Letters of Credit vs Documentary Collection in International Business Transactions

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What’s the best way to ensure the quality of products and timely payment for business transactions across international borders? Letters of credit are an established mechanism for ensuring that sellers will receive payment for goods that have been properly shipped, as long as the correct documents are presented upon delivery. For buyers, a letter of credit ensures that the buyer won’t have to pay for the goods unless the presented documents are in full compliance with the letter of credit. Although letters of credit have been one of the most important international payment methods, particularly for import and export industries, there are alternative mechanisms, such as documentary collection, that may reduce some of the cost and administrative burden of the transaction. Thus, for companies wishing to achieve an optimum balance between payment security, quality assurance, and low transaction costs, it’s important to understand the differences between a letter of credit and documentary collection, and the risks that come with both.

Letters of Credit in a Nutshell

A letter of credit is an arrangement where an issuing bank (typically, the buyer’s or importer’s bank) unconditionally guarantees to pay the seller’s bank when the goods are delivered along with specific documents containing very precise information. For an import/export transaction, the documents typically include a receipt or invoice for the goods, a bill of lading, and may also include inspection documents, insurance policies, certificates, and other common export documents. Most of the lawsuits regarding letters of credit have focused on whether the documents contained the precise wording required in the letter of credit. Generally, courts around the world have required the presented documents to be in strict compliance (rather than “substantial compliance”). Thus, many transactions that are otherwise “perfect” deliveries can become major problems simply due to an error, omission, or even slight deviation from the required wording in a letter of credit.

Documentary Collection in a Nutshell

Documentary collection is a payment security method that is similar to a letter of credit, however, there is an important difference. Unlike a letter of credit, in documentary collection, the bank is not required to pay the seller or exporter if the buyer decides that it does not want to buy. What’s the use of documentary collection, if the buyer decides it doesn’t want to pay? While documentary collection won’t give you a right to payment from the bank when you present fully compliant documentation, if you ever have to take a buyer or importer to court for revoking a contract, the documentary collection mechanism will provide you with solid evidence to establish your case in court.

When to Use Letters of Credit vs. Documentary Collection

Letters of credit are perhaps most useful for doing business with a person or company that you do not know well. Buyers have the comfort of documentation verifying the quality and characteristics of the goods before having the obligation to pay, while sellers are guaranteed payment as long as they comply with the terms of the letter of credit. Additionally, letters of credit are highly useful when a buyer’s country has political or economic instability or restrictive foreign exchange controls. For sellers, the risk of a letter of credit lies in whether the documents are drafted perfectly. Sometimes, unethical buyers will deliberately make the documentary requirements incredibly tedious, hoping that the documents will be noncompliant in order to give them a better position to renegotiate their contract after the goods are shipped. If your documents aren’t in strict compliance and you refuse to negotiate or give them better terms, they may simply refuse to pay and cancel their contract with you – it’s their right to do so. This gives them a lot of leverage, and gives you a big incentive to make sure your export documents are correct before you ship them.

Documentary collection, on the other hand, can be a better option in some circumstances. While a letter of credit often costs between 1%-2% of the total payment obligation, documentary collection can be much less expensive. This method is best used for parties that know each other well and do not anticipate any financial problems between them, nor much risk of the buyer rejecting the goods. Unlike letters of credit, where strict compliance is required in the wording of all documents, minor errors or omissions may not serve as an unequivocal basis for the buyer to reject the goods because the buyer may reject the goods anyway! Yet while the buyer may still reject the goods, he may still be “on the hook” for the sales contract even if the documents are not perfect.

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