Increasingly, business transactions are becoming multinational deals. This shift to global commerce can make what should be a simple purchase more complex, with two or more sets of national laws, regulations and customs applying to the agreement’s terms. One tool that makes international commerce transactions easier is the letter of credit (LC). The LC assures a seller that the buyer’s obligation to pay a certain amount of money by a specific date will be met, if not by the buyer then by the issuing bank. Obtaining an LC from a banking institution with whom you have an existing relationship is a relatively straightforward process, though the complexity can depend on the type of LC you need.
To obtain a letter of credit from a bank, you should have an excellent credit history as a buyer and ideally a relationship with the bank as a customer. You'll also need to submit the bank's required application forms and documentation regarding the sale in question.
What Is a Letter of Credit?
A letter of credit is a formal, legal document issued by a bank that guarantees payment of a particular amount of money when that payment is due. The LC involves at least three basic parties: the buyer, the seller and the issuing bank. If the buyer doesn’t make payment to the seller as promised, then the seller must present certain documents to the issuing bank. If the correct documents are filed, the bank issuing the letter of credit must pay the amount itself.
Types of Letters of Credit
There are many types of letters of credit that a bank can issue. The appropriate one for a specific kind of transaction depends on factors such as the nature of the transaction, the amount involved and the countries of origin for each of the parties. For example, a standby letter of credit serves as a backup source of funding in the event something prevents the parties from carrying out their obligations. Other types of letters of credit facilitate the deal itself.
Additionally, letters of credit have become crucial tools in carrying out international commerce and trade. As a result, different countries have different laws governing transactions, and the distances that can be involved in international deals can be challenging when trying to execute large or complex transactions. Therefore, the rules that apply to a specific type of LC in one country may be inapplicable in another country, even for the same deal. It’s important to make sure you understand all your rights and obligations before agreeing to the terms of a letter of credit.
Irrevocable Letter of Credit
One common kind of LC is the irrevocable letter of credit. An irrevocable letter of credit or ILOC differs from other letters of credit in one major respect: it cannot be canceled or modified in any way unless all three major parties expressly agree in writing. In other words, the bank does not have the ability to change the terms of the ILOC unilaterally. That may not be the case with a standard or standby letter of credit, for example.
ILOCs present a seller with a greater degree of security. Sellers may often be reasonably concerned about receiving payment in full from a buyer. This may be because the buyer is unfamiliar to the seller, because the terms of the deal set a high price or because the transaction is in some way unusual for the seller. In these cases, an ILOC can provide the reassurance the seller needs to carry out the transaction. Thus the ILOC helps both the seller and the buyer to complete a deal that may otherwise never get closed.
When You Need a Letter of Credit From a Bank
Letters of credit may be warranted in several different circumstances. As mentioned, international transactions for import and export agreements are increasingly used to facilitate transactions. Another reason for their use in international deals is the rise in the rates of attempted fraud in such transactions. Letters of credit can dramatically decrease the odds of fraudulent deals resulting in losses to the innocent party.
A related issue is the concept of “country risk.” When a buyer is located in a country that’s experiencing political turmoil or a volatile economic climate, this presents additional risk to the seller. The seller, in turn, may decide it’s prudent to require some additional reassurance about the buyer’s ability to pay. A letter of credit provides that reassurance.
Applying for a Letter of Credit
To obtain a letter of credit, the buyer simply applies for one through the company’s bank. It is always preferable to request a letter of credit from a bank with which you have an established relationship, as opposed to applying at a new bank. This is especially true for new companies that don’t have an established credit history with excellent scores.
The bank generally requires full documentation of the agreement in question, as well as whatever application documents it uses for internal processing. If the cash is present in the company’s account, the bank will require the buyer to remit those funds up front or it may alternatively reserve a margin amount for use in satisfying the buyer’s obligations. The margin amount varies from buyer-to-buyer, depending on credit score and history, transaction history and how well-established the company is, among other factors. Risky buyers may be required to put up 100 percent of the purchase price to secure a letter of credit, while established buyers with excellent credit may be required to front as little as 1 percent of the total sales price.
Once the LC is produced, there are other documents related to the LC that may need to be arranged and filed. It is important to clarify what other requirements must be met in addition to the LC itself, and at what point in time they need to be filed.