Archives: Letters of Credit

This is a guest post from Renaud Anjoran. Renaud runs a product quality inspection business in Shenzhen and he also writes the truly excellent and perennially helpful Quality Inspection Tips. My firm has worked with Renaud on a number of China product matters and we have consistently found him to be highly knowledgeable about China product sourcing. This post arose from a long email “conversation” between co-blogger Steve Dickinson and Renaud, which ended as so many of those do: with me suggesting that it be turned into a blog post.

So here’s the blog post, written by Renaud Anjoran.

 

Most transactions with Chinese suppliers are done through bank transfers. This payment method was described in a previous China Law Blog post, China Manufacturing Payment Terms. Limit Your Risks.

Many importers/foreign manufacturers are not familiar with Letters of Credit (LC) as an alternative to bank transfers. Letters of Credit were designed to protect both product buyers and product supplier in international trade. In practice, they are usually more favorable to the buyer.

How a letter of credit protects the buyer

An importer that pays by LC does not have to wire a deposit before production and it usually has the option to cancel the payment in the following cases:

  • If a supplier does not ship at the right time.  Typically if this happens, the LC simply expires, but the buyer still has the choice to pay if it wants the goods.
  • If a supplier does not honor the product specification or if there are too many defects. One of the conditions of the LC should be that the LC will not be paid on unless and until the product buyer has signed off on product quality or a specified third party QC agency has issued its certificate of inspection.
  • If the seller fails to provide any document listed as required in the LC or the documents do not fully conform to the LC’s requirements.

Why letters of credit can be cancelled by the buyer in most cases

Even something as small as a typo in the LC, or the fact that a quantity is written in dozens rather than in pieces in the invoice is usually enough to cause a discrepancy in the LC, which in turn allows the buyer to cancel payment.

In practice, a small minority of LCs are “clean,” i.e., without any discrepancy. In all other cases, the buyer has the option to refuse payment and cancel the transaction, even if the goods are already on a boat (in which case the buyer will not get the documents to get the products out of custom).

CLB Note:  We are aware of a Seattle buyer company that refused goods that had already arrived in Seattle because the street address (which was irrelevant) of one of the parties in the letter of credit was off by a single letter.

Tips for negotiating payment by letter of credit

For the reasons mentioned above, Chinese suppliers typically refuse to accept Letters of Credit. Here is how you can increase your chances of finding a Chinese company that accepts this payment method:

  • When sourcing your product, try to identify as many potential suppliers as possible. This will at least increase your chances of finding one that will accept an LC.
  • In your first conversation with your potential suppliers, mention that you always pay by LC on your first order. Try to get the supplier to accept this payment method in writing
  • Sell your project to your potential suppliers. Good manufacturers are inundated with customer inquiries, so you need to make yourself stand out. Explain why they should work with you. Call the Chinese company’s sales manager if necessary
  • Send your potential Chinese manufacturer a draft of the LC before opening it. You will usually need the commercial invoice, the packing list, the certificate of origin and/or GSM form A, the bill of lading, and an inspection certificate. Try to avoid putting “soft terms” into your Letter of Credit that will make it even more difficult for suppliers to collect payment.
  • If possible, use a major international bank. This will tend to reassure your suppliers.
  • Unfortunately, bank fees are much higher for an LC than they are for a bank wire, so an LC only makes sense for transactions of at least USD$30,000.
  • Chinese exporters are good at guessing whether a project is likely to become a source of long-term business. When they see what they think will be a a one-shot deal, they generally insist on getting a deposit and will not agree to an LC payment arrangement.

In summary, Letter of Credit are a payment tool that makes it unnecessary to transfer a 30% (or more) deposit to your Chinese manufacturer. They are usually more favorable to the buyer’s side, and for that reason, many Chinese companies refuse to accept them. But some Chinese product suppliers have been paid via Letters of Credit from some of their foreign customers for years, and sometimes Chinese manufacturers will accept your Letter of Credit if they really want your orders.

 

What do you think?

I know nobody wants to hear this and I know this is going to cause me to get hate mail from those whose livelihoods are tied in to China’s continuing to boom, but I am seeing all sorts of bad news on the horizon with respect to China’s economy.

A client meeting yesterday was the last straw. The client I met with is very sophisticated, very large, and, most importantly, very experienced. The client is a very large commodity seller who sells massive amounts to China. This company typically sells its product to Chinese private companies that use letters of credit. Prior to 2008, this client’s Chinese customers pretty much always paid. Then in 2008, they started contesting the letters of credit and seeking lower prices than that to which they had agreed. Soon after that, they started rejecting the shipments entirely. My client told me that in the last 3-4 weeks, nearly all of his non SOE (State Owned Entity) Chinese clients have contested the letters of credit and have sought lower prices of around twenty percent. They are confessing to my client that they cannot get loans and without loans they cannot pay so much.

If it were just that, I might chalk it up to problems in one industry, but it is not just that. Chinese companies that are going out of business or believe they are going out of business have an annoying tendency to ship bad or fake or no product at all. In 2008, pretty much every week we were getting calls from companies saying that the product they had ordered just was not coming. We handled one case where a company had bought about a million dollars of fish and received containers of cheap bricks surrounded by fish. That fake shipment was the dying gasp of a company that ceased to exist. We have started to get those same sort of calls in large numbers again.

We are also seeing it on the flip side of Chinese companies buying product from our U.S. clients or even trying to buy U.S. companies outright. The numbers are small to begin with, but it just seems like we are seeing an increase in Chinese companies that paid a deposit simply walking away from their deals.

What are you seeing out there? Is it really this bad, cause it sure feels like it?

I have a lawyer friend who is always saying “it’s incredibly easy to get clients…what’s difficult is getting paying clients.” The same holds true for selling product to China. The tough part is getting paid.

If you are going to sell product into China (or anywhere else internationally), you should consider employing the following to increase your chances of not getting stiffed:

  1. Secure all of the payment in advance. Sophisticated buyers typically will not accept this unless you put up a performance bond or open a standby letter of credit so that it can get its advance payment back. Note, however, that it can sometimes be difficult for Chinese companies to obtain government approval to make full payment in advance.
  2. Conduct due diligence on your buyer.
  3. Secure some of the payment in advance. This obviously will not guarantee you full payment, but it is better to lose some as opposed to all from a sale.
  4. Secure a Documentary Letter of Credit. With this, you will be paid when there is documentary evidence you have shipped the product according to the terms and conditions of the letter of credit. Smart buyers typically require an inspection certificate to ensure the product complies with the specifications in the contract or the purchase order. This sort of letter of credit mitigates your risk because your buyer’s bank has irrevocably guaranteed to pay upon presentation of the required documents.

We generally recommend our clients secure this letter of credit from a major (not a tiny) Chinese bank, such as Bank of China, China Construction Bank, Industrial and Commercial Bank of China, China Development Bank, and Bank of Communications, or a  branch of a known American, Asian or European bank. WARNING:  We have seen more than our share of fake letters of credit.

To encourage exporting, many countries, including the United States, make it fairly easy and cheap to purchase insurance to cover an improper non payment on the letter of credit.

There are all sorts of variations on the above, but these are the basics.