International Trade

Letter of Credit (L/C or Documentary Credit)

The term “Letter of Credit” (sometimes referred to as “Documentary Credit“) refers to an undertaking made by a bank to pay a beneficiary (usually the seller of goods) the sums owed by an account holder (usually the buyer of such goods), provided a pre-determined set of conditions are met.  It is essentially a guarantee made by an issuing bank that a seller will get paid for goods, provided that those conditions are met.  Hence, a Letter of Credit is a financial instrument that serves the interests of the seller, by guaranteeing payment, while also serving the interests of the buyer, by establishing credit with the seller.  Letters of credit are often used during the early phases of a business relationship to establish higher levels of trust and creditworthiness.

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Contractual relationships created or substantiated under a Letter of credit
There are essentially three obligations that are created under an L/C, namely:

1. First there is a contractual arrangement directly between the buyer and seller of the goods or services in question.  This agreement is spelled out in the “sales contract” between the two parties.
2. Second, there is the “Application and Security Agreement” or “Reimbursing Agreement” between the buyer and the issuing bank.  This agreement spells out the terms under which the bank may release funds to the seller.
3. Third, the “Letter of Credit” (or “Documentary Credit”) is issued between the issuing bank and the beneficiary (typically the seller of the goods).

Each of these contracts is distinct and creates an obligation between the contracting parties. 

Fraud
It should be noted that while the Letters of credit are excellent tools when used as a method of payment, fraud cannot be mitigated entirely - there are many documented cases where a fraudulent Documentary credit was issued by a totally fictitious bank.  In this case the seller would never get paid!