Paying internationally might be complicated, because the importer is concerned they will lose their money, and the seller is concerned they will not get paid for the product they are shipping. Each party must agree to a payment method before the order is placed. A Letter of Credit is one of the most common ways to pay internationally.
A Letter of Credit is a formal, binding legal agreement between an importer and foreign seller. A Letter of Credit is one of the most secure methods of payment between the seller and the buyer. It can balance the risk for both the seller and buyer. The seller gets paid automatically once they meet all the terms of the Letter of Credit.
Basics of a Letter of Credit:
- Sales Agreement
A purchase order is the first contract to the seller, stating that the importer is ready to commit to purchasing the goods. A purchase order must be taken seriously since it covers the key details between the seller and buyer. Once order details are negotiated, the buyer will contact a bank (the issuing bank) to obtain a Letter of Credit. The importer must put all the requirements on the Letter of Credit as indicated on the purchase order.
- Submitting the Letter of Credit
Once the Letter of Credit application is received by the buyer’s bank, they work on the conditions of the Letter of Credit. The application must be in accordance with the terms of the sales agreement (purchase order.) Once the importer and bank agree on the terms of the Letter of Credit, the importer’s bank issues the Letter of Credit.
- Transmitting the Letter of Credit
Once the Letter of Credit’s terms are finalized between the buyer and their bank, the issuing bank submits the Letter of Credit to the seller’s bank (beneficiary bank.) The beneficiary bank, and seller, checks the conditions of the Letter of Credit. If there are any conditions of the Letter of Credit not agreed to by the seller, they should contact the buyer for corrections. Since the Letter of Credit is a binding agreement between the seller and buyer, it is important to finalize the terms before starting to manufacture the goods.
- Presentation of the documents to the issuing bank
Once the goods are manufactured and loaded, the shipper collects all the required documents. The shipper must meet all the conditions of the Letter of Credit when they are presenting the required documents to the bank. The beneficiary bank checks all the documents before returning the Letter of Credit to the issuing bank, and they inform the shipper if there are any discrepancies. The shipper either corrects the documents, or they decide to submit the Letter of Credit to the issuing bank as-is. The discrepancies on the Letter of Credit will give the buyer the right to refuse the shipment and payment of the goods. Even a minor discrepancy might be a reason for the buyer to refuse payment. Discrepancies might include any errors, including misspellings or missing documents.
If there are no discrepancies, the Letter of Credit will be automatically accepted by the issuing bank, and the funds will be transferred from the buyer’s bank to the seller’s bank.
If there are discrepancies:
- The buyer might waive the discrepancies and accept the documents as-is. The issuing bank transfers the funds.
- The buyer might refuse the shipment and the payment, or they might renegotiate the amount of the Letter of Credit to compensate the loss due to discrepancies.