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Letters of Credit: How to Get Paid When Trading Internationally
HGA Takeaway | International Trade
Letters of Credit: How to Get Paid When Trading Internationally
Selling overseas can open up exciting opportunities, but how do you protect yourself when you're shipping goods thousands of miles away to a customer you may barely know? Here's a practical introduction to Documentary Letters of Credit, how they work and the mistakes that could delay your payment.
You've secured an exciting international order. Now comes another important question: how are you going to get paid?
When you're trading internationally, agreeing the payment method isn't just an administrative detail.
You're potentially manufacturing stock, committing cash, arranging freight and sending goods to another country before the money reaches your account.
Different payment methods divide that risk differently between buyer and seller.
At one end, payment in advance offers significant protection to the seller but requires the buyer to take more risk. At the other, open account terms can be attractive to the buyer but leave the supplier waiting for payment after goods have been supplied.
A Documentary Letter of Credit sits between those positions and can provide exporters with a much greater degree of payment security when it is structured and handled correctly.
The biggest takeaway?
A Letter of Credit can help protect your payment, but it doesn't remove the need for attention to detail. The bank pays against compliant documents, so getting the paperwork right is absolutely critical.
Takeaway 1
First, understand where the risk sits
There are several ways businesses can arrange payment when trading internationally.
| Payment method | What it means in practice |
|---|---|
| Cash in advance | The seller receives payment before supplying the goods, reducing the seller's payment risk but increasing the buyer's risk. |
| Letter of Credit | A bank undertakes to pay against a complying presentation under the Letter of Credit. |
| Documentary Collection | Banks handle documents and payment or acceptance instructions, but this is not the same payment undertaking as a Letter of Credit. |
| Open Account | The seller supplies the goods and allows the customer to pay later, leaving more payment risk with the seller. |
There isn't one payment method that's automatically right for every export sale.
The right choice depends on the customer, country, order value, relationship, commercial leverage and your appetite for risk.
Takeaway 2
So, what actually is a Letter of Credit?
A Documentary Letter of Credit, often shortened to an L/C or LC, is a bank undertaking used to facilitate payment in international trade.
In simple terms, the buyer arranges for its bank to issue the Letter of Credit in favour of the seller.
If the seller presents the documents required by the Letter of Credit and those documents comply with its terms and conditions, payment is made in accordance with the credit.
Think documents, not products
One of the most important concepts to understand is that a Documentary Letter of Credit is fundamentally a documentary transaction. The documents you present need to demonstrate compliance with the terms of the credit.
Documentary Credits are commonly governed by the International Chamber of Commerce's Uniform Customs and Practice for Documentary Credits, UCP 600, where incorporated into the credit.
Takeaway 3
Who's involved?
A typical Documentary Letter of Credit involves several parties.
The Applicant
Usually your overseas customer or importer. They ask their bank to issue the Letter of Credit.
The Issuing Bank
The buyer's bank, which issues the Letter of Credit.
The Beneficiary
Usually you, the exporter or seller, in whose favour the Letter of Credit is issued.
The Advising Bank
The bank through which the Letter of Credit is advised to the beneficiary.
Depending on the arrangement, other banks and parties can also become involved.
Takeaway 4
How does it work?
The exact process varies, but a simplified transaction might look like this:
1. You agree the sale.
You and your overseas customer agree the goods, price, payment arrangements, delivery terms and other commercial details.
2. The buyer applies for the Letter of Credit.
The importer asks its bank to issue the credit in your favour.
3. The Letter of Credit is issued.
The issuing bank sends it through the appropriate banking channel to the advising bank.
4. You receive and check it.
This is a critical stage. Make sure the credit is workable and that you can meet every relevant requirement before shipping.
5. You ship the goods.
Shipment takes place in accordance with the agreed terms and the requirements of the credit.
6. You present the documents.
The required documents are presented through the banking channel within the applicable presentation period.
7. The documents are examined.
If the presentation complies, the banks deal with payment in accordance with the Letter of Credit's terms.
Takeaway 5
Check the Letter of Credit before you ship
This is probably the most important practical advice in the entire process.
Receiving a Letter of Credit doesn't mean you should immediately start shipping.
Read it carefully and establish whether you can actually comply with it.
Check things like:
✓ The beneficiary and applicant details
✓ Currency and amount
✓ Payment terms, for example at sight or at a later date
✓ Latest shipment date
✓ Presentation period
✓ Ports and airports
✓ Whether part shipments are allowed
✓ Whether transhipment is permitted
✓ Required documents
✓ Bank charges
✓ Any additional conditions
If something isn't workable, don't just hope it'll be fine.
Request the necessary amendment and make sure it has been received and checked before you ship.
Takeaway 6
Make sure your Incoterms® work with the transaction
Incoterms® rules are another important part of international trading arrangements.
They help define the responsibilities of buyer and seller around the delivery of goods, including who arranges particular elements of transport and where risk transfers.
The presentation references the Incoterms® 2020 rules including:
EXW | FCA | FAS | FOB | CFR | CIF | CPT | CIP | DAP | DPU | DDP
The chosen Incoterm® should reflect the actual commercial and logistics arrangement and be considered alongside the Letter of Credit requirements.
For example, don't agree to provide a document under the Letter of Credit that your agreed shipping arrangement won't realistically allow you to obtain.
Takeaway 7
Know which documents you'll need before agreeing to provide them
A Letter of Credit can require documents produced by your own business as well as documents issued by third parties.
Third-party documents could include:
Transport documents such as a Bill of Lading, Air Waybill or CMR
Vessel certificates
Insurance certificates or policies
Inspection certificates
Health certificates
Origin documents such as Certificates of Origin or EUR1 documents where applicable
Other documents could include:
Bills of exchange or drafts
Commercial invoices
Packing or weight lists
Beneficiary's certificates
Analysis, quality or quantity certificates
Installation certificates or certificates signed by the applicant
Think about document availability before accepting the wording.
If another organisation has to produce a document, make sure they understand exactly what will be required and can provide it in the required format and timeframe.
Takeaway 8
Tiny mistakes can become big problems
One of the key terms to understand is discrepancy.
A discrepancy is a problem identified when the documents presented don't comply with the terms of the Letter of Credit, applicable UCP rules or each other.
And the presentation demonstrates just how ordinary some of those mistakes can be.
Common discrepancies include:
✕ Documents missing dates or signatures, or being dated incorrectly
✕ Incorrect currency
✕ Spelling inconsistencies
✕ The wrong Letter of Credit number or no L/C number
✕ Information being inconsistent between documents
✕ Incorrect ports
✕ A Bill of Lading missing the required shipped-on-board notation
✕ Missing endorsements
✕ Providing an insurance certificate when the credit requires an insurance policy
✕ Incorrect origin information
✕ Presenting documents too late
✕ Presenting the wrong number of documents
✕ Part shipping goods where part shipment isn't allowed
✕ Documents not being certified or legalised where required
A mistake that looks insignificant internally can therefore affect whether the presentation is compliant.
For Home & Gift Businesses
Why does this matter to our industry?
Letters of Credit may become relevant when a Home & Gift business begins dealing with larger or unfamiliar overseas customers, higher-value orders or markets where open-account trading would expose the supplier to more risk than it is comfortable accepting.
Imagine you've secured a significant order from an overseas department store, distributor or retail group.
You may need to manufacture thousands of units, purchase raw materials, commission packaging and pay suppliers before the goods leave the UK.
Waiting until after delivery to discover that your customer cannot or will not pay could have a serious impact on cash flow.
Particularly worth considering when:
You're dealing with a new international customer
The order is unusually large for your business
You're committing substantial money to production before being paid
The buyer is located in a market where you are less comfortable with the commercial or payment risk
Your agreed trading arrangement calls for a Letter of Credit
A Letter of Credit isn't necessarily the cheapest or simplest solution, so discuss the available payment methods and costs with your bank or international trade adviser.
The Golden Rule
Don't ship first and fix the paperwork later
If the Letter of Credit contains a condition you cannot meet, request an amendment.
Make sure the amendment has been received and checked before shipping.
Once the goods have gone, your ability to fix certain problems may be very limited.
Practical Checklist
Your Letter of Credit Checklist
Received a Letter of Credit from an overseas customer? Work through this before the goods leave your business.
Before agreeing the sale
☐ We've agreed the payment method with the buyer.
☐ We've agreed the currency.
☐ We've agreed appropriate Incoterms® 2020 rules.
☐ We've considered who will pay the relevant banking charges.
☐ We've discussed the proposed Letter of Credit requirements before the buyer applies where possible.
When the Letter of Credit arrives
☐ The business names and details are correct.
☐ The currency and amount are correct.
☐ The payment terms are what we agreed.
☐ The product description is workable.
☐ The latest shipment date is achievable.
☐ The presentation period is achievable.
☐ The ports or airports are correct.
☐ We understand the rules around part shipments and transhipments.
☐ We understand every document being requested.
☐ We can obtain every required third-party document.
☐ We've reviewed the additional conditions.
If something is wrong
☐ We've identified all required amendments together where possible.
☐ We've requested those amendments from the buyer.
☐ The amendments have actually been received.
☐ We've checked that the amendments solve the problem.
☐ We have not shipped while a necessary amendment remains outstanding.
Before shipping
☐ We've reconfirmed the latest shipment date.
☐ Our freight forwarder understands the documentary requirements relevant to them.
☐ Other organisations issuing documents understand exactly what is required.
☐ We've requested draft copies of relevant third-party documents where practical.
☐ We've checked that the planned shipment complies with the Letter of Credit.
Before presenting documents
☐ Names and spellings have been checked.
☐ Dates have been checked.
☐ Currency and amounts have been checked.
☐ L/C references have been checked.
☐ Ports and shipping information have been checked.
☐ Signatures, certifications and endorsements have been checked.
☐ Information is consistent across the document set.
☐ We have the correct type and number of documents.
☐ Third-party documents have been checked against the credit.
☐ We are still within the required presentation period.
One final check
Don't just ask whether each document looks right on its own. Check the complete document set against the Letter of Credit and for consistency between documents.
Put it into practice
Six rules to remember
1. Don't assume.
If you're unsure what a requirement means, clarify it before shipping.
2. Make sure the credit is workable.
Only accept requirements that you can realistically meet.
3. Fix problems before shipping.
Get necessary amendments received and checked first.
4. Control third-party documents.
Explain requirements clearly and obtain draft copies where practical.
5. Keep it simple.
Unnecessary conditions and documents create more opportunities for discrepancies.
6. Check, check and check again.
Small documentary errors can have much bigger consequences than they first appear to.
The HGA Takeaway
A Letter of Credit can protect your payment, but only if you can comply with it
1. Agree how you're getting paid before committing to an international order.
2. Understand the roles of the buyer, seller and banks within the Letter of Credit.
3. Treat the documents as a critical part of the transaction.
4. Make sure every requirement is achievable before shipping.
5. Get necessary amendments received and checked before the goods leave.
6. Pay particular attention to documents supplied by freight forwarders and other third parties.
7. Check the complete document set carefully before presenting it.
A quick note
This HGA Takeaway provides a general introduction to Documentary Letters of Credit based on the Business West presentation and should not be treated as legal, financial or banking advice. The appropriate payment method and requirements will depend on the transaction, parties, countries, banks and wording of the individual credit. Businesses should discuss individual transactions with their bank or an appropriately qualified international trade adviser before shipping goods.
One question to ask before you ship
If somebody handed us this Letter of Credit today, could we produce every document it asks for, exactly as required and within the required timeframe?