Confirming quality when paying by irrevocable letter of credit

Supplier ManagementIn my last article, I explained how an importer can confirm his product’s quality while paying by bank wire.

The other very widespread mode of payment is the letter of credit (L/C), or documentary credit. Generally speaking, buyers should look out for the same risks, so I won’t repeat most of them. But there are specific issues to be aware of, as listed below.

First, how does a payment by L/C work?

A bank is used as a third party to guarantee that a payment will be done if a number of conditions (such as the quantity of products shipped out, the shipment date, etc.) are met by the supplier. In practice, the importer (aka “applicant”) opens an L/C with his bank, who contacts the bank appointed by the exporter (aka “beneficiary”).
This way, the supplier can get a cash advance from his bank and use it for purchasing and producing. And he can be reasonably sure of getting paid if he complies with all the requirements.

There are many types of L/Cs. I’ll focus on irrevocable L/Cs in this post. The payment to the supplier can take place upon receipt and confirmation of the documents (aka “at sight”), or 30 days after shipment, or even 60 or 90 days after.

Generally the L/C is opened only after prototypes have been approved by the buyer. In general the factory waits for the notice of the L/C opening before purchasing the fabrics and accessories to use in bulk production.

What should an importer do to keep quality under control while paying with an L/C? What are the risks?

# Risk No. 1: not being precise enough in the description of the requirements.

The supplier will be able to ship and get paid if he respects all the requirements listed in the L/C. So you’d better be very precise about what you want to receive.

The best practice is to develop product specifications during the development stage, and then incorporate them in the L/C when the time comes to open it.

# Risk No. 2: Forgetting some elements in the L/C requirements.

The L/C includes a list of documents that have to be given to the importer’s bank. They prove that the correct products were shipped out the right way, so they are used to trigger the payment. The importer also uses these documents to get the products out of customs.

For example, a common document required in L/Cs is a passed inspection report issued by a designated quality control company. It is an excellent way of letting the factory know, in advance, that an inspection will take place.

Note: the bank will not care whether you had a contract with your supplier. The payment obligation is only based on the L/C terms. I am not saying that an OEM contract is useless, but it alone will not prevent the bank from paying your supplier. A good contract still gives you some leverage over your supplier, though.

# Risk No. 3: requiring too much in the L/C terms.

This one might be surprising, but I have seen factories refuse L/Cs and stop everything because of “soft terms”. It is easy to set unreasonable requirements (e.g. a document issued by the importer himself). The buyer basically retains the right to cause a discrepancy, and this way to cancel the payment. Suppliers are not sure they will be paid even if they do a perfect job, and their bank wouldn’t give them a cash advance.

Here is the best way to proceed: the importer sends a draft of the L/C terms to his supplier, who will point out the details that look incorrect or abusive.

# Risk No. 4: thinking that the L/C is the solution to all problems.

An exporter can ship what he wantsif there is no product inspection, even under an L/C, and receive payment… Nothing replaces a presence in the factory during production, and quality control before shipment.

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Comments

  1. Lora Brady says

    Is there a rule of thumb on how much an L/C cost? What kind o interest reates do banks charge for a cash advance on L/Cs. I have issued a TT to a vendor in China for a hard goods prototype. I paid about US $40.00 I believe.

  2. Renaud Anjoran says

    Hi Lora,
    Usually it costs the buyer between 200 and 800 USD, from the top of my mind. Of course it depends on the amount of the purchase.
    For the exporter I have no idea. They can get some cash advance, but I don’t know what interest rate is charged to them in that case.

  3. Werner says

    Excellent post! It’s amazing how many misconceptions still exist about how L/C work. Was contacted yesterday by a client who’s out of 65000 USD b/c he had neglected to specify a quality control certificate and got shipped a container of junk…but with all documents specified in the L/C present. He didn’t know that the bank only deals with documents, not with quality.

  4. Renaud Anjoran says

    Hi Werner,
    You are right, some banks don’t suggest “standard” clauses, and inexperienced buyers don’t understand the process, which leads to such cases. Ouch…

  5. James says

    Re #Risk No. 1:

    No matter how precise the L/C applicant stipulates his requirements, the beneficiary can always meet such requirements by presenting “strictly compliant” documents while suppying goods of inferior quality, since, as Werner said, an L/C deals with documents only. An independent surveyor can be employed to do the Q.C job, of course; but even an inspection certificate issued by such surveyor does not guarantee 100% quality, though, especially for sophisticated machinery and equipment .

    • says

      If you want quality to be “100% guaranteed”, don’t source in China in the first place… The L/C is a good tool to reduce risks, even though it is not perfect. That’s my point.