As I explained before in Confirming quality when paying by irrevocable letter of credit, an importer can pay his suppliers through letters of credit (L/C). An L/C triggers the payment once the bank receives a pre-determined list of documents from the supplier.
It protects buyers much more than a regular bank wire, since there is no upfront deposit. Payment happens after shipment!
More specifically, a letter of credit prevents:
- Shipment delays, since the letter of credit has an expiry date (which can be extended by the importer)
- Last-minute cost increases, since prices are written down and can only be modified by the importer
- Product quality issues, if the buyer does not forget to request a certificate from a third-party inspection company
The good thing: L/Cs can be cancelled
Suppliers know that, however hard they try, their documents seldom respect all the requirements listed in the L/C. The buyer’s bank nearly always finds some discrepancies, and then it is up to the buyer to decide whether to waive them or not.
A specialist who has worked on thousands on letters of credit told me the proportion of “clean” L/Cs (with no discrepancy) is below 1%. In practice, it means buyers can cancel the L/C and the purchase order. In this case, the supplier knows he won’t get paid, and the transaction is over.
As a result, the suppliers who accept letters of credit and who know that you can cancel the order (without pissing your customers off) tend to be more cautious and more honest.
The bad thing: payment is triggered before the goods arrive
As I wrote previously, buyers are not 100% protected by a letter of credit. It is entirely possible to pay by L/C and to receive a container of garbage. In that case, it is too late. Payment is done. The transaction can’t be undone.
Remember: banks deal with documents. Not with products. The right way to proceed is to nominate a third-party quality control firm, and to request an inspection certificate from them. And then, to refuse shipment if the QC report is not satisfactory…