Purpose of a Letter of Credit

A letter of credit is typically an arrangement between three parties: the issuer of the letter of credit, the payor and the beneficiary. As a type of advanced agreement for financing, a letter of credit enables a seller to determine the actual amount of money that will be received from the issuer of the letter of credit. A creditor may also use a letter of credit to ensure that the issuer of the letter will pay the creditor’s drafts as agreed upon.

Two Types

The dual types of letters of credit are commercial and standby, according to Agasha Mugasha’s 2003 “The Law of Letters of Credit and Bank Guarantees.” As a payment mechanism, a commercial letter of credit is designed to lower the risk of non-payment for products delivered to the buyer. If the transaction is performed to the satisfaction of the buyer, the seller draws upon the commercial letter of credit. The bank, or the issuer of the letter of credit, pays the seller on behalf of the buyer. In contrast to a commercial letter of credit, a standby letter of credit does not have to be associated with the purchase of products or services. As a security mechanism, the parties in the arrangement of a standby letter of credit don’t expect to use it. If a problem arises with the transaction, the demand for payment is secured by the standby letter of credit.

Documentation

The commercial letter of credit accounts for the actions taken by the seller to fulfill his responsibilities in the transaction. The letter typically includes the products and a title, or bill of lading. The ownership and transfer of these documents are of commercial value in as much as they represent the ownership and transfer of products. There is no standardized documentation for standby letters of credit. It is typically a drawing certificate attached to a draft. Although it asserts conditions concerning the success or failure of the applicant to perform his obligations, it doesn’t have commercial value. The document can’t be used to transfer products.

The Independence Rule

The effectiveness of letters of credit revolves around their independence, according to David P. Twomey’s 2011 “Anderson’s Business Law and The Legal Environment.” The issuer of a commercial letter of credit, or the bank, must pay the seller once the goods are in hand. Even if the buyer is dissatisfied with the goods, the bank’s only concern is to strictly comply with the terms of the letter of credit. Its promise to pay the seller remains independent of any other contractual issues between the buyer and the seller.

The Length

As issuers, banks typically use standardized forms for letters of credit as a matter of convenience. The duration of a letter of credit can continue for as long as is specified by the issuer. The document will typically state a maximum amount of money. The letter of credit is exhausted when the buyer has paid the aggregate amount, whether in installments or a single lump

About the Author

Kay Tang is a journalist who has been writing since 1990. She previously covered developments in theater for the "Dramatists Guild Quarterly." Tang graduated with a Bachelor of Arts in economics and political science from Yale University and completed a Master of Professional Studies in interactive telecommunications at New York University.

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