Letters of credit: Overview, definition and example
What is a letter of credit?
A letter of credit (LC) is a financial document issued by a bank or financial institution that guarantees payment to a seller, provided that specific conditions outlined in the letter are met. It acts as a security for both parties in a transaction, ensuring that the seller receives payment and that the buyer's payment is only made after the required goods or services are delivered according to the terms of the contract.
Letters of credit are commonly used in international trade transactions to reduce the risks associated with cross-border deals, where the buyer and seller may not have a long-standing relationship or trust in each other's financial reliability.
Why is a letter of credit important?
A letter of credit is important because it provides a reliable payment method for international trade and business transactions. For the seller, it assures that they will receive payment once they meet the required conditions. For the buyer, it ensures that payment will only be made when the seller delivers the goods or services as specified in the contract, minimizing the buyer's risk. Additionally, the letter of credit adds a layer of trust and security by involving a reputable financial institution in the transaction.
Including a letter of credit in a contract can help both parties mitigate financial risks, especially in transactions with large sums or in unfamiliar markets.
Understanding letters of credit through an example
A company in the United States agrees to purchase goods from a supplier in China. Due to the distance and lack of a trusted relationship, the buyer requests a letter of credit from their bank. The letter of credit guarantees that the seller will receive payment upon delivery of the goods and presentation of the required documents (such as shipping receipts). The bank acts as an intermediary, verifying that the seller has met the conditions before releasing the funds to them.
An example of a letter of credit clause
Here’s how a letter of credit clause might appear in a contract:
“The Buyer shall open an irrevocable letter of credit in favor of the Seller in the amount of $[Insert Amount], issued by a reputable financial institution acceptable to the Seller. The letter of credit shall be payable upon presentation of the following documents: (1) Bill of Lading, (2) Commercial Invoice, (3) Proof of Delivery. Payment shall be made only upon the Seller’s fulfillment of all contract conditions as specified in this Agreement.”
Conclusion
Letters of credit are essential tools for reducing risk and ensuring secure transactions in international trade and complex agreements. They provide a guarantee of payment, contingent upon the fulfillment of agreed terms, ensuring both the buyer and seller are protected. A well-structured letter of credit clause in a contract clearly outlines the terms, conditions, and documentation required for payment, fostering trust and facilitating smoother business 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.