What Is a Letter of Credit?
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Talk to our experts- Letter of credit
- A letter of credit is a bank's commitment, made at a buyer's request, to pay a seller once the seller presents the documents the letter calls for, such as proof of shipment. In export sales, it lets the exporter rely on the buyer's bank rather than the buyer's own credit.
Also called: LC
How it works
A letter of credit moves the promise to pay from the buyer to a bank. The International Trade Administration (trade.gov) describes it as a contractual commitment by the foreign buyer's bank to pay once the exporter ships the goods and presents the required documentation. It is useful when reliable credit information about a foreign buyer is hard to get, but the exporter is satisfied with the creditworthiness of the buyer's bank.
Compared with a documentary collection, where banks release the documents to the buyer for payment, trade.gov says documentary collections are generally less expensive but offer no verification process and limited recourse if the buyer does not pay.
How a letter of credit moves from sale to payment
Once the sales agreement is complete, the importer applies to its bank to open a letter of credit in favor of the exporter.
The importer's bank drafts it from the sales agreement terms and sends it to the exporter's bank, which reviews it and sends it on.
The exporter ships the goods as the letter of credit provides and submits the required documents to its bank.
The exporter's bank checks the documents against the terms. Errors and discrepancies must be amended and resubmitted.
The importer's bank pays the exporter's bank and releases the documents so the importer can claim the goods and clear customs.
In the US, Article 5 of the Uniform Commercial Code (UCC) sets these rules:
- Documents decide payment. The issuer must honor a presentation that appears on its face strictly to comply with the terms and conditions of the letter of credit. Unless agreed otherwise with the applicant, it must dishonor one that does not.
- Separate from the sale. The issuer's obligations to the beneficiary are independent of whether the underlying contract is performed.
- Irrevocable by default. A letter of credit is revocable only if it says so.
- Seven business days. The issuer has a reasonable time after presentation, but not beyond the end of its seventh business day after receiving the documents, to honor or to give notice of discrepancies.
This page explains the instrument; it is general information, not legal or financial advice.
Who is involved
UCC section 5-102 names the parties:
- Applicant: the person at whose request or for whose account the letter of credit is issued. In an export sale, that is the importer.
- Beneficiary: the person entitled under its terms to have a complying presentation honored. In an export sale, that is the exporter.
- Issuer: a bank or other person that issues the letter of credit.
- Adviser: a person who notifies the beneficiary that a letter of credit has been issued, confirmed or amended.
- Confirmer: a nominated person who undertakes, at the issuer's request or with its consent, to honor a presentation under a letter of credit issued by another.
Example
A manufacturer sells a new overseas distributor 400 cases of fittings at $55 a case: 400 x $55 = $22,000. The distributor's bank issues a letter of credit for $22,000 that calls for a commercial invoice and a bill of lading.
First, the manufacturer ships and presents both documents. The invoice shows 400 cases at $55, matching the letter, so the documents go on to the distributor's bank and payment follows. If the invoice had shown $21,500 instead, the bank would flag a discrepancy, and the manufacturer would amend and resubmit before payment.
On Shopify
A letter of credit is arranged between banks, but the order behind it can live in Shopify. On a B2B draft order, you can set payment terms such as Due on fulfillment, where payment is due after all items in the order are fulfilled, or Fixed date, where payment is due on a specific calendar date.
For customers who don't pay by credit card, Shopify offers manual payment methods. Common types include cash on delivery, money orders and bank transfers. Orders that accept manual payments are marked as unpaid, and after you receive payment you can mark the order as paid.
How Uncap helps
Uncap's guide to B2B payment terms treats terms as part of the deal. Uncap Quotes keeps the deal side of that record: every quote carries a validity window and a full revision history, so any rep who works the account can see what was offered and what was accepted.
Sources
Frequently asked questions
What is required for a letter of credit?
The documents the letter of credit names. Under UCC Article 5, the issuer must honor a presentation that appears on its face strictly to comply with the letter's terms and conditions. The International Trade Administration notes that the required documents are detailed and prone to errors and discrepancies, so it advises having trained professionals prepare them.
What are the disadvantages of a letter of credit?
The International Trade Administration says letters of credit can be labor-intensive and relatively expensive because of bank fees. The required documents are detailed and prone to errors and discrepancies, which can lead to payment delays and extra fees.
What is the purpose of a letter of credit?
A letter of credit protects both sides of a trade. The exporter gets a bank's commitment to pay once it ships and presents the required documents, while the importer can get reasonable payment terms and has no payment obligation until the goods have been shipped as promised.
