Letter of credit: Overview, definition, and example
What is a letter of credit?
A letter of credit (LOC) is a financial instrument issued by a bank or financial institution that guarantees payment to a seller or beneficiary, provided specific conditions outlined in the letter are met. The bank acts as an intermediary, ensuring that the seller receives payment once they fulfill their obligations, such as delivering goods or services. Letters of credit are commonly used in international trade to reduce the risk for both buyers and sellers.
For example, a company in the U.S. importing goods from a supplier in China might use a letter of credit to assure the supplier that payment will be made upon proof of shipment.
Why is a letter of credit important?
A letter of credit is important because it mitigates risk in transactions, particularly in cases where the buyer and seller operate in different countries or lack an established relationship. It provides assurance to the seller that they will receive payment as long as they meet the specified terms, such as delivering goods or providing necessary documentation.
For buyers, an LOC ensures that payment is only made if the agreed-upon conditions are met, protecting them from potential fraud or non-performance. For sellers, it provides security and confidence in receiving payment, even if the buyer defaults.
Understanding a letter of credit through an example
Imagine a U.S.-based retailer purchases goods from an overseas manufacturer. To ensure payment, the manufacturer requests a letter of credit. The retailer’s bank issues an LOC guaranteeing payment of $100,000 once the manufacturer provides proof of shipment (e.g., a bill of lading). Upon receiving the documentation, the bank pays the manufacturer, and the retailer reimburses the bank.
In another example, a construction company obtains a letter of credit from its bank to guarantee payment to subcontractors. The subcontractors are assured of receiving payment as long as they meet the milestones specified in the contract.
An example of a letter of credit clause
Here’s how a letter of credit clause might appear in an agreement:
“The Buyer shall provide an irrevocable letter of credit in favor of the Seller for the total purchase price, issued by a bank acceptable to the Seller. The letter of credit shall be valid for a period of [duration] and shall require payment upon presentation of specified documents, including but not limited to a bill of lading, commercial invoice, and certificate of origin.”
Conclusion
A letter of credit is a vital tool for mitigating financial risks in commercial transactions, particularly in international trade. It ensures payment to the seller while protecting the buyer by tying payment to specific, verifiable conditions. For businesses, incorporating clear and detailed LOC terms in agreements fosters trust, reduces uncertainty, and facilitates smoother transactions.
This article contains general legal information and does not contain legal advice. Cobrief is not a law firm or a substitute for an attorney or law firm. The law is complex and changes often. For legal advice, please ask a lawyer.