How to Use a Letter of Credit As Collateral

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There are two types of letters of credit: the commercial letter of credit and the standby letter of credit. The commercial letter of credit is normally used in the import/export business to facilitate transactions involving the sale of goods by a manufacturer in one country to a buyer in another country. The standby letter of credit is a document issued by a bank that attests to its customer's ability to undertake and pay a financial obligation.

Things You'll Need

  • Contract for the sale of goods or commercial invoice
  • Bill of lading or other shipment document such as an airbill
  • Other paperwork as necessary
  • Use a bank that issues letters of credit (LOC). Certain banks specialize in import/export finance or corporate finance, and these banks are accustomed to issuing LOCs. Not all banks issue LOCs. Small community banks, credit unions and savings banks are unlikely to issue LOCs.

  • Provide your contract or commercial invoice to the banker if you are the buyer. This will provide the information the bank needs to identify a correspondent bank in the seller's country, which will act as the authorizing or confirming bank for the seller. This bank will receive the LOC and confirm that the document came from a valid bank and that it represents the buyer's ability to pay for the goods on arrival.

  • Check issuance of the LOC for accuracy of information and completeness of documentation. The issuing bank will issue the LOC to the confirming bank, stipulating the documentation needed to approve payment of money to the seller. Such documentation includes shipping receipts (bills of lading or airbills), customs documents, invoice or detailed listing of goods, and anything required by the port of entry. The confirming bank will then confirm to the seller that the goods may be sent.

  • Monitor the expected delivery date of your goods. When the goods arrive, the issuing bank checks the paperwork and you check the shipment. When all is in order, the issuing bank alerts the confirming bank, which also checks the documentation before paying the seller's bank.

  • Present the LOC as collateral for a loan to finance further inventory creation if you are the seller. At any time in the process, the seller may assign the LOC for payment to any other party, just as one might endorse a check to a third party. LOCs are irrevocable instruments, unless specifically stated otherwise on the face of the document. So, an LOC can be used as collateral by the seller on a loan or purchase, as well as represent a collateralized ability to pay on the part of the buyer.

  • Employ a standby LOC as collateral for a bridge loan in order to start a project, until full financing is received. A standby LOC is a bank guarantee of its customer's ability to pay and is held by a contractor or supplier that maintains an open account for the buyer. As long as the buyer pays as promised in the services contract covering the open account, the LOC will just remain as a guarantee until revoked by the issuing bank. If the buyer fails to pay, the contractor or supplier will claim payment from the issuing bank.

Tips & Warnings

  • A bank issuing a commercial letter of credit will require either money on deposit or collateral to back up the promise to pay inherent in the letter of credit. The collateral can be the goods being bought, but if you are a new customer or the seller is either new or questionable, the bank may require additional collateral for the commercial LOC.
  • A bank issuing a standby letter of credit may also require offsetting deposits or physical collateral to secure the guarantee of payment.
  • LOCs are delicate things. Any errors or inconsistencies in the documentation will disrupt the whole process, and only under extreme circumstances and rapid correction will the LOC remain valid. Inconsistencies in the price, description of the goods, differences in the names of the parties, missing documents and any changes not previously authorized and appearing on the LOC will halt payment and transfer of the goods.

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