Search Back Issues

Letter of the Law on Credit Tool

By on
The letter of credit is a useful tool to help secure payment in an uncertain market.
The sale of goods or services on credit holds inherent risk, particularly when dealing with a new customer or one located in a foreign jurisdiction. But there is a tool for securing payment that is often overlooked: the letter of credit.

A letter of credit is a written agreement that commits a financial institution (the bank) to pay a creditor (the vendor) up to a specified amount if the vendor provides the bank with evidence of performance within a predefined timeframe. Similar to a guarantee, a letter of credit provides the vendor with an additional means of collection in the event a debtor/customer fails to make payment in a timely fashion. Letters of credit are particularly useful in foreign trade, where the uncertainty of payment can be a significant concern.

The first step in obtaining a letter of credit is having the customer contact the bank to request the letter for the benefit of the vendor. Not all banks issue letters of credit, and those that do will require the customer to guarantee the funds. Generally, this is done by depositing a specified amount with the bank or by pledging collateral.

Typically, a letter of credit contains specific provisions regarding the amount, its expiration date, the documents required before payment will be disbursed, and the location where the documents must be sent. If no expiration date is identified, the letter of credit generally expires one year from the date of issuance. In order to avoid ambiguity or confusion, it is recommended that universally accepted business terms be used within the letter of credit. If the vendor does not believe the bank is a stable institution, or is concerned that it lacks the ability to pay, the vendor can request that the letter of credit be “confirmed” by another bank that will, in turn, guarantee the funds.

Many contractual provisions are set forth within letters of credit. Among the most important is whether the letter of credit is revocable or irrevocable. Revocable letters of credit are infrequently used because, unless otherwise stated, the bank can amend or cancel the letter at any time prior to receiving the requisite documents without the consent of the vendor or the customer. In contrast, an irrevocable letter of credit cannot be amended or cancelled without the vendor’s written authorization. As a result, a vendor is much more likely to be paid on an irrevocable letter of credit and can be more confident in advancing credit.

Extremely important for letters of credit is what’s known as the “Independence Principle.” Simply stated, it means a letter of credit is a separate and independent agreement between the bank and the vendor. It is “independent” of any agreement between the vendor and the customer or between the customer and the bank. Parties to the letter of credit are required to strictly comply with the terms of the letter regardless of whether there is a dispute between the vendor and the customer with regard to their contract or business relationship.

If the conditions that permit a vendor to draw upon the letter of credit come to pass, the vendor can demand payment from the bank. In order to perfect these payment rights, the vendor must comply with the requirements as set forth within the letter of credit. This generally requires the vendor to demonstrate that the method, time, place and conditions of delivery have been satisfied and that the necessary documentation has been provided to the bank. Documents generally required prior to payment are those that demonstrate the vendor’s performance of its obligations to the customer, such as purchase orders, invoices, bills of lading, etc. The customer may also request that the bank require an inspection certificate be produced in order to ensure the goods delivered by the vendor have been inspected and accepted. Finally, the bank is required to abide by the standard of strict (or, at a minimum, reasonable) compliance when reviewing the documentation provided by the vendor.

If a vendor has not produced the necessary documents by the deadline set forth in the letter of credit, then the bank is entitled to withhold payment. However, if the vendor satisfies the requirements of the letter of credit, then the bank is obligated to issue payment to the vendor. Should the bank fail to perform its obligations in this regard, it is liable to the vendor for breach of contract.

The letter of credit can be an excellent tool to ensure the payment of trade debt from a customer whose credit is questionable or who resides in a remote location. Care must be taken in negotiating, drafting and enforcing such an agreement, but if done carefully and strictly enforced, a letter of credit can mean the difference between payment and an empty pocket.

Current News