Understanding Letters of Credit
Avoiding Pitfalls in International Transactions
Letters of credit are complex financial tools that can be risky if not properly understood. This post will explain what letters of credit are, delve into potential complications, and provide advice to avoid risks when using them for international transactions.
A Cautionary Letter of Credit Tale
Recently, a large Spanish company contacted us through their domestic attorney. The company had completed a significant international deal using a letter of credit but had not been paid. Although we eventually secured payment, it was due to the honesty of the foreign company, not the letter of credit, which had been done incorrectly and almost left them without recourse.
Letter of Credit Risks and Misconceptions
Letters of credit rank low on my list of favorite subjects due to their intricacy and the frequent misunderstandings surrounding them. Here are some common misconceptions and risks:
- Document Discrepancies: Even minor discrepancies in the documents submitted can lead to non-payment.
- Issuing Bank Refusal: Some banks, particularly in countries like China, refuse payment by alleging discrepancies, real or fabricated.
- Fraudulent Letters: Fake letters of credit can be issued, rendering them worthless.
- Bank Insolvency: Banks may refuse to honor letters of credit due to insolvency concerns, whether real or fabricated.
- Political Actions: Government actions can prevent payment, even if the terms are met.
Letter of Credit Basics
Here are the basic types of letters of credit and some critical points to consider:
1. Types of Letters of Credit
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- Irrevocable Letters of Credit. Cannot be modified or canceled without the consent of all parties involved.
- Revocable Letters of Credit. Can be modified or canceled by either party, which can be risky as it may leave you unpaid.
2. Ensuring Legitimacy
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- Always confirm that the letter of credit is issued by a reputable bank. Fake letters of credit are common, especially in some regions.
3. China-Specific Risks
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- Chinese banks are known for collaborating with local Chinese companies to find reasons not to pay. This risk is not unique to China, but serves as a strong example of why due diligence is essential.
4. Compliance with Terms.
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- Make sure you can comply with every term listed in the letter of credit. Any non-compliance can lead to non-payment.
How to Avoid Letter of Credit Pitfalls
To minimize risks when using letters of credit, follow these steps:
- Vet the Issuing Bank. Ensure the bank is reputable and the letter of credit is legitimate.
- Thoroughly Review Requirements. Prepare the exact documents needed.
- Prompt Document Presentation. Submit documents quickly to avoid delays.
- Consult Legal Counsel. Have a lawyer draft or review the letter of credit terms. Use a lawyer who truly understands letters of credit. Our law firm does huge amounts of international legal work, yet only one of our lawyers has truly mastered letters of credit. Most of our other international lawyers — myself included — are scared to death of them.
- Diversify Risk. Use multiple banks or payment sources to spread risk.
- Plan for Contingencies. Have a backup payment plan in case the letter of credit fails.
Letters of credit can facilitate international transactions, but they come with complexities. Use them with caution and always seek professional advice to ensure they are used effectively and safely.
