Saturday, February 20, 2010

How letters of credit work

It is an unfortunate fact that there are many individuals in other countries who would love to take advantage of their confusing legal system and their geographic distance in order to defraud honest businessmen.  When dealing with more developing economics such as China and India, it is much harder for a purchaser to ensure that the seller of goods is honest and able to supply the goods that they claim they can.  Sometimes, they will simply take your money and you will be unable to contact them further.

There is a way which can somewhat protect purchasers from this problem, though, and it is called a "letter of credit."  Simply put, a letter of credit is a payment to the seller of the goods which they are guaranteed to have turned over to them once they establish with a bank that they have shipped the goods according to the purchaser's standards.  These are often referred to as LOC, L/C, or LC on websites such as Alibaba or Made in China.  Sellers who are unwilling to use them are generally risky and you should avoid them.

To obtain a letter of credit, you should find a larger bank in your area and speak to their commercial banking department.  You need a larger bank because many smaller banks do not deal with letters of credit because such letters require a reputable name for the seller to trust that they will be paid.

You must figure out feasible conditions for the seller that the payment should be contingent upon, and have your bank add those in the letter of credit that it makes for you.  For example, you may require that they have documentation from a freight company proving that the items were shipped (this is a basic).  You may further require proof that insurance was purchased on the shipment.

Once you have had your letter of credit drafted and issued, it is sent to the seller, who will bring it to a local bank in their area which assists them in getting the payment from the purchaser's local bank which issued the letter of credit.  They will have to bring the documents which you required in their letter of credit in order to receive payment.

Letters of credit do not always protect you, though.  You still run the risk that the seller ships the wrong goods, or damaged goods, or counterfeited goods.  For this reason, it is advisable to work only with well-established traders whom other domestic sellers in your country have had good dealings with.  If you are dealing with a larger sum of money, you might also be able to hire a lawyer or other respected professional in the seller's country to first inspect the goods being shipped and make a letter of their approval of the goods a requirement that must be fulfilled for the letter of credit you issue.

For more information, here is a sample letter of credit:

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