Letters of Credit

Letters of Credit

A bank provides a letter of credit on behalf of an importing customer conditionally guaranteeing payment to the exporter.

Letters of Credit

Letters of credit

A bank provides a letter of credit (L/C), which may also be known as a documentary credit, on behalf of an importing customer conditionally guaranteeing payment to the exporter (via the exporter’s bank) if the exporter provides all the documents specified in the letter of credit. Because the L/C is a form of credit the importer must apply for credit approval from its bank.

The L/C agreement between the buyer and seller is separate from the sales contract and while the sales contract is fulfilled when the seller provides the requested goods in exchange for payment, the L/C agreement is fulfilled when the necessary documents are exchanged by the importer and exporter’s banks.

Payment under an L/C may be at sight, i.e., when the importer’s bank is presented with the necessary documents or at usance, i.e. where payment is made after a specified time after sight or shipment date.

 

 

Variations on normal letters of credit include:

  • Transferable L/C - this allows a beneficiary, such as an export broker, to pass on the payment benefit of an L/C to one or more third parties, such as a manufacturer or wholesaler.
  • Revolving L/C - this may be used where regular deliveries are made over a period of time and allows an importer to use a revolving clause in the letter of credit. The issuing bank restoring the credit amount each time the credit is used or drawn down.
  • Confirmed L/C - where the exporter may have reservations about the importer’s bank or its country of origin, the exporter may seek a confirmed L/C through which a second bank, usually in the exporter’s country and at the request of the exporter, also commits to pay the seller for the goods upon fulfilment of the conditions of the documentary credit, confirming the L/C.
  • Standby L/Cs - this is very similar to a bank guarantee and is intended to be used in the event that the buyer defaults on a contractual obligation, including not making payments when due.  The standby L/C may be used as a backstop, enabling buyers and sellers to trade on an open account basis. The buyer’s bank will act as guarantor and will pay it a specific sum, usually requiring a written demand for and documentary evidence of default.