Bank letters of credit (L/Cs) have been used in commerce since medieval times. They come in two basic types, commercial (also called documentary) and stand-by. Each has a distinct purpose, but both types were created to assure the parties in a commercial transaction that contractual obligations will be honored. L/Cs are governed by an international set of rules, the Uniform Customs and Practice (UCP).
Basic Purpose of Commercial L/Cs
Commercial L/Cs are the preferred payment and financing mechanisms for individual international trade transactions. Issued on behalf of an importer, a bank L/C assures the foreign supplier that he will be paid for the goods ordered, provided the L/C's terms and conditions are complied with. Once any discrepancies have been resolved and the export documents conform, the exporter gets his money and the transaction is finished.
Basic Purpose of Stand-by L/Cs
Stand-by L/Cs do not support discrete trade transactions. Banks issue them to guarantee a customer's performance or vouch for his or her credit worthiness to a contractual third party. They may “stand” behind monetary obligations, ensure the refund of advance payment, support performance and bid obligations and insure the completion of a sales contract. They stay in force until maturity. Normally, the parties involved do not expect the L/C ever to be drawn upon.
Most commercial L/Cs are issued as “irrevocable,” meaning they may not be changed or canceled unless buyer and seller both agree. Commercial L/Cs may also be “confirmed” by the exporter's bank; instead of merely “advising” that it has received an L/C in his or her favor, the bank adds its own promise to pay on top of the issuing bank's for extra protection.
Stand-by L/C's nomenclature is less precise. They are described by their intended use; for instance, the L/C will support an “open account” arrangement, or it will secure a customer's credit facility with another bank. Special types of guarantees issued in the form of stand-by L/Cs are Bid Bonds, Advanced Payment and Warranty and Performance Bonds. Stand-by L/Cs are issued only as irrevocable instruments.
Commercial L/Cs may involve a dozen or more discrete processing steps, each being highly susceptible to delays and errors--the documentation requirements are strict and often complex. Completing a standby L/C is comparatively simple. Once the bank is satisfied with its customer's ability to perform, it issues what may be just a one-page document that simply states when and how the beneficiary may draw on it. Often only a simple demand will suffice to trigger a draw. The supporting documentation requirements will be minimal.
Commercial L/Cs are governed by the UCP 600 issued by the International Chamber of Commerce (ICC), last revised in 2007.
Cross-border standby L/Cs are also subject to UCP 600; domestic stand-by and special types of guarantees (such as Bid Bonds, Advanced Payment and Warranty and Performance Bonds) are subject to the Uniform Commercial Code and laws of the country in which issued.