Procedure for issuance of letters of credit: Overview, definition, and example
What is the procedure for issuance of letters of credit?
The procedure for issuance of letters of credit involves a series of steps taken by a bank or financial institution to guarantee payment on behalf of a buyer to a seller in international trade transactions. A letter of credit (LC) serves as a promise by the bank that payment will be made to the seller, provided that certain terms and conditions are met. The procedure ensures that both the buyer and the seller are protected in the transaction, as the bank acts as an intermediary to verify that the seller fulfills the required conditions before payment is made.
The typical process involves the buyer requesting the issuance of an LC from their bank, the bank evaluating the buyer's creditworthiness, and the seller submitting the necessary documents (such as shipping documents or invoices) to prove that the terms of the contract have been fulfilled. Upon verification, the bank releases payment to the seller.
Why is the procedure for issuance of letters of credit important?
The procedure for issuance of letters of credit is important because it provides security to both buyers and sellers in transactions where trust or payment might be a concern, especially in international trade. For the seller, the letter of credit ensures that they will be paid once the terms are met. For the buyer, it ensures that the seller will only receive payment if the goods or services are delivered as agreed.
This process helps minimize risks, such as the risk of non-payment for the seller and the risk of receiving faulty goods or services for the buyer. It is a crucial tool for facilitating smooth, reliable international trade and building trust between parties who may not have an established relationship.
Understanding the procedure for issuance of letters of credit through an example
Imagine an importer in the United States is buying a large shipment of machinery from a supplier in Germany. The buyer requests their bank to issue a letter of credit in favor of the German supplier to ensure payment is made once the goods are shipped. The U.S. bank verifies the buyer's creditworthiness and issues the LC to the German supplier's bank, which informs the supplier.
Once the supplier ships the machinery and submits the required shipping documents (such as a bill of lading) to the bank, the bank verifies that the terms are met. Upon verification, the bank releases the payment to the supplier, ensuring that both parties are satisfied and protected under the terms of the contract.
An example of a procedure for issuance of letters of credit clause in a contract
Here’s how a clause regarding the procedure for issuance of letters of credit might appear in an international sales agreement:
“The Buyer shall arrange for the issuance of a confirmed and irrevocable letter of credit in favor of the Seller for the amount of $[amount] upon signing of this Agreement. The letter of credit shall be issued by a reputable bank and shall be available for payment upon presentation of the required shipping and inspection documents. The letter of credit shall remain valid for [number of days] from the date of shipment.”
Conclusion
The procedure for issuance of letters of credit is a structured process that ensures secure payment in international trade transactions. By involving banks as intermediaries, it protects both buyers and sellers by guaranteeing payment once the agreed terms are met. This procedure is crucial for mitigating risks, ensuring fairness, and facilitating trust in transactions between parties that may not have a long-standing relationship.
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.