Lesson 27: Basics of Letters of Credit

As part of Article 5: Letters of Credit, this lesson delves into the fundamentals of Letters of Credit (LoC). A letter of credit is a financial tool that facilitates international trade by providing a guarantee from a bank to the seller that the buyer will fulfill their payment obligations.

Definition

According to Wikipedia, a letter of credit is a document from a bank guaranteeing that a buyer's payment to a seller will be received on time and for the correct amount. In case the buyer is unable to make the payment, the bank will cover the full or remaining amount of the purchase.

For a more in-depth understanding of Letters of Credit, consider the book 'Understanding Letters of Credit: A Comprehensive Guide'.

Parties Involved

There are typically four primary parties involved in a letter of credit transaction:

  • Applicant: The buyer in the transaction.
  • Beneficiary: The seller in the transaction.
  • Issuing Bank: The bank that issues the letter of credit on behalf of the applicant.
  • Advising Bank: The bank that advises the beneficiary that a letter of credit has been issued.
Note: The role of the advising bank is crucial in verifying the authenticity of the letter of credit.

How Letters of Credit Work

The following diagram illustrates the basic workflow of a letter of credit:

graph LR A["Applicant (Buyer)"] --> |"Requests LoC from"| B["Issuing Bank"] B --> |"Issues LoC to"| C["Advising Bank"] C --> |"Notifies LoC to"| D["Beneficiary (Seller)"] D --> |"Sends goods to"| A A --> |"Provides proof of shipment to"| D D --> |"Receives payment from"| B

Types of Letters of Credit

There are several types of letters of credit, each serving different purposes:

  • Revocable and Irrevocable: A revocable letter of credit can be altered or canceled by the issuing bank without prior notification to the beneficiary. An irrevocable letter of credit cannot be changed without the consent of all parties involved.
  • Confirmed and Unconfirmed: A confirmed letter of credit involves a second bank (confirming bank) that guarantees the payment in addition to the issuing bank. An unconfirmed letter of credit only involves the issuing bank’s guarantee.
  • Standby Letter of Credit: This functions as a secondary payment method, used when the primary payment fails. It is often used in domestic transactions.

Legal Framework

Under the Uniform Commercial Code (UCC) Article 5, letters of credit are governed by specific provisions to ensure fairness and clarity in commercial transactions. For more details on the rights and obligations under these laws, consider reviewing:

Example Code

Here is an example of how a letter of credit might be represented in a document:



  Letter of Credit Example
  Letter of Credit
  Issuing Bank: Bank of Commerce
  Applicant: John Doe
  Beneficiary: ABC Exports
  Amount: $50,000
  Expiry Date: 31st December 2023
  This letter of credit is irrevocable and confirms that the payment will be made upon presentation of the following documents:
  
    Bill of Lading
    Commercial Invoice
    Packing List

Conclusion

Letters of credit are essential tools in both domestic and international trade, providing security to both buyers and sellers. Understanding their structure, types, and the legal framework under the UCC is crucial for law students and practitioners involved in commercial transactions.

For further reading, check out the related lessons:

For further reading, you might also enjoy 'The Law of Letters of Credit: The Views of Leading Experts'.

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