Letter of Credit: Legal Definition, Types and Purpose

What is a Letter of Credit?

A Letter of Credit is a financial instrument issued by a bank or financial institution guaranteeing that a buyer’s payment to a seller will be received on time and for the correct amount.

Letter of Credit: Legal Definition and Introduction

Legal instruments have been crafted over centuries to support and facilitate global commerce. Among the most significant are Letters of Credit (LC).

A Letter of Credit is a binding document that a bank or a financial institution issues at the request of its customer, typically a buyer.

It guarantees that the bank will pay a seller upon presenting specified documents proving the seller has performed its obligations under a sales contract.

Navigating the intricate maze of international trade can be daunting, and understanding Letters of Credit can offer a strategic advantage to stakeholders in various industries.

The Importance of Letter of Credit in International Trade

In international transactions, parties often face challenges such as unfamiliarity with foreign legal systems, concerns over payment security, and potential credit risks. LCs help mitigate these risks by:

  • Building Trust: They offer a reliable payment mechanism, ensuring sellers will be paid once they present conforming documents.
  • Providing Security: Buyers are protected as banks release payments only upon receiving compliant documents.

Types of Letters of Credit

  • Commercial Letters of Credit: Commonly used in international trade, the issuing bank pays the beneficiary upon presenting specific documents.
  • Standby Letters of Credit: Operates like a safety net. Payment is made only if the opposing party fails to perform as contracted.
  • Revolving Letters of Credit: Useful for multiple shipments over a period. The credit amount “revolves” either by time or value.
  • Red or Green Clause Letters of Credit: Allows advance payment to the seller before shipment. The red clause permits a certain percentage in advance, while the green clause covers warehousing costs.

Key Parties Involved

  • Applicant/Buyer: Requests the LC.
  • Beneficiary/Seller: Entitled to receive payment.
  • Issuing Bank: Issues the LC and ensures payment upon receipt of compliant documents.
  • Advising Bank: Advises the LC to the beneficiary. It might also act as the confirming bank, guaranteeing payment if the issuing bank defaults.

The Letters of Credit Process

  1. Contractual Agreement: Buyer and seller agree to use an LC as a payment method.
  1. Issuance: Buyer applies to their bank to issue an LC in the seller’s favour.
  1. Advising/Confirmation: The LC is sent to the advising bank, informing the seller of its terms.
  1. Presentation: Once goods are shipped, the seller presents the required documents (like bills of lading) to the bank.
  1. Examination: The bank verifies documents against LC terms.
  1. Payment: Upon confirmation of valid documents, the bank makes the payment.

Read article: UCC 3-104 (Negotiable Instrument): Legal Commentaries and Analysis

UCP 600

The International Chamber of Commerce (ICC) introduced the Uniform Customs and Practice for Documentary Credits (UCP 600) to standardise Letters of Credit operations globally.

Common Issues and Legal Disputes

Discrepancies between presented documents and Letters of Credit terms can lead to payment refusals. Legal disputes may also arise from:

  • Ambiguous terms in the LC.
  • Late presentation of documents.
  • Non-compliance with UCP guidelines.
  • Fraudulent document presentations.

The Difference between a Letter of Credit and a Line of Credit

FeatureLetter of CreditLine of Credit
NatureDocumentary credit to facilitate trade.Revolving loan facility.
PurposeGuarantee payment to a seller on behalf of a buyer.Provide borrowers access to funds as needed.
UsageUsed mainly in international trade.Used for any purpose, often business expenses.
IssuanceBy banks at the request of a buyer for a seller.By banks or financial institutions for borrowers.
BasisBased on documentary compliance.Based on the borrower’s creditworthiness.
DurationTypically tied to a specific transaction.It can be open-ended or for a fixed term.
SecurityPayment is made upon presentation of specific documents.Usually unsecured, but can be secured.
InterestNot applicable unless payment is delayed.Interest is charged on the amount borrowed.
Letter of Credit vs Line of Credit

How does a back-to-back Letter of Credit work?

A back-to-back Letter of Credit involves two Letter of Credit used in tandem. A seller, an intermediate buyer, receives a Letter of Credit from the end buyer (first Letter of Credit). Using this as collateral, the intermediate buyer then requests their bank to issue a second Letter of Credit in favour of their supplier (second Letter of Credit).

Both Letters of Credit are separate but mirror significant terms of the original LC, such as product specifications and shipment dates.

The supplier ships goods directly to the end buyer and presents conforming documents to their bank for payment under the second Letter of Credit.

In contrast, the intermediate buyer does the same with the first Letter of Credit.

How does the advising bank differ from the confirming bank in a Letter of Credit?

An advising bank primarily acts as a messenger. It receives the Letter of Credit from the issuing bank and ensures delivery to the beneficiary (usually the seller).

This bank verifies the Letter of Credit’s authenticity but does not commit to paying the beneficiary.

Conversely, a confirming bank adds an extra layer of security for the beneficiary. By confirming a Letter of Credit, this bank provides a guarantee of payment on top of the issuing bank’s commitment, provided the beneficiary presents compliant documents.

Essentially, it “confirms” the credit and takes on the risk of the issuing bank’s potential default.

In some transactions, the advising bank can also act as the confirming bank. Still, it is essential to distinguish between these roles and their accompanying obligations and risks in Letter of Credit operations.

Can multiple shipments be covered under a single Letter of Credit?

A single Letter of Credit can cover multiple shipments, known as a Revolving Letter of Credit. In such arrangements, once a shipment is made and payment is received, the Letter of Credit is “revived” to its original value, permitting further shipments and payments up to a specified limit or duration.

This structure benefits both parties: sellers receive payment assurance for continuous supply, and buyers avoid the hassle of opening a new Letter of Credit for every shipment.

However, the terms, including shipment intervals and replenishment details, should be clearly specified in the LS to avoid misunderstandings and ensure smooth transactions throughout the contract period.

The Future of Letters of Credits

With the rise of blockchain technology, digital or “smart” Letters of Credit are emerging. They promise to streamline the LC process, reducing costs and time.

Additionally, the increased focus on sustainability in global commerce may lead to the evolution of the ‘Green Letter of Credits’, which prioritises eco-friendly practices.

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