[NEWSLETTER | APRIL 2021] – INTRODUCTION ABOUT LETTER OF CREDIT

Let’s talk about money! Money for trading goods. 

Financing international sales of goods can be, and usually is, quite challenging. But fortunately, international trade has been successfully conducted regularly and in high frequency for centuries. As a result, finance tools for international sale and movement of goods are well established and understood by experts.

There are two major sets of risks involved in international trade. One set is related to the sourcing and shipping of products. The other set is related to the flow of funds to pay for the shipped products. Many of the risks from the first set can be mitigated by using skilled people and by purchasing freight insurance. The second set of risks related to funds can be mitigated by working with international trade finance specialists and by using the appropriate form of financing. So, what forms of financing are available?

Once we establish a good relationship between our buyers and sellers, there are usually two challenges to finance the transaction: 1) ensuring the purchase funds are available, and 2) exchanging the goods and capital in a way that minimizes transaction risks. Noble Network offers a class that explains the most common forms of exchanging goods and capital.

In our on-line self-paced class, we describe: 1) Open Account, 2) Telegraph Transfer, 3) Cash On Delivery, 4) Documents Against Acceptance, 5) Documents Against Payment, and 6) Letter of Credit. Financing solutions are addressed on a case-by-case basis; however, we often recommend a bank Letter of Credit (LC) for our clients. 

The LC complies with the Uniform Customs and Practice for Documentary Credits (UCP) and relies heavily on a solid international network of participating banks to fully guarantee payment for delivery. In principle, it replaces the credit worthiness of buyers with that of banks.

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In its most basic form, the LC is a letter or electronic SWIFT document from the buyer’s bank (Issuing Bank) that confirms they guarantee the payment due to the seller’s bank according to the terms of the purchase agreement. The Issuing Bank must make this payment if the conditions of the LC are satisfied regardless of the circumstances. The LC itself may not be negotiable, but an associated Bill of Exchange can be sold or used as loan collateral to improve cash flow.

A key feature of the LC is the list of “Shipping Documents” required by the Purchase Agreement. Risks are addressed by requiring certificates and signed documents in the Shipping Documents that ensure Purchase Agreement compliance.

The LC is established by the buyer’s bank to assess the risks associated with accepting the payment liability on behalf of the buyer. In order to issue the LC, the buyer’s bank needs to also negotiate the terms of the financing itself with the buyer, such as collateral rights, down payments, loan terms, service features, assignability, etc. 

The buyer puts in place the required down payment and rights to collateral. Likewise, the buyer’s bank puts in place the line of credit needed to finance the entire transaction. This process results in the buyer’s bank issuing a Proof of Funds letter and providing it to the buyer to proceed with the seller. 

The buyer and seller finalize the purchase order with an Irrevocable Corporate Purchase Order (ICPO) from the buyer to the seller and a Full Corporate Offer (FCO) from the seller to the buyer which is subsequently formally accepted by the buyer. 

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Finally, the buyer’s bank issues the Letter of Credit and the shipment can safely proceed.

The seller’s bank is then paid by the buyer’s bank for the payment funds. Payments are normally finalized within two weeks or less of delivery of the Shipping Documents. However, this is often within two weeks of goods delivery since the Shipping Documents often include an Acceptance Protocol inspection reports from both the factory before shipping and at the final delivery destination upon delivery. Further, banks may need to resolve discrepancies between the contents of Shipping Documents and Purchase Agreement requirements.

There are some ways the LC can be leveraged to guarantee payment, mitigate cash flow challenges, and minimize effects of delays. More details on this can be found in our newly launched class on Noble Network Education Center.

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