Rather than asking each party to an agreement to trust the other, letters of credit give assurances to both parties that the money for a deal will be there when needed. A letter of credit is a guarantee from a bank that a buyer can pay for the seller’s goods. In effect, the bank substitutes its credit worthiness for that of the buyer.
Documentary Letters of Credit
A documentary letter of credit guarantees a buyer’s payment to a seller. Virtually all documentary LOCs are irrevocable, meaning the buyer cannot modify the terms or cancel the letter. The LOC contains the terms the seller must meet in order to cash in the LOC. If the seller fulfills the listed obligations on an irrevocable LOC, the bank cannot refuse payment. A confirmed irrevocable LOC is one in which the seller’s bank also guarantees to pay the seller. Traders often use confirmed LOCs in high-risk situations, such as war zones or collapsed economies. A LOC might or might not be transferable to another seller, depending on how the buyer draws up the terms.
A back-to-back LOC uses one LOC as collateral for a second one. Intermediaries in a trading deal favor this type of arrangement. For example, a Texas department store wants to buy expensive custom jewelry from a wholesaler in New York’s Diamond District. The store works with its bank to draw up a non-transferable irrevocable LOC for the benefit of the wholesaler, which must now pay a designer in Israel to fabricate the jewelry. The wholesaler arranges a new LOC for the benefit of the designer, using the first LOC as collateral for the second one. The terms on both LOCs mirror each other regarding important terms, such as the quality and description of the goods, inspection and shipping.
Only non-transferable LOCs require back-to-back treatment. If the original LOC is transferable, then the intermediary can transfer all or part of the proceeds to the seller. This type of arrangement is common in East Asia. When a party transfers a LOC, the new beneficiary is responsible for meeting the letter’s terms. In contrast, an assignable LOC transfers the proceeds to a new beneficiary, but the party in the middle is still responsible for fulfilling the deal’s terms. When the new beneficiary presents an assigned LOC to the middle party's bank, the bank attempts to comply with the assignment instructions. An assigned LOC leaves the assignee dependent on the middle party fulfilling the arrangement and is thus riskier for the assignee.
A documentary LOC is usually a thick, complicated contract. A simpler alternative arrangement is a standby LOC, which a seller only uses as backup should the buyer fail to make payment. A standby LOC helps break the ice when two parties trade for the first time. This type of LOC guarantees loan repayment, contract fulfillment and payment for third-party goods. The standby LOC is used primarily in the United States and a beneficiary can cash the letter on demand. Other forms of LOC include ones that postpone payment until a later date, ones that pay the seller in advance and ones that the buyer can automatically renew.
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