Legal Definitions - open letter of credit

An open letter of credit is a type of financial instrument, issued by a bank, that provides a guarantee of payment to a seller (beneficiary) on behalf of a buyer (applicant). Unlike a standard letter of credit that might be used for a single, specific transaction, an "open" letter of credit is typically revolving or flexible. This means it allows for multiple draws or transactions over a period, up to a specified maximum amount, without requiring a new letter of credit for each individual payment or shipment.

It essentially acts as a continuous payment assurance, replenishing the available credit amount after each draw or at regular intervals, making it suitable for ongoing business relationships or projects with phased payments.

• Example 1: International Retail Supply Chain

  A large electronics retailer in the United States regularly imports components from a manufacturer in South Korea. Instead of arranging a new letter of credit for each monthly shipment, they establish an open letter of credit with their bank. This allows the South Korean manufacturer to draw payment for multiple shipments over a six-month period, up to a total agreed-upon value. Each time a shipment is made and documents are presented, the manufacturer receives payment, and the available balance under the letter of credit replenishes, ensuring continuous payment assurance for subsequent deliveries within the agreed timeframe.

  This illustrates an open letter of credit because it facilitates multiple, recurring transactions (monthly shipments) under a single, revolving financial guarantee, rather than requiring a new guarantee for each individual shipment.

• Example 2: Large-Scale Construction Project

  A real estate developer is building a new commercial office tower. The construction project will span three years and involve numerous payment milestones for the general contractor (e.g., completion of foundation, structural steel, exterior facade, interior finishing). To assure the contractor of timely payments throughout the project, the developer's bank issues an open letter of credit. This letter of credit allows the contractor to draw funds at each agreed-upon milestone, up to a specific amount for that phase. After each draw, the available credit amount for future milestones is restored, guaranteeing payment for all subsequent phases of the project without needing a separate letter of credit for every single payment.

  This demonstrates an open letter of credit by providing a continuous financial guarantee for a series of phased payments over an extended period, ensuring the contractor is paid at multiple stages of the project from a single, revolving instrument.

• Example 3: Long-Term Raw Material Supply Agreement

  A major automotive manufacturer has a five-year contract with a steel supplier for a continuous supply of specialized steel sheets. To ensure the supplier is confident in receiving payment for regular, large-volume deliveries, the automotive manufacturer's bank issues an open letter of credit. This arrangement allows the steel supplier to present invoices and shipping documents for monthly deliveries and receive payment directly from the bank, up to a pre-defined monthly or quarterly limit. The credit amount then resets for the next period, providing ongoing payment security for the duration of the long-term supply agreement.

  This exemplifies an open letter of credit because it supports a long-term, continuous supply relationship involving multiple, regular deliveries and payments. The "open" nature means the payment assurance is ongoing and replenishes, rather than being exhausted after a single transaction.