Legal Definitions - commercial letter of credit

A commercial letter of credit is a financial instrument issued by a bank on behalf of a buyer (often an importer) to a seller (often an exporter). It serves as a guarantee from the bank that the seller will receive payment for goods or services, provided they meet specific conditions outlined in the letter.

Essentially, it's a promise from a bank to pay the seller a specified amount of money by a certain date, as long as the seller presents the required documents (such as shipping documents, invoices, or inspection certificates) that prove they have fulfilled their part of the agreement. This mechanism significantly reduces the financial risk for both parties, especially in international trade where trust can be challenging and legal recourse across borders complex.

Here are some examples illustrating how a commercial letter of credit works:

• International Trade: Pharmaceutical Ingredients

  A pharmaceutical company in Canada (the buyer) needs to import a specialized chemical compound from a supplier in India (the seller) to manufacture a new drug. The Canadian company's bank issues a commercial letter of credit to the Indian supplier. The letter specifies that the Canadian bank will pay the Indian supplier the agreed amount once the supplier presents documents confirming the shipment of the chemical compound, including a bill of lading, a certificate of analysis, and an export license, all conforming to the terms of their contract.

  Explanation: This arrangement protects the Indian supplier by guaranteeing payment from a reputable Canadian bank, even if the Canadian pharmaceutical company encounters financial difficulties or attempts to dispute the quality after shipment. It also protects the Canadian company by ensuring that payment is only released once the critical chemical compound is confirmed to be shipped and meets the specified quality and regulatory standards.

• Domestic High-Value Purchase: Industrial Machinery

  A large food processing plant in California (the buyer) decides to purchase a custom-built, multi-million dollar packaging machine from a specialized manufacturer in Michigan (the seller). Given the high cost and custom nature of the equipment, both parties want financial security. The California plant's bank issues a commercial letter of credit in favor of the Michigan manufacturer. The letter stipulates that the California bank will pay the manufacturer upon presentation of documents verifying the machine's successful factory acceptance testing, shipment to California, and proof of delivery at the processing plant.

  Explanation: This letter of credit assures the Michigan manufacturer that they will receive full payment for their expensive, custom-built machinery once they fulfill their manufacturing and delivery obligations. Simultaneously, it assures the California plant that their bank will only release the substantial funds after the machine is confirmed to be built, shipped, and delivered as per their agreement, mitigating the risk of paying for undelivered or non-conforming equipment.

• Long-Term Supply Contract: Renewable Energy Components

  A solar farm developer in Australia (the buyer) enters into a multi-year contract with a solar panel manufacturer in China (the seller) for a continuous supply of high-efficiency solar panels. To manage the ongoing financial commitment and ensure reliable supply, the Australian developer's bank issues a commercial letter of credit to the Chinese manufacturer. The letter allows for periodic payments to the manufacturer upon presentation of shipping documents, quality control certificates, and invoices for each batch of panels delivered to the Australian port.

  Explanation: This provides the Chinese manufacturer with consistent financial security for their ongoing production and shipments, knowing that a bank guarantees payment for each verified delivery of solar panels. For the Australian developer, it ensures that payments are directly tied to confirmed shipments and quality checks, preventing them from paying for panels that haven't been dispatched or don't meet the required specifications for their project.