letter of credit (L/C)

Definition

Written commitment to pay, by a buyer's or importer's bank (called the issuing bank) to the seller's or exporter's bank (called the accepting bank, negotiating bank, or paying bank). A L/C guarantees payment of a specified sum in a specified currency, provided the seller meets precisely-defined conditions and submits the prescribed documents within a fixed timeframe. These documents almost always include a clean bill of lading or air waybill, commercial invoice, and certificate of origin. To establish a L/C in favor of the seller or exporter (called the beneficiary) the buyer (called the applicant or account party) either pays the specified sum (plus service charges) up front to the issuing bank, or negotiates credit. L/Cs are formal trade instruments and are used usually where the seller is unwilling to extend credit to the buyer. In effect, a L/C substitutes the creditworthiness of a bank for the creditworthiness of the buyer. Thus, the international banking system acts as an intermediary between far flung exporters and importers. However, the banking system does not take on any responsibility for the quality of goods, genuineness of documents, or any other provision in the contract of sale. Since the unambiguity of the terminology used in writing a L/C is of vital importance, the International Chamber Of Commerce (ICC) has suggested specific terms (called Incoterms) that are now almost universally accepted and used. Unlike a bill of exchange, a L/C is a non-negotiable instrument but may be transferable with the consent of the applicant. Although L/Cs come in numerous types, the two most basic ones are (1) Revocable-credit letter of credit and (2) Irrevocable-credit letter of credit, which comes in two versions (a) Confirmed irrevocable letter of credit and (b) Not-confirmed irrevocable letter of credit.