What is Letter of Credit (LC)?

May 17, 2011

By John Wong

It’s a contract between an importer and exporter may call for payment under a letter of credit, often shortened as LC.

In brief, LC is a written commitment by a bank to make payment of a defined amount of money to a beneficiary (exporter) according to the terms and conditions specified by the applicant (importer). The LC should set a time limit for completion, and specify which documents are needed to confirm the transaction’s fulfillment.

It’s important to remember that a LC is an additional contract dealing with credit between the importer and exporter (also the issuing bank), and it’s separate from the original business contract between the importer and exporter.

Proper LC possesses the following basic components:

1. The Applicant – the party applying for the LC, usually the importer.

2. The Beneficiary – the party in whose favor the LC is issued, usually the exporter.

3. The Issuing Bank – the bank that issues the LC and assumes the obligation to make payment to the beneficiary.

4. Amount – the sum of money, usually expressed as a maximum amount of the credit and defined in a specific currency.

5. Terms – the requirements, including documents that must be met for the collection of the credit.

6. Expiry – the final date for the beneficiary to present against the credit.

The aforesaid are the necessary components of any LC for the credit to become valid, operable instrument.

In addition, LC comes in various forms that define their level of risk. For instance, a revocable LC allows the issuing bank (at the importer’s request) to amend or cancel the credit at any time without the approval of the exporter – it’s the most risky form.

In contrast, an irrevocable LC has terms and conditions that cannot be amended without the expressed consent of ALL parties (the importer, exporter, issuing bank).

Finally, the addition of a commitment by a bank other than issuing bank irrevocable LC honoring the payment of the credit results in a confirmed irrevocable LC provided the exporter meets all the terms and conditions of the credit.