Legal Definitions - letter of exchange

A letter of exchange, also commonly known as a draft or bill of exchange, is a formal written order from one party (the drawer) to another party (the drawee) to pay a specified sum of money to a third party (the payee) on demand or at a definite future time. It is a type of negotiable instrument, meaning it can often be transferred from one party to another.

Essentially, it acts as a written instruction for payment, where the drawer is telling the drawee (who typically holds funds belonging to the drawer or owes the drawer money) to pay a specific amount to the payee. This instrument is frequently used in commercial transactions, especially in international trade, to facilitate secure and structured payments.

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

• International Trade Transaction: A furniture importer in the United States (the drawer) purchases a large shipment of handcrafted tables from a manufacturer in Italy. Instead of sending cash directly, the importer issues a letter of exchange instructing their bank in New York (the drawee) to pay the Italian manufacturer (the payee) a specific sum of money once the shipping documents confirming the tables have been dispatched are presented. This ensures the manufacturer gets paid only after the goods are on their way, and the importer's bank handles the secure transfer of funds.

  This illustrates how a letter of exchange acts as a written order from the importer to their bank, directing the bank to release funds to the Italian manufacturer under specific conditions, facilitating secure international trade.

• Business Debt Settlement: A marketing agency (the drawer) is owed a significant amount by a large corporate client (the drawee) for a completed advertising campaign. The marketing agency, in turn, owes a freelance graphic designer (the payee) for their work on the same campaign. To streamline payment, the marketing agency issues a letter of exchange instructing the corporate client to pay the graphic designer directly from the funds owed to the agency.

  Here, the letter of exchange serves as a direct instruction from the marketing agency to its client, diverting a portion of the payment the client owes the agency to a third-party designer, simplifying the settlement of multiple debts.

• Securing Future Payment for Services: A property developer (the drawer) is building a new residential complex. To secure payment for a specialized landscaping contractor (the payee) who will begin work in six months, the developer issues a letter of exchange to their construction loan bank (the drawee). This letter instructs the bank to pay the landscaping contractor a specified amount on a particular future date, provided certain construction milestones are met.

  This example demonstrates the use of a letter of exchange to create a future, conditional payment obligation. The developer is ordering their bank to pay the contractor at a later time, ensuring the contractor's payment is secured against the developer's funds held by the bank.