Tuesday, March 27, 2012

Letters of Credit versus Bank Guarantees

Letter of Credit Definitions:
The “issuing bank” is the financial institution that issues the letter of credit or bank guarantee. They are usually located in the same geography as the party they are issuing the letter of credit or bank guarantee on behalf of.
The “advising bank” is financial institution is the bank, usually in another geography that the issuing bank will transfer money to per the letter of credit or bank guarantee

Letters of Credit
Letters of credit are used when there are concerns over potential payment especially when dealing with international transactions. They can be an alternative to requirements for requests for advance payments by suppliers. In a letter of credit a buyer would contact an issuing bank to create the letter of credit on behalf of the buyer. The bank would reserve money in the buyer’s accounts to pay for the letter of credit. The supplier who will be the beneficiary of the letter of credit will select the advising bank in their location where they want the funds transferred.

A Letter of credit “LOC” requires pre-conditions be met before payment is made (such as proof of delivery). The supplier needs to provide the required documentation to the advising bank. If the advising bank agrees the conditions have been met, they will notify the issuing bank. The issuing bank withdraws the funds that were reserved and transfers payment to the advising bank who then credits the account of the supplier that had the LOC issued to them.

In a LOC situation if the condition has not been met, there is no payment. If the condition has been met and there is a problem with what was delivered, the customer would need to go against the supplier to resolve the problem. The only exception to that would be if there was fraud by the advising bank. In that case the issuing bank could go against the advising bank. The buyer could not go directly against the advising bank as there is no agreement between them so they have no privity of contract between them. LOC’s are most frequently issued on behalf of buyers to supplier although reverse letters of credit could be used in situations where the supplier may have payment obligations to the customer.

One key requirement in a letter of credit used with procurement is that it must be irrevocable. That way the supplier knows that the funds will be available when they ship. Buyers place specific requirements that must be met for the payment to be made. These may include the date(s) by which the shipments must be made, a requirement for a commercial invoice that complies with the requirements of the agreement, as that will be needed for import purposes. The bill of lading that describes what was included in the shipment and proves that it was shipped. It will also include other documents that prove the supplier complied with the contract requirements. Those can include proof of insurance if insurance was required to protect the items during transit or proof of export licenses if the supplier was responsible to obtain the export license. Letters of credit may be written to be either payment on sight or on specific dates or terms after delivery. Sight means that there will be an immediate payment upon presentation of all the documents that are required by the Letter of Credit. Date or term payments are similar to net terms where payment is made on a specific date or terms after meeting the Letter of Credit obligations. If the supplier fails to meet one of the obligations they do not get paid. If the obligation was for a specific delivery date and the supplier was unable to meet it, the letter of credit would need to be amended for payment to occur.

Bank Guarantees

A Bank Guarantee is similar to a performance bond. It is a third party guaranteeing that monies are available to complete the work if the party the party they guaranteed fails to complete the work. Bank Guarantees are usually established by a line of credit that is secured. That way their supplier’s funds are not reserved and are not tied up for the duration of the contract. The issuing Bank is protected by the Line of Credit agreement and the securities or assets that were pledged to secure that credit. The guarantee could go directly to the customer or it could go to a receiving bank that has agreements with the receiving bank if the bank guarantee was international. With Bank Guarantees any claims would first go against the issuing bank. If there was both an issuing and receiving bank you would need to provide proof of the failure and claim to the receiving bank who would then claim against the issuing bank. Bank guarantees are usually issued on behalf of suppliers or contractors although there could be situations where a customer might be required to provide a bank guarantee as an assurance of payment over a longer duration contract where individual letters of credit would be cumbersome.

If there were uncovered losses after collecting upon the letter or credit or bank guarantee, the customer could still go against the supplier or the supplier could god against the customer for any difference under a claim for breach of the contract. They could seek any uncovered damages sustained as a result of breach.

There are a number of different variations of both LOC and Bank Guarantee terms. When you are dealing internationally what you don’t want to do is have to litigate in another country to be able to recover against them whether it’s the supplier, buyer or the issuing bank. A major bank can provide the advantage of having operations in both the issuing location and the receiving location where they can manage any problems that arise with the issuing bank

There are alternative to letters of credit and bank guarantees. For the most part they are not balanced. Approaches that are good for the seller have higher risk for the buyer and vice versa. The best way to always protect yourself is do your homework in advance and only deal with business partners that you trust.

There was a post in Linkedin about a company being abused by a Supplier where they had made an advance payment to the Supplier, only had received 20% of the order and the Supplier was demanding a new larger order as a condition of shipping the balance. The question was what would you do and I thought you might enjoy my response that directly ties to this post.

“I would never pay anyone in advance for goods. If the supplier has a concern about your paying them I would provide them with a letter of credit. Letters of credit protect the Buyer because to collect the supplier has to meet the requirements of the letter of credit. They are required to provide proof of shipment of all the materials, not part. If they ship less they don't get paid. If they claim they have shipped all but haven't it’s then a criminal act of fraud.

For other types of purchases after doing the due diligence they should have done. if I still had any concern before giving them the agreement I would consider requiring a performance bond in the amount to the value of the work. That gives you another party you can go after to complete the performance if they don’t.

I would absolutely never give them any more business or orders as all that they are doing is a form of extortion. I would use the information of their actions to terminate the agreement for cause. I would send them a cure notice. When they fail to deliver, I would then send them a termination notice. Then the decision comes down to whether its economically viable to go against them in court to not just recover the part of the payment that they didn't earn but also to collect any damages you have sustained for the excess cost of re-procurement (cover). If it isn't chalk it up to an expensive lesson on how to not to conduct business. You could possible assign your rights to a third party that could go after them, That's similar to companies selling their receivables. They would pay you pennies on the dollar but that may be better than nothing.

Lastly, before posting any information about your experience with the company on any websites, I would also talk with your attorneys to coach you on how to do that without being subject to libel or slander claims.” Any company that would try to extort you into giving them more business is the same type of company that would come after you claiming libel or slander of their “good” name."