A letter of credit is by nature, a tool that protects exporters from the non-payment risk.
As developed in our article which details the process of a letter of credit , if you require a commitment from a confirming bank located in your country , you have a full guarantee that the payment will be made by the bank even if the importer fail to do so.
However, this protection comes with costs (fixed and variable fees) paid by the importer and therefore you don’t want to ask for the letter of credit to be confirmed unless it is necessary. After all as a business man your aim is to make your customer happy, which implies that you do not want to induce extra expenses for him unless it is justified by the existence of a real risk.
Considering the following aspects can help you to have a better a sense of whether you should require payment via a confirmed letter of credit
The size of the transaction
As a general rule, the bigger the size of a transaction, the more the non-payment risk can potentially harm the overall business of a company. Having said that, one should consider the size of a deal in comparison to a global turnover. In other words, the absolute and relative size must be both taken into consideration in order to determine the level of protection that is needed.
For the sake of simplicity, we can assume that deals of less than a 100 00 Euros (or USD) can be processed via an open account or advance payments, unconfirmed letter of credit and even documentary collection. On the other hands, International deals above this limit requires to adopt a protection against non-payments such as a confirmed letter of credit.
This aspect is very important since the longer the distance between your home country and the country where you export , the more we tend to think that the risk of doing business increases.
However this is partially true, because while the absolute distance in terms of kilometers could be huge, we might find other aspects that can make a distant country really close.
Let me explain.
We have to bear in mind that in case of non-payment what we want, is to be able to enforce the terms of the sales contract that you and your trading partner agreed upon.
Generally, it is much easier to enforce the application of a sales contract with a customer located in your own country since the legal framework is the same.
Nonetheless, in a cross-border environment, determining the legal framework that will prevail could be a little bit tricky.
This is why a sales contract must absolutely specify the applicable governing law and the jurisdiction under which potential litigations will be settled .
In other words, one should define clearly from the beginning , which countries’ law must be referred to, in case of a dispute, as well as the exact court where legal disputes will be settled.
Furthermore, one should rely on a strong legal framework which is easily enforceable and predictable. Put differently the extent to which the “rule of law ” prevails in a country determine the degree of protection that sales contracts can benefit from.
In this respect , countries are not created equal since there is a large spectrum of countries where the state of “rule of law “ is weak and others where it is reliable.
Luckily , we have some free tools that can help us to have a sense of how good the state of the rule of law is, in a given country.
The WJP Rule of law index:
The World Justice Project is a non-profit organization which publish yearly a report regarding the state of the rule of law around the world(see screenshots below).
The WJP rule of law index is based on a large survey made among 120 000 households across in 126 countries. The size of the sample used is large enough so that margin of error remains acceptable and the methodology is cross-checked by experts.
This index is built on 5 questionnaires including “ The civil and Commercial Law” and “The Criminal Justice” questionnaires, that are of particular interest for us since they provide precious insights about the state of the rule of law in a given country with a focus on commercial aspects.
For more on the WJP Rule of law index click here
The World Bank “Rule of Law index”
The world bank has developed a set of statistics called the “ Worldwide Governance Indicators” which include the rule of law index. (see screenshot below)
Those statistics are based on methologies that are continually refined and improved by scholars. This index is based on 30 high-quality data sources which are compiled and rescaled so that the size of the dataset is large enough for guaranteeing a strong level of reliability (low margin of error).
One of the main advantage of this kind of tools is that it allows to compare 200 countries which is precisely what we need.
The rule of law index is scaled from 0 to 2 .
You can access to this raking here
As a “take home advice” we can simplify by saying that if the state of the “rule of law” is weak in the country of your buyer, you must require a confirmed letter of credit.
Moreover the sales contract must refer to a strong governing law and contain jurisdiction clauses which identify clearly the court of a given country which will be responsible in case of legal dispute.