What is a Letter of Credit?

Collections Training Resource
September 4, 2012 — 1,084 views  
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Large financial transactions are full of complex negotiations and intricate formulas, and it takes an industry expert to navigate these complicated fields. However, common forms of payment called letters of credit are much easier to understand.

If you are a collection professional or attorney looking to learn more about letters of credit, read on for some of the basic principles.

The letter of credit process

Five parties are involved in the drafting, approval and eventual implementation of a letter of credit. These groups are the seller, the buyer, the seller's bank, the buyer's bank and finally the 3rd party service or carrier. Keep in mind this is not limited solely to banks - lending agencies and loan companies engaging with the buyer and seller are also applicable.

Essentially, an agreement is reached between a buyer and a seller. This is formalized in a written contract, and then the buyer's bank presents a letter of credit to the seller, which explains that the bank will pay the seller when the goods are delivered by a third party to the respective buyer.

Imagine that Bayer Pharmaceuticals wants to buy 100,000 vials of a drug ingredient from a supplier. Bayer's bank would draft a letter of credit and give it to the supplier, who then hires UPS to deliver the goods. No money has been exchanged yet, and if anything happens, the buyer can pull out (or sue, depending on the language of the contract).

UPS then provides a "bill of lading" to the drug seller, which is a charge for services outlined in a letter of credit. The seller gives the bill to its bank, which pays UPS and then gives the bill to the buyer's bank. Basically, the payment and bill of lading is passed from party to party until it gets to the buyer, who pays his or her own bank and then presents the bill of lading to the carrier as proof of purchase.

Clauses to include in a letter of credit

The scope of payment, time constraints, goods descriptions and location of the delivery must all be specified in a proper letter of credit. In the same example used above, the seller would have to list all the Bayer companies that were receiving drugs, along with the respective charges and time limits associated with the delivery. This way, if anything goes wrong, at least both parties will have legal documents that will hold up in a courtroom setting.

Collections Training Resource