Letters of Credit (LOC)

A letter of credit is a guarantee of payment upon proof that the contract terms have been met. This is commonly used in international trade transactions. In a letter of credit, your bank guarantees (for a fee) that it will pay the purchase price on behalf of the buyer upon completion of the contract. In most cases, you should have an established line of credit with your bank.

The process works as follows:

• The importer will go to his or her domestic bank and request a letter of credit designating the exporter as a beneficiary.
• The importer’s bank, after underwriting the deal and approving the importer, agrees to issue a letter of credit. The bank is not advancing payment to the importer, just approving credit and taking on the liability if the importer defaults. For companies that do not have good enough credit, they can qualify by deposition of cash or taking out a CD with the issuing bank—common with small companies that are not well established.
• The bank sends a LOC to the exporter’s bank; the exporter’s bank informs the exporter of the LOC, who then ships the products to the importer.

There are several different types of LOCs, including:

Stand-By Letter of Credit: This LOC guarantees payment to the beneficiary. If the importer in our previous example did not pay the exporter, the exporter can demand the importer’s bank pay the amount of the transaction upon proof of unpaid invoices with the supporting documentation.

Revolving Letter of Credit: This LOC is useful when there are regular transactions between exporter and importer. This eliminates the need of applying for a new LOC for each transaction.

Irrevocable Letter of Credit: This LOC cannot be canceled or changed without the agreement of all parties involved in the contract.

Revocable Letter of Credit: This LOC allows the issuing bank to cancel the LOC without the beneficiary’s approval.

Transferable Letter of Credit: Under this arrangement, the beneficiary can transfer the LOC to another beneficiary. In our previous case, the exporter can transfer the LOC to another business partner, i.e., the exporter’s vendor. The beneficiary can transfer all or a portion of the LOC to a third party and can only do this once.

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