Letter of Credit
What It Is:
A letter of credit is a bank's written promise that it beneficiary) if the customer does not.make a customer's (the holder) payment to a vendor (called the
How It Works/Example:
Letters of ability to pay for them.
To address this, Company XYZ gets a letter of from its bank, Bank of Alabama, indicating that Company XYZ make good on the $100,000 payment in, say, 60 days, or Bank of Alabama pay the bill itself. Bank of Alabama then sends the letter of to Company ABC, which then agrees to ship the widgets.
After the shipment goes out, Company ABC (or Company ABC's bank) then asks for its $100,000 by presenting a written draft (also called a bill of exchange) to Bank of Alabama. Although letters of mostly benefit sellers, they also protect buyers, because Company ABC must present Bank of Alabama with written proof of the widget shipment in order to get paid. This proof usually includes a commercial invoice, bill of lading, or an airway bill. After Bank of Alabama pays Company ABC, it turns to Company XYZ for reimbursement (usually by debiting Company XYZ's bank account).
Banks usually require a pledge of securities or cash collateral in order to a letter of to a holder. Banks also collect a fee for issuing letters of ; the fee is usually a percentage of the size of the letter of credit. The International Chamber of Uniform Customs and Practice for Documentary governs letters of used in international transactions. In the United States, the Uniform Commercial Code governs letters of used for domestic transactions.
There are several kinds of letters of :
A commercial letter of is one of the most common and is reflected in the example above. This kind of letter acts as the primary payment mechanism between the customer and the ; that is, the issuing bank makes the actual payments to the every time. So in our example above, Bank of Alabama pays Company ABC directly, even if Company XYZ has the cash and the means to fulfill its to Company ABC.
A standby letter of , on the other hand, is a secondary payment mechanism, meaning that the bank pays the only when the holder cannot. Both parties to a standby letter of never hope to have to use it. In our example above, Bank of Alabama would only pay Company ABC directly if Company XYZ couldn't.
A revolving letter of lets the customer make any number of draws for a certain period as long as they do not exceed a certain limit.
A traveler's letter of is a promise that the issuing bank honor drafts made at certain foreign banks.
A confirmed letter of is a letter of that has another bank besides the issuing bank standing behind it. This second bank is called the confirming bank, and it is usually (but not always) the seller's bank. The confirming bank ensures payment under the letter of if the holder and the issuing bank default on the letter of . This is usually done at the request of the issuing bank in international transactions.
Letters of are usually negotiable instruments, meaning that the issuing bank must pay the or any bank nominated by the beneficiary. In some cases, letters of are also transferable, meaning that the has the right to assign the right to draw to another entity (such as a corporate parent or even a third party).
Why It Matters:
A letter of
It is important to that a letter of is not the same as a bank guarantee, although with both instruments the issuing bank accepts a customer's liability if the customer defaults. With a , the seller's claim goes first to the buyer, and if the buyer defaults, then the claim goes to the bank. With letters of , the seller's claim goes first to the bank, not the buyer. Although the seller probably get paid in both cases, letters of more assurance to sellers than generally do.