Payment against a Letter of Credit (LC) is a highly secure and widely used method in international trade, ensuring that an exporter receives payment for goods or services provided the agreed-upon documentary conditions are met.
Understanding Payment Against Letter of Credit
A Letter of Credit (LC), also known as a documentary credit, is a financial instrument issued by a bank (the issuing bank) on behalf of a buyer (applicant) to a seller (beneficiary). It serves as an irrevocable undertaking by the issuing bank to pay the seller a specified amount of money, provided the seller presents documents that fully comply with the terms and conditions stipulated in the LC.
This mechanism significantly reduces the risk of non-payment for the exporter and ensures that the importer pays only when the goods have been shipped and all conditions are met. For a deeper dive into Letters of Credit, you can refer to resources like Investopedia's explanation.
How Payment Against LC Works
The process of payment against an LC involves several steps, from the initial agreement to the final payment:
- Trade Agreement: The buyer (importer) and seller (exporter) agree on the use of an LC as the payment method for their international trade transaction.
- LC Application: The importer applies to their bank (the issuing bank) to open a Letter of Credit in favor of the exporter.
- LC Issuance and Advising: The issuing bank reviews the application, issues the LC, and sends it to the exporter's bank (the advising bank). The advising bank authenticates the LC and informs the exporter.
- Goods Shipment: The exporter ships the goods as per the trade agreement and the LC terms.
- Document Presentation: After shipment, the exporter prepares and submits all required documents (e.g., commercial invoice, bill of lading, packing list) to their advising bank.
- Document Verification: Both the advising bank and the issuing bank meticulously check the presented documents against the terms and conditions of the LC for strict compliance.
- Payment Guarantee/Execution: If the documents are found to be compliant, the issuing bank makes the payment to the exporter (or the advising/confirming bank, which then pays the exporter). This payment commitment is the core of "payment against LC." The bank issuing the letter of credit will make payment in the case that the importer does not pay for the exported goods, providing crucial financial security.
Key Parties Involved
- Applicant (Buyer/Importer): The party requesting the LC and responsible for ultimately paying the issuing bank.
- Beneficiary (Seller/Exporter): The party who receives payment under the LC.
- Issuing Bank: The bank that issues the LC on behalf of the importer and undertakes the payment guarantee.
- Advising Bank: Typically the exporter's bank, which receives the LC from the issuing bank, verifies its authenticity, and forwards it to the exporter.
- Confirming Bank (Optional): Another bank (often in the exporter's country) that adds its own guarantee to the LC, providing an extra layer of security for the exporter, particularly in cases where the issuing bank's creditworthiness is a concern.
Types of Payment Under LC
The timing of payment against an LC can vary based on the agreed terms:
- Sight Payment: Payment is made immediately upon presentation of compliant documents to the nominated bank (usually the advising or confirming bank). The exporter receives funds almost instantly.
- Deferred Payment (Usance): Payment is made at a future, specified date (e.g., 30, 60, 90 days after sight or bill of lading date). While the actual cash transfer is delayed, the bank's commitment to pay at maturity is firm, providing the exporter with a guaranteed future payment.
- Negotiation: A bank (the negotiating bank) purchases the drafts and documents from the beneficiary (exporter) and makes payment upfront, with recourse or without recourse, depending on the terms.
- Acceptance: The nominated bank accepts a time draft (bill of exchange) presented by the exporter, thereby obligating itself to pay the exporter at the maturity date of the draft.
Benefits of Payment Against LC
Payment against LC offers significant advantages for both exporters and importers, making it a preferred choice for secure international transactions:
- For Exporters:
- Payment Assurance: The primary benefit is the guarantee of payment. The bank issuing the letter of credit will make payment in the case that the importer does not pay for the exported goods, significantly reducing the risk of default and non-payment. This shifts the credit risk from the importer to the issuing bank.
- Market Expansion: With the assurance of payment, exporters gain the confidence and opportunity to expand into new and potentially riskier international markets more securely, without extensive credit checks on unknown buyers.
- Improved Cash Flow: Predictable payment terms allow exporters to manage their finances better and potentially obtain pre-shipment financing against the LC.
- Reduced Commercial Risk: Protection against the importer's inability or unwillingness to pay.
- For Importers:
- Reduced Risk: Assurance that payment will only be released once the goods have been shipped and all documentary conditions (proof of shipment, quality certificates, etc.) have been met.
- Proof of Commitment: Issuing an LC demonstrates a serious commitment to purchase, helping build trust with new suppliers.
- Negotiating Power: Can negotiate favorable payment terms, such as deferred payment, which provides working capital flexibility.
Essential Documents for Payment
For an exporter to receive payment against an LC, they must present a precise set of documents to the bank, strictly adhering to the LC's terms. Common documents include:
- Commercial Invoice: A detailed bill from the seller to the buyer.
- Bill of Lading (B/L) or Air Waybill (AWB): A transport document indicating that goods have been shipped.
- Packing List: Details the contents of each package.
- Certificate of Origin: Confirms the country where the goods were produced.
- Insurance Certificate: Proof of insurance coverage for the goods during transit.
- Inspection Certificate: (If required) Verifies the quality or quantity of goods.
- Draft/Bill of Exchange: (For usance LCs) A demand for payment at a future date.
Practical Example
Consider a scenario where an American company (importer) wants to purchase specialized industrial machinery from a German manufacturer (exporter). The German manufacturer is hesitant to ship without upfront payment due to the high value of the machinery and lack of established credit history with the American buyer.
To mitigate this risk, the American company approaches its bank to issue a Letter of Credit in favor of the German manufacturer. The LC specifies that payment will be made upon presentation of documents confirming the shipment of the machinery, including a bill of lading, commercial invoice, and an inspection certificate from a third-party agency. Once the German manufacturer ships the machinery and presents the compliant documents to its bank, the American bank guarantees payment. This assurance allows the German company to proceed with the shipment confidently, knowing that the bank will pay even if the American company later faces financial difficulties or attempts to dispute the payment.
LC Payment Process Summary
| Step | Description | Key Participant(s) |
|---|---|---|
| 1. Agreement | Buyer and Seller agree to use an LC for the transaction. | Importer, Exporter |
| 2. LC Application | Importer applies to their bank to open an LC. | Importer, Issuing Bank |
| 3. LC Issuance/Advise | Issuing Bank issues the LC; Advising Bank authenticates & forwards to Exporter. | Issuing Bank, Advising Bank |
| 4. Goods Shipment | Exporter ships the goods as per LC terms. | Exporter |
| 5. Document Present. | Exporter submits required documents to their bank. | Exporter, Advising Bank |
| 6. Document Check | Banks verify documents for strict compliance with LC terms. | Advising Bank, Issuing Bank |
| 7. Payment Guarantee | Issuing Bank guarantees and/or makes payment to the exporter (or their bank) upon compliant presentation. | Issuing Bank, Exporter |
Payment against an LC fundamentally mitigates payment risk for exporters in international trade by shifting the payment obligation from the importer to a reputable financial institution, thereby facilitating global commerce and reducing uncertainties for both parties.
