Understanding Credit Lines

Description

All thankfulness Ron Borcky for his development of this Condition

Purpose:
The purpose of this document is to provide a general understanding of letters of credit, their use and attention.

The topics roofed are the following:

* General background information;
* Types of letters of credit;
* Common problems with letters of credit;
* Procedures for establishing letters of credit;
* Amendments; and
* General tips to both buyers and sellers.

In addition, this document details a step-by-step letter of credit procedures.

Definition:
Letters of credit are commonly used to reduce credit risk to sellers in both domestic and global sales preparations. By having a bank issue a letter of credit, in essence, one is substituting the bank’s credit worth for that of the consumer.

Types:

There are two basic forms of letters of credit:

1. Defend and Documentary. Documentary letters of credit can be either Revocable or Irrevocable, although the first is extremely rare.
2. Irrevocable letters of credit can be Confirmed or Not Confirmed. Each type of credit has compensation and disadvantages for the buyer and for the seller, which this information will review below.

Charges for each type will also vary. But, the more the banks take upon yourself risk by guaranteeing payment, the more they will charge for providing the benefit.

Documentary Revocable Letter of Credit
Revocable credits may be modified or even canceled by the buyer lacking notice to the seller. Therefore, they are generally unacceptable to the seller.

Documentary Irrevocable Letter of Credit
This is the most common form of credit used in global trade. Irrevocable credits may not be modified or canceled by the buyer. The buyer’s issuing bank must follow owing to with payment to the seller so long as the seller complies with the conditions listed in the letter of credit. Changes in the credit must be approved by both the buyer and the seller. If the documentary letter of credit does not mention whether it is revocable or irrevocable, it involuntarily defaults to irrevocable. See Credit Handing out, Sample Procedure for Handing out of a Documentary Irrevocable Letters of Credit for a systematic procedure for establishing an irrevocable letter of credit.

There are two forms of irrevocable credits:

• Unconfirmed credit (the irrevocable credit not confirmed by the advising bank)In an unconfirmed credit, the buyer’s bank issuing the credit is the only party responsible for payment to the seller. The seller’s advising bank pays only after getting payment from the issuing bank. The seller’s advising bank merely acts on behalf of the issuing bank and, therefore, incurs no risk

• Confirmed credit (the irrevocable confirmed credit)In a confirmed credit, the advising bank adds its guarantee to pay the seller to that of the buyer’s issuing bank. Once the advising bank reviews and confirms that all documentary supplies are met, it will pay the seller. The advising bank will then look to the issuing bank for payment. Confirmed Irrevocable letters of credit are used when trading in a high-risk area where war or social, biased, or fiscal shakiness are real threats. Also common when the seller is unfamiliar with the bank issuing the letter of credit or when the seller needs to use the confirmed letter of credit to obtain financing its bank to fill the order. A confirmed credit is more expensive because the bank has added liability.

Defend Letter of Credit

This credit is a payment or performance guarantee used primarily in the United States. They are often called non-performing letters of credit because they are only used as a backup should the buyer fail to pay as agreed. Thus, a stand-by letter of credit allows the consumer to set up a rapport with the seller by showing that it can fulfill its payment commitments. Defend letters of credit are used, for example, to guarantee refund of loans, to ensure implementation of a contract, and to secure payment for goods delivered by third parties. The beneficiary to a defend letter of credit can cash it on demand. Stand-by letters of credit are generally less complicated and involve far less documentation supplies than irrevocable letters of credit. See Credit Handing out, Sample Procedure for Handing out of a Defend Letter of Credit for a systematic procedure for establishing a defend letter of credit.

Special Letters of Credit;

The following is a brief description of some special letters of credit.

Back-to-Back Letter of Credit
This is a new letter of credit opened based on an by now existing, nontransferable credit used as collateral. Traders often use back-to-back preparations to pay the ultimate supplier. A trader receives a letter of credit from the buyer and then opens another letter of credit in favor of the supplier. The first letter of credit serves as collateral for the second credit.

Deferred Payment (Usance) Letter of Credit
In Deferred Payment Letters of Credit, the buyer accepts the ID related to the letter of credit and agrees to pay the issuing bank after a fixed cycle. This credit gives the buyer a grace cycle for payment.

Red Clause Letter of Credit
Red Clause Letters of Credit provide the seller with cash prior to shipment to finance production of the goods. The buyer’s issuing bank may advance some or all of the funds. The buyer, in essence, extends financing to the seller and incurs the risk for all advanced credits.

Revolving Letter of Credit
With a Revolving Letter of Credit, the issuing bank restores the credit to its first amount once it has been used or drawn down. Usually, these preparations limit the number of times the buyer may draw down its line over a predetermined cycle.

Manageable Letter of Credit
This type of credit allows the seller to conveying all or part of the proceeds of the first letter of credit to a second beneficiary, usually the ultimate supplier of the goods. The letter of credit must visibly state that it is manageable for its to be painstaking as such. This is a common financing tactic for middlemen and is common in East Asia.

Assignment of Proceeds:
The beneficiary of a letter of credit may assign all or part of the proceeds under a credit to a third party (the assignee). But, unlike a transferred credit, the beneficiary maintains sole rights to the credit and is only responsible for complying with its terms and conditions. For the assignee, an assignment only means that the paying bank, once it receives notice of the assignment, undertakes to follow the assignment instructions, if and when payment is made. The assignee is needy upon the beneficiary for compliance, and thus this agreement is riskier than a transferred credit. Before in contract to an assignment of proceeds agreement, the assignee should carefully review the first letter of credit.

Common Problems with Letters of Credit:
Most problems upshot from the seller’s incapacity to fulfill obligations confirmed in the letter of credit. The seller may find these terms hard or impossible to fulfill and, either tries to fulfill them and fails, or questions the buyer to amend to the letter of credit. As most letters of credit are irrevocable, amendments may at times be hard since both the buyer and the seller must agree.

Sellers may have one or more of the following problems:

The shipment schedule cannot be met;
The conditions concerning goods costs are unacceptable;
The price becomes too low due to chat rates fluctuations;
The amount of product approved is not the expected amount;
The description of product is either insufficient or too detailed; and,
The stipulated ID are hard or impossible to obtain.

Even when sellers accept the terms of a letter of credit, problems often arise late in the administer. When this occurs, the buyer’s and seller’s banks will try to negotiate any differences. In some cases, the seller can right the ID and present them surrounded by the time specified in the letter of credit. If the ID cannot be corrected, the advising bank will question the issuing bank to accept the ID even with the discrepancies found. It is vital to note that, if the ID are not in accord with the specifications of the letter of credit, the buyer’s issuing bank is no longer constrained to pay.

Basic Procedures for Establishing a Letter of Credit:
The letter of credit administer has been even by a set of rules published by the Global Chamber of Buying (ICC). These rules are called the Standardized Customs and Practice for Documentary Credits (UCP) and are controlled in ICC Periodical No. 500. The following is the basic set of steps used in a letter of credit transaction. Specific letter of credit transactions follow somewhat uncommon procedures.

1. After the buyer and seller agree on the terms of a sale, the buyer arranges for his bank to open a letter of credit in favor of the seller. Note: The buyer will need to have a line of credit established at the bank or provide cash collateral for the amount of the letter of credit.
2. The buyer’s issuing bank prepares the letter of credit, counting all of the buyer’s instructions to the seller concerning shipment and required documentation.
3. The buyer’s bank sends the letter of credit to the seller’s advising bank.
4. The seller’s advising bank forwards the letter of credit to the seller.
5. The seller carefully reviews all conditions stipulated in the letter of credit. If the seller cannot comply with any of the provisions, it will question the buyer to amend the letter of credit.
6. After final terms are agreed upon, the seller ships the goods to the apt port or location.
7. After shipping the goods, the seller obtains the required ID. Please note that the seller may have to obtain some ID prior to shipment.
8. The seller presents the ID to its advising bank along with a draft for payment.
9. The seller’s advising bank reviews the ID. If they are in order, it will forward them to the buyer’s issuing bank. If a confirmed letter of credit, the advising bank will pay the seller (cash or a bankers’ acceptance).
10. Once the buyer’s issuing bank receives and reviews the ID, it either (1) pays if there are no discrepancies; or (2) forwards the ID to the buyer if there are discrepancies for its review and praise.

Opening a Letter of Credit

Level of Point
The diction in a letter of credit should be simple, but specific. The more detailed an L/C is, the more liable the seller will reject it as too hard to fulfill. At the same time, the buyer will wish to mark out in point what its is paying for.

Type of Credit
Letters of credit used in trade are usually either irrevocable unconfirmed credits or irrevocable confirmed credits. In choosing which type to open both the seller and the buyer should premeditated the generally usual payment processes in each people, the value and demand for the goods, and the reputation of the buyer and seller.

ID
In specifying required ID, it is very vital to include those required for customs and those shiny the contract reached between the buyer and the seller. Required ID usually include the bill of lading, a commercial and/or consular invoice, the bill of chat, the certificate of foundation, and the insurance document. Other ID required may be an inspection certificate, copies of a cable sent to the buyer with shipping information, a confirmation from the shipping companionship of the state of its ship, and a confirmation from the forwarder that the goods are accompanied by a certificate of foundation. Prices should be confirmed in the currency of the letter of credit and ID should in the same language as the letter of credit.

The Letter of Credit Attention
The following information should be addressed when establishing a letter of credit.

1. Beneficiary
The seller should provide to the buyer its full corporate name and right take up. A simple mistake here may translate to inconsistent or inappropriate documentation at the other end.

2. Amount
The seller should state the real amount of the letter of credit. One can question for a maximum amount when there is doubt as to the real count or amount of the goods. Another option is to use words like “approximate”, “circa”, or “about” to indicate an check 10 % plus or minus from the confirmed amount. For uniformity, if you use this diction you will need to use it also in connection with the amount.

3. Legality
The seller will need time to ship and to prepare all the de rigueur ID. Therefore, the seller should ensure that the legality and cycle for document presentation after the shipment of the goods is long enough.

4. Seller’s Bank
The seller should list its advising bank as well as a reimbursing bank if applicable. The reimbursing bank is the local bank appointed by the issuing bank as the disbursing bank.

5. Type of Payment Availability
The buyer and seller may agree to use sight drafts, time drafts, or some sort of deferred payment mechanism.

6. Much loved ID
The buyer specifies the de rigueur ID. Buyers can list, for example, a bill of lading, a commercial invoice, a certificate of foundation, certificates of analysis, etc. The seller must agree to all documentary supplies or suggest an amendment to the letter of credit.

7. Say Take up
This is the take up to say upon the imminent arrival of goods at the port or airport of destination. A notification listing hurt goods is also sent to this take up, if applicable.

8. Description of Goods
The seller should provide a small and strict description of the goods as well as the amount caught up. Note the comments in step #2 above concerning approximate amounts.

9. Confirmation Order
With global preparations, the seller may wish to confirm the letter of credit with a bank in its people.

Amendment of a Letter of Credit:
For the seller to change the terms noted on an irrevocable letter of credit, it must question for an amendment from the buyer. The amendment administer is as follows:

1. The seller supplies a modification or amendment of questionable terms in the letter of credit;
2. If the buyer and issuing bank agree to the changes, the issuing bank will change the letter of credit;
3. The buyer’s issuing bank notifies the seller’s advising bank of the amendment; and
4. The seller’s advising bank notifies the seller of the amendment. Tips for Buyers and Sellers

Seller

1. Before signing a sales contract, the seller should make inquiries about the buyer’s creditworthiness and affair practices. The seller’s bank will generally help in this investigation.

2. In many cases, the issuing bank will specify the advising and/or confirming bank. These designations are usually based on the issuing bank’s established correspondent relationships. The seller should ensure that the advising/confirming bank is a financially sound institution.

3. The seller should confirm the excellent permanent of the buyer’s issuing bank if the letter of credit is unconfirmed.

4. For confirmed letters of credit, the seller’s advising bank should be willing to confirm the letter of credit issued by the buyer’s bank. If the advising bank refuses to do so, the seller should question for another issuing bank as the current bank may be or is in the administer of apt in receivership.

5. The seller should carefully review the letter of credit to ensure its conditions can be met. All ID must conform to the terms of the letter of credit. The seller must comply with every point of the letter of credit specifications; if not the wellbeing given by the credit is lost.

6. The seller should ensure that the letter of credit is irrevocable.

7. If amendments are de rigueur, the seller should friend the buyer at once so that the buyer can instruct the issuing bank to make the de rigueur changes quickly. The seller should keep the letter of credit’s end date in mind throughout the amendment administer.

8. The seller should confirm with the insurance companionship that it can provide the coverage specified in the letter of credit and that insurance charges listed in the letter of credit are right. Predictable insurance coverage is for CIF (cost, insurance and goods) often the value of the goods plus about 10 percent.

9. The seller must ensure that the goods match the description in the letter of credit and the invoice description.

10. The seller should be familiar with foreign chat limitations in the buyer’s people that could hinder payment procedures.

Buyer

1. When choosing the type of letter of credit, the buyer should premeditated the standard payment methods in the seller’s people.

2. The buyer should keep the details of the buy small and concise.

3. The buyer should be set to amend or re-negotiate terms of the letter of credit with the seller. This is a common procedure in global trade. With irrevocable letters of credit, the most common type, all parties must agree to amend the document.

4. The buyer can reduce the foreign chat risk by buying forward currency contracts.

5. The buyer should use a bank veteran in foreign trade as its issuing bank.

6. The validation time confirmed on the letter of credit should give the seller ample time to produce the goods or to pull them out of stock.

7. A letter of credit is not fail-safe. Banks are only responsible for the ID exchanged and not the goods shipped. ID in agreement with the letter of credit specifications cannot be rejected on foundation that the goods were not delivered as specified in the contract. The goods shipped may not in fact be the goods approved and paid for.

8. Buy contracts and other agreements pertaining to the sale between the buyer and seller are not the concern of the issuing bank. Only the letter of credit terms are binding on the bank.

9. ID specified in the letter of credit should include those the buyer requires for customs clearance.

This condition was written by Credit Investigate Foundation www.crfonline.org