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What is a Letter of Credit?

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What is a Letter of Credit?

Use of Letters of Credit, reduce the exposure to risk inherent in international business transactions, when certain methods of payment are implemented.

The Letter of Credit is the means by which parties may reduce risk in international transactions.  With a Letter of Credit a seller of goods assures that the expected payment will be received, most typically in international business transactions.  In practice, it has been standardized by a universally accepted set of rules, namely, the Uniform Customs and Practice for Documentary Credit, issued by the International Chamber of Commerce.

In international business transactions, the methods of payment used payment in advance, on open account, or C.O.D.  C.O.D. is accomplished generally, by payment against collection documents, that is, the seller will forward the customary shipping documents through the seller's bank to the buyer's domestic bank, including a draft drawn on the buyer for collection.  Then draft is honored and paid or, if appropriate, accepted, the buyer will obtain delivery of the documents, which entitle the buyer to delivery of the goods.

If cash is paid to seller in advance, the buyer's risk includes defective performance or non-performance.  With a C.O.D. or collection transaction, the documents are presented after the goods have been shipped and often after arrival at the destination port. Thus, if the draft is not honored, the risk is that the buyer may not pay for the manufacturing/fabrication and shipping.  The seller bears the maximum risk of non-payment, in a sale on open account.

 What is a Standby Letter of Credit?

Similar to commercial Letters of Credit standby letters of credit are documentary, that is, collection is achieved through the presentation of one or more documents, such as a draft or other demand.  A standby letter of credit is applied in an unlimited variety of transactions, including sale of goods and its purpose is to assure a party to a contract that the other party will perform its obligations.  The standby letter of credit is similar to a performance guarantee in function.

What is the typical structure of the Letter of Credit transaction?

Typically, in a sale of goods, the Letter of Credit transaction is made up of three contracts, as follows:

(1)       Buyer-Seller Contract. The buyer and seller contract for the purchase and sale of the goods requiring payment through a documentary credit.

(2)       Buyer-Bank Contract.  The buyer ("account party") applies for a letter of credit, instructing the buyer's bank ("issuer") to open the credit for the benefit of the seller based upon the application terms.

(3)       Advising Bank-Seller.  The issuing bank issues the letter of credit and forwards it to an advising bank within the country of the seller. The advising bank, advises the seller of the opening of the credit in seller's favor.

What information is contained in a Letter of Credit?

Generally and most often, a letter of credit contains the following:

(1)       The names of the Parties (including the advising bank).

(2)       The credit amount.

(3)       Expiration Date.

(4)       The undertaking of the issuer to pay upon presentation of the draft and specified documents and generally, whether payable on presentation ("a sight draft") or payable at a time after presentation ("a time" or "issuance draft").

(5)       Merchandise description; whether partial shipments and transshipments will be permitted.

(6)       All special conditions and/or instructions.

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