Letter of Credit
Letter of credit (LC) is usually issued by banks and generally has four participants. Beneficiary (Seller), Applicant (Buyer), Issuing bank (Applicant bank), and the Advising Bank (Buyers Bank).
When a company wants to import goods or a service from another company, a Letter of Credit will be used. Lets say for example your company is in the United States and you want to import a shipment of 100 units of washing machines from a company in China. Both of you now have agreed on a price and delivery, who will go first? would you pay for the goods upfront and wait for the company in China to deliver the goods or will you wait for the goods to be delivered and then you will pay? Of course as a buyer you will choose the second option you would want to receive the goods first inspect the product and then pay the company in China. But what if you were the one selling the washing machines would you ship 100 units and then wait for the buyer to pay? of course not. Same way you do not trust the company in China to deliver the goods, the Company in China do not trust you to pay. Here is when a Letter of Credit is used.
How does it work?
After the Buyer and Seller agree on all the terms such as payment, unit price, delivery, and shipping method. The applicant (Buyer) would go to his Bank and open a Letter of Credit in favour of the Beneficiary (Seller). The bank then will check the buyer's credit and will hold the amount of the Letter of Credit. Example you want to buy goods worth of $100,000 when you issue an LC your bank will take that $100,000 and keep it on hold with them. When the LC is issued your bank will then send the LC to the Beneficiary's Bank (Advising Bank). Remember once an LC is opened you will not be able to cancel the LC, unless all three other parties agree or the LC expires.
Now the seller knows 100% that you are able to pay for the goods. So he will proceed with manufacturing the goods and deliver it your company. Once the seller ship the goods to you he will submit all documents that are required in the Letter of Credit to his bank. The documents required in LC is the "Proof" so make sure that you require documents that cannot be tampered with. Such as Bill of Lading, Certificate of Origin issued by Chamber of Commerce or Legalized by an embassy, a pre shipment inspection certificate issued by an independent company. When the seller submit all these documents to his bank, his bank (Advising Bank) will forward these documents to your bank (Issuing Bank). Your bank will then check these documents if they meet the conditions of the LC, if all requirement are met, your bank will pay the advising bank, and will call you to come and collect the documents which you will need to collect the goods.
Letter of Credit Documents and Conditions
Usually there are four documents that are always required in a Letter of Credit. Invoice, Transport Document i.e. Bill of Lading, Air Way Bill, Truck Consignment Note and etc., Packing List and Certificate of Origin. You should always add more documents based on the goods you are buying. You can add conditions to these documents. For example documents cannot be dated prior to LC issuance date, Bill of lading must show shipping marks, Invoice must indicate full name and address of the applicant.
There is no limit to what you can require. But remember that the seller must be able to submit the documents, if the seller is unbale to provide the document you require he might refuse the LC, always agree on the documents required and conditions before opening a Letter of Credit.
A Letter of Credit will always show an issuing date, expiry date, latest date of delivery, amount, place of taking charge and place of discharge, payment terms, and latest date of presentation.
Letter of Credit Amendments
A Letter of Credit clauses can be changed / amended only by the issuing bank generally by the instructions of the applicant. Once an amendment has been issued all other parties need to agree to accept or decline the amendment. If the amendment gets declined by the advising bank or the beneficiary then the amendment will be deemed void and the LC will stay in effect the same way with no changes.