In most of the world and, indeed, in much of the United States the parties to a transaction often do not know each other and are concerned that the transaction will not proceed without problems. The manufacturer or supplier is concerned that it will not be paid for goods or services rendered. The buyer is worried that defective goods will be supplied or will arrive late or incomplete. The seller wants cash up front and the buyer does not want to pay until the goods are in hand, inspected, and approved.
The situation is exacerbated when transactions occur across international borders. First, practically speaking, it is difficult to enforce contractual commitments far from home and most often far more expensive than litigation in a local arena. Secondly, many jurisdictions are corrupt, or slow, or hostile to foreign litigants. Some huge markets, as China, with flourishing economies, do not have any effective court system at all, to their own dismay. While arbitration of disputes in a neutral locale and effective Terms and Conditions on invoices can resolve many of the problems, most international businesses and quite a few domestic businesses utilize a more direct method of assuring both payment and performance – THE LETTER OF CREDIT.
In its most simple form, a Letter of Credit is simply a guaranty that one financial institution will pay monies to another financial institution upon certain events occurring. The money is deposited into one of the banks (“Assigning Bank”) which guaranties payment to the other bank and the money can not be removed by the depositor (is “irrevocable Letter of Credit’) absent consent of the other party or collapse of the entire transaction (usually, passage of time without delivery of goods, etc.). On the other end of the transaction, the money will not be released by the receiving bank until conditions are met, such as timely delivery of a stated number of goods or inspection of the quality of the goods by a expert. (Note the banks do not normally provide the inspection services. They merely release the money if and only if the expert you arrange presents a certificate of successful completion of the conditions.)
The purpose of this article is to give the reader the basic workings of the typical types of letters of credit, defining terms that the reader may encounter.
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