A letter of credit is an abstract, conditional promise to pay an exporter by an importer of goods, shown by the presentation of a letter of credit document. The letter of credit is now widely used to secure international trade transactions.
The documentary credit is the process by which an issuing bank undertakes to order, on account of its client importing goods to settle the exporter’s bill in a specified period. And this is typically done through an intermediary bank (or advising bank), and the specified amount against the delivery of documents should strictly conform to justify value and shipment of goods.
Abstraction means that the payment from the bank is legally dissociated from the underlying transaction which is independent and is next to the sales contract.
Conditional implies that the fulfillment of the promise to pay is subject to conditions, which are always transactional in nature. The letter of credit is thus a means by which foreign trade (rare in domestic trade) meets the payments interests of buyers and sellers of goods.
The buyer derives the capacity to provide a guaranteed official promise in this form of execution that he shall pay only if the seller has delivered the goods ordered, as proven through the presentation of proper documents.
The seller gets the assurance that after the delivery of the goods and the presentation of proper documents to the bank he will receive the sales proceeds.
Parties to a credit arrangement generally involve the buyer or importer who is the initiator of the documentary credit from the bank. The issuing bank in this case is the originator. It issues the documentary credit, notifying the bank that is receiving the letter of credit, and submits to the recipient after reviewing the compliance of the conditions laid out.
The recipient is the exporter who receives the letter of credit through his bank. If credit permits, the recipient may return the documents and ask for payment to another bank in his country to be fowarded to the advising bank.
Since letters of credit abstract, that is, differentiate from the underlying contract, the parties to the settlement of a letter of credit deal only with the documents, which represent the actual product. This means that upon presentation of letter of credit documents the payment for the goods is effected even when the goods are faulty.
If the documents do not entirely meet the requirements of the letter of credit, an irrevocable promise to pay the issuing bank becomes obsolete. Legal recourse for disputes surrounding such transactions is often falls under the jurisdiction of the exporter.