Letter of credit or documentary collection: what to use for a first import order

On a first order with a foreign supplier, the payment question comes down to a mutual and legitimate mistrust: the seller does not want to ship without being sure of payment, and the buyer does not want to pay without being sure of delivery. Two bank instruments break the deadlock: the letter of credit and the documentary collection. Their paper trail looks similar; the way they allocate risk does not.

The letter of credit: a bank undertaking

Under a letter of credit, also called a documentary credit, the buyer’s bank (the issuing bank) undertakes to pay the seller provided the seller presents documents that comply with the terms of the credit: invoice, bill of lading, certificate of origin, and an insurance document where the chosen Incoterms® 2020 rule requires one. Most credits are subject to the International Chamber of Commerce’s Uniform Customs and Practice for Documentary Credits, UCP 600, the 2007 revision. Two principles follow. The credit is a transaction separate from the sale contract: the bank is not bound by the commercial contract, even if the credit refers to it. And the bank examines documents, not goods; it has a maximum of five banking days following presentation to decide whether the presentation complies.

Under UCP 600, a credit is irrevocable even if it does not say so: it can be neither amended nor cancelled without the agreement of the issuing bank, the confirming bank if there is one, and the beneficiary. The credit may also be confirmed: a second bank, usually in the seller’s country, adds its own undertaking to that of the issuing bank. Confirmation protects the seller against a default by the issuing bank and against country risk, such as restrictions on transferring foreign currency. It comes at a cost. An unconfirmed credit remains common where the seller is comfortable with the issuing bank and its country.

For electronic presentation, the ICC has added a supplement to UCP 600, the eUCP, now at version 2.1, and one to URC 522, the eURC, at version 1.1. The Uniform Rules for Digital Trade Transactions (URDTT), in force since 1 October 2021, govern fully digital transactions. All of them apply only where the parties expressly refer to them.

The documentary collection: D/P and D/A

In a documentary collection, the seller ships the goods, then hands the documents to its bank, which forwards them to a bank in the buyer’s country with a collection instruction. The applicable rules are the ICC Uniform Rules for Collections, URC 522, the 1995 revision. The banks act in good faith and with reasonable care, but they only check that the documents received appear to be those listed in the instruction. They do not check their accuracy and do not guarantee payment.

• D/P, documents against payment: the buyer only receives the documents needed to take delivery of the goods once it has paid.
• D/A, documents against acceptance: the buyer receives the documents against acceptance of a draft payable at a future date. The seller is, in effect, extending credit.
• If the collection instruction for a future-dated draft does not specify the option, URC 522 provides that the documents are released only against payment.

For the seller, the risk is real: if the buyer refuses to pay, the goods are already at destination and must be resold, shipped back or abandoned. Under D/A the risk is higher still, since the buyer holds the goods before paying for them. For the buyer, a collection is comfortable: no credit line is tied up. But it gives no assurance on quality: the buyer pays against documents, not after inspecting the goods.

Who carries the risk: a side-by-side comparison

Discrepancies, a frequent cause of rejection

A letter of credit rests on strict compliance. A complying presentation meets the terms of the credit, UCP 600 and international standard banking practice, which the ICC codifies in ISBP (publication 821, 2023 edition). Any divergence is a discrepancy. A bank that refuses must send a single notice listing every discrepancy. Payment is then no longer guaranteed: it depends on the buyer waiving the discrepancies or on a corrected presentation within the time limits. The most common discrepancies:

• Late presentation: unless the credit says otherwise, original transport documents must be presented no later than 21 calendar days after the date of shipment, and before the credit expires.
• A description of the goods on the invoice that does not correspond to the one in the credit.
• A bill of lading without an on-board notation, or bearing a clause on the condition of the goods or packaging.
• Conflicting data between documents: weights, number of packages, ports, container numbers.
• An insurance document dated after shipment, or an insufficient insured amount.

For the buyer, the lesson is the mirror image: every requirement added to the credit is another opportunity for a discrepancy. A short credit modelled on the contract and the pro forma invoice protects better than one that piles on documents.

Costs of a different order

A letter of credit is the most expensive instrument and the heaviest to administer. It combines issuing and amendment fees, usually for the buyer’s account, with advising, document-handling and, where applicable, confirmation fees, generally for the seller’s account, plus charges if discrepancies arise. It also ties up the buyer’s credit line. A documentary collection costs less and involves less paperwork. There is no universal tariff: terms vary by bank, country, amount, tenor and country risk, and only your own bank’s tariff is authoritative.

When to move to a bank transfer with a deposit

Once the relationship is established, the cost and rigidity of a letter of credit become hard to justify, and the parties generally move to a documentary collection, then to bank transfer. A common pattern, though by no means a standard, is a 30% deposit on order and the balance against a copy of the bill of lading, before the original is released. The proportions and the document that triggers each payment are negotiated case by case.

This pattern leaves the buyer with two risks to cover by other means. The deposit is paid with no bank undertaking in return: it presupposes that the beneficiary company and the match between its name and its bank account have been checked. The balance is paid on the strength of a copy: a pre-shipment inspection by a third-party body, whose report gates that payment, reduces the risk.

1. First order, significant amount, unknown counterparty: an irrevocable letter of credit, confirmed if the issuing bank or the buyer’s country concerns the seller.
2. Subsequent orders, without incident: documentary collection on D/P terms.
3. Proven relationship, regular flows: bank transfer with a deposit and the balance against documents, combined with a pre-shipment inspection.
4. D/A only where the seller knowingly agrees to extend credit to the buyer.

This article sets out general principles; it does not constitute banking or legal advice. Your bank’s terms and the regulations of the destination country prevail.

SELA INTERNATIONAL LTD settles its transactions by irrevocable letter of credit, documentary collection, or bank transfer with a deposit on order and the balance against documents. The applicable terms appear in each offer and depend on the amount, the corridor and the maturity of the commercial relationship.