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Letters of credit - doing business in a global market.

A vital link in the chain of international commerce

Doing business abroad is difficult enough without having to deal with how to pay for merchandise and services. The author tells us about a variety of letters of credit and how each is used in international business.

The expansion of international trade over the years has involved increasing numbers of diverse languages, customs, and credit procedures. The letter of credit (L/C) is designed to act as a protective and simplifying device for facilitating trade and the process of paying for goods and services. Domestically, as well, whenever a company needs the special protection that L/Cs provide, these instruments can be equally useful.

A standard, negotiable, irrevocable, import L/C - as illustrated in the exhibit - by definition, is a written undertaking issued by a bank, acting at the request and on instructions of its customer (the applicant for the credit, account party, or buyer), in which the bank obligates itself to -

* make payment to the beneficiary (seller of goods or services) up to an amount stated in the L/C,

* within a prescribed time frame, and

* upon presentation of documents, (e.g., commercial invoice, bill of lading, inspection certificate, visa documentation, etc.) by the beneficiary that conform to terms and conditions set by the buyer, expressed in the L/C.

In issuing the L/C, the buyer's bank substitutes its credit standing for that of the buyer. The seller is then assured of receiving payment when it presents documents that comply with the terms and conditions of the L/C, independent of the ability or willingness of the buyer to pay.

In order to facilitate international transactions, besides the standard L/C the following variations are available:

* Revolving letter of credit

* Deferred payment letter of credit

* Transferable letter of credit

* Back-to-back letter of credit

* Red clause letter of credit

* Standby letter of credit

In discussing each of the above in the following paragraphs, examples are structured around Coleman, USA, a U.S. purchaser of manufactured goods; World Trading, the foreign agent for the U.S. purchaser (the agent often makes arrangements on behalf of the purchaser with foreign manufacturers); and Century Mfg., the foreign manufacturer. The banks servicing the three parties are Buyer Bank (Coleman's bank), Middle Bank (World Trading's bank), and Seller Bank (Century's bank).

Revolving Letter of Credit

When a buyer and seller operate under an arrangement for goods to be shipped on a continuing basis over a stipulated period, it may be desirable to establish a single or revolving L/C to handle the shipments as they occur, rather than an individual L/C for each shipment. The credit will contain instructions allowing the beneficiary to draw designated amounts over specified periods and may also restrict the amount available for each shipment or control the frequency of shipments during a specified period. Revolving L/Cs are either cumulative or noncumulative. The difference lies in the amounts available for draw against the L/C during a specified time period.

To illustrate a revolving L/C, Coleman USA, seeks to purchase trousers from Century Mfg. and arranges for delivery of the trousers over a five-month period. Coleman also arranges with Buyer Bank to open a revolving L/C for the purchase of all the trousers. The L/C allows Century Mfg., upon supplying the documentation set forth in the L/C, to draw down funds as deliveries are made.

Deferred Payment Letters of Credit

A deferred payment L/C is normally used by the buyer to obtain extended payment terms from the seller for a period usually beyond six months after delivery, while giving the seller the flexibility of obtaining funds sooner. Under this type of L/C the selling exporter, after shipment, presents complying documents to the buyer's bank, which acknowledge that delivery of the goods has taken place. The actual draw-down, however, cannot occur for six months or some other designated period. If the seller requires interim financing, the seller can use the paying bank's promise of future payment to obtain credit from its own bank. The seller will be unable to discount the draft to obtain financing, however, as in the case of a banker's acceptance. A deferred payment L/C results in the issuance of a sight draft, which cannot be sold or discounted. For incurring this liability, the seller's bank assesses a deferred payment commission, usually a fee similar to its regular acceptance commission.

In our example, if the L/C called for deferred payment, Century Mfg., the seller would not be able to draw down the proceeds from Coleman USA's L/C for a defined period of time - say six months after shipment - but would instead use the Coleman USA L/C, issued by Buyer Bank, as collateral to borrow interim funds from Seller Bank, its own bank, to finance the transaction.

Transferable Letter of Credit

When an L/C is designated as transferable, the beneficiary may request that the paying bank transfer all or part of the credit due to one or more transferees (third parties) up to the total value of the original L/C. The respective rights under the credit are passed to the transferee who must comply with the terms and conditions of the transferred credit in order to receive payment. A transferable L/C is often used when the beneficiary is not the ultimate supplier of merchandise but the middleperson between the supplier and a buyer. For credit to be transferable, the beneficiary must arrange for the buyer to have a credit opened expressly stipulating that it is transferable. Additionally, before any transfer can be made, the beneficiary must send a written request to the transferring bank to effect such a transfer. The transferring bank, however, is under no obligation to execute the transfer until it is paid for its services. Although the terms and conditions of the transferred credits can be no greater than the original credit, the dates should be prior to and amounts less than the date and amount of the original credit - creating a hedge - the date and amount of the original credit.

In our example, Coleman U.S.A. seeks to purchase men's trousers from Century Mfg. To complete this transaction, Coleman U.S.A. can open a transferable letter of credit for $10,000 in favor of World Trading, the foreign importing agent who acts as a middle person between Coleman U.S.A. and Century Mfg. World Trading, upon receipt of the L/C, transfers all of its rights under the L/C to Century Mfg., who will complete the transaction.

Back-to-Back Letters of Credit

The beneficiary (the seller or middle person in a purchase transaction) of an irrevocable L/C occasionally wants to use the L/C as a form of credit support for having its bank open a companion irrevocable L/C in favor of the manufacturer or supplier of the goods being purchased under the first credit. Back-to-back credits are usually requested by middle persons who do not have sufficient credit available at their banks to open their own L/Cs to the ultimate suppliers. Under a back-to-back L/C the middle person will ask a bank to issue a second L/C in favor of the ultimate supplier, while using the L/C issued by the buyer as collateral. When one L/C is used as security to obtain the issuance of a second L/C covering the same transaction, and when all terms and conditions of both credits are identical, except for amounts and dates in the second L/C which must be smaller and earlier, the arrangement is defined as a back-to-back L/C.

There are inherent risks associated with every back-to-back credit arrangement since performance under the original L/C is contingent upon timely and perfect execution of the second L/C. For this reason, banks generally are averse to issuing back-to-back L/Cs.

The parties involved in the transferable L/C example could have arranged the transaction on a back-to-back basis. In this case, Coleman's bank (Buyer Bank) would issue an L/C to World Trading Company for $10,000. World would take the L/C to its bank (Middle Bank) and use it as collateral to obtain a smaller, say $8,000, L/C in favor of Century Manufacturing Company, due earlier than the Coleman L/C and, in this case, with a comfort level or hedge of $2,000.

Assignment of Proceeds

A beneficiary may wish to instruct the paying bank to pay an assignee (third party) all or part of the proceeds available under the credit. An assignment of proceeds should not be confused with a transferable credit despite this apparent initial similarity. For an L/C to be transferable, it must clearly state that it is transferable - no other terminology is acceptable. The fact that a credit is not transferable, however, does not affect the beneficiary's right to assign proceeds to another party. As with a transferable L/C, under an assignment of proceeds, the beneficiary of an L/C can assign all or part of the proceeds of the credit to the assignee. Under an assignable L/C, however, unlike under a transferable L/C, the beneficiary maintains its rights under the credit and is solely responsible for complying with its terms and conditions. The assignee has no rights under the credit and is dependent on the beneficiary for compliance with the credit. Thus, for an assignment of proceeds to have monetary value to third parties, the beneficiary must perform as required. An assignment of proceeds arrangement is therefore much more risky for the assignee than a transferable credit since payment to the assignee must depend on the beneficiary to fulfill the terms and conditions of the credit.

Continuing with the prior example, under an assignment of proceeds arrangement, Coleman, USA would have Buyer Bank issue the L/C to World Trading for $10,000. World Trading assigns the proceeds to Century, Mfg., the manufacturer. Century Mfg's. position is not as secure as it would be under a transferable letter of credit. Century Mfg's. ability to receive the proceeds under the assignment of up to $10,000 is tied to World Trading's ability to perform as specified in the original L/C.

Red Clause Letter of Credit

A beneficiary may require financing in order to complete the manufacture or purchase of merchandise to be sold. A red clause L/C (use of the term "red" is derived from the traditional practice of writing the clause identifying this option in red ink) helps the beneficiary achieve this. Upon instruction from the buyer, the issuing bank authorizes the confirming bank to make a cash advance to the beneficiary against the beneficiary's written guarantee that the documents evidencing shipment will be presented in compliance with the credit terms. A red clause L/C allows the beneficiary, to obtain an advance of part or all of the amount of the credit depending on what the L/C permits. Subsequently, when documents called for under the L/C are finally presented by the beneficiary, the paying bank effects payment to the beneficiary for the amount specified on the documents less the amount of the prior advance and less any interest charges due on the advance. Should the beneficiary fail to ship the goods or meet the credit requirements, the paying bank looks to the issuing bank to obtain reimbursement of the amount of the advance plus the interest charges on the advance. The issuing bank then charges the account of the buyer - who may or may not have received the goods.

Payment of the beneficiary's drafts is always restricted to a specific overseas bank. In our example, the overseas bank would be Middle Bank, the bank of the agent, World Trading. It should be noted that a red clause L/C is usually issued only under very limited circumstances.

Continuing our example, Coleman might instruct its U.S. bank to authorize a bank operating in the foreign market to advance $4,000 to Century Mfg. against the purchase of the trousers. Century Mfg. would warrant to the local bank, probably Seller Bank, that it will comply with the terms of the original L/C totaling $10,000. When the transaction is completed, Seller Bank is instructed by Buyer Bank to pay the $6,000 due, $10,000 due under the original L/C less the $4,000 previously advanced. If Century Mfg. does not comply with the requirements under the terms of the original L/C, Century Mfg's. bank, Seller Bank will request that Coleman USA's bank, Buyer Bank, reimburse it for the value of the original $4,000 advance. At this point Buyer Bank would charge Coleman USA's account for the $4,000 advance made to the seller, but for which no merchandise had been received.

Standby Letter Of Credit

Standby L/Cs differ from commercial L/Cs; they do not usually cover shipments of goods, but more often services or performance. The standby L/C is not secured by underlying merchandise as is usually the case with conventional L/Cs. In this respect, the standby L/C is much like an unsecured loan and requires careful advance scrutiny by the issuing bank.

If the buyer performs his or her obligation, there will be no need for the beneficiary to draw against the standby letter of credit which supports the obligation. Standby letters of credit are commonly used to -

* assure the refund of advance payments;

* support the obligation of a successful-bidder to accept a contract and to perform under the terms of the contract (i.e., in lieu of bid or performance bond);

* back up bonds issued by insurance companies; and

* stand behind a monetary obligation under a promissory note or another like commitment (rental payments, etc.).

Standby L/Cs are similar to the other types of L/Cs discussed in that they represent the irrevocable obligation of the issuing bank to make payment to the beneficiary upon presentation of the required documents - usually a sight draft and a statement that the purchaser has failed to uphold its obligations to the beneficiary. As with all L/Cs, banks deal in documents only, and must effect payment if the documents presented comply on their face with the terms of the standby L/C as issued. The bank, as usual, looks to their customer (the purchaser) for reimbursement.

For example, Coleman USA instructs its bank to issue a standby letter of credit of $10,000 to Century Mfg., the seller. In this case, there is no middle person involved in the L/C arrangements. The L/C at this point acts as collateral to guaranty that the amounts due will be paid by Coleman USA to Century Mfg. when due. If Coleman USA defaults, then Century Mfg. can prevail upon Buyer Bank to pay the $10,000 due under the terms of the original transaction.

It is very apparent that the complexities surrounding alternative types of letters of credit be understood so that their benefits can be linked effectively for doing business in a global market.

Ira Weissman; CPA, is a management consultant to the apparel industry, an instructor at Dauberman Chaykin and Fox Gearty CPA review programs, and an adjunct professor at Baruch College of the City University of New York and Rutgers University.
COPYRIGHT 1996 New York State Society of Certified Public Accountants
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Author:Weissman, Ira
Publication:The CPA Journal
Date:Jan 1, 1996
Words:2561
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