Letter of Credit (LC) - Documentary / Commercial:
Note: This definition is more involved than most found in The Dictionary of Financial Scam Terms© due to the myriad ways in which swindlers misrepresent Letters of Credit and their attending terms and possibilities. A solid, basic understanding of Letters of Credit is vital to recognizing the scams.
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.
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 (see The Scam, below).
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." Again, see The Scam, below.
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.
A scammer is always careful to stipulate that a Letter of Credit must be irrevocable, negotiable, transferable, assignable, preferably revolving, and that he be named the Beneficiary. This is so that if by any chance the victim actually does purchase a legitimate LC, it can be easily handed over to the swindler with no recourse. Once that is accomplished, the swindler has every right to present himself to the issuing bank in order to obtain a Draft; however, in most instances the swindler insists that the victim obtain and hand over the Draft as well.
Supposedly, the LC will then be entered into a Trade Program (HIGH-YIELD INVESTMENT PROGRAM or HYIP) where it will be used to generate impossibly huge profits in an impossibly short time ("impossible" because the entire planet would go broke if their claims were true, or we'd all be wheeling around wheelbarrows full of cash to buy a loaf of bread). The victim is supposed to receive around 50% of the profits, and the Trader receives 50%. From this they are each to pay their respective INTERMEDIARIES.
Forfaiting: While a Letter of Credit may be forfaited (also known as export factoring, the international trade equivalent of factoring), that is not a procedure to be taken up by the inexperienced. Without an intimate knowledge of trade finance, trade law, international politics and economics, and a career-based understanding of banks and banking, you can quickly find yourself up the creek without a paddle.
Fraudsters truly enjoy using the term "forfaiting." I believe that this is because, especially when the native language of their intended mark is English, the term "factoring" is too readily understood. Nothing appeals more to the psyche than an exotic term, and swindlers make full use of this all too human trait.
The scam is that one can purchase Letters of Credit either from banks or from Beneficiaries for far less than the face value (value at maturity), then "forfait" them at enormous profit. Just how this is done is never really explained and any attempts at getting an explanation are artfully turned aside or simply fabricated, or the SECONDARY MARKET sale is inserted into the scam.
The usual swindler approach involves persuading the target that a Letter of Credit can be purchased at enormous discount in exchange for the victim's funds, and that a few weeks or months later this same financial instrument will be worth hundreds of thousands more or can be sold for hundreds of thousands more. Sometimes the numbers slip into the hundreds of millions.
Another form of patter would have you believe that you can purchase a Letter of Credit at Top-euro Bank for only 25 or 45% of the full value, immediately walk across the street to Prime-euro Bank and sell it for full value, then turn around and do the same thing the following day. The reason the swindler can do this is by special contract or dispensation with Top-euro, and you can be a lucky participant because the swindler likes you so much.
A favored ploy is to insert the bogus term CUTTING HOUSE into the structure of the scam. Once again, this mixes a straight out Letter of Credit scam with the High-Yield Investment scam. In this scenario, the victim is told that LC's are BANK GUARANTEES, aka BG's or PBG's (Prime Bank Guarantees). According to the swindler, Bank Guarantees are printed out in bulk by the Cutting House, an alleged establishment much like a printing company that spits out financial instruments like the Treasury prints money, and does this on demand for Top or Prime European banks such as the one with which the so-called TRADER has a contract.
If the Trader has a contract with or is "connected" to the so-called Cutting House, then the victim is made to feel he has really hit the jackpot.
The Trader needs your funds to purchase the bulk LC's/BG's on a FUNDS-FIRST basis so they can be SEASONED overnight (seasoning actually takes at least a year), then sold to the Secondary Market the following day. The much-used statement is that this can be accomplished 40 times a year, except for the period between November 15th and January 15th of the following year. Why? Because supposedly all trading comes to a halt during that time.
Another scam is to purport to be a PROVIDER of Letters of Credit. The phony Provider has a special in with Top or Prime banks and can obtain Letters of Credit on the victim's behalf. Most of those who fall for this are victims who are not creditworthy enough to apply for an LC through regular channels, or people who have no working knowledge as to how LC's are really used and therefore believe that there is some magic way to turn them into majestic profits. In this type of scam the value of the LC is almost always in the 100's of millions of dollars.
There are yet more scams involving Letters of Credit, some of which are particular to Standbys and some of which involve fraud committed by financial institutions, exporters, importers, and any entity that has access to Letters of Credit in all their formats. For every type of Letter of Credit, there is an attending scam.
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