Using letters of credit to mitigate risk 

Every facet of a credit manager’s day-to-day work relates to risk mitigation, as they work tirelessly to protect their company through each transaction. When you are uncertain about a customer and their ability to pay within terms, it is time to consider new protective measures. 

Why it matters: One way to shield your company from risk and prevent major losses due to nonpayment is through letters of credit (LC). An LC is a written understanding by a bank, acting on a request from a customer, to make payments to a third-party beneficiary. The bank agrees to accept and pay bills drawn by the beneficiary. 

There are three main types of LCs. 

Standby letter of credit: This is an LC where the issuing bank agrees to make payment once appropriate documentation is shown, often a statement in writing by the beneficiary, that the customer did not pay according to terms.  

Confirmed irrevocable documentary letter of credit: These LCs transfer the payment responsibilities from the customer to a bank (often located in the same country as the seller) that did not open the letter of credit but agrees, at the request of the issuing bank, to be bound by the terms of the letter of credit. The confirming bank agrees to make payment upon seeing documents conforming to the contract of sale.  

Irrevocable documentary letter of credit: This letter is similar to a confirmed irrevocable letter of credit except that the bank that issued or opened the letter of credit bears the responsibility of payment. Most often, this is the customer’s bank accepting the payment responsibility.  

An LC can help control the riskiness of a transaction by shifting responsibility away from the customer to the bank, meaning that as long as the documentary requirements are met, the seller will be paid. “I don’t use letters of credit every day, but they definitely come into play when we’re dealing with higher-risk international transactions or when working with new customers where trust hasn’t yet been established,” said Gabriel Laza, CCE, CICP, director of credit and collections at CoolSys (Brea, CA). “We typically use letters of credit when there’s a large dollar value involved, when there are concerns about payment risk or when we’re entering a market with uncertain political or economic conditions.” 

An LC may be a helpful way to maintain a relationship with a customer who you suspect is approaching bankruptcy in the coming year. If you spot a customer having operational issues or cash flow problems that you worry may spiral into bankruptcy, an LC is an added level of protection that allows you to continue selling without exposing your company to risk. 

“We use them more for our higher-risk customers to ensure the receivables and securitize them with a standby letter of credit,” said Phillip Becker, CCE, ICCE, senior credit risk manager at the Coca Cola Company (Atlanta, GA). “In the past, when customers seemed to be approaching financial or operational failures, we have reached out to negotiate a standby letter of credit to keep shipping to the customer and prevent our company from incurring any losses should they file bankruptcy.”  

An LC offers a degree of protection similar to credit insurance, albeit with different requirements for documentation. “A lot of newer customers who are only a year or two old don’t have a lot of credit experience and it’s hard to get credit insurance on them without paying an exorbitant amount of money,” Becker said. “We found out that with the documented letters of credit, although there’s a little more work involved in the outright, getting paid is much easier than going through the credit insurance.”  

As with any contract, it is important that credit managers have a thorough understanding of what is being agreed upon. Mistakes in documentation can lead to banks denying payment until mistakes are fixed, delaying the process and creating extra work for credit managers.  

“Before accepting a letter of credit, we always do a thorough review,” Laza said. “We check all the terms against the sales contract, verify the accuracy of the beneficiary and applicant names, shipment details, expiration dates and make sure the document requirements are clear and attainable. Any discrepancies can delay payment, so we try to catch issues upfront, sometimes with help from our freight forwarder or bank.” 

The bottom line: Risky customers may pop up in any corner of your portfolio. Whether they operate in a region facing economic headwinds or they don’t have much credit history, a letter of credit can help protect your company from the risk of nonpayment. It is critical that credit managers understand the documentary requirements that accompany each type of letter of credit to best protect their company from lost or delayed payment.