Letter of credit

A letter of credit (abbreviated to 'L/C') is a written undertaking from the buyer's bank guaranteeing payment to the seller if the terms of the letter of credit are met. The bank's obligation to pay applies regardless of the buyer's financial situation. This offers the seller a significant advantage, as the credit risk shifts from the buyer to the buyer's bank. In many countries, obtaining accurate credit information about companies is difficult. Bank risk is therefore preferable to customer risk.

A letter of credit is always irrevocable unless otherwise stated and cannot be withdrawn without the seller's consent. This gives the seller strong protection if market conditions change or the buyer receives a better offer from another supplier and wants to withdraw from the agreement.

The letter of credit is entirely separate and independent of the agreement between the parties.

The buyer's bank issues the letter of credit and sends it to the seller's bank (the advising bank), which then forwards it to the seller by post or electronically.

The terms of the letter of credit are based on the agreement between the buyer and seller. It requires various documents, such as an invoice, transport document and packing list, to be presented before payment can be released. You must present these documents within the specified deadlines (the shipping deadline and the deadline for presenting documents) to demonstrate that the seller has fulfilled their part of the agreement.

The banks will check the documents against the terms of the letter of credit, and the seller is guaranteed payment if all the terms are met. The buyer is protected because no payment is made until the seller has demonstrated that they have dispatched the correct goods on time. If the seller does not meet the terms of the letter of credit, they are not entitled to payment. It is worth noting that the banks consider the content of the documents, not the goods themselves. The letter of credit can be amended, but both parties must agree to the changes.

If you are unsure whether the buyer's bank can meet its payment obligations, your bank can confirm the letter of credit (a confirmed letter of credit). This may be relevant if the buyer is based in a country with significant political or economic uncertainty. By confirming the letter of credit, the confirming bank assumes the same payment obligation as the buyer's bank. This allows you to avoid bank and country risk in the buyer's country, leaving you exposed only to the credit risk of the confirming bank. This will normally be your Norwegian bank, but it may also be another Norwegian or foreign bank. The cost of confirming a letter of credit depends on the bank and country risk. The higher the risk, the higher the cost. However, given the risk of delayed payment or loss, this may be money well spent. It represents a relatively small percentage of the total value, while the consequences of a loss are greater.

Another advantage for the seller of having the letter of credit confirmed is that it can then be discounted (paid in advance) without recourse. If payment has been deferred until 90 days after the shipping date, the seller can receive full payment upon presentation of the documents, shortly after shipment. This is a favourable form of financing that supports healthy cash flow.

Using a letter of credit gives you, as the buyer, greater control over the delivery of goods. The letter of credit will include a description of the goods and often refer to a reference number (contract, purchase order number, agreement number, etc.). The seller's invoice must confirm that these are the goods that have been dispatched. This ensures that no payment is made until the ordered goods have been dispatched on time. A transport document will provide evidence that the goods are on their way. Businesses that import seasonal goods depend on receiving them on time, and many use letters of credit to ensure this.

By providing the supplier with a letter of credit as security, you may be able to negotiate a better price for the consignment because it offers a high level of payment security. You can also avoid advance payment by offering a letter of credit. A letter of credit is considered the second most secure payment method after advance payment.

A letter of credit is based on the agreement between the buyer and seller, but unfortunately, we see too many transactions where the foreign party largely dictates its terms. Norwegian companies need to be more assertive about setting requirements, as failing to do so with letters of credit can have serious consequences.

If you, as the seller, cannot meet the terms of the letter of credit, you will not receive payment. It is therefore particularly important that exporters help determine these terms. The buyer and the buyer's bank should not decide them alone.

We recommend creating fairly detailed standard terms for using letters of credit, covering document requirements, payment dates and other deadlines. Your export sales team enters into agreements with buyers and will naturally have less knowledge of letters of credit than the colleagues who handle them in practice.

We recommend maintaining good communication across departments to avoid including terms in the letter of credit that you cannot meet, which could result in losing payment security. You can prevent this by taking a few simple steps and seeking support from your bank. Practical tools and standardised procedures can help your sales team draw up sound, secure agreements. Your chosen delivery terms (Incoterms 2010) should also align with the documents required under the letter of credit.

The terms of the letter of credit are also important for importers. Make sure you request the documentation you need to confirm that the quality and quantity of the goods are as agreed. Who should issue the document, and what should it contain? For example, if you request a quality certificate without providing further details, you risk receiving a certificate signed by the seller stating that the goods have been inspected and found to be in less than satisfactory condition. You would then have to accept this document as it stands because the letter of credit does not specify who should issue it or the required quality of the goods.

Many businesses buy and sell goods on open account, meaning without security. We trust each other. Given today's uncertain economic outlook and ongoing conflicts in different parts of the world, a letter of credit can make trade safer and more predictable. Choose a letter of credit if you are unsure about:

• the other party's financial situation
• the amount is substantial or deferred payment has been agreed
• if the counterparty is located in a part of the world with political risk (country and bank).

We encourage businesses to contact their bank for advice on international payment methods.

In summary, a letter of credit provides protection against credit risk, bank and country risk, as well as risks related to the delivery and quality of goods. You can also use it for financing.
When choosing a payment method, you should therefore carefully consider the different types of risk before making your decision.

The purpose of a letter of credit is to make transactions easier for parties located far apart. Letters of credit are widely recognised in most countries. A common set of international rules (UCP 600), drawn up by the International Chamber of Commerce (ICC), ensures a shared understanding wherever in the world you buy from or sell to. However, letters of credit are most commonly used in Asia, the Middle East and Africa.