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What Is a Letter of Credit?

Letter of Credit Definition and Examples

Quick Answer

A letter of credit (LC) is a financial document issued by a bank guaranteeing payment to a seller once certain delivery or performance conditions are met. It’s commonly used in international trade to reduce the risk of non-payment between unfamiliar buyers and sellers.

Breaking Down the Definition

A letter of credit works like a promise from the buyer’s bank to pay the seller — but only if specific conditions are fulfilled.

Key features include:

Issuer: A bank or financial institution.
Beneficiary: The seller who will receive payment.
Applicant: The buyer requesting the LC.
Conditions: Often include submitting shipping documents like a bill of lading, invoice, or insurance certificate.

It is not a loan — it’s a payment guarantee.

There are different types of letters of credit, such as:

Irrevocable LC: Cannot be changed unless all parties agree.
Confirmed LC: A second bank (usually in the seller’s country) adds its guarantee.
Standby LC: Acts more like a fallback guarantee if the buyer defaults.

Why It Matters

Letters of credit are essential in international business transactions, where trust between buyer and seller may be limited. They help solve three major problems:

Payment Risk: Sellers want to ensure they get paid.
Delivery Risk: Buyers want to ensure goods are shipped correctly.
Cross-Border Complexity: Legal systems and enforcement mechanisms differ across countries.

Common Use Cases:

Import/Export Deals: Especially when shipping goods across continents.
Construction Projects: To guarantee payments to subcontractors or material suppliers.
Large Equipment Purchases: Such as machinery or vehicles bought from overseas suppliers.

In high-value or politically sensitive industries like oil & gas, infrastructure, and medical devices, a letter of credit can be the difference between closing a deal or not.

It also builds commercial trust: the buyer shows financial credibility, and the seller gets confidence that funds will be released when conditions are met.

Legal or Practical Implications

Letters of credit carry significant legal weight in cross-border transactions.

In Contracts:

Many international sales contracts specify that payment will be made by LC within a set number of days after shipment or inspection.
Banks typically follow UCP 600 (Uniform Customs and Practice for Documentary Credits), a global set of rules for letters of credit published by the International Chamber of Commerce.

Risk Allocation:

Shifts risk away from the seller, since the bank assumes payment responsibility.
Requires careful document accuracy — even a small discrepancy (e.g., a spelling error on a shipping document) can delay or cancel payment.

Negotiation Dynamics:

Sellers may push for a confirmed LC to protect against risks in the buyer’s country.
Buyers may request flexible conditions to account for partial shipments or customs delays.
Disputes can arise if terms are unclear or if one party claims the documents don’t match the agreement.

Different countries may also apply local banking regulations, requiring prior approval for issuing or receiving LCs above a certain value.

Example Clause or Use Case

Scenario: A UAE-based renewable energy company is importing wind turbine components from a German supplier.

The contract clause might read:

“Payment shall be made via irrevocable, confirmed letter of credit issued by a first-class international bank, payable upon presentation of the following documents: (i) Commercial Invoice, (ii) Bill of Lading, (iii) Certificate of Origin, and (iv) Insurance Certificate. All documents must be compliant with UCP 600 rules.”

Explanation:

The clause ensures that the German supplier only gets paid once they prove they’ve shipped the goods.
The confirmation by a “first-class international bank” adds protection for both parties.
The inclusion of UCP 600 ensures standard interpretation globally.

This clause helps reduce payment risk, speed up customs clearance, and keeps the transaction compliant with trade law.

Call-to-Action

Are you negotiating a cross-border deal or importing goods from a new supplier? A well-drafted letter of credit clause can protect your business from costly delays and disputes.

[Download our sample LC clause] or get in touch for help reviewing or drafting payment terms for international contracts.