Understanding Letters of Credit
Letters of credit are complex financial tools that can be dangerous if not understood properly. This post will explain what letters of credit are, delve into specifics on potential complications, and provide advice to avoid risks when using them for international transactions.
A Cautionary Letter of Credit Tale
I got a call the other day from a large Spanish company referred to us by their domestic Spain attorney. Seems this company had done a large international deal via a letter of credit, and they had not gotten paid. They were looking for our assistance and though we were eventually able to get them paid, it was actually due to the honesty of the foreign company, not to the letter of credit, which had been done all wrong and which almost certainly would not have given them any recourse at all.
Letter of Credit Risks and Misconceptions
Letters of credit rank low on my list of favorite subjects. They are intricate, and their complexity often goes unnoticed, making them a trap for the unwary.
Another Real-World Letter of Credit Example
Just by way of an example. I have a very honest friend/client who when he first came to the United States, worked with a less than reputable Russian company. This Russian company once gave a letter of credit to a product supplier and then after receiving perfectly fine product, blocked the release of the letter of credit because one number on the letter of credit differed from the number on the invoice with which it was supposed to correspond. My friend attended the bank meeting at which his company refused to release the funds based on this technicality and he loves telling this story for two reasons. One, he decided then and there to quit the Russian company because it was so unethical and two, he refuses to do business by letter of credit.
The Complexities and Potential Pitfalls
It amazes me how many people think they understand letters of credit when they actually have no clue. We direct all letter of credit issues through one international attorney in our law firm, as he’s the only one who truly grasps them. And trust me when I tell you that most attorneys do not understand international letters of credit, and far too many of them think that they do when they don’t!
Letters of credit have many technicalities that can trip up unwary users. The below are but some examples of complications that can arise with them:
- The beneficiary fails to submit the exact documents required by the letter of credit. Even a minor discrepancy can lead to non-payment.
- The issuing bank decides to refuse payment by alleging discrepancies even if none exist. This is common with Chinese banks.
- Fraudulent or altered letters of credit are presented, rendering them invalid.
- The bank revokes or modifies the letter of credit before the beneficiary can claim payment.
- Political/government actions prevent payment, even if the letter of credit terms are met.
- The issuing bank refuses to honor the letter of credit due to real or fabricated insolvency concerns.
Letter of Credit Basics
Here are the extreme basics on international letters of credit, which should constitute just enough to convince you that unless you really know what you are doing with these or unless you retain someone who does, they have the potential to be more dangerous than helpful.
1. There are primarily two types of letters of credit. An irrevocable letter of credit and a revocable letter of credit. The big difference between the two is that a revocable letter of credit can be modified pretty much at the will of either party. In other words, your counterparty can usually modify these so that you do NOT get paid. Did you know that?
2. There are fake letters of credit out there and those are of no value at all. If you are going to sell based on a letter of credit, at least make sure it really does come from a reputable bank. Have you been doing that?
3. Many China bank letters of credit have been faked.
4. China banks are usually in cahoots with the Chinese company, and they are notorious for coming up with valid and invalid reasons for not paying on a letter of credit.
5. Read the terms of the letter of credit and make sure you will be able to do everything necessary to comply with them. Did I say EVERYTHING?
How to Avoid Letter of Credit Pitfalls
When using letters of credit, be sure to take these steps to minimize risks:
- Carefully vet the issuing bank and confirm the legitimacy of the letter of credit.
- Review all requirements thoroughly and prepare the exact documents needed.
- Arrange for documents to be presented for payment quickly.
- Consult legal counsel to draft or review letter of credit terms.
- Diversify risk across multiple banks/sources of payment.
- Have a plan B payment option just in case the letter of credit fails.
Letters of credit obviously have their place in international transactions, and they make a lot of sense under certain circumstances. Letters of credit can facilitate international transactions, but they come with complexities. Use them with caution.
