A letter of credit is a common financial document used by businesses and customers during transactions. There are two types of credit letters, a commercial version and a standby version. The letters are used for different purposes, and the process for obtaining them changes based on the borrower and the transaction. However, both letters involve detailed contracts with banks that set their own qualifications on how the parties must apply for and use the documents.
Commercial Letter of Credit
The commercial letter of credit helps a customer buy a product or service through a business, and is especially common in financial trade, where neither side is fully confident in the other. This letter is an agreement that an issuing bank makes on behalf of a customer, authorizing a second confirming bank to make a payment to the selling business. This essentially functions as a contract between the buyer and seller and their respective banks, so each party can reach an understanding and be confident in payment.
Exemptions and Qualifications
Buyers apply for a commercial letter of credit through their own issuing banks, which creates the contract that is agreed upon by all involved parties. In this case, the seller is only entitled to payment if the seller can show documentation of the letter of credit, which is a separate confirmation of the arrangement and not directly a part of the contract. The letter of credit lists terms that must be met for the issuing bank to pay and be reimbursed by the buyer. These letters are negotiable, and may or may not be able to be passed on to others. Many banks also reserve the right to revoke the letters of credit if they are used inappropriately, or new information emerges concerning the parties involved.
Standby Letter of Credit
A standby letter of credit gives the seller credibility when working on a project for a particular buyer or owner, much like a type of surety bond. Instead of a surety agent guaranteeing the funds, a bank agrees to back the seller through a letter of credit. This guarantees payment for the seller, and has many more applications than a contract-based surety bond. The buyer must apply to the bank for a letter of credit in favor of the seller.
Common Documents Required
With a standby letter of credit, several types of documents must be verified by the issuing bank. For instance, a commercial invoice shows the billing for goods and services, and acts as proof for a specific payment. A bill of lading shows similar pricing for transportation. A warranty of title is needed when a title is being conveyed with the transaction, and a letter of indemnity may be needed to protect the buyer from specific order-based liabilities.
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