Business Law 101 / LETTERS OF CREDIT

By Albert L. Kelley

In the business world, many people have heard the phrase “letters of credit” however, what these actually are is commonly misunderstood. A letter of credit is more than a loan; it is an arrangement where the issuer (a bank, for instance) agrees to make payment to the beneficiary of the letter, under instruction of the payor. As an example: John Smith needs to buy 50 blue chairs for his store from Bob Jones. Smith (the payor) can ask his bank (the issuer) to issue a letter of credit to Jones (the beneficiary) for up to a predetermined amount. Based upon this letter of credit, Jones has assurance that he will be paid for the chairs from Smith’s bank (For sake of oversimplification, I will continue to use this example through the article).

Letters of credit usually have conditions that must be met before the money is issued (the bank won’t just give the money to Jones without some proof that the money is owed). The letter may simply state that the beneficiary (Jones) needs to provide proof of delivery, or it may require more details such as insurance, purchase requests, etc. The payor needs to take care in setting the conditions. If the conditions simply state that the bank will pay when the goods are delivered, the bank will be required to honor the letter of credit even if the goods do not meet the approval of the payor. In other words, if the letter of credit says Jones will deliver 50 chairs and he delivers 50 red chairs instead of blue, the bank is still obligated to pay him, even though the merchandise is incorrect.

The issuance and completion of a letter of credit actually involves several contracts. First, there is a contract between the issuer and the payor (the bank and Smith) where the issuer agrees to issue the letter under the payor’s instruction. Second, there is a contract between the issuer and the beneficiary (the bank and Jones). This is the actual letter of credit, which is a contract, in that it obligates the issuer (bank) to make payment once the beneficiary (Jones) has met the terms of the letter. Finally, there is the underlying contract for sale of goods or services between the payor (Smith) and the beneficiary (Jones). While the letter of credit is a contract, no consideration is required to establish or modify the letter. The letter of credit should state a time period that it will be valid, and once issued cannot be revoked or modified by the issuer or the payor unless the beneficiary consents to the change or revocation.

A letter of credit must be in writing, signed by the issuer, and must state specifically that it is a “letter of credit”. This is what is called a “term of art” which means that the words have a specific meaning in the law. If the letter fails to include these words, it may be considered a mere guarantee.

There are several risks with a letter of credit. The bank takes the risk that the documents presented by the beneficiary are legitimate and the conditions are met. If the conditions are not met and the bank makes payment, they cannot get reimbursed for their loss. The issuer, however, is not required to verify the details behind the papers submitted. The payor will still be obligated to reimburse the bank. The bank also cannot get reimbursed if they honor the letter after the expiration date or if the payment is more than the amount in the letter.

Al Kelley is a Florida business law attorney located in Key West and previously taught business law, personnel law and labor law at St. Leo University. He is also the author of “Basics of Business Law” and “Basics of Florida’s Small Claims Court” (Absolutely Amazing e-Books). This article is being offered as a public service and is not intended to provide specific legal advice. If you have any questions about legal issues, you should confer with a licensed Florida attorney.

 

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