Legal Definitions - letter of credit

A letter of credit is a formal document issued by a bank, acting as a guarantee that a buyer's payment to a seller will be made on time and for the correct amount. Essentially, the bank steps in to back the buyer's promise to pay, providing assurance to the seller that they will receive their funds once certain agreed-upon conditions are met. This mechanism significantly reduces the financial risk for sellers, especially in transactions involving large sums, international trade, or parties who do not have an established relationship.

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

• International Trade of Goods: An electronics distributor in the United States wants to purchase a large shipment of custom-made microchips from a manufacturer in Taiwan. The Taiwanese manufacturer is hesitant to produce and ship the chips without upfront payment, as they have no prior relationship with the U.S. distributor and are concerned about payment default across international borders. The U.S. distributor's bank issues a letter of credit in favor of the Taiwanese manufacturer. This letter guarantees that the Taiwanese bank will pay the manufacturer once they provide proof that the microchips have been shipped according to the agreed specifications. This assures the manufacturer they will be paid, and the distributor knows payment will only be released after the goods are on their way.

  This illustrates how a letter of credit mitigates risk in international transactions by having a trusted financial institution (the bank) guarantee payment, bridging the trust gap between distant parties.

• Large Domestic Equipment Purchase: A small manufacturing company in Ohio needs to buy a new, expensive industrial robot from a supplier in Michigan. The robot costs several hundred thousand dollars. The Michigan supplier requires assurance of payment before delivering and installing such a high-value piece of equipment, while the Ohio company wants to ensure the robot is delivered and functions correctly before releasing the full payment. The Ohio company's bank issues a letter of credit to the Michigan supplier. This letter guarantees that the bank will pay the supplier the agreed amount once the supplier provides documentation proving the robot has been delivered, installed, and successfully tested at the Ohio factory. This protects both the buyer and the seller.

  This demonstrates how a letter of credit can secure a significant domestic transaction, ensuring the seller receives payment upon fulfilling their obligations and the buyer's funds are protected until those obligations are met.

• Construction Project Subcontractor Payment: A general contractor is overseeing the construction of a new office building. They hire a specialized plumbing subcontractor for a major phase of the project. The subcontractor is concerned about potential delays in payment or the general contractor's financial stability during the long project timeline. To provide assurance, the general contractor arranges for their bank to issue a letter of credit in favor of the plumbing subcontractor. This letter guarantees that the bank will pay the subcontractor for completed work milestones (e.g., upon completion of rough-in plumbing, or final fixture installation) once certified by an independent inspector, even if the general contractor faces temporary cash flow issues. This ensures the subcontractor can continue work without financial worry.

  This example highlights the use of a letter of credit to guarantee payment to a service provider or subcontractor upon the completion of specific, verifiable stages of work, providing financial security throughout a project.