Letter of credit facility: Overview, definition, and example
What is a letter of credit facility?
A letter of credit facility is a financial arrangement between a buyer and a bank that guarantees payment to the seller for goods or services provided. In this arrangement, the bank acts as a middleman, assuring the seller that they will receive payment as long as they meet the conditions specified in the letter of credit. This facility is often used in international trade to reduce the risk of non-payment and increase trust between trading parties.
For example, when a company in the U.S. buys products from a supplier in another country, they might use a letter of credit facility to ensure the supplier gets paid as long as they ship the goods according to the agreed-upon terms.
Why is a letter of credit facility important?
A letter of credit facility is important because it reduces the risk of payment disputes or non-payment in transactions, especially in international trade where parties may not know each other well. It provides security for both the buyer and the seller: the seller is assured of payment, while the buyer ensures that payment is only made when the agreed-upon terms are met.
For businesses, using a letter of credit facility helps build trust and establish smoother transactions with suppliers, enabling them to secure goods and services without the concern of non-payment or delivery issues.
Understanding letter of credit facility through an example
Imagine a U.S. company orders raw materials from a manufacturer in Germany. The U.S. company arranges a letter of credit facility with its bank, which guarantees the payment to the German manufacturer, as long as the manufacturer ships the materials as specified. Once the goods are shipped and the documents confirming the shipment are presented to the bank, the bank will release the payment to the seller, ensuring that the transaction is completed smoothly.
In another example, a small exporter in Canada sells goods to a buyer in South Africa. The Canadian seller might request a letter of credit facility to protect against the risk of non-payment. With this facility, the buyer’s bank guarantees that the seller will be paid once they meet the delivery terms outlined in the letter of credit.
An example of a letter of credit facility clause
Here’s how a letter of credit facility clause might look in a contract:
“The Buyer agrees to establish a letter of credit facility with a reputable financial institution to guarantee payment to the Seller for the full purchase price upon fulfillment of the terms specified in this Agreement. The letter of credit must be confirmed by the Buyer’s bank and shall remain in effect until the Seller receives payment.”
Conclusion
A letter of credit facility offers a secure way to facilitate transactions, especially in international trade, by guaranteeing payment once the terms are met. It provides peace of mind for both buyers and sellers, reducing the risks involved in the exchange of goods or services. By including a letter of credit facility in contracts, businesses can ensure smoother transactions and mitigate potential financial risks.
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.