Back-to-Back Letters of Credit – Definition

Cite this article as:"Back-to-Back Letters of Credit – Definition," in The Business Professor, updated July 30, 2019, last accessed August 9, 2020, https://thebusinessprofessor.com/lesson/back-to-back-letters-of-credit-definition-2/.

Back To: COMMERCIAL LAW: CONTRACTS, PAYMENTS, SECURITY INTERESTS, & BANKRUPTCY

Back-to-Back Letters of Credit Definition

Back-to-back letters of credit are used in business transactions where an intermediary is needed between a buyer and a seller. Back-to-back letters of credit comprises of two distinct letters of credit (LCs), one is issued by the buyer’s bank and the other is issued by the intermediary’s bank.

A firm, a broker, or financial consultant can act as an intermediary between a buyer and a seller. LCs are used in financing a transaction, one LC is issued by the buyer’s bank to the intermediary and the inetrmediary’s bank also gives the buyer the second LC stating that it will make payment if the buyer does not.

Key Takeaways

  • Back-to-back letters of credit for business transactions involving an intermediary.
  • In some business transactions that involve intermediaries, the seller might not have a direct contact with the buyer.
  • Back-to-back letters of credit are commonly used for international transactions.

A Little More on What is a  Back-to-Back Letter of Credit (LC)

When a business transaction is to happen between a buyer and a seller, especially if they are not in the same region or location, an intermediary is often needed. In a bid to guarantee payment in such transaction, back-to-back letters of credit are used. A seller is assured to get payment once the terms of the contract are fulfilled and evidence presented to the intermediary’s bank.

Two letters of credit (LCs) are used in this transaction. The original and first LC is issued by the buyer’s bank and given to the intermediary. The intermediary takes this original LC to his bank for the issuance of the second LC in which the seller will be the beneficiary.

Example of a Back-to-Back Letter of Credit Transaction

Brandy Inc is a U.S company that sells heavy equipment used for large production, a company in China got to know of this and is interested in purchasing the equipment. Julian is a broker and got to know of the interest of China-based company and offers to facilitate trade between the two parties. Despite that Brandy Inc wants to sell the equipment, the fear of default payment has hindered them from selling all this while, Julian as a Broker assures them of payment.

Back to back LCs will be used as collateral, the first is issued by the China-based company to the broker while the second LC is issued by the broker’s bank with the seller as the beneficiary. Once the seller fulfils the delivery of the equipment, the proof is given to the broker’s bank for payment.

Reference for “Back-to-Back Letters of Credit (LC)”

Academics research on “Back-to-Back Letters of Credit (LC)”

Increasing the Transferability of Documentary Letters of Credit, Waldmann, R. J. (1967). Increasing the Transferability of Documentary Letters of Credit. Harv. Int’l. LJ8, 116.

Bank Guarantees and Letters of Credit: Time for a Return to the Fold, Kozolchyk, B. (1989). Bank Guarantees and Letters of Credit: Time for a Return to the Fold. U. Pa. J. Int’l Bus. L.11, 1.

Letter of credit-Doing business in a global market, Weissman, I. (1996). Letter of credit-Doing business in a global market. The CPA Journal66(1), 46.

Assignability of Letter of Credit Proceeds: Adapting the Code to New Commercial Practices, McJohn, S. M. (1993). Assignability of Letter of Credit Proceeds: Adapting the Code to New Commercial Practices. The right to receive payment under a letter of credit may be assigned, even if the letter of credit prohibits assignment of proceeds. This article argues that this rule should be changed, to give effect to clauses barring assignment of proceeds. The rule made sense where letters of credit were primarily used in sales of goods transactions. In that context, the rule simply mirrored the contract law doctrine that the right to receive payment under a sales contract may be freely assigned (subject to any defenses the payor might have). But letters of credit are not used in a broader range of transactions, and are often used as a standby security device, as opposed to a primary means of payment. Where such letters of credit are more like collateral than a means of payment, the parties should be free to agree on the structure of the transaction, including limits on assignment. In addition, the parties can effectively bar assignment by drafting the conditions for drawing the letter of credit. The bar against assignment then, is both outdated and ineffective (and thereby inefficient, because the parties must expend some resources in structuring and drafting around the rule).

Commercial Paper, Bank Deposits and Collections and Letters of Credit, Bailey III, H. J. (1964). Commercial Paper, Bank Deposits and Collections and Letters of Credit. Bus. Law.20, 711.

Was this article helpful?