Know Your Letters of Credit

Letters of Credit can provide smooth payment for your transactions. Here’s how they work.

Letters of Credit (LC) are the luxury cars of payment terms. They can provide a smooth ride for your transactions, thanks to their internationally-accepted standards and generally secure payment. If you would like to “test drive” one, I am passing on some tips from colleagues at EDC and at law firm Fraser Milner Casgrain.

By definition, an LC is an irrevocable document that is often used to pay for the purchase of foreign goods or services. It guarantees to the supplier (the beneficiary) that the money will be paid by the issuer of the LC — usually the foreign customer’s bank — as soon as the contractual terms agreed on by the buyer and seller are met. Since the LC follows internationally-recognized standards, your own bank at home can accept this form of payment to provide the funds to you.

What should you watch out for when accepting an LC? In general, these Letters follow uniform rules which are recognized in most parts of the world, but may be subject to special laws in some emerging markets. You should find out if any such exceptional conditions apply in your export market. There could also be minor differences in how each LC is written – some of which may be material.

No matter what, you should always take good care to review the terms and conditions of the LC. You, the exporter, must be sure that the document is in the required form, so that you will receive payment once your part of the bargain is met. And your customer should likewise be satisfied with the terms in the LC, such as shipment schedule, insurance, title transfer and expected condition of the goods upon receipt.

How do you decide whether to ask for a Letter of Credit? Here are some questions that can help you define your company policy on payment terms for sales outside of Canada:

  • Does the country you are exporting to require use of an LC for funds to be transferred abroad?
  • What are the costs to your bank and to your buyer; are they reasonable and who will pay the fees?
  • Is the customer creditworthy? Do you have an existing relationship or do you have access to a credit report that will provide you with details on the buyer’s credit status?
  • What are the country risks? What is the political climate like and is the country considered a good financial partner, i.e., are its financial institutions reliable and respected abroad?
  • Is it standard practice to use an LC in that country or in trading a particular commodity?
  • What advice and insurance do you have? Banks may recommend using an LC in certain situations and credit insurers may insist on it in some cases.

If you decide a Letter of Credit is the best option for you, you will need to find out more about the different types. A confirmed and irrevocable LC is generally your most secure option. Consult your business, bank or legal advisor for more precise information. EDC can offer insurance, just in case an LC is not confirmed by your own bank.

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