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Commercial Letters of Credit – What They Are & Issues That May Arise


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Congratulations! A potential foreign customer for your small business has placed an order. You’re going global. That’s terrific!

But as good as it is, there are challenges with export orders that far surpass the challenges of domestic orders, such as export controls, customs documents, origin marking requirements, and payment challenges. How will your foreign customer pay you for your goods?

If they’re willing to pay in advance by wire transfer, that’s probably the best option for you since it’s almost immediate and could even be free. However, both your bank and your customer’s bank might charge a wire transfer fee, which could range from $20 up to $100, depending on your account and your bank’s expertise. If the order value is too low, it won’t be worth it.

Then, there are credit cards and debit cards. Payment solutions such as Visa, Mastercard, and PayPal are all great options, and they tend to charge a tiny percentage of the order value, but they have a different challenge: After you’ve accepted payment, the customer could conceivably claw it back, filing a claim against the order and demanding a refund through their credit card if they’re dissatisfied, depending on their card or bank’s policy.

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Both of these approaches assume the customer is willing to pay in advance. But what if they’re not? Many foreign customers will rightly think, “The vendor’s in a foreign country. If I pay upfront, what’s to guarantee that they’ll really ship the goods – and that the goods will be what I’m expecting to receive?”

You likely have a similar fear, such as “If I extend credit, then once I ship the goods to the customer, how do I know they’ll pay for them?” The larger the order, the more serious this challenge becomes.

When it comes to orders valued in the thousands of dollars, the banking community provides a solution for international orders with just this challenge: the commercial letter of credit, also known as the documentary letter of credit or LoC. (Not to be confused with products with very similar names that have nothing to do with payment vehicles, such as the Standby Letter of Credit, which is a performance guarantee.)

What Is a Commercial Letter of Credit?

On an international transaction, both the seller and buyer have valid concerns. If they’re cheated by someone in a foreign country, their own country’s legal system is extremely limited in its ability to help them get justice. So the banking community invented the LoC to enable a single moment of exchange in which the rights to the goods in question are transferred at the exact same moment the money is transferred. That provides the best possible protection for both parties – but only if both parties understand the process and do it right.

In an LoC, the buyer (known as the applicant) asks their bank to create a special account for the seller (known as the beneficiary) for a certain period, value, and set of conditions. The account is usually opened for the full value of the goods plus transportation costs, with a list of stipulations that, when met in full, allow the vendor to collect their money.

This list of requirements is often drawn up as a team effort between the customer and their customs broker, using the bank’s template as the base. The customer’s bank sends the list to a notifying bank in the seller’s country, and they negotiate to accept it as is or make changes. Once the requirements are accepted, the clock begins, and the seller gets to work on the order.

When this process works perfectly, the seller produces and ships the goods as agreed-upon, then works with their freight forwarder to produce all the documents required by the LoC, using the exact text the customer requires. The seller then directs their bank to present the document packet to the customer’s bank as provided for in the current version of the Uniform Customs and Practices (UCP) of the global banking industry.

Once the documents have been presented, the destination bank has to decide whether to accept them as compliant, accept them with discrepancy (mismatch) charges, or reject them outright and return them.

If the customer’s bank agrees that the document packet matches the expectations of the LoC, it accepts the documents and arranges payment. If the customer’s bank finds discrepancies, it gives the customer the choice of accepting them or rejecting them. If the customer rejects them, the bank returns the paperwork, and the seller can direct their carrier to turn the shipment around and return it.

The most the seller loses on the deal, in this case, is the round-trip transport cost and a few bank fees, but not the goods themselves.

What Can Go Wrong?

Before we dive into some of the specific issues that can arise, let’s begin by saying that misunderstandings about how LoCs work are at the root of most problems. Misunderstandings typically involve:

  • Protections. The LoC depends on two primary protections to be effective: the carrier’s hold and the customs hold. If done right, the customer must accept the document packet to obtain both a cargo release from the carrier and a customs clearance from the destination government. Unfortunately, customers often talk their vendors into waiving both of these protections in the interest of simplicity, leaving the vendor unprotected if the customer refuses the document packet.
  • Time. An LoC takes time – time to negotiate and time to arrange. Assume two to three weeks from the shipment date to the date when the customer’s bank can expect to receive the documents. That makes the LoC process ideal for long ocean shipments but dreadful for airfreight as you’re stuck with huge storage bills, plus the risk of theft or loss, with every day the cargo sits in a foreign airport.
  • People. An LoC requires the involvement of people in several categories, including purchasing, engineering, law, transportation, accounting, and logistics. For a small business, the same person may wear all of these hats, but your outside vendors – both suppliers and carriers – still play a role. A primary cause of LoC failure is the seller neglecting to involve all the people needed to determine when all the products can come together and be shipped. Accepting too early a deadline, out of eagerness for the sale or to please the customer, can lead to the need for extensions, possible concessions, and even the loss of the sale.
  • Compliance. Customers often put unnoticed or impossible requirements into an LoC, requiring text that’s banned by U.S. anti-boycott laws or even demanding shipment to or through illegal places. That’s true of any contract, but with so many more people involved in LoCs, there’s a higher chance than with other contracts that such violations will be caught and reported.

The commercial letter of credit is a wonderful tool and the only way for foreign companies without a credit relationship to safely do business together, but it requires extreme care at every level. That said, it’s great that you can sell something for $100,000 to someone halfway across the planet, and it’s worth the extra work and care that an LoC demands.

Here are the most common LoC issues that may arise, as well as what you can do to avoid them or mitigate them if they occur.

1. Discrepancies

Every export shipment requires international documentation: an invoice, a packing list, a bill of lading (B/L), and sometimes a certificate of origin. These documents must contain enough details to enable export clearance in the origin country and import clearance in the destination country.

An LoC adds certain requirements to these documents to ensure they meet the customer’s expectations. Any difference from these expectations is called a discrepancy. Discrepancies may include:

  • Description of the Goods. LoCs usually state how the goods must be described, along with their harmonized tariff codes, origin, quantities, and values. Discrepancies can be major, such as a difference in quantity or a completely different product, or minor, such as a different part number for the same product. You may know that the product is sold under two different part numbers, but the bank doesn’t, so you must ensure that the documents match the expectation.
  • Consistent Information. LoC documents are not all in the shipper’s control. The freight forwarder and the owner of the vessel shipping the goods create the bill of lading, and LoCs often require other documents that carriers, banks, suppliers, and even the local chamber of commerce must create. All such documents must match the same information and exact wording stipulated in the LoC, to the letter. For instance, if the LoC says to ship out of Houston, but your bill of lading says Galveston, you may know that’s the same general port area, but the bank doesn’t, so it will record the difference as a discrepancy and assume you’ve broken your promise.
  • Compliance Requirements. LoCs often include demanding requirements, some unavoidable and some inserted purposefully, that make full compliance – known as a “clean” letter of credit – difficult. They may demand a relatively new ship through a vessel age requirement or that goods ship on a vessel registered under the laws of a particular country, which reduces your shipping options and adds to your transportation cost. Every such requirement means that you must allow more time to ship because even if you have the goods available today, it could be a month or two before the right ship is available in this particular lane.

Differences from expectations on any of these will result in costly and potentially fatal discrepancies. Every mismatch could mean a banking fee of about $80 to $125, but more importantly, every mismatch means there’s a chance the customer will refuse the order, defeating the very purpose of an LoC as a safe and binding agreement.

2. Compliance Issues

Many freight forwarders boast that they’re diligent enough to ensure that your packet will always comply. That means they will change everything they need to in order to match the LoC and satisfy the destination banker.

The problem with this is that forwarders sometimes can’t tell the difference between a harmless change, such as writing “Long Beach” instead of “Los Angeles,” and an actual lie, such as claiming U.S. origin because the LoC demands it when you’re actually filling the order with a Canadian or Mexican product.

Yes, you need to comply with the LoC, but you must also comply with the law by always telling the truth. Never lie to satisfy an LoC.

3. Revocation

“Irrevocable” may be the most important word in this transaction. If your LoC isn’t irrevocable, the customer can simply tell their bank they’ve changed their mind and want the project closed, even after you’ve ordered your materials, begun production, and perhaps even shipped the goods.

Never accept a customer’s LoC unless it’s marked as irrevocable.

4. Customs Hold

In almost all countries, the ministry of customs will not allow an importer to pick up cargo until they’ve filed their import entry for it. Theoretically, the importer cannot do this until they receive the documents from the bank.

But this protection is undermined if the seller agrees to email, fax, or courier a set of copies to the importer in advance “just to be helpful.” Should this happen, the importer can clear the hold through customs without authorizing their bank to pay you.

To avoid this issue, do not provide the customer with any other sets of documents, even “non-negotiable” ones. Your goal should be to ensure that authorizing the customer’s bank to pay you is the one and only way for the customer to get the documents. Period.

5. Freight Hold

In almost all countries, an ocean carrier’s original bill of lading (OBL) constitutes the title to the goods, and the seller can sue the carrier if they release the goods to a customer who doesn’t possess that title-bearing document. The LoC should include this original document so that acceptance of the document packet truly constitutes a transfer in ownership of the goods.

A problem arises when some customers talk their vendors into using a “wire release” or an “express B/L,” thereby waiving or bypassing the title document completely. This eliminates your carrier’s ability to hold your cargo hostage until the customer pays you.

Without the requirement that a customer present the original document, which can only be obtained by authorizing the bank to pay you, a customer can just collect the cargo as soon as it clears customs.

In addition, note that this protection only exists for ocean cargo; there is no such thing as a bill of lading that conveys title in air, road, or rail shipments. You should, therefore, only use LoCs on ocean shipments.

6. Amendments

After you’ve completed the original negotiation on the LoC, there is always the possibility that you or the customer may want or need to change something, such as the shipment date, destination, or carrier. Remember that each amendment is a chance to not only make the changes you want but also for the customer to make changes you don’t want.

Amendments are a dangerous game. Make sure that you can always live without an amendment. If you ask for an amendment to push out the latest shipping date, for instance, your customer may make it conditional on a price cut by putting both in the same amendment.

7. Incoterms

The shipping terms most commonly used across the world today are those defined every 10 years by the International Chamber of Commerce (ICC). These Incoterms set forth which responsibilities are the obligation of the seller and are included in the total sale price.

LoC customers often want to buy on EXW or FCA terms, which means they use their own carrier. While this desire is understandable, it’s dangerous for the seller because you are now turning over your goods to a customer’s own carrier, often at your own door. If something should fall through, the carrier has a relationship with the customer, not with you.

While there are some exceptions, the best Incoterm for an LoC shipment, from the perspective of the seller, is almost always CIP, which allows the seller to select a forwarder with whom they have a relationship.

8. Bank Issues

An LoC’s purpose is to lift the burden of credit risk from the customer’s shoulders and place it on the shoulders of their bank. But in many cases, that’s not enough. What if the bank is iffy too? Or what if the bank is in a country with severe political risk, such as Venezuela?

Banks can offer a sort of insurance program, known as confirmation, in which they guarantee that a valid LoC will still be paid even if the destination bank improperly refuses or is banned by its government from honoring it. The cost of this protection varies from country to country, but for some banks and countries, it’s money well spent.

9. Anti-Boycott Issues

Since the mid-1970s, the U.S. government has forbidden participation in the Arab League’s boycott against Israel. While this is a broad set of regulations that could theoretically apply to any other boycott the U.S. disapproves of, the anti-Israel action is the one that appears the most and the only one the U.S. government heavily enforces.

Part of the reason for this is that it appears so often in LoC text. Customers or their forwarders may put it in, or customer’s banks may build boycott language directly into their templates so that customers don’t even realize they’re participating.

Part of your obligation as a seller is to have anti-boycott training; the U.S. government provides some for free. You can expect your freight forwarder and bank to help you with boycott language, but don’t count on them entirely. And even if you strike the clauses that need to be stricken, you may still have to file a quarterly report on the matter.

10. Export Controls

With whom can you do business legally?

You may like to think you can accept any order you want, but the U.S. government rightly restricts trade for national security and foreign policy reasons. Key export controls include:

  • Country Restrictions. You are generally forbidden from selling goods to or through North Korea, Cuba, Iran, and Syria. There are more limited bans with several other countries.
  • Party Restrictions. You are generally forbidden from doing business with anyone – such as terrorists, Mafiosi, drug cartels, and front companies – that appears on any of numerous lists published by our government and our allies’ governments. See OFAC’s Specially Designated Nationals list, for example. The sanctions against Russia that arose from Russia’s annexation of Crimea in 2014 added greatly to this complexity.
  • Product Restrictions. Without first obtaining federal government permission, you cannot share goods, money, technology, software, information, or many other commodities with certain otherwise-legal entities, depending on the countries involved if they are defined as being “export controlled” under the Export Administration Regulations or the International Traffic in Arms Regulations.

These rules aren’t solely applicable to a commercial letter of credit; they apply no matter how you accept payment. However, shipments with these issues often tend to be the type that need an LoC for other reasons. In an LoC, additional specific text is provided, additional transactional parties are named, and specific products are identified – all of which may increase the odds of an export control issue.

While you should obtain export control training from your freight forwarder anyway, when using LoCs as a payment vehicle, be sure to always include an export control check as part of the process. Every time there’s a new amendment, it’s an opportunity for the customer to announce another party or change the routing, possibly to a destination or partner that is banned, making you a criminal by agreeing.

11. Beneficiary Statements

Letters of credit often require extra documents confirming qualification for special issues, sometimes making the process very difficult. These include:

  • Ex-Im Bank Qualification. A customer may have obtained financing for the purchase by telling the U.S. Export-Import Bank that they were buying American-made products from you, but they may not have checked with you first. Since the Ex-Im Bank has different qualification thresholds for different programs, even if you know that you or your vendor made the product in the U.S., that doesn’t guarantee qualification for your customer’s deal. Make sure to review the rules and see if you can prove qualification – in writing – before agreeing to this.
  • A Country Flag Requirement. LoCs often stipulate that the shipment be made on a ship sailing under a U.S. flag or the flag of the destination country. While that sounds harmless, the vast majority of ships are flagged in Panama or Liberia. This kind of restriction, which requires a document issued by the carrier, adds both cost and time to your project as goods could sit waiting in port for three to five weeks before the next ship with the required flag is available.
  • A Vessel Age Requirement. Again, this document issued by the carrier may sound harmless, but most ships are not new; many are 10, 20, 30, or even 40 years old.  Depending on the routing, it may be difficult to find a ship that meets a 10- or 15-year age requirement in the shipping lane at hand. Add time and money to the shipping plans when these requirements surface.
  • A Free Trade Agreement (FTA) Certificate of Origin. A normal certificate of origin merely states where each product was manufactured. An FTA certificate goes further by claiming that the product was not only made in the country in question, but that it qualifies for the special duty-free treatment provided by NAFTA, CAFTA-DR, the U.S.-Australia FTA, the U.S.-Israel FTA, or any of the many other such agreements in place all over the world. Each one has different rules of origin, and it’s common for the same product to qualify for a couple of these FTAs but not for others. You must have a proper analysis process before issuing such forms, and you must retain the backup for years in case your customer is audited.

Always remember these are legal documents submitted not only to the bank but also to government agencies and taxing bodies. It’s not just about satisfying the bank to get paid; government agencies can check to confirm whether these documents were validly issued or not.

Falsifying an origin claim to obtain an Ex-Im Bank loan, for example, or issuing an FTA certificate without backup to help your customer import goods duty-free, is considered fraud. So be sure to get these documents right.

12. Process-Related Requirements

There are several requirements of the LoC process that you might not expect to be a big deal, but they are.

  • Partial Shipment Allowed or Prohibited. Nobody really wants to split up an LoC shipment into multiple shipments, but sometimes you have to, such as to expedite a portion of the order at the customer’s request. Always demand that partials be allowed because if they are prohibited, you can’t even help the customer until you get an amendment.
  • Transshipment Allowed or Prohibited. “Transshipment” is an odd word with many different definitions in international trade. Under the banking rules, a transshipment occurs when un-containerized cargo is unloaded from one ship and reloaded onto another one midway through the voyage. A full container, unopened, can change ships at a transshipment port without being considered a transshipment by the bank. Unfortunately, not every banker understands this distinction, and your shipments may occasionally include partial containers or other breakbulk goods (un-containerized or un-containerizable cargo). To be safe, always insist that transshipment is allowed in the LoC.
  • Shipment Dates. Your LoC will have a last shipment date, last presentation date, and expiry date. If you miss a date, the customer has the opportunity to rethink the whole deal and tell his bank to refuse the shipment. Always allow enough time to meet deadlines.

Customers may act in negotiations like these concerns don’t matter. They may tell you, “We can always change things later in an amendment” or “Don’t worry about an amendment; I’ll waive the discrepancies.” As much as you’d like to trust your customer, never accept such lighthearted approaches to potential errors.

The only reason for an LoC is protection, and discrepancies eliminate your protections. The more your shipment is worth, the more dangerous errors become.

13. Costs

In case you haven’t guessed yet, LoCs are expensive.

It costs money to involve multiple banks in multiple countries, a specialized banking communication service (called SWIFT), and many different parties going back and forth to get the documents just right. These costs add up, and that means that LoCs are only the right choice for shipments of a certain value.

There’s no reason to take a loss on an LoC, of course; plan for the banking costs and include them in your price so that you still enjoy the margin you want on your sale. And don’t let the customer talk you into accepting charges that turn your sale into a loser.

The following charges vary widely from country to country and from bank to bank, so the ranges given are rough estimates.

  • Application Fee. Your customer will pay 1% to 2% or more, with a several-hundred-dollars minimum, for their bank to open up the LoC in the first place.
  • Advising and Courier Fees. Your bank will charge you a couple of hundred dollars to cover the notification when they receive the original LoC by SWIFT, as well as to cover the back-and-forth of amended versions through the negotiations and any later amendments. They will also charge a courier and processing fee when they send the official document presentation for you after you ship.
  • Confirmation Fee. If you choose to have the LoC confirmed (or insured), your bank will charge you a percentage based on the risk of the transaction, considering both your customer’s bank and country. This fee could easily range from 1% to several percent of the total order value. Regardless of the price, if your bank recommends confirmation, you should usually go with it; they monitor these risks regularly.
  • Amendment Fees. Every time there’s an amendment to the LoC after the original acceptance, the customer is charged anywhere from about $25 to $100, depending on the country. It’s customary for the parties to agree that the party requesting the amendment be the one to absorb the fee.
  • Discrepancy Fees. If there are errors, mismatches, or missing documents in the final presentation, your bank will charge about $100 to $150 per discrepancy, although how they count them varies from bank to bank. Remember, the primary fear with discrepancies is not the charge for the fee, but the risk that the customer will reject the order, leaving you stuck with goods at sea and no payment for them.
  • LoC Service Fee. Your freight forwarder or LoC expert service will charge you at least several hundred dollars to manage the LoC analysis and support, and possibly as high as a thousand dollars or so. It all depends on the complexity of the order and your relationship with the service.
  • Reimbursement Fees. Finally, when you obtain your payment, your bank will charge a service fee of a couple of hundred dollars for accepting the foreign wire and forwarding it to your account.

As you can see, there are a lot of charges. On an order worth only a few thousand dollars, it’s simply not worth it to use a commercial letter of credit; it’s better to roll the dice and accept payment by credit card.

But with a more substantial sale – say, in the tens of thousands of dollars or more – it makes sense. The protections afforded to ocean shipments by the LoC process are worth it, especially if you plan ahead by calling your forwarder and your bank first and build these costs into your quote so that you can’t be surprised.

Final Word

The greatest challenge in the use of commercial letters of credit is when everyone involved thinks they have performed the necessary steps and agreed to accept the offer, but then they find at the last minute that it’s impossible to accomplish the shipment on time.

Imagine a shipment in which the order requires goods made by two different vendors in the U.S., shipped on an Arab flag vessel in eight weeks, to be shipped without transshipment. Your vendors confirm the goods will be available in four weeks, and your carrier says they can have the goods shipped in six, so you’re sure you can meet your customer’s needs.

But it turns out that the two vendors can’t both have their goods at the same port on time, and marrying them together will make them too late for the port cutoff. Or perhaps the goods are just a bit too much to fit in one container, so you need to use one full container and one partial, which will violate the transshipment ban.

Perhaps the carrier changed their shipping schedule around, and there won’t be an Arab flag vessel in that lane between the goods’ availability and your latest shipping date. Or perhaps you find out at the end, when you get your documents from the vendors, that they filled one of the orders with goods made in another country, so you can’t comply with the origin requirement, and it’s too late to change suppliers.

In the final analysis, it’s not enough to be confident you can meet each individual responsibility of an LoC. You must put them together and see if you can meet them all. Can you provide the required goods to the required port on time, and provide the required documents from vendors and carriers alike? If there’s any chance you can’t, insist on another month to be sure you’re safe.

Remember, your goal in using LoCs is that the customer cannot back out once they open the LoC and you accept it. Even if they change their mind, they can’t get out of it. You can ship the goods, provide the documents, and get paid, without the customer being able to stiff you – as long as you don’t have discrepancies. But once you have a discrepancy, the customer’s bank has to call them up and give them a chance to get out of it while your cargo is already on the water, and maybe even in the customer’s port.

Letters of credit are wonderful things – one of the greatest tools the modern global economy provides to companies both big and small. But use them carefully, select trustworthy freight forwarders and banks, and pay close attention to every line of the agreement.

Done right, this is the only way to ensure that you can sell to someone halfway across the world and not get cheated. You just can’t beat that.


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John F. Di Leo is a Chicagoland-based international trade compliance trainer, writer, and actor. He has been helping companies big and small to navigate the choppy waters of international transportation for decades.