This publication on letters of credit was prepared by Marc Louet. Marc is a freelance consultant in Contract & Claim Management.
It was originally published on www.contractence.fr, the French blog on contract management by Jean Charles Savornin. Jean-Charles is the author of several books on contract management, the latest of which is “Putting leadership into your projects (published in French)”.
Letters of credit
Both a payment guarantee and a way of paying, the letter of credit (L/C) or documentary credit is a banking tool that is well known to exporters and importers. We can summarize the rules by saying that an L/C is an undertaking by the buyer’s bank to pay the seller when the seller sends him the documents detailed in the L/C without requiring the buyer’s agreement.
These documents are intended to attest to the seller’s proper performance of its obligations and typically include invoice, packing list, transport document, insurance certificate, certificate of origin, etc. The documents must be consistent with each other and scrupulously comply with the conditions set out in the L/C. These conditions are often difficult to meet.
What impact can the choice of an L/C as a payment method and guarantee have on contract management?
As a payment guarantee, the L/C is usually one of the conditions for the entry into force of the contract or the start of the contractual time periods. Any delay in its issuance could therefore have a mechanical effect on the project planning and generate a first claim situation.
Considering that it is not the buyer but his bank that opens the L/C, it will be in the buyer’s best interest to secure the subject in advance. A good practice is to attach to the contract a model of L/C on which the parties agree and which has been validated by the buyer’s bank (remember that the bank is not required to obey its customers and that L/C is a commitment independent from the contract…).
Discrepancies in documents
One of the key principles of L/Cs is that banks are only required to pay if the documents are strictly in accordance with the terms of the L/C. If they are not, the banks may request instructions from the buyer or even refuse to pay and return the documents to the seller. If the documents are incorrect, the risk is that there is a delay in payment, the duration of which depends on the buyer and its bank (I have known of some that lasted up to 1 year!) but for which responsibility can be shared between the seller, a third party (the carrier or insurer who has not provided all the details requested) and the buyer who has not obtained from the bank that it accepts and pays promptly, based on the incorrect documents. Between the needs of the on-site teams and the warning signals sent by your controller, I let you imagine the discussions that will proliferate on the clause “suspension in the event of late payment”…
The management of the contract, its changes and their impact
Before addressing this question, the first point to be stressed is that the L/C is independent from the contract. If the contract evolves, the L/C will have to be modified accordingly. And this implies having the bank’s agreement to do so.
This having been mentioned, let us imagine that an amendment with an increase in the contract price must urgently be implemented (e.g. repair/replacement of a damaged part). You may have difficulty obtaining the necessary L/C amendment if your customer does not have sufficient credit lines with its bank or if the bank is itself subject to credit restrictions (typical case of countries with low currency reserves). Again, expect discrepancies between the project’s operational needs and financial risk control.
Letter of credit at the end of the contract
Finally, let’s analyze what can happen at the very end of the contract (not considering the warranty period). Let’s imagine that you too have already known a customer who shows unwillingness to sign the acceptance reports even though he has put the equipment into production. But that, this time, thanks to a well negotiated contract, you will be able to invoice your last term with a report signed only by you on the basis of the deemed acceptance clause … If this clause is not transcribed in the terms of the LC, you will quickly see that it is as if it does not exist …
And what will happen with your last-minute claim in which you have put your extra costs, which have been validated “on the fly” by the customer? You may well realize that they will never be paid. Instead of financial compensation you should have offset these additional costs otherwise, for example by trading them for a reduction in your commitments.
As you understood from the above examples, the contract management can be strongly impacted by the need to have a letter of credit. Without questioning its usefulness in situations where the risks of non-payment are high, or where exchange regulations are stringent, a letter of credit can generate difficulties that the contract manager should not be underestimating.
PS: To simplify reading, I avoided in this article some aspects of letters of credit. Such as the difference between letters of credit and documentary credit or the complexity added by the L/C confirmation on the management of irregularities. I would be happy to answer any questions you may have and thank you in advance for your comments and feedback.
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