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| Letter of Credit - Part I |
iHR Business Consultant - Andy Li |
Definition A documentary credit is the written promise of a bank, undertaken on behalf of a buyer, to pay a seller the amount specified in the credit provides the seller complies with the terms and conditions set forth in the credit. The terms and conditions of a documentary credit revolve around two issues:
In simple terms, banks act as intermediaries to collect payment from the buyer in exchange for the transfer of documents that enable the holder to take possession of the goods. Documentary credits provide a high level of protection and security to both buyers and sellers engaged in international trade. The seller is assured that payment will be made by a party independent of the buyer so long as the terms and conditions of the credit are met. The buyer is assured that payment will be released to the seller only after the bank has received the title documents called for in the credit. Documentary credits are so named because of the importance of documents in the transaction. Letter of credit (L/C) is the historic and popular term used for a documentary credit because such credits were and are transmitted in the form of a letter from the buyer’s bank. Both “documentary credit” and “letter of credit” will be used for our discussions. Types of Credits There are a number of different types of standard and special documentary credits. Each type contains a variety of features designed to meet the different needs of buyers, sellers, or the banks involved. For example, standard documentary credits can be either revocable or irrevocable, or confirmed or unconfirmed. The most popular variation for sellers is the irrevocable confirmed credit because it cannot be cancelled by the buyer, and a second bank adds it guarantee of payment to that of the buyer’s bank. Specialized credits include revolving credits, red clause credits, standby credits, transferable credits, and back-to-back credits. Limitations of Letters of Credit Although documentary credit provide good protection and are the preferred means of payment in many international transactions, they do have limitations. They do not, for example, ensure that the goods actually shipped are as ordered nor do they insulate buyers and sellers from other disagreements or complaints arising from their relationship. It is up to the parties to settle questions of this nature between themselves.
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