A guarantee from a lending institution ensuring that the liabilities of a debtor will be met. In other words, if the debtor fails to settle a debt, the bank will cover it.
These mechanisms are used by exporters and importers, and usually provided by the importing company`s bank to the exporter to safeguard the contractual expectations and particularly financial exposure of the exporter of the goods or services. (Also called `export letters of credit, and `import letters of credit`.)
When an exporter agrees to supply a customer in another country, the exporter needs to know that the goods will be paid for.
The common system, which has been in use for many years, is for the customer`s bank to issue a `letter of credit` at the request of the buyer, to the seller. The letter of credit essentially guarantees that the bank will pay the seller`s invoice using the customer`s money provided the goods or services are supplied in accordance with the terms stipulated in the letter, which should reflect the agreement between the seller and buyer. This gives the supplier an assurance that their invoiced amount be paid, beyond any other assurances or contracts made with the customer. Letters of credit require careful drafting to protect the interests of buyer and seller. The customer`s bank charges a fee to issue a letter of credit, and the customer pays this cost.
The seller should also agree the wording of the buyer`s letter of credit, and should take professional advice.
In short, a letter of credit is a guarantee from the issuing bank`s to the seller that if mentioned documents in LOC are presented by the seller to the buyer`s bank within the given time using method and format mentioned at specified place, then the buyer`s bank will pay the seller the amount due. All terms mentioned in the LOC should be followed by seller/exporter. It is also important for sellers to use professional services to validate the authenticity of any unknown bank issuing a letter of credit.