By Walter (Buddy) Baker

Letters of credit (L/Cs) are a popular tool for credit managers.  They provide a fairly simple way to place credit risk with another party—in this case a bank—who may be in a better position to evaluate and assume the credit risk of a particular buyer.  After all, companies are in business to sell goods and services, not to take credit risks and provide financing.  L/Cs are especially popular in managing export transactions, where the risks are particularly difficult to assess.  Credit information is harder to obtain for foreign companies and not always reliable, laws the buyer is subject to are unfamiliar, and there is country risk to deal with: balance of payments issues, exchange controls, government stability, etc.  Letters of credit can shift all of these risks to a bank, either in the buyer’s home country or in North America.  Banks are in the business of evaluating credit risks, including country risks, and providing financing.  When a letter of credit is used, the bank issuing the L/C becomes obligated to pay the exporter.  If there is a “confirming bank,” what you have is a second bank, probably in North America, who is adding their engagement to pay.

Payment Against Documents

But not everything about letters of credit is popular.  In order to obtain payment from the bank, the exporter must provide the bank with documentation the bank can themselves use to obtain payment from the buyer.  Up front, the buyer agrees with the bank what this documentation will be and signs a legal agreement with the bank to reimburse the bank if and when they receive this documentation.  The bank then writes the letter of credit to the exporter and lists this documentation.  Ideally, this should all be documentation the exporter can easily produce.  Usually it is just the documentation the exporter prepares anyway, like an invoice and maybe a packing list, plus a copy of the transport document demonstrating the goods were shipped, and, maybe, evidence the goods were insured.  These documents should reflect the agreement between the buyer and seller as to what goods were to be shipped; how, when, and where they were to be shipped; and who was to cover transportation and insurance costs.  Nonetheless, creating this documentation and presenting it to the bank for payment seems like a hassle to most North American exporters.  And no wonder, once you realize that 60 to 80% of the documents presented to the banks do not comply with the letter of credit requirements, at least according to the banks.  Why do exporters have such a problem presenting compliant documents?  Are the banks overly picky?  This is what I will attempt to explain in this article, as well as how to avoid discrepancies and, ultimately, how to get paid notwithstanding discrepancies.

Letter of Credit Mechanics

The first thing to understand is that standard practice with an export letter of credit is not to present the documents called for directly to the bank that issued the letter of credit, who is probably in another country, but to a “nominated bank” in the country of the exporter.  (If there is a confirming bank, documents must be presented to them.)  The nominated bank will generally provide the service of examining the documents for compliance with the letter of credit and then obtaining payment from the issuing bank.

The nominated bank can often effect payment to the exporter by obtaining funds from the issuing bank’s account at a bank where they keep U.S. dollars on deposit. (Authorization to charge this account must be contained in the L/C.) The bank where the funds are on deposit is called the “reimbursing bank.”  The system for clearing reimbursement is efficient enough—usually taking 5 days or less—that the beneficiary can be, and often is, paid before the issuing bank even sees the documents. Nonetheless, upon receipt of documents, the issuing bank will still examine them and, if they do not conform strictly with the terms of the credit, the bank has no right to obtain payment from the buyer.  The bank therefore has the right to refuse the documents and demand a refund of the amount paid (plus interest). It follows, therefore, that a nominated bank will pay an exporter only upon the presentation of documents that it feels certain will not be refused by the issuing bank. Because any discrepancy is grounds for refusal, the nominated bank will insist the documents strictly comply with the terms of the letter of credit. As I’ve already mentioned, over 60% of all documents are found to contain discrepancies upon presentation to the nominated bank. About half of these discrepancies can still be corrected (or “cured”), while the other half cannot. Obviously, the preferred course of action would be to avoid discrepancies to begin with.

Avoiding Discrepancies

A large portion of the discrepancies found in letter of credit documents occur with a great deal of frequency.  Three common problems can be avoided if the exporter carefully checks the following before shipping:

1. 1. The credit amount is sufficient to cover the shipment (particularly if the shipping terms are CIF or CIP).
   

2. 2. Documents will be available and can be presented before the expiry date of the credit.
   

3. 3. The latest shipment date (if there is one) specified in the letter of credit can be met.
   

After shipping, documents must be properly prepared and presented on a timely basis.  The most common discrepancies encountered by banks examining documents under letters of credit represent errors or misunderstandings in how to prepare documents.  They include the following:

1. 1. Documents contain conflicting data.
   

2. 2. Documents were presented more than 21 days after the date of shipment (or other presentation period specified in the L/C).
   

3. 3. Full set of transport documents was not presented or other required documents are missing.
   

4. 4. Draft is drawn incorrectly or for the wrong amount.
   

5. 5. Draft is not signed or not endorsed.
   

6. 6. Invoice does not describe merchandise in exact accordance with the letter of credit.  Note: If the letter of credit describes merchandise in a foreign language, then the exporter must describe the merchandise in that language in the invoice; translations are not acceptable.
   

7. 7. Invoice does not show the same shipping terms as specified in the L/C.
   

8. 8. Invoice includes charges inconsistent with the shipping terms.
   

9. 9. Invoice is not made out in the name of the applicant shown in the L/C.
   

10. 10. Insurance coverage is insufficient or does not include the risks specified by the L/C.
    

11. 11. Insurance certificate or policy is not endorsed.
    

12. 12. Insurance certificate is dated later than the shipment date (acceptable if coverage is stated to be warehouse-to-warehouse).
    

13. 13. Transport document is not “clean” (defective condition of goods or packaging indicated).
    

14. 14. Transport document does not clearly indicate the name and capacity of the signer and who the carrier is (must be signed “ABC Co. as carrier” or “XYZ Co. as agent for ABC Co., the carrier”).
    

15. 15. Transport document is not consigned correctly or is not endorsed (if endorsement is necessary).
    

16. 16. Multimodal transport document was presented when L/C calls for a bill of lading (acceptable if an “on board” notation has been added that includes the name of the vessel and the port of loading). 
    

17. 17. Multimodal bill of lading was presented when shipping terms are FOB (i.e., port to port) and does not indicate inland freight has been prepaid or otherwise fails to meet requirements for port-to-port shipment.
    

18. 18. Transport document is not marked “freight prepaid” or “freight collect” as required under the credit or in agreement with the invoice and shipping terms.
    

19. 19. Not all documents show license number, letter of credit number, or other identification required in the credit.
    

20. 20. Documents are not signed in accordance with L/C terms (any document called a “certificate” must be signed).
    

Discrepancies like these can generally be avoided by reviewing the terms and conditions of the letter of credit and preparing documents that follow the instructions found there.  [See the page “A Document Examination Checklist” and the sidebar “Using an L/C Document Preparation Service.”]  Keep in mind that banks deal only in documents and have no business getting involved in the underlying contract between the exporter and the buyer.  The bank’s reimbursement from the buyer depends on the documents complying.

Obtaining Waiver of Discrepancies

After examining the documents, the nominated bank will notify the exporter of any discrepancies found and work with the exporter to “cure” as many discrepancies as possible.  If the exporter’s documents cannot be corrected to fully comply with the credit terms, he has various alternatives available to still collect payment. It should be noted, however, that he has lost a key element of the letter of credit: the issuing bank’s obligation to pay. Even if the issuing bank waives discrepancies, the confirming bank, if there is one, may choose not to extend its confirmation to cover the waiver, which is, in essence, an amendment to the credit.

The most common course of action, despite the fact that it is expensive and time consuming, is that the exporter asks the nominated bank to cable the issuing bank describing the discrepancies and requesting authority to pay. Although under no obligation to do so, the issuing bank may then contact the buyer and, if the buyer agrees to payment despite the discrepancies, the issuing bank will then cable the nominated bank giving the authority to pay.  Alternatively, if the exporter is comfortable with his relationship with the buyer and thinks that there is no real danger the buyer will refuse to allow payment, the exporter can direct the nominated bank to forward the documents with the discrepancies to the issuing bank “for approval.”

Using Shippers’ Indemnities to Obtain Immediate Payment Despite Discrepancies

If documents are being sent for approval, the exporter may further request that the nominated bank go ahead and pay against his indemnity. [See the page “Sample Shippers’ Indemnities.”] Under such an arrangement, the exporter agrees to return payment to the nominated bank in the unlikely event such payment is not approved by the issuing bank.

Although the use of such “shippers’ indemnities” is infrequent  in North America, banks are generally willing to accept such indemnities from their own customers so long as the credit standing of the customer is satisfactory. Despite a high discrepancy rate (30% even after fixing curable discrepancies), the actual incidence of issuing banks refusing documents is very low (on the order of 3 out of 10,000 sets of documents).  This is due to the facts that buyers who can obtain letters of credit to begin with are normally good credit risks, they want the merchandise that was shipped and will therefore agree to pay even though documents do not comply, they wish to remain on good terms with their suppliers, and, unless the underlying contract of sale has been violated, they are legally obligated to pay anyway. The use of shippers’ indemnities is highly recommended as a way to obtain payment days or weeks sooner as well as to avoid cable expenses. Indeed, with a blanket indemnity in place, the nominated bank may be willing to pay before even checking the documents.  Because indemnities will be accepted only by banks with whom the exporter has credit lines, beneficiaries wishing to make use of such arrangements should present documents to their own banks for examination rather than follow the common, but often unfavorable, practice of submitting documents to the advising banks.  [See the diagram “How Letters of Credit Work.”]

When All Else Fails

If your documents get refused by the issuing bank, it does not mean you will not be paid.  Although you have lost the credit protection of the letter of credit, you still have the contract of sale to fall back on and the buyer’s own obligation to pay.  The bank can assist you in determining the whereabouts of the goods and will not release the documents to the buyer until they receive your instructions for disposing of the documents.  If the buyer has taken possession of the goods (presumably because possession did not depend on having the documents), the bank may even pressure them to pay.  It will certainly damage the buyer’s reputation with their bank if the bank knows the buyer is taking advantage of the letter-of-credit system to obtain goods they don’t pay for.  Unfortunately, beyond this, collection proceedings will be subject to local laws in the buyer’s country—one of the main problems you were trying to avoid by getting a letter of credit in the first place.

Buddy Baker is an expert in trade finance with Fifth Third Bank.  He is based in Chicago, is a member of the Board of Directors of the ICTF, and serves on the FCIB Hotline Committee to answer members’ questions about letters of credit and other financial services.  He can be reached at buddy.baker@53.com.