ADVANTAGES, DISADVANTAGES AND THE RISKS OF PAYMENTS MADE BY DOCUMENTARY LETTER OF CREDIT

International trade is no longer only for the big corporate giants. As the global economy continues to evolve, an increasing number of small, family run businesses are beginning to do business in the international market place. One of the most crucial details of trading, particularly in the international area, is effecting payment. Letters of credit have been the preferred method of payment in international trade transactions for centuriessince their inception in 1645. It is likely that they will continue to be needed for the foreseeable future. The purpose of this research is to provide information regarding the pros and cons as well as the risk when it comes to using letters of credit.

FOREIGN TRADE UNIVERSITY ENGLISH FOR SPECIFIC PURPOSES

ADVANTAGES, DISADVANTAGES AND THE RISKS OF PAYMENTS MADE BY DOCUMENTARY LETTER OF CREDIT

Group 18

Nguyen Trang Linh : 1411110374

Instructor: Mrs Phan Kim Thoa

Hanoi, March 2017

Abstract 3

Introduction 4

Background 5

I Procedure involved in a letter of credit cycle 7

1 Parties to a letter of credit 7

2 Procedure involves in a letter of credit 7

II Advantages and disadvantages of payments made by Letter of Credit 10

1 To the Importer: 10

2 To the exporter: 11

III Risks analysis 14

1 Exporters’ risks 14

2 Importer’s risks 18

Conclustions and future study 23

References 24

International trade is no longer only for the big corporate giants As the globaleconomy continues to evolve, an increasing number of small, family run businessesare beginning to do business in the international market place One of the mostcrucial details of trading, particularly in the international area, is effecting payment.Letters of credit have been the preferred method of payment in international tradetransactions for centuries-since their inception in 1645 It is likely that they willcontinue to be needed for the foreseeable future The purpose of this research is toprovide information regarding the pros and cons as well as the risk when it comes

to using letters of credit

As the payment instrument, letter of credit has become widely used in internationaltrade Letter of credit is even described as” the life-blood of international commerce”.Letter of credit takes care of the interests of both the exporter and importer, so it isconsidered to be the most effective and safest method to secure the payment ininternational trade transaction However, each letters of credit party still bears someamount of risk in the real practice The problem will be discussed under three chapters:Procedure involved in a letter of credit cycle; the advantages and disadvantages ofusing letter of credit to the exporter and to the importer and risks analysis Chapter 1will focus on providing some basic knowledge about the commonly used internationalpayment method- letter of credit Chapter 1 also gives a detailed description of stepsinvolved in using a letter of credit Chapter 2 discusses the advantages anddisadvantages of payment made by documentary letter of credit A letter of creditenjoys various advantages by being highly customizable and reducing credit risks butalso brings some disadvantages with additional cost to international trade transactions.Chapter 3 focuses on analyzing the risks The main parties, which involve in theprocess of letters of credit, are exporter, importer, and banks The same as anypayment pattern, all of these parties bear different risks These risks are going to beanalyzed based on the two principles of credit The research paper will also give somereal cases to dive deeper into the risks analysis

2 Importer A person, company, etc that buys goods from another

country in order to sell them in their own country

3 Exporter A person, company or country that sells goods to another

country

4 Issueing Bank The bank which prepares the credit in accordance with the

applicant’s instructions and issues it addressed to the beneficiary

5 Advising Bank The bank selected by the issuing bank to authenticate the

credit and advice it to the beneficiary

6 Applicant The importer (buyer) who submits an application for the

opening of a credit and who stipulates its term and documentary requirements

7 Beneficiary The exporter (seller) to whom the credit is addressed and

to whom the issuing bank gives its irrevocable undertaking

8 Flexible clauses The clauses that can control the beneficiary, and can be

revocable in any time They can damage the benefit of exporter a lot and exporter should try to avoid these clauses

9 Free on Board

(FOB) One of the incoterms of international trade FOB is ‘free on board’ (…named port of shipment).’free on board’

means that the exporter fulfills his obligation to deliver when the goods have passed over the ship’s rail ant the named port of shipment This means that the importer has

to bear all costs and risks of loss of or damage to the goods from that point The FOB term requires the seller toclear the goods for export This term can only be used for sea or inland waterway transport

10 Cost & Freight

(CFR) Also one of the incoterms of international trade CFR is ‘cost and freight’ (…named port of destination).’cost and

freight’ means that the exporter must pay the costs and freight necessary to bring the goods to the named port of destination but the risk of loss of damage to the goods, as well as any additional costs due to events occurring after the time the goods have been delivered on board the vessel, is transferred from the exporter to the importer when the goods pass the ship’s rail in the port of shipment The CFR term requires the seller to clear the goods for export This term can only be used for sea and inland waterway transport

11 “All risks” term The term stands for a relatively broad form of insurance It

covers property damage and, depending on the wording, the business interruption loss caused by property damage, irrespective of its cause The scope of cover is defined by the exclusions, these being indispensable in order to guarantee the risks’ insurability Thrsten Steinmann,

‘exposure (property & engineering)’, issue NO.8, February, 2002 Those risks related to two (or more) belligerents engaging in hostilities, whether or not there has been a formal declaration of war Such risks are excluded by the F.C & S.(free of capture and seizure) warranty, but may be covered by a separate war risk policy, at an additional premium

12 A bill of lading

(BL) A document which is issued by the transportation carrier to the shipper acknowledging that they have received the

shipment of goods and that they have been placed on board a particular vessel which is bound for a particular destination and states the terms in which these goods received are to be carried

I Procedure involved in a letter of credit cycle.

A letters of credit is a financial instrument issued by a bank or other intermediarywhich guarantees payment to a third party, the bank is referred to as the issuer Thebank’s customer is referred to as the account party and the third’s party is thebeneficiary In effect, the letters of credit substitutes the bank’s credit for itscustomer’s credit so that the risk to the seller is virtually eliminated The seller drawseither sight or time drafts against the letter upon presenting the bank with appropriatedocuments indicating compliance with the letter’s stipulated requirements The bank isrepaid the purchase price plus interest and fees when the buyer pays or takes out a loanwhich is often secured by the goods being purchased

From a legal standpoint, a letter of credit has legal life that is entirely independent ofthe transaction between the account party and the beneficiary it supports According tothis independence principle, the bank’s obligation to pay under the credit isconditioned only upon the presentation of the proper documents and not upon whetherthe account party is satisfied with the transaction Actually, there are three separatecontracts involved with each transaction First, there is the contract between theaccount party and the beneficiary Secondly, there is a contract between the accountparty and the bank Finally, a contract exits between the bank and the beneficiary

1 Parties to a letter of credit

Applicant

Issuing bank

Advising bank

Beneficiary

2 Procedure involves in a letter of credit

1 After signing the contract, it is up to the buyer to take the first step by applying to their bank ( the bank referred to as the issuing bank in terms of payment) to issue the agreed L/C

2 The issuing bank must progress a formal credit approval of the application and check that local permissions, import licences or currency approvals, if

needed, have been granted When all formalities and procedures have been dealt with, the L/C is issued as stipulated in the terms of payment, and forwarded to the selected advising bank.

3 Upon arrival of the L/C from the issuing bank- by letter, fax or mostly nowadays as a SWIFT message- the advising bank will assess its contents and determine where it should be made payable If the advising bank is instructed to add its confirmation, this involves a separate credit decision in this bank, after which the seller is notified of the L/C and its details,

including information about where it is to be honoured for payment

acceptance or deferred payment, and whether it has been confirmed by the advising bank

At this point, it is vital that the seller checks the terms of the L/C against the agreed terms of payment to make sure that all the details and instructions can be met a later stage when the documents are to be produced and

delivered If not, the seller must immediately communicate directly with the buyer so that the necessary amendments are made and confirmed to the seller through the banks Only then does the seller have the security on which the whole transaction is based

4 After shipment, the seller receives the transport documents and prepares the other documents required Checks are also made to ensure that they conform

to the terms of the L/C, but equally important, that the contents of the

documents presented are consistent between themselves

The documents are then forwarded to the advising bank, which checks their conformity with the terms of the L/C The seller is contacted about any discrepancies Discrepancies that cannot be corrected at this late stage, for example wrong shipping details or late presentation, will be subject to later approval by the buyer, and any payment made by the advising bank will then be with recourse, subject to this approval

5 The issuing bank will also check the documents and the buyer has to

consider any discrepancies When approved, or if the documents are

compliant, the buyer has to pay If not approved, the documents will be held

at the disposal of the advising bank, pending any new negotiation between

the buyer and the seller of the terms for such an approval, or ultimately

returned to the advising bank and the seller against repayment of any earlier payment made with recourse to the seller

6 The documents are released to the buyer against payment at sight or at any date as stipulated in the L/C

II Advantages and disadvantages of payments made by Documentary Letter

of Credit.

A letter of credit enjoys various advantages by being highly customizable and reducingcredit risks but also brings some disadvantages with additional cost to internationaltrade transactions

1 To the Importer:

a Advantages:

 Time-saving: The buyer can control the time period for shipping of the goods

He can also minimize time, as bank acts on behalf of him The terms of a letter

of credit can specify that fax presentments are allowed and that the draw must

be honored (or notice of dishonor given) within a few days or less Unlike othershipments, a shipment under Letter of credit is treated with most care to meet delivery schedule and other required parameters by the exporter The

documents receive by buyer promptly and quickly with complete sets Unless meeting delivery schedule and prompt documentation, the supplier does not get his payment from opening bank This is one of the major advantages of LC for

advantage for the buyer on fulfillment of meeting commitments on shipments

 Efficiency: An importer/buyer is concerned; he can plan his payment schedule

properly by anticipating the requirements under letter of credit This

arrangement makes importer for easier planning Based on timely delivery schedule, buyer receives goods on time thereby he can execute his business plansmoothly and efficiently, in turn satisfying his clients promptly and effectively

b Disadvantages:

 Strict compliance: One of the major disadvantages of letter of credit is that LC

is operated on the basis of documentation and not on the basis of physical verification of goods on its quality, quantity or other parameters In other words, an LC issuing bank can effect payment to beneficiary of LC on the basis

of documentation produced as per the terms and conditions of letter of credit The parties under letter of credit do not have any right to physically verify the contents of goods So, if the buyer needs to confirm and satisfy on the quality ofgoods he buys, he can appoint an inspection agency of international repute and instruct exporter to enclose certificate of such inspection by mentioning a condition in letter of credit

Once opened a confirmed and irrevocable letter of credit, the importer/buyer already tied up with the said business credit line and will not be able to change

in between Due to various reasons, especially on selling price variation, if buyer needs to stop his export order he is unable to do so

 Cost: Compared to other payment mode of transactions, cost of operating letter

of credit procedures and formalities are more expensive Eventually, there may

be additional expenses to an importer especially on amendment, negotiation etc

2 To the exporter:

a Advatages

 Security: The major advantage of Letter of credit to a supplier is minimizing of

credit risk In an import and export trade, the geographical distance between importer and exporter is very far; hence ascertaining credit worthiness of buyer

is a major threat In a mode of Letter of credit, such risk can be avoided

Buyer is unable to deny payment by raising dispute on quality of goods, as letter of credit terms and conditions are based on documentation This is a major advantage of Letter of Credit in terms of seller point of view Some of thefraudulent buyers deliberately delays or hold payments by complaining on quality of goods In a letter of credit terms of business transactions, rejection of export payment by raising complaint on quality of goods will not be effected Another thing that makes letter of credit add security to the exporter is

demonstrated when disagreement occurs In the case of dispute between the

trading partners, the exporter can withdraw the fund as agreed upon in the letter

of credit and resolves the disputes later in the court The beneficiary’s right to the full amount is described in the phrase “pay now, litigate later” by the courts

 Efficiency: LC provides a security to exporter which is another advantage of a

letter of credit Based on such security, the exporter can preplan his further business activities to strengthen his business world

Assurance to receive money in full and on time is another advantage of letter of credit In a letter of credit, an exporter can ensure that he receives full amount

as per LC which helps seller to plan future business ideas As you know,

‘finance at right time’ is a prime factor for any business transaction So if a business man receives his anticipated amount on time, he can plan his business activities smoothly without wasting time

Meeting delivery schedule by proper production plan is one of the major

advantages under a letter of credit terms of business Normally, under a non LC business terms, the buyer may keeps on changing delivery schedule as per their requirements time to time So this change of delivery schedule at importer’s interest leads exporter to rearrange his overall daily business activities

Moreover, in a letter of credit, any dispute in transaction can be settled easily,

as LC terms and conditions are under the guidelines of uniform customs and practice of documentary credit This is another advantageous to an exporter.Normally and widely, a confirmed irrevocable LC is opened by buyer and sellerwhich is suitable for both A ‘confirmed irrevocable letter of credit’ is a

‘confirmed order’ for any exporter is concerned So the exporter does not need

to worry on cancellation of his export order or changes in said order This helps

a lot for an exporter for his business plans in various levels including financial plans, minimizing production risk, saving time etc

 Time-saving: In a letter of credit, all required documents have been mentioned

well in advance of shipment and there is no confusion or misunderstanding to the importer (buyer) to inform supplier to act in between This is a good

advantage for a supplier to preplan efficiently which saves time