Legal Definitions - negotiation letter of credit

A negotiation letter of credit is a specific type of financial guarantee, typically issued by a bank, that facilitates payment in commercial transactions, especially in international trade. To understand it, it's helpful to first understand a general letter of credit.

A letter of credit (LC) is a promise from a bank (the "issuing bank") to pay a seller (the "beneficiary") a specified amount of money, provided the seller presents certain documents that prove they have fulfilled their contractual obligations (e.g., shipped goods, completed a service). This reduces risk for both the buyer and the seller, as the buyer knows they won't pay until conditions are met, and the seller is assured of payment once they meet those conditions.

In a negotiation letter of credit, the issuing bank authorizes another bank (the "negotiating bank"), often in the seller's country, to purchase the seller's payment requests (known as "drafts") or documents. This means the negotiating bank pays the seller upfront, usually after verifying that all required documents are in order. The negotiating bank then sends these documents to the issuing bank and seeks reimbursement. This arrangement is particularly beneficial for sellers who need quick access to funds, as they don't have to wait for the issuing bank to process the documents and send payment.

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

• Example 1: International Apparel Trade

  A clothing manufacturer in Bangladesh (the seller/beneficiary) receives a large order from a fashion retailer in France (the buyer). The Bangladeshi manufacturer needs immediate cash flow to purchase raw materials and pay its workers to fulfill the order. The French retailer's bank issues a negotiation letter of credit.

  How it illustrates the term: Once the clothing is manufactured and shipped, the Bangladeshi manufacturer presents the shipping documents and a payment request (draft) to its local bank in Bangladesh (the negotiating bank). The Bangladeshi bank verifies that all documents comply with the letter of credit's terms. Upon verification, the Bangladeshi bank immediately pays the manufacturer, often at a slight discount. The Bangladeshi bank then forwards these documents to the French bank for reimbursement. This allows the manufacturer to receive payment quickly, enabling them to fund their next production cycle without delay, while the French bank ultimately pays the Bangladeshi bank.

• Example 2: Renewable Energy Project

  A specialized engineering firm in Spain (the seller/beneficiary) is contracted by a utility company in Morocco (the buyer) to design and install a new solar power plant. The project involves multiple stages, and the Spanish firm requires prompt payment upon the completion of each milestone to cover ongoing costs and maintain project momentum.

  How it illustrates the term: The Moroccan utility company's bank issues a negotiation letter of credit. As the Spanish engineering firm completes each agreed-upon project milestone, it submits certified completion reports and invoices (drafts) to its bank in Spain (the negotiating bank). The Spanish bank reviews these documents for compliance with the letter of credit. Once satisfied, the Spanish bank pays the engineering firm immediately. The Spanish bank then sends these documents to the Moroccan bank to claim its reimbursement. This ensures the engineering firm has consistent access to working capital throughout the multi-phase project.

• Example 3: Agricultural Commodity Export

  A cooperative of rice farmers in Thailand (the seller/beneficiary) sells a large shipment of rice to a food importer in the United Kingdom. The Thai farmers operate in a region where direct international banking transfers can be slow, and they prefer to deal with their established local bank for quick access to funds after harvest.

  How it illustrates the term: The UK food importer's bank issues a negotiation letter of credit. After the rice is loaded onto the vessel and the farmers obtain the necessary export documents, they present these documents to their regional Thai bank (the negotiating bank). The Thai bank examines the documents to ensure they meet the letter of credit's requirements. Upon approval, the Thai bank pays the cooperative directly. The Thai bank then forwards the documents to the UK bank for reimbursement. This method provides the farmers with swift payment through their familiar local banking system, streamlining the process despite the international nature of the transaction.