Letters of Credit are incredibly useful and sometimes necessary tools in the course of international trade. They essentially serve to notify a seller of goods that a buyer has a line of credit with a credible financial institution. This allows the seller to feel more assured that in the event the buyer is unable to cover the costs of the goods, the seller will still get paid by the bank.

Enforceable Letters of Credit authorize a company to “draw” on the bank up to an aggregate amount upon demand according to certain terms and condition. The Letter of Credit must specify the total amount that may be drawn by the company from time to time, usually upon written demand. The bank promises to honor the demand, again up to a certain amount.

The letter of credit should also include the term of the line of credit, whether it is indefinite or whether it will only continue up to a certain expiration date. A provision discussing automatic extension of the agreement may also be included. Usually the bank will have the option to notify the company in writing that they are electing not to extend or renew the line of credit. In this case, the company will be responsible for paying the amount outstanding on or before the expiration date of the agreement.

There is typically a fee for opening a line of credit with a bank. The applicant pays the LC fee to the bank, and may in turn charge this on to the beneficiary. From the bank's point of view, the LC they have issued can be called upon at any time (subject to the relevant terms and conditions), and bank then looks to reclaim this from the applicant.

It is critical to define the parties to a Letter of Credit agreement – most importantly the beneficary and the issuing bank. The beneficiary is the party entitled to payment as long as he can provide the documentary evidence required by the letter of credit. The letter of credit is a distinct and separate transaction from the contract on which it is based. All parties deal in documents and not in goods. The issuing bank is not liable for performance of the underlying contract between the customer and beneficiary. The issuing bank's obligation to the buyer, is to examine all documents to insure that they meet all the terms and conditions of the credit. Upon requesting demand for payment the beneficiary warrants that all conditions of the agreement have been complied with.

The issuing bank's liability to pay and to be reimbursed from its customer becomes absolute upon the completion of the terms and conditions of the letter of credit. Under the provisions of the Uniform Customs and Practice for Documentary Credits, the bank is given a reasonable amount of time after receipt of the documents to honor the draft. The issuing banks' role is to provide a guarantee to the seller that if compliant documents are presented, the bank will pay the seller the amount due and to examine the documents, and only pay if these documents comply with the terms and conditions set out in the letter of credit.