Letter of Credit – Definition

Cite this article as:"Letter of Credit – Definition," in The Business Professor, updated March 25, 2019, last accessed August 8, 2020, https://thebusinessprofessor.com/lesson/letter-of-credit-definition/.


Letter of Credit Definition

A Letter of Credit is a form provided by a credit worthy bank to give assurance of the payment of goods and services to a seller of goods as long as the seller presents it with the correct documentation. Financial institutions such as banks are the ones which generally issue these letters of credit although under special circumstances, some financial services companies which are credit worthy, for example mutual funds, can issue them too.

A little more on What is a Letter of Credit

The letter of credit is constituted by three parties. These are the beneficiary who receives payment, the buyer of the goods or services who needs the letter of credit, and finally the institution which issues the letter of credit. The beneficiary may request that instead of being paid directly, the payment is made to a bank in which he/she is a client. This is usually done if the bank financed the transaction on behalf of the beneficiary until payment was made.

Mostly these letters are utilized in international trade where they are regulated by the rules of the International Chamber of Commerce in the form of Uniform Customs and Practice for Documentary Credits (UCP). The use of letters of credit in Europe began long ago when they were being regulated by internationally recognized rules and procedures instead of national laws.

There are various categories of these letters, and they seek to be utilized in several markets for the fulfillment of multiple issues. Examples of these categories include the following:

  •         Import/export: A single letter of credit can be either an import or export letter depending on the perspective of the user ( who can be either an importer or exporter)
  •         Revocable/irrevocable: This determines if the buyer and the issuing bank can control the letter of credit without the seller’s permission. Changes or termination are channeled through the issuing bank by the applicant with the beneficiary’s approval and authentication. However, this category is becoming irrelevant since UCP 600 considers all letters or credit as irrevocable.
  •         Confirmed/Unconfirmed:  A letter of credit (LC) is confirmed when another bank guarantees to honor a presentation put forth as a request by the issuing bank.
  •         Restricted/Unrestricted: In the case of a restricted LC, an advising bank can buy a bill of exchange from the seller. If a confirmation bank is not mentioned, an exporter can present the bill of exchange to any bank for payment on an unrestricted LC.
  •         Deferred/Usance: This is a credit that is assigned after a stipulated period accepted by the buyer and seller and not immediately after the presentation. The seller gives the buyer the authority to pay after he takes and sells the goods involved.

The following are some of the unique terms of the LCs that relate to the payment conditions in the underlying reference documents.

  •         At Sight:  This is a credit that is paid as soon as possible by the announcer bank after it is done inspecting the seller’s documents.
  •         Red Clause: This is a situation where the seller can deposit the prepaid money in the bank before he sends the products.
  •         Back to Back:  This is issued for the purpose of promoting intermediary trade.
  •         Standby Letter of Credit: This is an LC with the objective of providing a source of payment in the case of non-performance of a contract. It is used as a failsafe against an unfulfilled obligation.

The payments related to LCs take a while because of the legal procedures of banking institutions. Due to this, the terms and conditions of the letters of credit should be detailed beforehand. The LCs have gained popularity as transaction instruments in international trade since they establish the credit-worthiness of a buyer.

References for Letters of Credit

Academic Research on Letter of Credit (L/C)

The Law Merchant and the Letter of Credit, Trimble, R. J. (1948). Harvard Law Review, 61(6), 981-1008. This paper states that confusion and discrepancies are present in the decisions resulting from the discussion of the law regulating the LCs by many writes and the enforcement by many judges.

Enjoining Letter of Credit Transactions, Harfield, H. (1978). Banking LJ, 95, 596. This article analyzes recent cases to confirm the independence of LCs contracts and justify the injunctive relief only in situations where there are egregious fraud and no prejudice to the rights of innocent parties.

Enjoining Payment on a Letter of Credit in Bankruptcy: A Tempest in a Twist Cap, Chaitman, H. D., & Sovern, J. (1982). Bus. Law., 38, 21. This paper examines the Twist Cap decision and the theories of preference and executory contracts that the debtor advances with the aim of providing a basis for bankruptcy courts deny relief such as that granted in the Twist Cap.

The No-Guaranty Rule and the Standby Letter of Credit Controversy. Lord, R. A. (1979). Banking lJ, 96, 46. This article presents an argument that claims that the no-guaranty rule cannot coexist with the law that allows standby letters of credit for much longer.

Identity Crises in Letter of Credit Law,. Harfield, H. (1982). Ariz. L. Rev., 24, 239. This paper asserts that the main component of the utility of the letter of credit is its independence from other contracts, arrangements, and relationships which are part of the transaction from which the letter of credit arises.

The Legal Nature of the Irrevocable Commercial Letter of Credit. Kozolchyk, B. (1965). The The American Journal of Comparative Law, 395-421. This article reviews a brief history followed by an examination of various theories that attempt to explain the nature of the irrevocable commercial letter of credit.

Enjoining the International Standby Letter of Credit: The Iranian Letter of Credit Cases, Getz, H. A. (1980). Harv. Int’l. LJ, 21, 189. This article addresses the issues presented in the transactions of standby letters of credit where a sovereign state is deemed as the beneficiary of payment.

Third-party certification in new issues of corporate tax-exempt bonds: standby letter of credit and bond rating interaction. Stover, R. D. (1996). Financial Management, 62-70.

This paper extends the literature of commercial bank certification through the examination of the role of banks in issuing standby letters of credit in the corporate debt market which is tax-exempt.

The paperless letter of credit and related documents of title. Kozolchyk, B. (1992). law and Contemporary Problems, 55(3), 39-101. This article explores the presentation of paperless documents of title for the fulfillment of a condition of payment since the time is getting closer when the paperless documents will be presented to banks.

Practical Effect of the Uniform Commercial Code on Documentary Letter of Credit Transactions, Chadsey, H. M. (1954). University of Pennsylvania Law Review, 102(5), 618-628. This paper codifies the practices of the letters of credit as they exist in the United States and not revolutionize them.

A comparative analysis of the standard of fraud required under the fraud rule in letter of credit law. Xiang, G., & Buckley, R. P. (2003). Duke J. Comp. & Int’l L., 13, 293. This article presents a clear standard as an improvement from those applied throughout the world and suggest a method for implementing it after analyzing the law in several countries.

Fundamental Issues in the Unification and Harmonization of Letter of Credit Law, Byrne, J. E. (1991). Loy. L. Rev., 37, 1. This paper asks directional questions with the aim of yielding points that may be useful in plotting the course to be used in unifying and harmonizing the law of the letter of credit.

Estimating the direct impact of bank liquidity shocks on the real economy: Evidence from letterofcredit import transactions in Colombia, Ahn, J., & Sarmiento, M. (2013). Washington, DC: International Monetary Fund. This study examines the import transactions of the letter-of-credit in Colombia to provide an accurate estimate of the direct impact of bank liquidity shocks on actual economic activity.

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