By: Wilmington Trust

How can you, as a business owner, be assured of being able to collect money from a new customer? Or, what if you are purchasing supplies from a company overseas? How can you be confident that you will ever receive your order? If these are concerns you have, whether for domestic or international business transactions, a letter of credit may be a worthwhile consideration.

A letter of credit (LC) is a promise by a bank to pay the beneficiary of the LC a specific amount of money, within a limited time frame, if certain predetermined conditions are met. Typically, a prospective buyer of goods or services applies to the bank for an LC, and the bank determines if the buyer is creditworthy and whether the request should be approved. If the bank determines that the request should be approved, the bank will issue the LC in accordance with the instructions supplied to the bank by the prospective seller of the goods or services. LCs are generally governed by a set of policies - Uniform Customs and Practices -- which allow standard interpretation of LCs in most parts of the world.

There are two major situations in which individuals and/or corporations would obtain a letter of credit. The primary, and most prevalent, reason is to assist in buy/sell commercial transactions where the parties are not well known to one another or where national boundaries are crossed ("Commercial LCs"). The other need is to provide security to assure that promised performance is completed ("Standby LCs"), such as where governmental agencies seek to assure that agreed-upon infrastructure improvements are completed in a timely manner and in accordance with current building and zoning codes.

The typical sequence of events for a sales transaction involving a Commercial LC is as follows:

• A seller receives an order for goods or services and sends the buyer a pro forma invoice and very specific guidance on what language and conditions must be included in the LC.
• The buyer applies to a bank for the LC.
• The buyer's bank issues the LC based on the pro forma invoice and the buyer's and the seller's instructions.
• The seller ships the products to the buyer.
• The seller's bank confirms that all conditions of the LC have been met and forwards a request to the buyer's bank with directions regarding payment to the seller.
• The buyer's bank verifies that all of the terms and conditions of the LC have been satisfied and credits the seller's bank. At the same time, the buyer's account with its bank is debited for an identical amount.
• The seller's bank credits the seller's account.
• The buyer's bank forwards the documents to the buyer, which is now able to obtain the shipment.

As additional protection, the seller should insist that the LC be irrevocable. The extra stipulation will assure that the terms and conditions of the LC cannot be changed without the consent of all of the parties. If you are considering selling overseas, you may want to request a confirmed letter of credit through a U.S. bank. This means that a U.S. bank accepts responsibility to pay the seller, regardless of the financial situation of the buyer or foreign bank.

If you are a buyer, you do assume some risks in that you must rely on the seller to ship what was ordered. The bank does not examine the goods, but it does review all documents and makes sure they are in exact accordance with the terms and conditions of the sale prior to releasing the funds. For an additional fee, you can obtain an inspection of the products by the bank before the money is transferred and the shipment is received.

Depending on the terms of the LC, there are generally few risks to the seller. And, with the exception of payment in advance, an LC provides the greatest amount of security. But note that an LC is not a guarantee of payment. It is payment only if the exact terms of the LC are followed. If you are the seller, your bank, freight forwarder, and customs broker can help you to avoid potential problems.

As noted above, Standby LCs are also used by government agencies and other parties who need recourse against hard assets in the event that a party breaches its agreement. For example, a local government agency will often require a developer of large unimproved parcels of land to provide an LC for the total value of the project. This assures the government agency that the developer will complete infrastructure projects such as roads, sewers, street lighting, and other such improvements in a proper and timely fashion. If the developer falls behind in the work or does not comply with any of the terms of the LC, the government agency has the right to cash-in the Standby LC up to the full-face amount. This would provide the funds necessary to hire another entity to complete the project.

Updated: January 1, 2013

This article is for informational purposes only and is not intended as an offer or solicitation for the sale of any financial product or service or as a determination that any investment strategy is suitable for a specific investor. Investors should seek financial advice regarding the suitability of any investment strategy based on their objectives, financial situations, and particular needs. This article is not designed or intended to provide financial, tax, legal, accounting, or other professional advice since such advice always requires consideration of individual circumstances. If professional advice is needed, the services of a professional advisor should be sought.
© 2013 Wilmington Trust Corporation.