What are documentary credits?
Also known as “letter of credit” or “L/C’, a documentary credit is a written undertaking by a bank, at the request of the importer/buyer, to pay an exporter/seller for product(s) supplied, provided that the exporter/seller complies with the terms and conditions laid down in the documentary credit. The International Chamber of Commerce has drawn up a set of rules to which international banks have to adhere to when issuing letters of credit. These rules are know as The Uniform Customs and Practice for Documentary Credits (UCP 500 – 1993 revision). All letters of credits issued should state that they have been issued in accordance with the rules of the UCP.
Documentary credits are amongst the safest and most commonly used forms of payment in exporting (other than payment in advance). They are typically used to pay for exports to customers that you have not sold to before, as well as for customers and countries that represent particular credit risks. A documentary credit carries assurances for both the exporter and the importer. The L/C is an undertaking by a bank – the exporter therefore relies on the ability of the bank instead of the importer to pay. The importer, in turn, has the assurance that the bank will not release the money to pay for the goods until the exporter has presented the necessary documents which will include proof of dispatch of the goods to their final destination.
The process of issuing documentary credits starts with your customer – the importer – requesting the issuing of a letter of credit with their local bank (known as the “issuing bank”). In this letter of credit will stand all the instructions that you must follow and documentary evidence that you must supply to a correspondent bank (which will normally be specified in the letter of credit). This correspondent bank is known as the “advising bank”. The correspondent/advising bank may be a different bank to your own bank (it is in fact the local representative of the overseas issuing bank). As the exporter, you will receive a copy of the letter of credit from the importer, as will the advising bank.
Payment by letter of credit should be considered under the following conditions:
- When the financial status of a new customer is unknown.
- When foreign exchange is strictly controlled and payment for imported goods is subject to lengthy delays.
- When the exporter has previously experienced problems or delays in obtaining payment from the buyer in question.
What information appears in a documentary credit?
As an exporter, you will not be preparing a letter of credit. You will, however, have negotiated with the importer certain requirements – terms and conditions – which you need to ensure are mentioned in the L/C. Some of these requirements will be specified by the importer, while others will be specified by you – the L/C is there to protect both parties. The terms and conditions you will want mentioned in the L/C, will be outlined in your proforma invoice.
Having received your proforma invoice, the importer may negotiate certain of the items mentioned in the proforma invoice, such as your payment terms. When both parties are satisfied and the importer decides to accept your offer, he/she will request an invoice from you. The commercial invoice is essentially the agreed upon invoice between the two parties based on the proforma invoices that have gone before. Based on the requirements set out in the commercial invoice, the importer will then approach his/her local bank (the issuing bank) and request the issuing of an L/C. The L/C will include any or all of the following:
- Complete, on-board, ocean bills of lading
- Commercial invoice, original, six copies
- Packing slip providing a full description and indication of the quantity of the goods to be supplied (an original and six copies)
- Insurance certificates
- Inspection certificates
- Strict date limitations
- Terms of delivery/Incoterms
- Delivery terms, i.e. 15 days after receipt of the letter of credit by the exporter
- Payment terms, i.e. 30 days form bill of lading date
- Payment of bank charges
- Ports and/or places of loading
- Ports or places of discharge
- amounts, precise name, and address of the beneficiary (seller)
- References to mode of transport
- Currency in which the contract will be conducted
- Packaging requirements
- Physical markings to be included on the packaging
- Documentation to be supplied by the exporter to the importer
- and dozens of other conditions covered by the “Rules.”
The need for accurate documentary proof
Once you have dispatched the goods and attended to all of the requirements as stated in the letter of credit, you can approach the advising bank (the local bank representing the importer’s bank) and submit to them all of the documentary evidence (such as the shipping documents, phyto-sanitary documents, inspection certificates, etc.) of what you have done, and as is set out in the letter of credit. If your documentary evidence exactly meets the requirements as specified in the letter of credit, the advising bank will pay you as per the payment instructions (which may be immediately, or after a certain period of time or on a specific date).
It is important, however, that the documentary evidence that you supply to the advising bank meets the requirements as stipulated in the letter of credit, exactly – even a spelling mistake or a missing comma can result in their refusal to pay.
In the world of export payments, you will regularly come across these various terms and they may appear a little confusing. In this section, we try to provide a short explanation of each term.
- Issuing bank – this is the bank that the importer/applicant approaches to issue an L/C. It will probably be the importer’s own local bank, but need not be (i.e. the importer may bank with one bank, yet use another bank for the issuing of the L/C because of lower fees charged or some other reason such as a special request by the exporter).
- Correspondent bank – most banks around the world maintain a relationship with selected banks in other countries in order to enable them to do business with these countries. Such partner banks are known as correspondent banks. Correspondent banks are also referred to as advising banks when they are used by the issuing bank to advise or inform the exporter/beneficiary of the issuing of an L/C.
- Advising bank – this is normally a local bank representing the issuing bank (it may also be a branch of the issuing bank), that advises the exporter of the issuing of an L/C. The advising bank is also referred to as a correspondent bank.
- Confirming bank – the exporter may ask the advising bank or his/her own local bank or even another reputable international bank located in another country to confirm the L/C. In this instance the bank in question becomes known as the confirming bank. The confirming bank and advising bank are often one and the same, but do not have to be the same – it depends on which bank the exporter approaches to do the confirming of the L/C.
- Local bank – this is the local bank of the exporter.
Costs involved in a letter of credit transaction
Exporters wanting to secure a better method payment by opting for payment by a letter of credit, can expect additional bank charges, here are some of the expected charges:
- Establishment costs, charged by issuing bank, usually to the applicant. These vary from bank to bank and from country to country.
- Advising fees, charged by the advising bank, normally the beneficiary pays these fees.
- Confirmation fees, which are relative to the perceived risk. Thus, the cost varies widely. It must be agreed which party is to pay. In most instances the seller pays since the confirmation is usually at his request and for his benefit.
- Negotiating/handing fees, charged by the negotiating bank usually paid by the applicant.
- Payment charges, levied by the paying bank in respect of payments under usance drawings – usually levied to the buyer.
- Acceptance commission and discount charges, which arise when a term draft under a credit is discounted. Which party is to pay is a matter of negotiation between the buyer and seller.
- Amendment fees, charged by the issuing bank whenever a letter of credit is amended and followed by additional advising fees – usually levied to the buyer.
Different types of letters of credit
There are essentially three types of letters of credit, namely:
- Revocable letters of credit
- Irrevocable and unconfirmed letters of credit
- Irrevocable and confirmed letters of credit
Click here to find out more about these types of letters of credit.