Letter Of Credit Definition and Legal Meaning

On this page, you'll find the legal definition and meaning of Letter Of Credit, written in plain English, along with examples of how it is used.

What is Letter Of Credit?

(n) Letter of credit is the document issued by a bank sanctioning a credit to the customer for any particular transaction, guaranteeing the creditor availability of the fund to pay the amount due to the creditor when it becomes due.

History and Meaning of Letter Of Credit

A letter of credit is a letter issued by a financial institution or bank, guaranteeing that a buyer's payment to a seller will be received on time and for the correct amount. It is a common instrument used in international trade to reduce the risks involved in transactions between parties that may not know each other well. The concept of a letter of credit dates back to ancient civilizations, where merchants would use letters of credit as a way of securing payment for their goods.

Today, letters of credit are an essential tool for international trade, and they have evolved to become more complex and sophisticated over time. There are several different types of letters of credit, including commercial letters of credit, standby letters of credit, and revolving letters of credit, all of which serve different purposes.

Examples of Letter of Credit

  1. A furniture manufacturer in Italy wants to sell their products to a company in the United States. The buyer in the United States requests that the seller provide a letter of credit from an American bank guaranteeing the payment. The seller then obtains the letter of credit from their bank, which provides assurance that the buyer will pay for the furniture on time.

  2. An oil company in the Middle East has signed a contract to sell oil to a refinery in Japan. The Japanese company requests a letter of credit to be provided by a Japanese bank to guarantee payment to the oil company once the oil has been shipped.

  3. A construction company in the United Kingdom has been awarded a contract to build a road in Ghana. The Ghanaian government requests the construction company to provide a letter of credit to guarantee that the project will be completed on time, and the necessary funds will be available to pay for the work.

Legal Terms Similar to Letter of Credit

  1. Bank guarantee: A legal agreement in which a bank agrees to be responsible for a debtor's obligations towards a creditor if the debtor fails to pay.

  2. Surety bond: A guarantee provided by an insurance company or bank on behalf of a third party that the third party will fulfill their obligations under a contract.

  3. Performance bond: A type of surety bond that guarantees that a contractor will fulfill its obligations under a construction contract.