When selling internationally, a company may find it hard to protect their sale through the use of trade credit insurance and receivable puts. A more common way is confirming a letter of credit, particularly on export sales.
What does Confirmed mean?
In layman’s terms, when issuing an L/C, the Buyers Bank stands in the place of the buyer in a foreign or domestic country. This is not always an acceptable risk. This is where confirmation comes in. A confirmed irrevocable letter of credit enables a domestic bank to stand in place of the buyers bank, with permission from the buyers bank, creating a post-shipment domestic transaction with respect to the seller, and a pre-shipment foreign transaction with respect to the buyer and the buyer’s bank.
Many corporations adopt a policy that all export letters of credit (“L/Cs”) received must be confirmed by their banker(s) in order to cover the payment and country risks of the L/C issuing banks. In a prior survey I conducted, companies still confirm L/Cs, with 65% doing so for many of their L/Cs, and only 13% not doing for any of their L/Cs. It is not always apparent who pays for the confirmation fees, depending again on the trading relationship. Many times, larger companies will build both the confirmation charges and estimated discrepancy handling charges into the pricing if they have the leverage to do so. Other companies don’t have that luxury and hence the resistance felt by some suppliers in certain markets. Many times the driver for companies is to turn a recourse or Collection payment into a non recourse source of funding, particularly for large dollar sales.
Here’s some advice before you embark on confirming a Letter of credit and incur potentially unnecessary fees:
- Start by using S&P and Fitch Ratings to guide your decision process
- Be more proactive asking your bankers questions. We found companies have questions and could be much smarter in how they use confirmations (egs. Do Vietnam banks open confirmed L/Cs, what clauses to include for sight Confirmations in China, can you confirm in Venezuela, etc.)
- If companies look at it from a pure commercial risk perspective, typical markets needing confirmation need to be divided into two parts – state-owned companies in emerging markets and non-state owned companies. Many times, the real challenges come with the state-owned companies. They have the ability to pay, but sometimes they seem to erect barriers to prompt payment. Typically the state owned companies will require payment by L/C but will often include irrational, irrelevant, impossible or contradictory clauses in the L/Cs which will then take time and money to resolve. This is especially true with the commodity volatility we have seen over the last few years.
- Confirmation requests in certain markets such as China are the exception, and knowledgeable companies either don’t insist or pursue silent confirmations. In India, many times an L/C is required as a means for buyers to finance the goods. A confirmation request there may not be necessary (although there is high documentation risk).
Ultimately, get smart how your bankers approach confirmation, what markets they will cover and will not, and what risk mitigating techniques they require from the overseas issuing Banks. This is especially imperative as more banks reduce their correspondent Bank relationships due to onerous compliance requirements. So second and third tier banks in Pakistan, or Cambodia or the Middle East may now find it harder to do business. -Trade Finance Matters