Letters of credit are not the most common means of small business financing, but they are an important financing tool for companies that engage in international trade.
A letter of credit (LC) is simply a guarantee of payment upon proof that contract terms between a buyer and seller have been completed. LCs are just fancy, two-way IOUs often used to facilitate international credit purchases.
You, the buyer, go to your bank and request a letter of credit which they will grant you only if you have an adequate line of credit established with them. On your behalf (and for a fee), your bank promises (via the LC) to pay the purchase price to a seller (or his or her appointed bank) if stipulated and highly detailed conditions are met.
These conditions might include any or all of the following:
The "Rules" were drafted by the International Chamber of Commerce (ICC) in 1933 and revised as recently as 1993. They govern a standard letter of credit format accepted internationally and are known as the "Uniform Customs and Practice for Commercial Documentary Credits (UCP)."
The buyer's bank works as a kind of transfer agent, usually with the seller's bank, to exchange the purchase price for title or claim to goods. The parties thereby use their banks as intermediaries or middlemen to limit the risks of doing business with foreign trading partners. These risks include foreign currency exchange rate fluctuations as well as frequent shipping delays and the multitude of perils inherent in international trade.
Letters of credit are available in a variety of forms (for example., confirmed irrevocable letters of credit, confirmed letters of credit, acceptance letters of credit, or back-to-back letters of credit) with differing degrees of bank commitment. Generally you will only be dealing with irrevocable LCs.
If you are the importer, for example, you need to be assured that the proper goods will be delivered to you intact, on a date certain, in good condition and at the agreed upon cost. The sellers (exporters) need to know that when they comply with all the terms you've set forth in the letter of credit, they'll be paid the amount due in a timely manner. And everything must be thoroughly documented at both ends.
Keep in mind that banks deal with documents, not goods, and if the documents are incorrect — even if the goods arrive as promised — the letter of credit can be worthless if any party to the agreement has made a mistake in the paperwork. And the flip side is that the paperwork can be perfection personified and the LC therefore honored — but the wrong goods might be delivered. That's why you need to have an inspector (a customs broker, freight forwarder, or whatever) certify that what you ordered is what was shipped and that it arrived in good shape.
The key point to remember about LCs is the need for precision. Attention to detail and nit-picking legalese are mandatory. If an error is made or adjustments are needed subsequent to the issuance of an LC, amendments can be made to accommodate all parties to the transaction. But banks will follow these instruments to the (literal) letter so you need to be as concise and accurate as possible when specifying terms.
The devil, as usual, is in the details but the security an LC provides to
both buyer and seller is well worth the effort involved.