Suppose a seller in Malaysia wishes to sell some goods (e.g.: Palm Oil) to a buyer in Russia. Suppose further that the parties have not previously entered into any business relationship, thus they do not know each other. Although both parties are willing to enter into a relationship, they are very concerned about the other party’s financial reliability.
The seller wishes to get paid as soon as he has shipped the goods. He is afraid that, after shipping the goods the buyer may refuse to pay the purchase price, or even become insolvent. In both cases, the seller may have to engage himself into lengthy negotiations, or sue the buyer to seek enforcement of payment by the court, which will certainly incur great expenses. Not to mention the costs of shipping back the goods or storing them in the original country of destination until further actions.
On the other hand, the buyer is concerned that he may not get the goods in the agreed quality and/or quantity, thus he is not willing to pay unless he inspects the goods.
In a situation like this, where the buyer and the seller are distant from each other and transportation of goods is inevitable, it is impossible to have the seller paid upon shipment and at the same time allow the buyer to pay only upon inspection of the goods.
When difficulties such as distance, different currency (fluctuation of currencies), culture and foreign laws have to be dealt with, the parties are most likely willing to fall back on legal instruments, which reduce the risks both seller and buyer have to face in an international sale of goods.
One of these instruments created by the international trading community is the commercial letter of credit. By agreeing to a commercial letter of credit the parties invite a third, trustworthy party – a bank – into their relationship. Upon the buyer’s request, the bank will open a letter of credit in favour of the seller, agreeing “to assume the primary, direct and independent obligation to honour the seller’s draft presented under the letter of credit provided that complying documents specified in the letter of credit are tendered”.
This way the seller is assured that he will receive payment from an individual “paymaster” regardless of the financial situation of the buyer. On the other hand the buyer is also assured that payment will only be effected if the conditions, set by the buyer and appearing in the credit, are completely fulfilled.
In a basic letter of credit transaction three parties are involved: the buyer (usually referred to as the “Applicant”), the bank and the seller (usually the “Beneficiary”).