China question: How can I use letters of credit with Chinese suppliers?

1. Waive all discrepancies, release payment and get the documents (sometimes a discount is negotiated and the supplier issues a credit note)
2. Refuse the discrepancies and cancel the letter of credit. For the most common letters of credit, known as at sight, it means the buyer does not receive the documents

A minority of Chinese suppliers accepts letters of credit, so here is my advice. From the very first communication with a potential supplier, mention your payment terms. If they push back, tell them it is your company policy. If they still refuse, look for another supplier.

If you feel that a supplier might accept a payment by letter of credit, here are my tips to reassure them:

• Use a famous international bank if possible;
• Only ask for the necessary requirements (your bank's commercial department should be able to help you on this);
• Send a draft to your supplier before formally opening the LC and take their comments into account; and
• Open a letter of credit at sight. Do not try to extend the maturity, unless you feel the supplier really wants your order.

I can see two reasons why most Chinese suppliers refuse letters of credit. First, this payment mode protects the buyer more than the supplier. In theory, the opening bank guarantees to pay and the letter of credit protects the supplier against payment risks. In reality though, there are virtually always discrepancies. In case the buyer's account is empty, it might push the bank to manufacture discrepancies in order to give the buyer an easy way out. At the very least, the discrepancies allow for a payment delay.

As a consequence, the supplier prefers the solution of bank wires. This way the supplier hooks the buyer with a 30% down payment and can avoid payment delays by refusing to ship the products before receiving the remaining 70%.

Second, most Chinese manufacturers have little cash on hand. They need money to buy the components necessary for production and they cannot always count on their bank to discount a letter of credit.

This is why a supplier accepting a payment by letter of credit is a good sign. It means they have no financial problem and are relatively stable.

Renaud Anjoran, Sofeast, Shenzhen

The domestic perspective

A letter of credit is the most important payment method in international trade. There are two conditions in which a letter of credit can be revoked: 1) parties to the letter agree to cancel or amend the letter; and 2) the letter of credit expressly indicates that it is revocable. According to statistics, in more than 80% of international trade business transactions, contract parties pay through letters of credit. A letter of credit represents bank credit other than commercial credit. Bank credit is actually more reliable than commercial credit, because the banks act on guarantees for the underwriting transaction. The relevant banks only handle the documents. When the documents appear to constitute a complying presentation, the issuing bank, confirming bank or nominated bank, if any, must honour or negotiate.

Normally, when the exporter or seller does not fulfil the undertaking in accordance with the terms and conditions stated in a letter of credit, the presentation constitutes non-compliance. The issuing bank or nominated bank, if any, may refuse payment. When an issuing bank refuses to honour, or a confirming bank refuses to honour or negotiate and has given notice to that effect, it shall then be entitled to claim a refund, with interest, of any reimbursements made. In this case, the beneficiary, including but not limited to the exporter and seller, cannot be paid by the issuing bank and the confirming bank, if any. The applicant shall then be entitled to cancel the letter of credit and get the security deposit back. Furthermore, in the underwriting contract, the terms and conditions that the buyer is entitled to claim compensation include but are not limited to the interest of the security deposit if the seller did not fulfil the undertaking as stipulated by the terms and conditions in the letter of credit.

The most common drawback in the letter of credit practice is that the exporter or seller defrauds payment. This is done through the exporter or seller presenting false documents or using their knowledge on a letter of credit to fabricate pitfalls that compel the beneficiary into a detrimental position. The beneficiary is unable to receive the payment and has no right to get back the security deposit from the issuing bank, due to the beneficiary's non-performance. From the buyer's perspective, it should conduct due diligence investigations beforehand and then select the suppliers, who have good credit, standard operations, sufficient debt servicing capacity and an authentic transaction purpose and performance capacity. Nevertheless, the buyer should not conduct transactions with fly-by-night companies. How can buyers distinguish fly-by-night companies from other companies? One suitable option would be to employ a local law firm in the supplier's country.

Honouring or negotiating requires professional experience. In China, there are professionals in charge of managing letter of credits. Acting in compliance with the instructions of the issuing bank, confirming bank, or nominated bank is the most important rule when honouring or negotiating with Chinese banks. Keep in mind that a bank's rules and standards are conditional to their respective local regions. Since most buyers are unfamiliar with all such local rules and standards, they should communicate with the relevant banks beforehand in order to alleviate this issue. However, Chinese companies are reluctant to choose a letter of credit as a payment method because they believe it to be an excessive and complex process and think that the banking fees are too expensive. In addition, some Chinese companies have been defrauded by foreign companies and received little compensation due to the procedure's complexities and national discrimination. However, buyers can still increase the chances of the supplier using a letter of credit by explaining to the seller the rules, safety, convenience and supplying sufficient collateral. Moreover, selecting a well-known Chinese bank as the honouring bank or the confirming bank has the potential to increase a Chinese companies' confidence in deciding whether or not to use a letter of credit.

Victor Zhang, Han Kun Law Offices, Beijing