Letters of Credit
A Letter of Credit is an essential part of buying or selling services with a group outside your country. It is one of the most common and popular methods of securing payment in international business agreements. As international transactions with new or unfamiliar businesses can bring added risk, a bank can issue a letter guaranteeing payment, mitigating risk and expediting the supply of goods or services. Read this page to see how a Letter of Credit works and the situations where one can be useful.
Often, a group selling a product or service will seek a Letter of Credit to guarantee that payment will be issued. Here is how that might happen:
Group A has never conducted business with Group B, and they are in different countries and jurisdictions. Group A wants to make sure that the products are shipped, and Group B wants to make sure they will be paid for providing their products. A Letter of Credit facilitates a guarantee and allows both groups to proceed with confidence.
For example, imagine that Group A is a German company that is importing from Group B, a seller in the United States. Group B, the American exporter, and beneficiary, wants to ensure they have guaranteed payment before shipping the products to the company in Germany. Group A uses their bank in Germany, which has an excellent international reputation, to issue a document that states if, for some reason, Group A does not make payment to Group B, then the German bank will cover the payment. The document has specific terms and conditions that must be agreed to by both groups. This document is reviewed by Group B's bank in the United States and legitimized before the Letter of Credit is finalized and accepted by Group B.
There are a few common types of Letters of Credit:
- Irrevocable Letter of Credit - This type can only be canceled or revised with the consent of the beneficiary (seller).
- Revocable Letter of Credit - This type can be canceled or revised by the customer without a previous agreement with the beneficiary (seller).
- Stand-By Letter of Credit - The type is very similar to a bank guarantee and provides both parties with equal protections. This arrangement is common in project-based situations where the seller (service provider/beneficiary) fulfills their obligations but needs payment protection in case the buyer defaults with their payment.
Source: Saylor Academy
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