Glossary—letter of credit (L/C)

GISTnet Glossary—letter of credit (L/C)

A letter of credit is a separate contract entered into between a commercial bank (issuing bank), and an applicant, the bank's accountee, in which the bank promises a third party, the beneficiary, up to a certain sum of money in a stated currency upon the condition that the beneficiary perform a certain act, such as presenting a draft drawn in conformance with the L/C within a certain period of time; and, in the case of a documentary letter of credit, present specified documents, usually shipping documents, which conform to the L/C terms. Today, the traditional postal "letter" from one bank to another has largely been replaced with an authenticated electronic instruction message sent via a secure banking industry data network. (See definition for SWIFT message.) Most L/Cs are documentary L/Cs requiring the presentation of shipping documents, and issued subject to the Uniform Customs and Practices for Documentary Credits (UCP). An L/C is always separate and distinct from its underlying sale/purchase or other transaction between the accountee and beneficiary even though it may refer to the documents of the underlying transaction. Most L/Cs are irrevocable. (See irrevocable letter of credit.) If the beneficiary is in a different country, the issuing bank will typically, though not always, use the service of an advising bank in the beneficiary's country to inform the beneficiary of the L/C, and to act as an intermediary for purposes of authenticating the L/C, receiving the beneficiary's shipping documents and bills of exchange and perhaps letter of credit negotiation. In all cases, the L/C and the letter of credit advice letter will, together, set forth all the terms and conditions needed to comply with the L/C and receive payment. Since shipping documents must comply in detail with an L/C, a freight forwarder preparing such documents must have a copy of the L/C and letter of credit advice letter, and will need the original of these if he is also to perform the banking of the L/C. See also credit, negotiable letter of credit, and straight letter of credit.

For more information on the UCP publication, available for purchase from the ICC (http://www.iccbooks.com/)..

Per UCP, a letter of credit deals with documents only, and there is no engagement by the bank to authenticate or verify the accuracy of the documents in terms of the underlying goods, services or other transaction details to which they refer. An L/C does not protect against a dishonest beneficiary shipping non-conforming goods, short-shipping, etc., or providing erroneous or fraudulent documents, such as a fake inspection certificate, certificate of insurance or bill of lading.