A letter of credit is a contractual promise by a bank that a buyer's obligation to a seller will be made in full and in a timely manner. Letters of credit become especially important in the course of international trade, where payments can be slow. The letter of credit, in effect, creates something like an escrow in this sense.
The long history of letters of credit and the development of the Uniform Commercial Code (UCC) have led to certain features being standard in letters of credit and have set a degree of uniformity to them. It is wise to consult an attorney before entering business transactions that rely on a letter of credit because many of the rules related to letters of credit are esoteric and are not intuitive.
The beneficiary of a letter of credit has right to payment because of the letter of credit. This contractual relationship is independent of the relationship in trade that may have prompted the need for the letter of credit. To be negotiable, the letter of credit must contain either an unconditional promise to pay at any time the holder wishes or at a definite time. Negotiable notes become transferable in a way comparable to money when they have this feature.
A letter of credit may be revocable or irrevocable. In the case of a revocable letter of credit, it is possible that the obligation to pay may be revoked or modified at any time or for any reason. An irrevocable letter cannot be changed without agreement by all of the affected parties.
Domestic letters of credit, which are governed by the UCC, may be transferred as many times as desired and will remain effective. This holds true even where the letter of credit says that it is non-transferable to the extent that no one has yet performed actions pursuant to the letter of credit when the transfer occurs.
There are two possible features of a letter of credit that can trigger an obligation to pay: sight or time. A sight draft must be paid when the letter is presented for payment. A time draft must be paid after a certain period of time has elapsed. In both instances, the bank is allowed the opportunity to review the letter of credit to assure its validity.