Using Commercial Letters of Credit in Your Small Business

By John F. Di Leo

Congratulations! A potential foreign customer for your small business has placed an order. You’re going global! That’s terrific!

As good as this is, there are challenges with export orders that don’t exist with domestic orders –export controls, Customs documents, origin marking requirements, all sorts of challenges. Today, let’s talk about the payment challenges. How will your foreign customer pay for your goods?

Obviously, if he’s willing to pay in advance by wire transfer, that’s the best. Both your bank and your customer’s bank will charge a wire transfer fee, of course, which could range from twenty or thirty dollars up to a hundred, depending on your account and your bank’s expertise. If the order is too low a value, it won’t be worth it.

Then there are the credit card and debit cart approaches. Visa, MasterCard, Paypal, etc. are all great options, and they tend to charge a tiny percentage of the order value, but they have a different challenge: after you’ve accepted payment, the customer could conceivably claw it back, filing a claim against the order and demanding a refund through his credit card if he’s dissatisfied, depending on the policy at his bank or his card.

In both of these approaches, we’re assuming the customer is willing to pay in advance. But what if he’s not? Many foreign customers will rightly think, “The vendor’s in a foreign country, if I pay up front, what’s to prove that he’ll really ship the goods… and that they’ll really be what I’m expecting to receive?” And you have the same fear, asking yourself “If I extend credit, then once I ship it to him, how do I know he’ll pay for it?” The larger the order, the more of a problem this challenge becomes.

When we talk about orders in the thousands of dollars of value, therefore, we need to consider the solution that the banking community provides for international orders with just this challenge: The Commercial Letter of Credit, also known as the Documentary Letter of Credit, or LoC. (There are other products with very similar names, such as the Standby Letter of Credit (actually a performance guarantee), which have nothing to do with payment vehicles and must not be confused with them).

The Letter of Credit

On an international transaction, both the seller and the buyer have valid concerns: if they are cheated, their own country’s legal system is extremely limited in its ability to help redress them. So the banking community invented the LoC in order to enable a single moment of exchange in which the rights to the goods are transferred at the exact same moment that the money is transferred. It provides the best possible protection for both parties, but only if both parties understand the process and do it right.

In an LoC, the buyer (known as the Applicant) approaches his bank and asks to create a special account for the seller (known as the Beneficiary), for a certain period of time, a certain value, and a certain set of Conditions. The account is usually opened up for the full value of the goods plus the transportation costs, with a list of stipulations that, when met in full, will allow the vendor to collect his money.

This list of requirements is often drawn up as a team effort between the customer and his Customs broker, using the bank’s template as the base. The customer’s bank sends it to a notifying bank in the seller’s country, and they negotiate to accept it as-is or make changes. Once accepted, the clock begins, and the seller gets to work on the order.

When it works perfectly, the vendor produces and ships the goods as agreed, then works with his freight forwarder to produce all the documents required by the LoC, using the exact text the customer required, and directs his bank to present the packet to the customer’s bank (there are often more than two banks involved).

If the customer’s bank agrees that the document packet matches the expectations of the LoC, it accepts the documents and arranges payment. If the customer’s bank finds mismatches or failures (known as discrepancies), it gives the customer the choice of accepting them or rejecting them. If the customer rejects them, the bank returns the paperwork and the seller can direct his carrier to turn the shipment around and return it, so that the most the seller loses on the deal is the round trip transport cost, and a few bank fees, but not the goods themselves.

The problem is, it doesn’t always work out quite that perfectly.

What Can Go Wrong?

We’ll deal with some of the big issues in detail, one by one, but let’s begin by saying that a misunderstanding about how LoCs work is usually at the root of most problems. A few examples:

Protections: The LoC depends on two primary protections to be effective: the carrier’s hold and the Customs hold. If done right, the customer must accept the document packet in order to both obtain cargo release from the carrier and Customs clearance from the destination government. Unfortunately, customers often talk their vendors into waiving both of these protections (in the interest of simplicity), leaving the vendor unprotected if the customer refuses the document packet.

Time: The LoC takes time… time to negotiate, time to arrange. Assume two to three weeks from shipment date to the date when the customer’s bank can expect to receive the documents. This makes the LoC process wonderful for long ocean shipments, but dreadful for airfreight, as you will be stuck with huge storage bills (and risk of theft or loss) with every day the cargo sits in a foreign airport.

People: The LoC requires the involvement of purchasing, engineering, law, transportation, accounting , logistics, and maybe more. For a small business, the same person may wear all of those hats, but your outside vendors – both your suppliers and your carriers – still play a role. A primary cause of LoC failure is the seller failing to involve all the people needed to tell for certain when all the products can come together and be shipped. Accept too early a deadline, out of eagerness for the sale or eagerness to please the customer, and you have ensured a need for extensions, possible concessions, and possibly the loss of the sale.

Compliance: Customers often put unnoticed or impossible requirements into an LoC, requiring text that’s banned by our Anti-Boycott laws or even demanding shipment to or through illegal places. This is true of any contract, but with so many more people having visibility to LoCs, there is a greater chance here than with others that such violations will be caught and reported.

For all these reasons and more, the Letter of Credit is a wonderful tool – it’s truly the only way for foreign companies without a credit relationship to safely do business together – but it requires great care at every level. You can sell something for $100,000 to someone halfway across the planet; that’s a wonderful thing… and it is worth the extra work and care that the LoC demands.

The Basics

Any export shipment requires international documentation: an invoice, a packing list, maybe a certificate of origin, a bill of lading. These documents must be populated with enough details to enable export clearance in the origin country and import clearance in the destination country. An LoC adds certain requirements to these documents, to ensure that they meet the customer’s expectations in advance.

The LoC will usually state how the goods must be described, along with their harmonized tariff codes, origin, quantities and values.

These documents are not all in the shipper’s control. The freight forwarder and even the vessel-owner (the steamship line) create the bill of lading, and LoCs often require other documents that carriers, banks, suppliers, or even the local chamber of commerce must create. All such documents need to match the same information and exact wording stipulated in the LoC.

LoCs often include difficult requirements, sometimes unavoidable, but sometimes inserted purposefully to make full compliance – a “clean” letter of credit – difficult. They may demand a relatively new ship, through a Vessel Age requirement, or demand that goods ship on a US Flag vessel (or an Arab flag, or Brazilian), which reduces your shipping options and adds to your transportation cost. Every such requirement means that you need to allow more time to ship, because even if you have the goods available today, it could be a month or two before the right ship is available in this particular lane.

Differences from expectations on any of these will result in costly and potentially fatal discrepancies. Every mismatch could mean a banking fee of $80 to $125 or so, but more importantly, every mismatch means there is a chance the customer will refuse the order, eliminating the very concept that this was a safe and “irrevocable” agreement.

The Terms:

LoCs have a language all their own, so let’s go through a few of the key terms.

Discrepancy: Almost any difference between the expectation on the LoC and the presented documents. This can be major, like a difference in quantity or a completely different product… but it can also be minor, like a different part number for the same product. You may know that the product is sold under two different part numbers for the same thing, but the bank doesn’t; you must ensure that the documents match the expectation. The same goes for country and port names. If the LoC says to ship out of Houston but your bill of lading says Galveston, we may know that’s the same general port area, but the bank doesn’t, so the bank will record the difference as a discrepancy.

“Complying:” Many freight forwarders boast that they are diligent enough to ensure that your packet will always comply. This means they will change everything they need to, in order to match the LoC, to satisfy the destination banker. The problem with this is that forwarders sometimes can’t tell the difference between a harmless change (like Long Beach vs. Los Angeles) and an actual lie (like claiming US origin because the LoC demanded it, when you’re actually filling the order with a Canadian or Mexican product). We need to comply with the LoC, yes, but we must also comply with the law, by always telling the truth.

Confirmation: The idea of the LoC is that it lifts the burden of credit risk off the customer’s shoulders and places it on the shoulders of his bank. So far, so good. In many cases, that’s enough. But what if the bank is iffy too? Or what if the bank is in a country with severe political risk, like Venezuela or Nigeria? Banks can offer a sort of insurance program, in which a valid LoC will still be paid, even if the destination bank improperly refuses or is banned by its government from honoring it. We think of this as further lifting the burden of credit risk off the destination bank’s shoulders and placing it on the infinitely more trustworthy shoulders of a bank in the seller’s country. The cost varies from country to country, but for some banks and some countries, it’s money well spent.

Applicant: The buyer, the customer, the importer.

Beneficiary: The seller, the exporter, perhaps the manufacturer.

Presentation: Once all the documents are finished, the seller hands them to his bank, which formally hands over the document packet to the customer’s bank as provided for in the current version of the Uniform Customs and Practices (UCP) of the global banking industry. Once presented, the destination bank has to decide whether to accept them as compliant, accept them with discrepancy charges, or reject them outright and return them.

Customs Hold: In almost all countries, the ministry of Customs will not allow an importer to pick up cargo until he has filed his import entry for it. Theoretically, he cannot do this until he receives the documents from the bank… but this protection is undermined if the seller agrees to fax or courier a set of copies to him in advance, “just to be helpful.”

Freight Hold: In almost all countries, an ocean carrier’s original bill of lading constitutes the title to the goods, and the seller can sue the carrier if he releases the goods to a customer who doesn’t possess that title-bearing document. The LoC should therefore include this original document – the OBL – so that acceptance of the document packet truly constitutes a transfer in ownership of the goods. The problem here is that some customers talk their vendors into using a “wire release” or an “express B/L”, thereby waiving or bypassing that title document completely. In addition, note that this protection only exists in ocean cargo; there is no such thing as a bill of lading that conveys title in air, road, or rail shipments. LoCs should therefore really only be used on ocean shipments.

Amendments: After you’ve completed the original negotiation on the LoC, there is always the possibility that you or the customer may want or need to change something, such as a shipment date, a destination, or a carrier. Remember that each amendment is actually a chance to not only make the changes you want, but also the changes you don’t. Make sure that you can always live without an amendment. If you ask for an amendment to push out the latest shipping date, for instance, your customer may make it conditional on a price cut, by putting them in the same amendment. Amendments are a dangerous game.

Incoterms 2010 Rules: The shipping terms most commonly used across the world today are those defined every ten years by the International Chamber of Commerce, the ICC. These Incoterms set forth which responsibilities are the obligation of the seller, and are therefore included in the total sale price. LoC customers often want to buy on EXW or FCA terms, which means the buyer uses his own carrier. While this desire is understandable, it’s dangerous for the seller, because you are now turning over your goods to a customer’s own carrier, often at your own door. If something should fall through, the carrier has a relationship with your customer, not with you. While there are some exceptions, the best Incoterm for an LoC shipment – from the perspective of the seller – is almost always CIP, so that the seller can select a forwarder he has a relationship with.

Irrevocable: This may be the most important word in your transaction. Your LoC must be irrevocable, or your customer can simply tell his bank he’s changed his mind and he wants the project closed, even after you’ve ordered your materials, begun production, perhaps even after you’ve shipped. Never accept a customer’s LoC unless it is marked Irrevocable.

Anti-Boycott Issues

Since the mid-1970s, the US Government has forbidden participation in the Arab League’s boycott against Israel. While this is a broad set of regulations that actually theoretically could apply to any other boycott unapproved by the USA, the anti-Israel action is the one that appears the most, and the only one that the US government heavily enforces against. Part of the reason for this is that it appears so often in LoC text. Customers may put it in… their forwarders may put it in… their banks may even build the boycott language directly into their templates, so the customer doesn’t even realize he’s participating.

Part of your obligation as a seller is to have anti-boycott training; he US Government provides some for free, on their website here (https://www.bis.doc.gov/index.php/enforcement/oac). You can expect your freight forwarder and bank to help you with this, but don’t count on them entirely… and even if you strike the clauses that need to be stricken, you may still need to file a quarterly report on the matter.

Export Controls

With whom can you do business, legally?

We’d like to think we can just accept any order we want, but in fact, the U.S. government rightly restricts trade for national security and foreign policy reasons. Among the key ones:

Country restrictions: We are generally forbidden from selling goods to or through North Korea, Cuba, Iran, and Syria, and we have much more limited bans with several other countries.

Party restrictions: We are generally forbidden from doing business with anyone (terrorists, Mafiosi, drug cartels, front companies, etc.) appearing on numerous lists published by our government and the governments of our allies; see OFAC’s Specially Designated Nationals list, for example. The sanctions against Russia that arose from Russia’s annexation of Crimea a few years ago added greatly to this complexity.

Product restrictions: Without first obtaining federal government permission, we cannot share goods, money, technology, software, information, or many other commodities with certain otherwise-legal entities (depending on the countries involved), if they are defined as being “export controlled” under our Export Administration Regulations or the International Traffic in Arms Regulations.

These rules don’t really have anything to do with your Letter of Credit – they apply no matter how you accept payment – other than the fact that shipments with these issues do often tend to be the type of shipment that needs an LoC for other reasons. In an LoC, additional specific text is provided, additional transactional parties are named, and specific products are identified that may all increase the odds of an export control issue.

While you should obtain export control training from your freight forwarder anyway, when using LoCs as a payment vehicle, be sure to always include an export control check as part of the LoC process. Every time there’s a new amendment, that’s an opportunity for the customer to announce another party or to change the routing, possibly to one destination or partner who is banned, making you a criminal by agreeing.

Beneficiary Statements

Letters of Credit often require extra documents confirming qualification for unusual issues, sometimes making the process very difficult. For example:

Ex-Im Bank qualification: A customer may have obtained financing to make this purchase by telling the US Export-Import Bank that he was buying US-made products from you… he may not even have checked with you first! Since the Ex-Im Bank has different qualification thresholds for different programs, even if you know you made the product in the USA, that doesn’t guarantee qualification for your customer’s deal. Make sure to obtain the rules and see if you can prove qualification – in writing – before agreeing to this.

A country flag requirement – LoCs often stipulate that the shipment be made on a ship sailing under a US flag, or the flag of the destination country, such as Saudi Arabia, the United Arab Emirates, Chile or Brazil. While this sounds harmless, we must remember that the vast majority of ships are flagged in Panama or Liberia. This kind of restriction (requiring a document issued by the carrier) adds both cost and time to your project, as goods could wait, sitting in port, for three or four or five weeks, before the next ship with the needed flag is available.

A vessel age requirement: Again, this document (issued by the carrier) may sound harmless, but most ships are not new; many are ten, twenty, thirty, even forty years old. Depending on the routing, it may be difficult to find a ship that meets a ten or fifteen year age requirement. Add time and money to the shipping plans when these rules surface.

A Free Trade Agreement certificate of origin: A normal certificate of origin merely states where each product was manufactured; an FTA certificate goes further, by claiming that the product was not only made in the country in question, but that it qualifies for the special duty-free treatment provided by NAFTA, DR-CAFTA, the US-Australia Free Trade agreement, the US-Israel Free Trade Agreement, or any of the many other such agreements in place all over the world. Each one has different rules of origin; it’s perfectly common for the same product to qualify for a couple of these FTAs but not for others. You must have a proper analysis process before issuing such forms, and you must retain the backup for years, in case your customer is audited.

Remember always that these are legal documents, submitted to not only the bank, but also to government agencies and taxing bodies. It’s not just about satisfying the bank to get paid; government agencies can check to confirm whether they were validly issued or not. Falsifying an origin claim to obtain an Ex-Im Bank loan, for example, or issuing an FTA certificate without backup to help your customer import the goods duty-free, would be viewed as fraud. We need to get these documents right.

Requirements specific to the LoC process

Then there are several requirements that you might not expect to be a big deal… but they are.

Partial Shipment Allowed or Prohibited: Nobody really wants to split up an LoC shipment into multiple shipments, but sometimes you have to, sometimes even as a courtesy to the customer. Always demand that Partials be allowed, because if they are prohibited, you can’t even help the customer by splitting it up at his request until you get an amendment!

Transshipment Allowed or Prohibited: Transshipment is an odd word, with many different definitions in international trade. Under the banking rules, a transshipment occurs when uncontainerized cargo is unloaded from one ship and reloaded onto another one, midway through the voyage. A full container, unopened, can change ships at a transshipment port without being considered a transshipment by the bank. Unfortunately, not every banker understands this distinction, and your shipments may occasionally include partial containers or other breakbulk goods. To be safe, therefore, always insist on transshipment being allowed.

Shipment dates: Your LoC will have a last shipment date, a last presentation date, and an expiry date. If you miss a date, the customer has the opportunity to rethink it all, and to tell his bank to refuse the shipment. Always allow enough time.

Customers may act – in the negotiations – like these concerns don’t matter. They may tell you “we can always change things later in an amendment” or “don’t worry about an amendment, I’ll waive the discrepancies.” We hate to sound untrusting, but never accept such lighthearted approaches to error. The only reason for an LoC is protection, and discrepancies eliminate your protections. The more your shipment is worth, the more dangerous errors become.

Costs

In case you haven’t guessed yet, LoCs are expensive.

Can’t blame them; it does cost money to involve multiple banks in multiple countries, a specialized banking communication (called SWFT), and going back and forth with all these different parties to get the documents just right. But it does add up, and that means that LoCs are only the right choice for shipments of a certain value.

There’s no reason to take a loss on it, of course; you should plan for the banking costs and include them in your price so that you still enjoy the margin you want on your sale. But just don’t forget, and don’t let the customer talk you into accepting charges that turn your sale into a loser. These charges vary widely from country to country, and from bank to bank, so these will just be very rough ranges.

Application fee: Your customer will pay one to two percent or more, with a several hundred dollars minimum, for his bank to open up his LoC in the first place.

Advising and Courier fees: Your bank will charge you a couple hundred dollars to cover the notification when he receives the original LoC by SWFT, and to cover the back-and-forth of amended versions through the negotiations, any later amendments, etc., and they will of course charge a courier and processing fee when they send on the official document presentation for you after you ship.

Confirmation fee: If you choose to have the LoC confirmed (insured), your bank will charge you a percentage based on the risk of the transaction, considering both your customer’s bank and his country. This could easily range from one to several percent of the total order value. Regardless of the price, if your bank recommends confirmation, you should usually go with it; they monitor these risks regularly.

Amendment fees: Every time there’s an amendment after the original acceptance, the customer will be charged anywhere from $25 to $100 or so, depending on the country. It’s customary for the parties to agree that the party requesting the amendment should be the one to absorb the fee.

Discrepancy fees: If there are errors, mismatches, or missing documents in the final presentation, your bank will charge about $100 to $150 per discrepancy, although how they count them varies from bank to bank. (Remember, the primary fear with discrepancies is not the charge for the fee, but the risk that the customer will say No, leaving you stuck with goods at sea and no payment for them)

LoC Service fee: Your freight forwarder or LoC expert service will charge you at least several hundred dollars to manage the LoC analysis and support, possibly as high as a thousand dollars or so. It all depends on the complexity of the order and your relationship with the service.

Reimbursement fees: Finally, when you obtain your payment, your bank will charge a service fee of a couple hundred dollars for accepting the foreign wire and forwarding it to your account.

As you can see, there are a lot of charges. On an order worth only a few thousand dollars, it is simply not worth it to use a commercial letter of credit. Better to roll the dice and accept payment by credit card.

But with a more substantial sale – say, in the tens of thousands of dollars or more – it makes sense. The protections afforded to ocean shipments by the LoC process are worth it… especially if you plan ahead, by calling your forwarder and your bank first, and build these costs into your quote so you can’t be surprised.

The Impossible Stew

The greatest challenge in the use of LoCs is when everyone involved thinks they have performed the necessary steps and agreed to accept the offer, then they find at the last minute that it’s impossible to accomplish on time.

Imagine a shipment in which the order requires goods made by two different vendors in the USA, shipped on an Arab flag vessel in eight weeks, to be shipped without transshipment. Your vendors confirm the goods will be available in four weeks, your carrier says he can have the goods shipped in six, so you’re sure you can meet the needs.

But it turns out that the two vendors can’t both have their goods at the same port on time, and marrying them up together will make them too late for the port cutoff. Or perhaps the goods are just a bit too much to fit in one container, so you need to use one full container and one partial, which will violate the transshipment ban. Or perhaps the carrier changed his shipping schedule around, and there won’t be an Arab flag vessel in that lane between goods’ availability and your latest shipping date. Or perhaps you find out at the end, when you get your documents from the vendors, that they filled one of the orders with goods that were made in another country, so you can’t comply with the origin requirement, and it’s too late to change suppliers.

In the final analysis, it’s not enough to be sure that we can meet each individual responsibility; we must put them together and see if we can meet them all. Can we provide the required goods to the required port on time, and provide the required documents from vendors and carriers alike? If there’s any chance we can’t, let’s insist on another month to be sure we are safe.

Remember, our goal in using LoCs is that the customer has no more ability to back out once he opens the LoC and we’ve accepted it. Even if he changes his mind, he can’t get out of it. We can ship the goods, provide the documents, and get paid, without the customer being able to stiff us… as long as we don’t have discrepancies. But once you have a discrepancy, the customer’s bank has to call him up and give him a chance to get out of it… while your cargo is already on the water, maybe even in his port.

Letters of Credit are wonderful things… one of the greatest tools that the modern global economy provides to companies both big and small. But use them carefully, select good freight forwarders and banks, and pay close attention to every line of the agreement.

Done right, this is the only way to ensure that you can sell to someone halfway across the world and not get cheated. You just can’t beat that!

Originally published in MoneyCrashers, September, 2020

John F. Di Leo is a Chicagoland-based Customs broker and trade compliance trainer. He has been working in international trade, in various capacities on both the manufacturing and service sides of the desk, for forty years now.

Note: this is a short summary of a very extensive topic, and does not constitute legal or tax advice. Readers are encouraged to use this as one of many resources to learn about the subject and to utilize major international banks and freight forwarders to ensure compliance and success.

Leave a Reply Cancel reply