Companies that only do three or four international sales a month are often not aware of the various payment mechanisms that are available to them.
“They may not focus on the risks that come with international transactions and how banks can help mitigate those risks,” says Ken Rosenberg, senior vice president and group manager for the International Banking Division at Bridge Bank.
Smart Business spoke with Rosenberg about letters of credit and the value they can provide in protecting companies engaged in international commerce.
What is an example of the risk businesses face doing business overseas?
Businesses may not have in-depth knowledge of their counterpart’s business, history and credit standing or know the legal environment in which it operates. So there might be a risk of a customer being unable to pay or capital being locked up or frozen by a foreign government.
The worst-case scenario is your goods arrive in a foreign country and the buyer is either unable or unwilling to pay for them. The seller then owns goods that are sitting in a foreign country and has to either be able to resell them or bring them back.
How can a business protect itself?
A letter of credit provides value to both the buyer and the seller. It is a foreign bank substituting its credit quality for that of the buyer. The foreign bank issues the letter of credit and in doing so, promises to pay the supplier as long as the supplier delivers documents proving delivery of goods or services. Presumably, the letter of credit comes through the seller’s bank, but it could also be advised through a different bank. In most cases, the seller wants that letter of credit coming through someone it knows.
The letter of credit provides security for the seller by guaranteeing payment upon delivery of goods or services. For the buyer, the letter of credit means that a payment is only being made when verification has been received that the goods or services have been shipped or delivered.
The letter of credit can also address country risk. When the domestic bank confirms the obligation to pay on that letter of credit, you now are taking U.S. risk rather than foreign country risk.
What is involved in getting a letter of credit?
The issuance is going to be based on the credit available to the applicant or the buyer. It can range all the way from a client that has an unsecured line of credit with a sublimit for issuance of letters of credit to a situation where the client provides the cash in advance for the bank to hold. It just depends on the relationship between the bank and the customer.
There are typically minimums for issuing and negotiating letters of credit. If you are below a few thousand dollars, the cost of using a letter of credit becomes a significant part of the value of the transaction. Once you get above a few thousand dollars, the costs are very minimal.
Is a letter of credit the same as a contract?
The letter of credit is simply a method of making payment. There has to be a contract or purchase order negotiated between the buyer and the seller that calls for the letter of credit as the method of payment. It is a contractual obligation for the bank to pay upon presentation of documents, but it is not the contract between the buyer and seller.
Exporters must be very careful about their ability to perform against the letter of credit. When they get a letter of credit issued in their favor, they really need to be certain that they can deliver the documents that it calls for including the invoice, bill of lading, insurance certificate and others that may be required by the buyer. Some of these documents may have to be obtained by a third party depending on shipping arrangements or other factors. Their bank’s trade finance specialists can guide them through the process and advise them on best practices.
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