Beware of the LC Scam

Letter of Credit Basics

Letters of Credit became necessary when trade between countries made it impossible to simply do business by handshake. They were initially introduced by the merchant banking system in Europe, and grew out of earlier contracts such as the "chop" in Asia and the personal "house" emblem embossed in hot wax used throughout Europe and Arabia.

Originally, a Letter of Credit (LC) was quite literally that - a letter addressed by the buyer's bank to the seller's bank stating that they could vouch for their good customer, the buyer, and that they would pay the seller in case of the buyer's default.

They were used then, as they are now, for any transaction wherein one or more parties to the transaction requires the comfort zone of guarantee of payment by a reputable bank. One may request a Letter of Credit for a transaction involving goods or services where the parties are on the other side of the world, or just across the street.

Nowadays, LC's are formatted to provide fill-in spaces for the various documentary requirements of international or domestic business. An LC is issued by a bank on behalf of one of it's creditworthy customers, whose application for the credit has been approved by that bank. (See sample of Letter of Credit Application, Guaranty Bank, Texas)

The sequence of information on an LC and the trade terms used are set forth in the standards established by INTERNATIONAL CHAMBER OF COMMERCE (ICC). The rules and language are very specific and cannot be changed, and are spelled out in the ICC's Uniform Customs and Practice for Documentary Credits - ICC Publication 500, or UCP500.

The parties to a Letter of Credit are

(1) the Buyer (the applicant)

(2) the Buyer's bank (the issuing)

(3) the Beneficiary (the seller/payee)

(4) the beneficiary's bank (the ADVISING BANK).

(5) the CONFIRMING BANK (often the same as the advising bank)

The LC outlines the conditions under which payment (credit) will be made to a third party (the Beneficiary). The conditions are specified by the buyer and may include insurance forms, Way Bills, Bills of Lading, Customs forms, various certificates - i.e. whatever documents the Buyer feels are necessary to safeguard the integrity of the purchased product or service upon delivery.

It is the responsibility of the issuing bank to ensure, on behalf of its client (the Buyer), that all documentary conditions have been met before the Letter of Credit funds are released.

In effect, a basic Letter of Credit is a financial contract between the bank, the bank's customer, and the beneficiary, and this contract* involves the transfer of goods or services against funds.

*Not to be confused with the private contract between the Buyer and Seller. The private contract between the Buyer and the Seller is not included in the list of documents that must be physically presented for approval prior to release of payment.

In order to get paid, the Beneficiary must present a DRAFT, or BILL OF EXCHANGE, plus the documents specified on the LC, to the advising bank. The documents are then forwarded to the issuing bank for approval. Upon notification of approval, the advising bank pays the Beneficiary the amount due, and processes the Draft through normal banking channels back to the issuing bank who then credits the advising bank for funds disbursed, just like any check.

Please understand that the LC is a contract whose terms and conditions must be met, and that it is NOT a check. While a LC may be NEGOTIABLE, TRANSFERABLE, and ASSIGNABLE, it is the Draft created against the LC that is paid, and this Draft is issued by the same bank that issued the LC.

It's also important to understand, as you will see under The Scam below, that a LC can be either REVOCABLE or IRREVOCABLE.

The terms and conditions of a Revocable Letter of Credit can be changed by the issuing bank at any time without notice for its own reasons, and therefore cannot be confirmed as good and payable. It's impossible to guarantee that any financial instrument whose conditions of payment can be changed without notice will be payable at any given time. Until the terms and conditions are solidified, the requirements the Beneficiary must adhere to in order to receive payment are up in the air.

An LC may be written for a short period of time, covering one shipment of goods and one single payment, or may be written as a REVOLVING LETTER OF CREDIT such that it renews as periodic shipments and attending documents are received and payment is released thereon. This is useful if the shipments are to be made periodically over the term of say, a year, as agreed upon between the Buyer and Seller in their private contract. (Note: a valid Letter of Credit never carries the term "one year and one day" which is a meaningless term created by fraudsters).

The maturity date on a Letter of Credit is the date on which the full value of the credit is payable.

Regardless of the terms and conditions of the LC, the buyer has to either have the funds on deposit in his bank to cover the full value, or has to have made other arrangements with his bank to cover the full value. A Letter of Credit cannot be purchased for only a small percentage of the face value and then cashed across the street for the full face value, a popular form of swindle-speak.

In the case where the Buyer has made arrangements to reimburse his bank - the issuing bank, at a later date for payments made by the issuing bank upon approval, the LC is called a DEFERRED PAYMENT or USANCE LETTER OF CREDIT, in which case the Buyer can obtain his goods and pay the issuing bank at a later specified date.

In international trade, a popular method of obtaining immediate funds against a Letter of Credit, for whatever financial reason the Beneficiary may have, is FORFAITING. The term "forfaiting" is noted here because it is so often used by swindlers, as opposed to "export factoring."

By using a forfaiting company or the forfaiting department at his bank, a Beneficiary can turn over all claims to the LC and in turn receive an amount less than the full value of the LC at maturity. The difference between the full value of the LC at maturity and the amount the forfaiting company pays for it is called the DISCOUNT. The Discount rate is based on a bevy of conditions including the creditworthiness of the Beneficiary, that of the issuing bank, and the stability and reputation of the country in which the issuing bank is located.

The Beneficiary goes on his merry way with immediate cash in hand, and the forfaiting company assumes all risks and benefits of the LC.

An in-depth review of all Letters of Credit with all their attending terms and circumstances of use will eventually find it's way into this dictionary. For now, and for the immediate purposes of outlining the scams listed below, the only other two LC's you need to understand are Commercial / Documentary Letters of Credit and STANDBY LETTERS OF CREDIT.

How does the scamster makes use of the Letter of Credit? Read it here!