Legal Definitions - confirmed letter of credit

A confirmed letter of credit is a financial instrument that provides an enhanced level of payment security, typically used in international trade. To understand it, it's helpful to first understand a standard letter of credit.

A letter of credit is a guarantee from a bank (the "issuing bank") to a seller (the "beneficiary") that the seller will receive payment from a buyer, provided the seller fulfills specific conditions, usually by presenting certain documents (like shipping manifests or invoices) within a set timeframe. It acts as a promise from the buyer's bank to pay the seller, reducing the risk for the seller.

A confirmed letter of credit adds an additional layer of security. In this arrangement, a *second bank* (the "confirming bank"), often located in the seller's country, adds its own independent guarantee to the letter of credit. This means the seller is assured payment not only by the original issuing bank but also by the confirming bank. This extra guarantee is particularly valuable when the seller has concerns about the financial stability of the issuing bank, the political or economic risks in the buyer's country, or simply wants maximum assurance of payment.

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

• International Trade with Emerging Markets:

  An apparel manufacturer in Vietnam (the seller) receives a large order from a new clothing retailer in a country experiencing significant economic volatility and banking instability (the buyer). The Vietnamese manufacturer is hesitant to ship the goods solely based on a letter of credit issued by the buyer's local bank, fearing potential payment delays or defaults due to the unstable economic environment.

  To mitigate this risk, the Vietnamese manufacturer insists on a confirmed letter of credit. A major international bank with a strong presence in Vietnam (the confirming bank) adds its guarantee to the letter of credit issued by the buyer's bank. Now, if the buyer's bank fails to make payment after the Vietnamese manufacturer ships the apparel and presents all required documents, the confirming bank in Vietnam is obligated to pay the manufacturer. This dual guarantee provides the seller with critical peace of mind, enabling the trade to proceed.

• High-Value Equipment Purchase with New Supplier:

  A mining company in Australia (the buyer) needs to purchase specialized, high-value excavation equipment from a manufacturer in Brazil (the seller). This is their first time doing business together, and the Brazilian manufacturer is concerned about the Australian bank's specific payment processes and potential foreign exchange risks over the long production cycle.

  The Brazilian manufacturer requests a confirmed letter of credit. The Australian mining company's bank issues the letter of credit, and a well-known international bank with a branch in Brazil (the confirming bank) adds its independent guarantee. This means the Brazilian manufacturer is assured payment by both the Australian issuing bank and the Brazilian confirming bank. If the Australian bank encounters any issues or delays in payment after the equipment is delivered and documents are submitted, the Brazilian confirming bank will step in and pay, ensuring the manufacturer's financial security for this significant transaction.

• Long-Term Supply Contract in Politically Sensitive Regions:

  A European pharmaceutical company (the buyer) enters into a multi-year contract to source a critical raw material from a supplier located in a region known for its political instability and potential for sudden government interventions in banking. The supplier needs assurance of consistent payment to maintain production and invest in capacity.

  To secure the supply chain and reassure the supplier, the European pharmaceutical company arranges for a confirmed letter of credit. Their European bank issues the letter of credit, and a reputable, globally recognized bank with a strong presence in the supplier's region (the confirming bank) adds its guarantee. This arrangement means that even if political events or banking restrictions in the supplier's country affect the European issuing bank's ability to transfer funds, the confirming bank in the supplier's region is still obligated to pay the supplier upon presentation of the correct documents. This provides the supplier with crucial stability and confidence to fulfill the long-term contract.