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A Letter of Credit as a Common and Effective Means of Settlement in Foreign Economic Activity

Foreign economic contracts have become widespread because of globalized economy. One of the main points in the conclusion of such a contract is agreements on terms and forms of payment. This is the most important point, since the time from the moment of shipment to the moment of goods receiving can be long enough, and not always representatives of both sides are present during the transfer of goods. So what kind of calculation instrument the parties should choose to minimize their risks?

In this article, we will consider such an instrument of payments on foreign economic activity as the letter of credit, which has been recognized as the most universal method of mutual settlements, and we will consider its advantages and disadvantages.

PAYMENT INSTRUMENTS UNDER FOREIGN ECONOMIC CONTRACT

In the context of the exchanging parties, such forms of payments as preliminary payment and deferred payment are opposite. There are other forms of calculation between them, such as a letter of credit, collection and bank guarantee. Each of these instruments are used depending on the details of a specific deal, such as:

– how much the counterparties trust each other,

– conditions of delivery,

– the sum of the transaction,

– how strong one of them is in relation to the other,

– representatives of which countries do business,

– what customs are in the market,

– how the transaction is financed, etc.

Of course, the safest method of payment for the seller is a preliminary payment. But not all purchasers will agree to this form of payment due to the high level of collateral risks. Therefore, if the seller works in a highly competitive or high-risk market, does not have a sufficient reputation in the market or is a newcomer in general, the probability that the purchaser will be able to agree on a preliminary payment is low.

On the other hand, the safest method of payment for the client is a deferred payment. This form is beneficial for the purchaser, because then he does not have any risks. But then the seller may not agree to such a high-risk deal for him, especially if the reputation of the purchaser is not known or is negative. In such cases it is possible, for example, to use a credit insurance instrument when the risk of non-payment is covered by the insurance company. Such transactions are common for relatively small sums, regular shipments, and in countries with developed market where they are a well-established custom of doing business – for example, Western Europe, and therefore are practically not used in transactions with companies from the third countries.

A LETTER OF CREDIT AS THE OPTIMAL MECHANISM OF SETTLEMENTS

A letter of credit is an obligation accepted by the bank on behalf of the purchaser (applicant) to pay the amount of the letter of credit in favor of the seller (beneficiary) after the latter provides all necessary documents according to the terms of the letter of credit within the period.

Today it is a standard tool in most international markets. At a relatively low cost, it allows to reduce risks for both purchaser and seller. The control over the transaction then passes to the bank. The seller is guaranteed to receive the money after the shipment, providing the shipping documents to the bank, and the purchaser receives a guarantee of the shipment of the goods of the proper quality and within the terms stipulated by the contract.

At the same time, using this instrument is not as easy as it seems at first glance. There are a number of points to consider, both to optimise the deal itself and to identify and prevent payment manipulation:

– to agree on the text of the letter of credit during the contract discussion phase and to include its text in the contract itself;

– determination of the type of letter of credit (an export one with simple drafting or an import one with the inclusion of as many conditions, under which the seller can withdraw money, as possible);

– approval of amendments in the second phase of the letter of credit.

Any omissions in the text of the letter of credit contract may be a bad thing for a party, so the sensitivity of the terms of the letter of credit will not be excessive.

RISKS OF RECOGNITION OF THE LETTER OF CREDIT TO BE INVALID

A letter of credit may be invalid if the seller is unable to fulfill a number of conditions. This may also be the result of the financing bank requirements, purchaser’s desire to be on the safe side, and it can be the result of deliberate manipulation with the terms in order to obtain more beneficial conditions from the seller, for example, unstipulated discounts on the post-fact supply. This often happens when the cargo is already in the process of loading on the ship or is already on the way, and the seller does not have another way as to agree to new terms. Otherwise, he urgently needs to resell the product, which is unlikely to be done on good terms, as information spreads instantly throughout the market, and new purchasers understanding their winning position will demand conditions that are good only for one party.

HIDDEN DEFECTS OF THE LETTER OF CREDIT

In addition to the risks, the letter of credit also has defects that need to be known. At the first glance, these are some harmless and insignificant conditions, which the counterparty did not notice when signing, but which will have a significant impact after filing documents to the bank. This is a very common practice which traders use leaving themselves the opportunity to refuse the goods, for example, in case of a fall in the market or, as it was mentioned above, in order to bring the seller to despair and demand maximum discount for themselves.

The location of issuance of documents. For example, under the terms of the letter of credit, it may be provided that the location of issuance of documents is the port of loading. However, such necessary in foreign economic trade documents as a certificate of origin of goods is usually issued by a competent authority outside the ports (in Ukraine, for example, it is the Chamber of Commerce and Industry of Ukraine and its subdivisions in regional centers). This small issue results in the entire package been recognized as out of divergence, and as a result, the bank will not pay the money.

This is one of the many examples that may arise if due consideration is not given to the terms of the letter of credit, or the conditions are not considered seriously. Such cases may completely offset the advantages of documentary credit as one of the most reliable forms of payment.

THE ADVANTAGES OF THE LETTER OF CREDIT

Although the laws of different countries may regulate this form of payment differently, there are Uniform Customs and Practice for Documentary Credits (UCP 600) which are developed by the International Chamber of Commerce. The reference to these Uniform Rules is mandatory when signing the letter of credit. This will help to solve the disagreements that may arise between the parties successfully.

Overall, it can be said that the letter of credit is a good payment instrument, but, like any other instrument, requires a careful and professional approach to its use. Any omissions or incomplete work in the terms of the letter of credit can lead to difficulties or even inability of receiving money on it, such refusal of payment will be legal and, in order to receive money, the seller will have to work hard. Therefore, professional assistance of the lawyer at the stage of conclusion of a foreign economic contact will not be excessive.

Author: Kydalov Igor

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Kydalov & Partners
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Publication Date: 08.04.2020
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