In import export business it may be case that the buyer and the seller do not know each other very well. In this case a letter of credit may help iron out payment issues, assuming the parties understand what letters of credits (LOC) are and how they work.
This payment method is only applicable in transactions where the parties involved have expressly agreed to it
What are letters of credit?
A letter of credit is a promise from a bank written on a legal document to another bank to serve as a guarantee for payments made to a specified person under specified condition, if those conditions are met.
How it works
The way LOC work can be summed up as follow, the buyer instructs a bank in their country (the issuing bank) to open a credit with a bank in the seller’s country (the advising bank) in favour of the seller, specifying the documents which the seller has to deliver to the bank if they wishe to receive finance. The instructions also specifying the date of expiring of the credit.
If the seller submits the correct documents before the credit has expired, the advising bank pays the seller the purchase price or accepts his bill of exchange drawn on it, or negotiate a bill of exchange which is drawn on the buyer.
In sale of goods contracts whether international or not you have to remember that the sale agreement is not part of a letter of credit this is because while yes the LOC agreement relies on what the buyer and the seller have agreed to LOC is a separate document issued by a bank
Pay attention to details.
As a buyer you should provide all the required information for the bank to issue the LOC, things like: the name and address of the seller (beneficiary), the amount, when and how the goods will be shipped, destination of shipment etc
Given that LOCs are legally bidding document whose interpretation is literal, bank has to get all the details correct
A typographical error can render the documents void hence the need to clear everything out. Remember with LOCs it’s the documents that matter and not the action undertaken.
Shipping good and documents needed
As pointed out earlier, seller’s ability receive payments with LOC will depends on whether they meet the requirements stipulated in agreement.
This means that the buyer has to ensure that the stipulations are properly drawn to mitigate their loss.
A stipulation that the seller is to be paid upon delivering proof that goods have been shipped, like in the event of using incoterms FOB, the seller is not responsible for what happens to the goods once they are on board a ship and is to be paid, yet it may be the case that the goods don’t make it.
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