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Commercial Letters of Credit

For beneficiaries, commercial letters of credit are a very useful form of protection. Sellers of goods can open new markets without worrying about the financial strength of new customers, and they do not have to investigate the credit of smaller customers. The prospect of fraud by a beneficiary always exists. A beneficiary might decide not to ship the goods at issue and simply present fraudulent documents to the issuing bank to receive payment.

Notwithstanding the fear of a fraudulent beneficiary, the commercial letter of credit is a useful tool to applicants, as well. Applicants may be able to purchase certain goods only through a letter of credit. The applicant can also control the shipment date and lot size of the goods through the letter of credit. Quality, however, is something that is beyond the scope of a letter of credit.

For the bank issuing a letter of credit, the following are risks that should always be analyzed:

  1. Credit Risk: The bank will be underwriting the applicant's credit risk unless the letter of credit is secured by cash.

  2. Issuance Error Risk: If the bank prepares a letter of credit with terms that are different from those set forth in the application for the credit, the bank will face financial exposure for departing from the application. The solution is to merge the letter of credit with the application; in other words, make the applicant sign off on the letter of credit.

  3. Payment Error Risk: If the bank fails to properly check documents, the bank may make an error in paying against documents. The most common area for this kind of error is in the description of the goods. As an example, if the letter of credit describes the goods and says the goods are yellow in color, but the invoice does not state a color, the bank will be liable for the applicant's loss if it pays on this letter of credit.

  4. Discrepancies: There is almost always something wrong with every letter of credit that would justify the bank in refusing to honor a presented draft. However, unless the bank wants to risk compromising its relationship with customers and correspondent banks, it is best if the bank notifies the beneficiary to cure the deficiency before the letter of credit expiry date.. Also, the applicant may nevertheless waive the discrepancy, and such waivers should be made by the applicant in writing to protect the bank.

 Types of Commercial Letters of Credit

1. Documentary Letters of Credit

This is the most common form of commercial letter of credit. The letter of credit, as discussed above, will usually require that drafts presented under the credit be accompanied by certain documents. Payment is made to the beneficiary as soon as the draft and the appropriate conforming documents are presented to the issuing bank.

2. Clean Letters of Credit

If the letter of credit conspicuously states that it is a letter of credit or is conspicuously so entitled, the beneficiary's draft must be honored without the presentation of documents if the letter of credit does not specify that documents have to be presented.

3. Banker's Acceptances

A banker's acceptance exists when a letter of credit is drafted with time payment terms, instead of sight terms. Banker's acceptances create a much higher risk for banks than documentary letters of credit. Standard commercial letters of credit, as mentioned above, create contingent liabilities for the bank. Banker's acceptances, however, create actual liabilities for the bank.

If a letter of credit states that payment is due "90 days on sight," this means that payment is not made to the beneficiary until 90 days after the bank receives conforming documents. This is different from the practice under a standard documentary letter of credit, where documents are presented by the beneficiary and inspected by the bank. The is automatically paid by the bank assuming all conforming documents are presented, and the applicant must automatically reimburse the bank.

When the letter of credit contains time terms for payment, known as a banker's acceptance, the series of events that unfold is different. As in the standard documentary letter of credit practice, the beneficiary presents to the bank all conforming documents and the bank inspects those documents. However, unlike the standard documentary letter of credit practice, assuming that the documents are conforming, the bank stamps "accepted" on the face of the beneficiary's draft order for payment. The bank is now obligated to pay the face amount of the draft to its holder (commonly the beneficiary) at maturity. The maturity date of the accepted draft (now a "banker's acceptance") will conform to the payment terms specified in the original letter of credit. In other words, if the letter of credit payment terms were "90 days sight," the maturity of the draft will be 90 days after the documents are presented and accepted. Following acceptance of the draft, the documents (and thus title to the goods) are released to the applicant. However, the applicant has no obligation to pay the bank for the goods that have been released to it until one day prior to the maturity of the draft.

The main reason for using a banker's acceptance is to take advantage of the delayed payment mechanism. The applicant can obtain release of the goods and then sell them before having to pay for them. The beneficiary seller likes the banker's acceptance because it provides more flexibility to its customer, the applicant, without compromising the guarantee of payment from the commercial bank issuing the letter of credit. Virtually all of the downside to a banker's acceptance deals with the bank's risk. In effect, the bank is making a 100% advance on inventory by surrendering the goods to the applicant before reimbursement is made on the letter of credit. One way of protecting against this risk is to obtain other collateral from the applicant.

4. Revolving Letters of Credit

These are similar to but different from revolving lines of credit. If an applicant plans to make multiple purchases from one beneficiary, a revolving letter of credit may be used. The bank sets a maximum amount covered under the revolving letter of credit and the beneficiary can then make multiple shipments up to the limit of the revolving letter of credit. As shipments arrive and the applicant reimburses the issuing bank, new availability opens up that the beneficiary can ship against.

5. Partial Shipments

Here, the letter of credit does not prohibit or limit partial shipments. As a result, the beneficiary may ship goods as they become ready and may obtain payment for whatever portion of the goods that are shipped.

6. Installment Letters of Credit

Under an installment letter of credit, the applicant controls the number and size of partial shipments. The letter of credit specifies the installment of goods that must be shipped. If the beneficiary misses the deadline for one shipment, the remaining installments are canceled.

7. Back-to-Back Letters of Credit

The main function of a standard letter of credit is to ensure payment. However, in a back-to-back letter of credit, the main purpose is to provide financing. This is a high risk transaction. By way of illustration, the bank's customer may have a letter of credit under which he is the beneficiary. The bank's customer then applies to the bank for a letter of credit, using the first letter of credit under which he is the beneficiary as collateral for the repayment of letter of credit for which he is the applicant.

8. Export Letters of Credit

With an export letter of credit, the bank becomes an advising bank, and the bank's customer becomes the beneficiary (exporter). The bank receives a letter of credit from a foreign correspondent representing the applicant. The bank then authenticates and mails to the customer the original letter of credit and a cover memo stating that a letter of credit has been established in his favor for the export of the goods. Once the beneficiary, the bank's customer, has a draft and the documents are in order, as specified in the letter of credit, the documents will be negotiated and sent to the foreign issuing bank for examination and payment. Once the funds are collected, a deposit will be made to the customer's account. The beneficiary should be informed of the deposit immediately.

9. Bills of Exchange and Trade Acceptances

Bills of exchange are similar to but different from sight drafts drawn under commercial letters of credit. In a bill of exchange, there is no letter of credit (in other words, the bank does not guarantee payment) and the draft order for payment represents an obligation of the importer only.

Extended terms can also be arranged through bills of exchange that convert to trade acceptances when accepted by the importer (again, there is no guarantee by the bank). In these cases, the bill of exchange is drawn under time terms, just as banker's acceptances are. Instead of the bank accepting the documents and guaranteeing payment, however, the trade acceptance represents an obligation of the importer only. Trade acceptance financing is much cheaper than banker's acceptance financing and may be acceptable to the seller (exporter), provided the seller has a great deal of confidence in the buyer (importer). The bank can obtain fees for processing documents, referred to as foreign collections.


Standby Letters of Credit

The difference between commercial letters of credit and standby letters of credit can be reduced to one word: default. Commercial letters of credit typically involve payment under a contract of sale. Payment is made upon presentation of conforming documents purportedly evidencing the movement of goods, the satisfactory performance of the beneficiary. The shipping documents triggering payment are standardized and enjoy nearly universal acceptance and use. In contrast, however, standby letters of credit can take the form of a surety device. Specifically, they become payable to the beneficiary upon the assertion of the applicant's nonperformance. The beneficiary of a standby letter of credit can trigger payment simply by making an assertion that a breach of performance has occurred. It is very difficult to draft a standby letter of credit in such a way that gives the applicant any protection against having the letter of credit drawn upon.

Commercial letters of credit are expected to be paid by the issuer. Payment is consistent with normal performance. With a standby letter of credit, however, the bank does not expect to pay. Payment demands under a standby letter of credit usually mean that something is wrong. Because the standby letter of credit is only paid when there is a problem, it is probably true that the applicant does not want the standby letter of credit paid.

Commercial letters of credit usually follow a pattern with the same documents accompanying the draft in case after case. The standby letter of credit follows no such pattern. A standby letter of credit is in substance a loan by the bank issuing it. However, it poses much more danger than a loan agreement presents. With a loan, a bank can immediately move against collateral once an event of default has occurred. With a standby letter of credit, the bank may have to wait until the standby letter of credit is drawn upon by the beneficiary before moving against any collateral. This is so even if the bank knows that the applicant's financial condition has deteriorated to the point where there soon may be nothing left

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