Legal Definitions - transferable letter of credit

A transferable letter of credit is a specialized type of financial instrument, building upon the concept of a standard letter of credit.

First, let's understand a letter of credit (LC). An LC is a commitment from a bank to pay a seller (the "beneficiary") a specified amount of money on behalf of a buyer (the "applicant"), provided the seller meets certain conditions, typically by presenting specific documents (like shipping manifests or inspection certificates) within a set timeframe. It's commonly used in international trade to reduce risk, assuring the seller they will be paid and the buyer that they will receive the goods or services as agreed.

A transferable letter of credit takes this a step further. It is an LC that explicitly allows the original beneficiary (the party initially entitled to receive payment) to transfer their rights to receive all or part of the payment to one or more other parties (known as "second beneficiaries"). This is particularly useful when the original beneficiary is an intermediary who needs to pay their own suppliers or subcontractors using the funds from the main transaction. The bank issuing the letter of credit must clearly state that it is "transferable" for this feature to be valid.

Here are some examples to illustrate how a transferable letter of credit works:

• Scenario 1: International Apparel Sourcing

  A large clothing retailer in the United States (the buyer) places an order for a new line of shirts with a trading company in Hong Kong (the original beneficiary). The Hong Kong trading company doesn't manufacture the shirts themselves; they source them from a factory in Vietnam (the second beneficiary). To secure the deal, the U.S. retailer's bank issues a transferable letter of credit to the Hong Kong trading company. The Hong Kong company then transfers a portion of this letter of credit to the Vietnamese factory. This allows the factory to begin production, knowing they are guaranteed payment directly from the bank once they ship the shirts and provide the necessary documents, without having to rely solely on the Hong Kong trading company's direct payment.

  This illustrates the term because the original beneficiary (Hong Kong trading company) transfers its right to receive payment, in part, to its supplier (Vietnamese factory), enabling the factory to get paid directly under the same financial instrument.

• Scenario 2: Large-Scale Construction Project

  A government agency (the buyer) awards a contract to a general construction company (the original beneficiary) for building a new public hospital. The general contractor will use several specialized subcontractors for different parts of the project, such as electrical wiring, plumbing, and HVAC systems (the second beneficiaries). To ensure the project proceeds smoothly and subcontractors are confident in payment, the government agency's bank issues a transferable letter of credit to the general contractor. The general contractor then transfers specific portions of this LC to each of its major subcontractors. This guarantees that once a subcontractor completes their specific phase of work and provides the required documentation, they can claim payment directly from the bank, rather than waiting for the general contractor to be paid first.

  This example demonstrates the term by showing how a main contractor (original beneficiary) can use a transferable LC to secure payment for its various subcontractors (second beneficiaries), streamlining the payment process and reducing financial risk for all parties involved in a complex project.