credit issued by your bank will clearly show the amount to be paid on delivery and compliance, date of expiration and list of conditions you demand to be fulfilled by the Seller. Customarily, an L/C will ask for specific documents to accompany the shipment, basically all the necessary documents for the Buyer/you will need to clear the US Customs.
In any case, however, Letter of Credit does not guarantee the quantity and quality of goods shipped!
Special Conditions would be those that can guarantee count, quality, and packing.
-Buyer informs his bank about:
-the nature of the transaction / goods he is buying
-the invoice amount to be paid
-the documents the beneficiary (exporter) must present in order to receive payment
-the latest date for presentation of the Shipping Documents
-the expiration date for the credit
As the L/C is issued, your bank then notifies the Seller’s bank in the country of the exporter to inform the beneficiary / the Seller that the L/C has been issued in his favor.
When your order arrives at your destination, say Denver, the documents come to your bank for so called negotiation, a process whereby your bank reviews the documents and makes sure that all of your conditions you specified were met.
Once again, beware: when Shipping Documents arrive to your bank, your bank will examine the Documents, but does not itself guarantee the quality and quantity of goods shipped! See a next post on what to do to guarantee you get what you ordered and the quality of goods meets your expectation.
If all the shipping documents are in order, proper Certificate of Origin, Textile Visa or any other document that was called for under the conditions of the L/C at the time of its issue are attached, your bank pays the draft and wire-transfers the payment for the goods to the Seller’s bank, and releases the documents to you so you can finish customs clearance and take possession of your goods. The purchase of your import order using Letter of Credit financing is completed.