The Importance Of Banks In A Letter Of Credit
Letters of credit provide advantages for both parties: the seller is sure to receive payment from a bank in his country, and the buyer obtains credit for payment of the goods.
However, central to the system that letters of credit put in place is the role of banks: it is because of the assurance that banks will pay that the parties feel confident in carrying out the sale transaction. That is exactly the purpose of the letter of credit. Such is the importance and success of this payment method in global trade, that it has been defined by courts as the lifeblood of international trade.
Yet, banks are far from being insulated from financial risks, and sometimes banks become insolvent.
In this article, we will see why it is so important that exporters and importers choose reliable banks as paymasters in a letter of credit transaction. Otherwise, nasty things can happen. There are infinite cases that can materialize depending on the financial arrangements between the parties; for the sake of brevity, let’s draw just two very possible events, i.e. either the advising bank or the issuing bank are insolvent.
1) The Advising Bank Is Insolvent
A Spanish food manufacturing company buys soybeans from a Brazilian farm. The Spanish company instructs the issuing bank in Spain to find a bank in Brazil that would serve as the advising bank.
The Brazilian seller ships the goods, but, upon presentation of documents to the advising bank in Brazil, finds out that the bank is insolvent.
This scenario is detrimental for the seller. The big advantage of the letter of credit is that the buyer must open a letter of credit before the sellers ships the goods. The seller has the assurance of getting paid just after shipment has taken place.
In this scenario, the seller loses such advantage, and is left with the only option to ask for payment directly to the buyer.
Therefore, the Brazilian farm will claim payment to the Spanish company; if the Spanish company refuses to pay, the Brazilian firm has to sue the Spanish company in Spain, with all the difficulties that this may entail.
Additionally, if the parties have agreed to settle the sale transaction by letter of credit as absolute payment, the seller could not go after the buyer in case the advising bank is insolvent.
2) The Issuing Bank Is Insolvent
Suppose that the advising bank pays the Brazilian farm according to the terms of credit. After passing the documents to the issuing bank in Spain and claiming refund, the advising bank finds out that the issuing bank is insolvent.
The advising bank will go after the Spanish firm and claim payment. If the Spanish firm has not yet commenced payment with the defaulting issuing bank, and is acting in good faith, it could refund the advising bank in Brazil and settle the transaction.
The problems for the buyer arise if he has already commenced payment, such as he has already deposited the sum to be paid to the seller with the issuing bank. Unfortunately, that money is lost in the issuing bank’s default.
In such a scenario the buyer will have to pay the advising bank anyway, out of new money. Essentially, the buyer will have to pay twice.
Protection For The Buyer: Absolute Payment
Both sellers and buyers can suffer tremendous damage from the insolvency of any of the banks involved in a letter of credit. Therefore, parties should only use reputable and trustworthy banks for such transactions.
However, assuming that the seller is able to sue the buyer in his country, this latter is the most exposed, having potentially to pay twice.
One protection for the buyer is to make to use the letter of credit as absolute payment.
An absolute payment is one that definitely settles a sale transaction. A payment in cash is an absolute payment, whereas a bill of exchange is a conditional payment. In fact, the seller is not relieved from a bill of exchange until the buyer or a third party pays the bill.
A letter of credit is a conditional payment; in fact, the seller can recourse to the buyer if the advising bank does not pay.
Yet, the parties may agree to make the letter of credit absolute payment. In this case, neither the seller nor the advising bank can go after the buyer for payment if the issuing bank or the advising bank itself are insolvent.
Of course, making a letter of credit absolute payment must be specifically stated in the terms of the contract.
Protection For The Seller: Take Initiative In Choosing The Banks
The best protection for the seller to insist that the buyer picks banks of the seller’s choice as issuing and advising bank. The seller could choose his own bank and then select a bank in the buyer’s country that is either a branch or a network bank.
One important caveat is that this inversion in initiative by the seller may be indicative of an implicit agreement to make the letter of credit absolute payment. Therefore, the seller should only select solid banks with sound fundamentals.
Globartis Research Center