Letters of credit provide a useful way to manage international trade – see our guide to LCs here.
Letters of credit (“LCs”) often do not work out as planned, and this is usually because the documents provided in support of a claim under the letter of credit do not meet the conditions (and are “discrepant”).
Here is our guide to managing discrepancies – and how discrepant documents changes the responsibilities that the banks have in the process.
But, don’t worry. Whilst discrepancies can cause some delays and additional costs with letters of credit, it is rare that a transaction fails completely.
1. Why does PrimaDollar get involved in letters of credit?
PrimaDollar often arranges letters of credit so that buyers (importers) don’t have to.
We provide supply chain finance that offers financial support to suppliers (exporters) before shipment.
- Buyers, importing goods, usually prefer to work on Open Account and to have deferred payment (so they work on sale contract paying 60, 90 or 120 days after shipment). This allows the buyer to achieve positive cash flow by selling the goods before he has to pay for them.
- But, the supplier, exporting the goods, often needs to borrow upfront from his local bank to fund the purchase of materials and to pay wages.
- There is a cash flow gap between supplier and buyer which is solved by PrimaDollar:
- without requiring collateral, we arrange a letter of credit before shipment that pays at sight to the local bank;
- with the LC arranged, the supplier can then usually get pre-shipment finance from his local bank;
- when the LC settles (at sight) the pre-shipment finance gets repaid and
- PrimaDollar then funds the deferred payment on a non-recourse basis.
- The buyer and the supplier both get what they want; PrimaDollar takes care of the cash flow gap.
At PrimaDollar, we have a great deal of experience at managing trades through all aspects of the letter of credit process – and dealing with the typical issues that are set out in this post.
2. Letter of credit: a reminder on how it works
The letter of credit provides a way for a buyer (“Importer”) and a supplier (“Exporter”) to trade safely with each other, even if they are in distant places and do not know each other very well.
As you can imagine, shipping valuable goods in advance of payment is uncomfortable for the Exporter. How do they know that they will get paid?
On the other hand, paying upfront and before shipment (also called “TT in advance”) can be just as uncomfortable for Importers. How do they know that the Exporter won’t run off with the cash?
Using a letter of credit means that both the shipping documents and the cash go through the banking system (bank-to-bank) and not between the Importer and Exporter directly. This makes the trade safer. Banks have been performing this role for centuries.
The LC solution:
The Importer’s bank (also called the “Issuing Bank”) knows the Importer and issues a letter of credit (a promise to pay money in the future) to the Exporter’s bank (also called the “Negotiating Bank”).
The promise to pay contained in the letter of credit is usually irrevocable and is conditional on (a) certain documents being provided and (b) certain dates being met.
With the letter of credit in hand, goods are shipped, documents are prepared and the Negotiating Bank then sends the documents to the Issuing Bank; if the conditions of the letter of credit are met, the Issuing Bank automatically pays the money as promised.
A key point is that the letter of credit will nearly always call for bills of lading in the list of documents that must be provided for the payment to be triggered. This means that the Exporter is physically shipping the goods before payment (since bills of lading are only available after the goods have been loaded onto the ship), but he can rely upon the guarantee of the Importer’s bank that payment will be made later via the letter of credit.
3. But what if the letter of credit conditions cannot be met
Letters of credit are only truly effective if the conditions (documents and timing) can be met by the Exporter and the Exporter’s bank.
- If the conditions are met, the documents (which the letter of credit will pay against) are referred to as “compliant”.
- If the conditions are not met, the guarantee of payment falls away (so the Issuing Bank will not pay automatically). In this situation, the documents are referred to as “discrepant”.
A discrepant letter of credit is not necessarily a disaster – in fact, it normally means only that there are some additional costs and potentially some delays whilst the situation is addressed.
In practice, the Exporter and the Importer (and the two banks involved) usually continue with their process. Goods are shipped, documents are collected, documents are presented – and the Issuing Bank (the Importers’ bank) will then delay payment and wait for an additional authorization from the Importer.
Importers do not often reject the documents and cancel the trade at this late stage (after shipment). If an Exporter knows that he will not meet the conditions of a letter of credit, he will typically discuss the situation with the Importer in advance and obtain an assurance that the Importer will accept the discrepancies and instruct his bank to pay for the documents once they are presented. Such a confirmation is not usually given in a legally-binding way – so the Exporter has to trust the Importer that he will not go back on his word.
So if the documents are discrepant, the letter of credit does not guarantee the payment. The Exporter has to ship the goods and trust that the Importer will pay later.
4. What is happening in practice?
With compliant documents:
- The Issuing Bank (on the Importer side of the letter of credit) is receiving the shipping documents and deciding whether to pay; he is working on behalf of the Importer. The instructions from the Importer are contained in the application for the letter of credit.
- Broadly, these instructions are: “please issue a payment guarantee on certain conditions and please pay out the guarantee automatically if the conditions are met.”
- Upon receipt of the documents, the Issuing Bank is working for the Importer to determine (in line with the given instructions) if the documents should be accepted and the payment should be made.
With discrepant documents:
- If the Issuing Bank decides that the documents are discrepant, the polarity (or direction) of the arrangements changes.
- The Issuing Bank is now no longer really working for the Importer – he is now responsible for the shipping documents to the Negotiating Bank (the Exporter’s bank) and will follow the Negotiating Bank’s instructions.
- Effectively, the letter of credit turns into a “documentary acceptance”. We have a post coming about documentary acceptance, which is also a service that PrimaDollar can arrange.
Unless there has been some instruction to the contrary, the Issuing Bank will (on behalf of the Negotiating Bank) automatically see if the Importer will still accept the documents, despite the discrepancies.
The process is typically as follows:
- The Issuing Bank will forward an analysis of the discrepancies to the Importer (the applicant on the letter of credit); there may be additional instructions received from the Negotiating Bank if a price change has been agreed between Importer and Exporter.
- The Issuing Bank will ask if the Importer accepts the discrepant documents and the terms proposed or rejects them.
- Various things can then happen:
- The discrepancies and terms proposed can be accepted as is. In which case, the Importer will sign a simple form to instruct the Issuing Bank to pay for the documents and release them to him.
- It may be that the Importer wants to make a counter-proposal and he may state further conditions. In this case the Issuing Bank will send a message to the Negotiating Bank asking if the proposed additional conditions can be accepted. If yes, the payment is made in line with the proposal and the documents are released to the Importer.
- If the Importer rejects the documents (or proposes conditions which are not accepted), then the Issuing Bank informs the Negotiating Bank and asks for instructions about what to do with the documents.
Reviewing the above mode of operation, it becomes clear how the emphasis of the process changes. If discrepant documents are presented, the Issuing Bank responsibility for the documents switches to the Negotiating Bank, and the Issuing Bank will take instructions from the Negotiating Bank about what he should do.
5. How often are letters of credit discrepant then?
This is quite hard to find out.
There are no published statistics that we can locate. However, we have heard from bankers (and also from the market generally) that probably around 80% of all letters of credit are thought to be discrepant on first presentation. This statistic probably includes the whole market and many different kinds of letter of credit.
But if we look at the specific situation of the export of manufactured goods, the discrepancy percentage may well be over 95%, although with variations by country and industry.
This is an extraordinary statistic. If letters of credit are so often discrepant, why do Exporters bother asking for them?
6. So, if they are nearly always discrepant, what are the benefits of letters of credit?
There is one main benefit to the Importer from using the letter of credit system:
- The Importer knows that no payment will be made if the conditions (set out in the letter of credit) are not met. The conditions are set in a way that gives the Importer the confidence that the goods involved have, indeed, been properly manufactured and also shipped.
There are three benefits to the Exporter from using the letter of credit system:
- The Exporter knows that, if he can meet the conditions specified, his bank (the Negotiating Bank) is guaranteed to receive the payment from the Importer’s bank (the Issuing Bank) – and the Importer cannot intervene to prevent this (the letter of credit is also usually stated to be “irrevocable” – which means it cannot be cancelled).
- Crucially, the original shipping documents are sent to the Issuing Bank (the Importer’s bank) and not to the Importer. This is very important to the Exporter. If the Importer were to receive the shipping documents, he would be able to take the goods (even if he had not paid for them). So routing the documents via the Importer’s bank means that there is a trusted third party holding the documents. If something goes wrong, and no payment is made, the Importer’s bank will return the documents to the Exporter’s bank, and will not hand them over. These are the rules.
- Also, experience shows that Importers who arrange letters of credit are much less likely to cancel trades. An Importer who arranges a letter of credit demonstrates a commitment to the trade, incurs costs, and accepts obligations (in front of his bank). As Exporters know very well, purchase orders can be cancelled and transactions aborted, even after goods have been made – and often Exporters (where there is no letter of credit in place) have little chance of getting compensation. This is also very important to the Exporter’s bank, who may provide pre-shipment credit to the Exporter to help with the cost of making the goods. Exporter banks strongly prefer to see letters of credit, because it gives them much greater confidence that the trade will happen and the Exporter will get paid.
If an Exporter has the benefit of a letter of credit that he knows will be discrepant later, then he still has benefits (2) and (3), even if the guarantee (1) falls away.
7. Why is it so hard to present compliant documents under letters of credit?
Many years ago, letters of credit were transmitted by telex and were simple. The conditions were kept to a minimum because each word had a cost.
Nowadays, letters of credit are sent by SWIFT, and many regular applicants (like PrimaDollar) have an electronic system provided by the bank. This means that the applicant can set lots of conditions. It is quite common for letters of credit to have 8 or 10 conditions, some of which may be very difficult for the Exporter to meet; there may even be conditions which are explicitly under the control of the Applicant.
A common reason for failing to meet conditions when manufactured goods are involved is late shipment – but mathematical errors, small differences between documents that should match, spelling mistakes – even sometime errors of punctuation – have been known to result in a letter of credit being treated as discrepant.
The more conditions there are, the harder it is to meet them all. One mistake is all it takes.
8. What can I expect if a letter of credit is discrepant?
There are three main issues involved in the management of discrepant letters of credit:
- Time: It can take some time for the two banks involved to exchange the various messages needed to agree the settlement, especially if the Importer and Exporter have not actually agreed.
- Costs: Both banks are doing more work, and this means that fees are incurred. Market practice has been to put these costs on to the Exporter, which is probably right. It is the Exporter that has failed to meet the letter of credit conditions (or agreed to proceed on the basis of a letter of credit with conditions that he cannot meet). The costs can be significant and the Exporter will therefore receive short payment at the end of the process.
- Disputes: If the Importer and Exporter cannot agree, then the documents can be rejected, and quite some time may pass. Time is the enemy in this situation, because the goods may well arrive at the destination port and significant storage costs can start accruing. Moreover, if the goods are freight collect, it may well be that the Exporter also has to pick up these costs as well as working out what to do with the failed shipment. All of this is a tragedy, which can be made worse if the communications are carried out via the two banks.
We can provide some simple advice; since nearly all letters of credit are discrepant in practice, this is the process that most trades should follow:
- Remember that the banks are there simply to handle communications. The two banks will not take any risks or make any decisions; they will not do anything until they are sure that both sides (Importer and Exporter) have agreed to proceed, and have agreed and confirmed the amount to be paid for the documents using the right paperwork. Even though one of the banks is called the “Negotiating Bank”, the banks do not “negotiate” in practice. It is the Importer and Exporter who have to sort it out and reach an agreement.
- As Importer, you want to get hold of the documents as quickly as you can to avoid demurrage costs at port. These are an avoidable expense that you will have to settle between yourself and your supplier (the Exporter) by set off or on other transactions. Discrepant documents are as much your problem as your supplier’s, in fact.
- As Exporter, you want to make sure that there are no delays in payment and no risk that the documents are rejected. Do not wait for the news that the documents are discrepant. Both you and your bankers will probably know this before the documents are sent. Approach the Importer and agree what will be done – and get your bank to send the documents with correct instructions upfront. This will save a lot of time, you will get paid earlier, and it should minimize additional costs.
9. Are there better alternatives to the letter of credit?
There are alternatives which are cheaper, quicker and simpler than the letter of credit and which provide, in practice, the same benefits:
- Both parties can agree to use “documentary acceptance” instead of the letter of credit.
- PrimaDollar offers and recommends this approach.
- Documentary acceptance costs less to arrange than a letter of credit because there is no payment guarantee but two of the three Exporter benefits are provided.
- Documentary acceptance is, basically, the same as a discrepant LC.
- Documentary acceptance is covered in another post (this will be posted to the website shortly).
- PrimaDollar has a new system, our “CAD Guarantee”.
- The CAD Guarantee is cheaper, quicker and simpler than the letter of credit.
- Our CAD Guarantee is now starting to be accepted by local banks in exporting countries.
- If you would like to know more, please contact us directly here.
Alternative solutions, such as our CAD Guarantee, can save the two trading parties (Importer and Exporter) $1,000 in costs for every $100,000 that is traded.
But letters of credit are certainly here to stay. Several centuries of culture, tradition and banking practice are invested in the letter of credit. LCs are well understood, if a little cumbersome and expensive at times. Letters of credit will continue to feature in international trade for many years to come.