Publication Chamber of Commerce website, August 2022 – www.kvk.nl

When importing or exporting goods, various factors create uncertainty. Will I receive my money? Is the product as agreed? With a Letter of Credit, you eliminate practically all uncertainties: buyer and seller know exactly where they stand. However, this involves a considerable administrative task and a price tag. That’s daunting, Marloes Wittebroek of Elceco knows, but she also sees advantages and opportunities.

You can close business deals with international partners in many different ways. You arrange payment in advance, or when the goods are in the port, or arrive at the agreed destination. Trust plays a major role in international payments. If you want absolute certainty, you arrange payment with a Letter of Credit. This way, you leave nothing to chance. This article covers the following topics:

What is a Letter of Credit?
Why do you use a Letter of Credit?
How does a Letter of Credit work?
Checking your Letter of Credit
Benefits of a Letter of Credit
Disadvantages of a Letter of Credit
3 questions about the Letter of Credit

What is a Letter of Credit?

“A Letter of Credit is a payment instrument for international trade. Especially for countries where working with advance payment is not obvious,” says Marloes Wittebroek. With her company Elceco, she arranges Letters of Credit for Dutch and Belgian exporters.

The Letter of Credit (L/C), also known as documentary credit, describes how the delivery and payment take place and which documents guarantee the payment. Topics that often appear in an L/C are: price agreements, date of shipment, transport documents, time of payment(s), the origin of a product, quality inspection and product details such as serial numbers of machines.

Details are important, Wittebroek confirms. “The conditions stated in the L/C must be met. For example, it is very important that you, as an exporter, meet the latest shipping date. If this is not possible, it is advisable to adjust the L/C.”

Why use an L/C?

An L/C is not the fastest or easiest way of doing business with a foreign party, but sometimes you have little choice. For example, because the government of your business partner requires payment with an L/C. “For example, in the Middle East, the Far East and parts of Africa. Especially in countries like Algeria, Saudi Arabia, China, India, Pakistan and Bangladesh. That is also a form of risk coverage. Because the bank of your customer reserves the owed order amount in his bank account. This gives you as an exporter a lot of security. Especially in countries where it is politically unstable or somewhat restless. On the other hand, the importer has the assurance that the correct goods are on their way to him.”

An L/C is often used for larger transactions. “It usually involves at least 15,000 euros. And then you are on the low side, because we often see them for much higher amounts,” says Wittebroek. Her clients include shipments of laboratory equipment, artificial grass, large machines, wood, raw materials in so-called big bags and live animals such as cows. “Everything comes along that the Netherlands is good at: the manufacturing industry, such as enormous gears of 30 meters in diameter. I always find that super cool.”

Four parties are involved in an L/C: buyer, seller, the buyer’s bank and the seller’s bank. Together they ensure that the goods and the money arrive at the correct destination. But how?

An L/C in 10 steps

Buyer (importer) and seller (exporter) conclude a contract.
The importer goes to his bank and has an L/C drawn up. This is done on the basis of the contract. The L/C contains a list of documents that the exporter must submit to be paid.
The importer’s bank reserves, under conditions, the amount intended for the exporter and sends the L/C to the exporter’s bank.

The exporter’s bank checks the L/C and advises the exporter or confirms the L/C.
The exporter puts the goods into transport.
The exporter sends the requested documents from the L/C to his bank within the agreed deadline.
The exporter’s bank checks whether the documents meet the requirements of the L/C. If this is the case and it concerns a confirmed L/C, the exporter’s bank pays the owed order amount to the exporter.
The exporter’s bank sends the documents to the importer’s bank.
With approval of the documents, the importer’s bank pays the owed amount to the exporter’s bank.
The importer’s bank hands over the documents to the importer.
The importer receives the documents from his bank in exchange for payment. The documents are needed to receive the goods.

As soon as the importer receives a (draft) L/C from his bank, an exporter can check whether he can meet the conditions set. “This is the time for changes,” says Wittebroek, who is experienced in this part of the process.

Checking your L/C

“When a customer comes to us with an L/C, we take a critical look: what does it say, what are the consequences, what does the financial paragraph look like, are there clauses, are the requirements feasible. There are always things you want to adjust. And things you have to adjust. For example, with a Certificate of Origin (CVO). Sometimes 3 original copies are requested. That is not possible. There is only 1 original, the other 2 are copies. Or the L/C states that ‘The Netherlands’ must be stated as the country of origin on the CVO, while the product was not made here.”

Details

The success of your sale via an L/C largely lies in the details of the agreements you make. Wittebroek gives an example: “Are you allowed to deliver in parts, or must everything be delivered in one go? This is important if you have a problem in your production. Or if you don’t have a small part in stock. In such a situation, it is nice if you can already deliver without any hassle. Outside the L/C, you then send the relevant part later by air freight.”

The definitive version of the transport document can often only be drawn up when the goods are fully ready for transport. Wittebroek: “Only then are you 100% sure of things like weight, or the actual time of departure of the boat or plane.”

Advantages of an L/C

The L/C is known to be complicated. But the documentary credit also offers opportunities.

Wittebroek recently saw this with a company that sells used agricultural machinery and only delivered on advance payment. “Working with L/Cs, they found it a hassle. ‘We’re really not going to do that,’ they said. In the end, they tried it once anyway and found that it wasn’t too bad.” They realized that the choice for an L/C was not made by the importer to be difficult. “And that it is simply the way from the other country to be able to do business. I think that’s beautiful. Because once they are over that threshold, the follow-up orders will also come. You can tap into new markets with the L/C. Especially in parts of Africa and the Middle East.”

Disadvantages of an L/C

With an L/C, it’s all about maintaining control, for all parties involved. Good agreements and underlying documents ensure a lot of certainty. But then everything has to be right and go according to plan. And that is currently, and in recent years, not a matter of course. Due to the shortage of containers, plans in shipping no longer offer guarantees. “There is a lot of delay in sea transport, that situation has not yet been resolved,” says Wittebroek. “L/Cs in which a ‘latest date of shipment’ is included, must be adjusted regularly.”

Adjustments are possible, Wittebroek emphasizes. “But every adjustment to the final version costs money. That’s why it’s nice to start with a draft L/C. Then you can propose adjustments at an early stage so that the final version does not cause surprises.”

“We regularly encounter errors with the transport date. ‘It left us on the agreed date,’ entrepreneurs say then. But it is about the goods being on the ship or in a plane on the agreed date. What we also see is that a delivery is not successful in one go, while that has been agreed.”

All letters and numbers must be correct

In the documents that the exporter must provide, all letters and numbers must be correct. “We stumble over every dot and comma. Sometimes that is annoying, but if we see something that is wrong, or questionable, we cannot ignore it. We cannot say afterwards: we had seen it, but we did not want to bring up something again.”

Sometimes a simple solution is obvious to solve problems and mistakes. Wittebroek illustrates: “For example, if you make a small mistake on a document, you can easily send a corrected version afterwards. Of course, you inform your customer in advance. You do lose your grip with it; you become dependent on the importer. But, if you have a good relationship back and forth, then the importer says to his bank: ‘Hey, something small deviates on this document, but we agree’, and then the payment takes place.

Pricing

Another disadvantage of the L/C is the price tag. Compared to other forms of payment, the documentary credit is expensive. The exact costs depend on your wishes and, for example, the country of destination. For an exporter, the costs average 1% of the value of the goods, according to Drip Capital. But, the international financier adds, the costs range from 0.25% to 2%. The costs at your own bank can always be found on its website.

3 questions about the L/C

1. What is a confirmed L/C?

With a confirmed L/C, your bank takes over the payment obligation that normally rests with the bank abroad. Your bank charges extra costs for a confirmed L/C and only cooperates if all documents are 100% correct.

Wittebroek: “At the time of the Gulf War, one of our clients had a confirmed L/C. Because of the war, the borders closed at one point. Because the L/C was confirmed, the client simply received his money.”

2. What is the difference between L/C and documentary collection?

With a documentary collection, just like with the L/C, 4 parties are involved: buyer, seller and a bank from both entrepreneurs. The difference lies in the payment. With the L/C, the importer’s bank freezes the required amount of money in the importer’s account. This does not happen with a documentary collection. In unexpected circumstances, for example in the event of bankruptcy, you as an exporter join the back of the line for your money.

Another difference is that a bank assumes the payment obligation with an L/C as soon as the documents are in order. This is not the case with a documentary collection. The importer may decide not to accept the documents, with the result that your goods are already on their way and you are not paid.

3. Does it matter which Incoterms® I agree on if payment is made via an L/C?

By agreeing on an Incoterm®, you know which of the two (buyer or seller) is responsible for arranging transport, who is responsible for the costs associated with transport and who bears the risk of damage to, or loss of the goods during this transport.

Several Incoterms® do not go well together with the L/C. These are Incoterms® in which the buyer is responsible for the main transport: Ex Works (EXW), Free Carrier (FCA), Free Alongside Ship (FAS) and Free on Board (FOB). Here, the importer concludes the transport agreement, while with an L/C, as an exporter, you want to have the transport in your own hands. It gives you control over the goods and is ultimately the key to payment. The L/C always stipulates that you as a seller must submit a transport document. And you get that document when you enter into the transport agreement.

L/Cs with conflicting Incoterms® do occur in practice, says Wittebroek. “If the entrepreneurs have already made agreements. Those obstacles are sometimes there anyway and then you have to see how you maneuver through them. I must honestly say, in all those years we have never experienced an unpaid L/C. Buyer and seller really both want to do business.”

Source: Chamber of Commerce

L/C offers security and opportunities abroad

What is a Letter of Credit?

Why use an L/C?