A letter of credit (LC) is a written undertaking by the buyer or the buyer’s bank, known as the issuing bank, to pay a certain amount of money to the seller or seller’s bank, i.e., the negotiating bank or the accepting bank.

LC Payment Terms and Conditions

There are certain LC payment terms that must be fulfilled when the letter of credit is issued. The LC terms are:

  • Beneficiary/exporter and the issuing bank who has undertaken the obligation to make the payment should confirm the letter of credit.
  • There must be a clear mention of the due date by when the beneficiary/exporter shall receive the payment from a bank issuing the LC.
  • The letter of guarantee commitment should clearly specify the percentage of the amount of risk associated with the confirmed letter of credit issued by the bank.
  • The letter of guarantee commitment relating to the guarantee issued should be precise and clear.
  • The export agreement should be properly drafted, covering all the relevant information.

Types of Letter of Credit

  • a)   Financial LC
  • b)   Documentary (or Standby) LC

LC at Sight Payment Terms

The seller/exporter needs to submit the required documents to the bank to get the payment quickly. Apart from a letter of credit, he is required to submit all the documents that prove he has met his obligations. For example, he must submit the documentary proof for shipped goods, i.e., bill of lading. The bank reviews the documents submitted and verifies their authenticity.

How a Standby Letter of Credit Works

Unlike a Financial LC, Standby LCs are issued to provide comfort to the beneficiary that payment will be forthcoming if some terms of a contract between the beneficiary and the applicant are not met. A common use case for a Standby LC is in commercial real estate. A prospective tenant, call them Party A (the Applicant), is looking to sign a 5-year lease with Party B (the landlord and beneficiary) for a 100,000-square-foot warehouse facility.

 Assume that the facility will require some modest customization. The landlord wants to know that, should they spend the money to do these renovations, Party A won’t default on its rent and leave them with a large facility that’s already been renovated to suit a specific tenant’s needs.

 Party B might ask Party A for a Standby Letter of Credit in the amount of 12, 18, or perhaps even 24 months’ rent to protect its financial interest in the property. Should party A default on its rent payments, Party B would go to its own bank (the Advising Bank) and declare that the contract terms were breached. The Advising bank would notify the Issuing Bank, which would immediately remit payment on behalf of the Applicant (its client).