The primary purpose of a letter of credit is to diminish the possibility that a party does not repay a financial obligation. A letter of credit guarantees that a bank or some other financial institution will make an intermediary payment on behalf of the customer. The creditor is paid first, and then the customer repays the financing institution. Should the customer fail to repay the debt, the creditor presents its letter of credit to the financial institution which has guaranteed funding, requesting to draw upon the promised credit. The financial institution is obligated to pay what it has promised, no questions asked, if the requesting party has followed all agreements outlined in the letter of credit.
Different options for letters of credit are available to fit the specific needs of each transaction, the two most common being a standby letter of credit and a documentary letter of credit. A standby letter of credit is frequently used in such transactions as supporting leases, construction contracts, acquisition agreements, and sales agreements. A documentary letter of credit on the other hand is commonly used in international business transactions. Regardless of the type of letter, the person requesting that letter must be in good financial standing with the person or institution providing the funds.
The Elements of a Letter of Credit
Whether it is a standby letter or a documentary letter, each letter of credit should include the following information:
- Customer – requests the letter of credit and is obligated to repay money to the bank or financial institution that provides the money for a purchase; This person or entity is also known as the applicant or account party.
- Beneficiary – draws upon the letter of credit and actually receives the funds provided by the financial institution. The letter of credit is beneficial since it guarantees, for example, that a landlord requiring a security deposit will receive the funds for that deposit.
- Issuer – provides the funds and guarantees payment to the beneficiary whenever the beneficiary provides the necessary paperwork requesting payment. It is usually a financial institution of some kind although it may be an individual with the resources to provide funding to the customer. The issuer is the person to whom the customer is indebted by the letter of credit. Since this is an independent transaction, it is not insured by FDIC, putting the issuer at greater financial risk.
- Confirmer – assures that the issuer will provide the necessary funds to the beneficiary by providing supplementary security or credit, also an indicator that the confirmer’s credit rating is stronger than the issuer. By acting as confirmer, this entity or person is responsible for fulfilling the letter of credit should the issuer be unable to do so. In that case the issuer becomes indebted to the confirmer by the letter of credit.
- Adviser – communicates to the beneficiary that the letter of credit has been amended, issued, and/or verified. Generally, the issuer the confirmer, or a different adviser requests this action.
The following language is typical of a letter of credit:
"We hereby issue our Irrevocable Standby Letter of Credit No. ______ (this "Letter of Credit") in your favor at the request and for the account of ______ in the amount up to but not exceeding the aggregate sum of Amount U.S. Dollars (U.S. $______) effective immediately and expiring as set forth below."
Templates for letters of credit are available on-line. However, adding, omitting, or misunderstanding information may have serious ramifications for all parties involved. An experienced business attorney is the smart choice for creating a precise and accurate letter of credit.
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