A letter of credit is a bank's written commitment ensuring that payment will be made to a seller of goods according to conditions specified by the buyer. A letter of credit allows the seller to draw on the issuing bank for payment. The term "letter of credit" was legally defined in the case of American Steel Company v. Irving National Bank as: "A letter requesting one person to make advances to a third person on the credit of the writer." The decision went on to state that letters of credit may be general or specific. "They are general if directed to the writer's correspondents generally. They are special if addressed to some particular person." Letters of credit involve four parties: the buyer, and the buyer's bank that issues the letter of credit, the seller, and the seller's bank.
Letters of credit work through the following steps:
In order to comply with these aforementioned steps, letters of credit are generally consistent with proscribed attributes and responsibilities. A letter of credit must clearly state that it is in fact a letter of credit. A letter of credit must have an expiration date and a set credit line. The buyer's bank is not required to reimburse the seller's bank without proper documentation of the transaction, and the buyer's bank is not obligated to referee any legal disputes that may arise between the parties. Finally, the buyer has a total obligation to reimburse his or her bank.
In letters of credit the buyer's bank is often referred to as the "issuing bank" and the seller's bank is often referred to as the "corresponding bank" or "confirming bank." The "applicant" is the buyer or party applying for the letter of credit and the "beneficiary" is the seller or the party "in whose favor the letter of credit is issued." The "amount" is the maximum sum of money for which the letter of credit is issued and is stated in terms of a specific currency. The "terms" are the requirements that must be met by both parties and the "expiry" is the final date by which the beneficiary must present a demand against the credit.
All of these components must be present for a letter of credit to be valid. The term "letter of credit" is often abbreviated as "LC" or "L/C." A revocable letter of credit allows the buyer or applicant to amend or cancel the letter without prior approval of the seller or beneficiary. This type of letter of credit can be hazardous for the seller. An irrevocable letter of credit cannot be amended without the consent of the buyer, seller, and issuing bank. There is also a "confirmed irrevocable letter of credit" by which a bank other than the issuing bank agrees to irrevocably honor the letter of credit providing the seller satisfies the terms of the agreement.
Letters of credit are most often involved in commercial transactions in which the buyer and seller reside in different countries and thus are involved in international trade. According to Ideacom International, potential hazards in international trade that letters of credit help to alleviate include: geographical distance, cultural differences, a host of intermediaries such as customs officials and freight forwarders, a myriad of regulations and procedures, and political instability. Other hazards that are also lessened by letters of credit are: economic risks such as changes in currency exchange rates or interest rates; political risks such as labor strikes, insurrections, and boycotts; natural disasters such as earthquakes and floods; transport risks such as shipwrecks, fire, and theft; and commercial risks such as default of payment and insolvency or bankruptcy.
Letters of credit are thus advantageous to both the buyer and the seller. Payment to the seller is guaranteed by either the issuing bank or the confirming bank, or sometimes by both. The buyer's funds are not immediately tied up by the transaction and, because payment is guaranteed, a discount price can often be negotiated. Since letters of credit have expiration dates, the delivery of goods is usually guaranteed before that date occurs. The respective banks profit from the fees they collect for their services. Bank charges are usually based on risk factors rather than a predetermined list of fees.
An international code of rules pertaining to letters of credit is known as the Uniform Customs and Practices for Documentary Credits (UCP). This code is issued by the International Chamber of Commerce headquartered in Paris. Although there is no formal legislative or judicial enforcement of the code, it is adhered to worldwide by most banks and commercial enterprises. A similar code in the United States that governs letters of credit is the Uniform Commercial Code (UCC). Like the UCP, there is no formal judicial or legislative enforcement of the UCC. Most deliberative bodies in the United States, however, write applicable legislation based on the UCC.
Generally the above information applies to commercial letters of credit. There are also traveler's letters of credit. These are letters of credit issued by a bank to a traveler and are meant to serve as an introduction of the holding party to banks in foreign countries. There are actually two variations of traveler's letters of credit, circular and specially advised. Specially advised letters of credit are addressed to a particular foreign bank, while a circular letter of credit is issued to foreign banks in general. The holder of a traveler's letter of credit generally makes payment to an issuing bank in advance and in an amount equal to the line of credit. The holder, however, may make arrangements to have withdrawals made from a deposit account as drafts are received by the issuing bank.
[ Michael Knes ]
Aster, Charles E., and Katheryn C. Patterson. A Practical Guide to Letters of Credit. New York: Executive Enterprises Publications, 1990.
Cotton Council International. "Letter of Credit." Washington: Cotton Council International, 1998. Available from www.cottonusa.org .
Dolan, John F. The Law of Letters of Credit. Boston: Warren, Borham & Lamont, 1996.
Ideacom International Inc. "The Letter of Credit—Introduction." London: Ideacom International, 1998. Available from www.tradewinds-tv.com/program6/enO61O.html .