Definition of a Letter of Credit Facility

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Letter of credit facilities finance international trade.
Letter of credit facilities finance international trade. (Image: world trade image by Chad McDermott from Fotolia.com)

A letter of credit facility is a line of credit taken by a business entity, which can come in a variety of types with a variety of terms and used for a variety of purposes. A letter of credit facility specifically refers to a line of credit taken by a business entity primarily for the purpose of financing international trade.

Collateralizing the Letter of Credit

A letter of credit (LOC) is a financial instrument used by a buyer of goods in one country to pay the beneficiary (seller) in another country for goods the beneficiary sold and shipped to the borrower. To obtain a letter of credit, buyers apply to issuing financial institutions. Some buyers must deposit sufficient funds to cover the face amount of the letter of credit. Other buyers use a line of credit. In the case of the line of credit, this is called a “letter of credit facility.”

Terms and Conditions of the LOC Credit Facility

As with other credit facilities, the payment terms, conditions and restrictions for the LOC line of credit are varied and negotiated between the financial institution and the borrower. Typically, financial institutions attempt to structure the “fine print” to conform to industry norms for the borrower's industry in addition to any requirements peculiar to a particular borrower. In addition to collateralizing the LOC with either cash or a loan, the buyer also pays the financial institution’s LOC issuing fee.

How the Letter of Credit Works

Ideally, the LOC protects the interests of both buyers and sellers in a transaction. In preparing the LOC documentation, the buyer names the beneficiary or agent, and provides the requisite shipping documents agreed to by the buyer and seller necessary for payment. After the goods are delivered to the final destination and the seller is in possession of the shipping documents, the LOC with documentation is presented to the issuing bank for payment. The bank reviews the documentation and makes payment if the documentation is in order. It is an important clarification that the LOC must be paid based on validation of the documentation irrespective of the condition of the goods after release of the documentation. The goods could be destroyed or vandalized in a third party warehouse while awaiting final transit to the buyer. This would be an issue that does not involve the seller. The seller is paid based upon the LOC documentation and nothing else.

Irrevocable LOCs

As with the terms and conditions for LOC credit facilities, LOCs come in a variety of types that can be tailored to meet the specific needs of the buyer and seller. By far, the most common LOC is the irrevocable LOC. This means that it cannot be changed or canceled after the issue date without agreement by all parties. Use of the irrevocable LOC as the preferred LOC for the seller is quite logical as the seller would be severely disadvantaged with a revocable LOC if the buyer changed the documentation requirements after the goods were shipped.

LOC Credit Facilities Help Cash Flow

LOC credit facilities make it easier to do business overseas without tying up a buyer’s cash reserves. Buyers are advised to consult with their financial advisers to determine the practicality and feasibility of LOC credit facilities and with international shipping specialists to determine the most appropriate LOC for their type of business entity. Buyers and sellers are both advised to have a clear understanding of documentation requirements as this is what triggers payment of the LOC, and the reasonable time period required for all documentation to move from shippers and other transit intermediaries back to the seller.

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