Legal Definitions - documentary credit

A documentary credit is a financial arrangement, typically provided by a bank, that guarantees payment to a seller (also known as the beneficiary) on behalf of a buyer (the applicant). The bank makes a firm promise to pay the seller a specific amount of money, but only once the seller presents certain required documents. These documents, which might include shipping documents, invoices, or certificates of origin, prove that the goods or services have been provided exactly as agreed. This method is widely used, especially in international trade, to reduce financial risk for both the buyer and the seller, ensuring the seller gets paid and the buyer receives the agreed-upon goods or services.

• Scenario: An electronics retailer in New York places a large order for custom-designed circuit boards from a manufacturing plant in Malaysia. The Malaysian plant is hesitant to ship the valuable order without guaranteed payment, and the New York retailer wants assurance that the correct circuit boards will be manufactured and shipped according to specifications before releasing funds.
  How it illustrates the term: To bridge this trust gap, the New York retailer's bank issues a documentary credit in favor of the Malaysian plant. The bank promises to pay the Malaysian plant once it presents specific documents, such as a bill of lading (proving shipment), a commercial invoice, and a quality inspection certificate. This arrangement ensures the Malaysian plant receives payment upon fulfilling its shipping obligations, and the New York retailer is protected because payment is only made after the required shipping and quality documents are submitted to the bank.
• Scenario: A construction company in Texas needs to purchase a specialized, custom-fabricated steel structure from a manufacturer in Ohio for a new bridge project. The steel structure is extremely expensive and custom-made, so the Ohio manufacturer requires a secure payment guarantee before starting production and shipment. The Texas construction company, in turn, wants assurance that the correct, custom-designed structure will be delivered.
  How it illustrates the term: The Texas construction company arranges for its bank to issue a documentary credit to the Ohio manufacturer. The bank commits to paying the manufacturer once it provides documents like a certificate of manufacture, a bill of lading confirming shipment of the specific steel structure, and an independent inspection report. This provides security for the Ohio manufacturer, knowing payment is guaranteed upon meeting the documentary conditions, and assures the Texas company that funds will only be released once proof of production and shipment is verified through the required documents.