Commercial vs Standby Letter of Credit

Letters of credit accomplish their purpose by substituting the credit of a bank for that of the buyer/customer. Letters of Credit are documentary transactions that are independent from the underlying contract between the debtor and the vendor. The bank honoring the Letter of Credit is concerned only to see that the documents conform with the requirements in the L/C.  They are used primarily when the buyer has an unacceptable or unsatisfactory credit history or credit rating.  A Letter of Credit helps assure that the seller receives payment provided that the seller complies with all of the terms, conditions, requirements and rules associated with receiving and presenting documents to the bank issuing the letter of credit. 

There are basically two types of letters of credit:

• The Commercial Letter of Credit, and 
• The Standby Letter of Credit 

A Commercial or Documentary L/C is the primary payment mechanism for a transaction. This means that the seller expects to receive payment for their shipment from or through the bank that issued the L/C - rather than from the buyer. It must be noted and emphasized that documents must be carefully prepared for submission to the issuing bank.  If the documents do not conform to the L/C requirements, the seller may not be paid.

In contrast, a Standby L/C is referred to as a secondary payment mechanism. A standby L/C (as the name suggests) affords the seller a guarantee of payment in the event that the buyer defaults on payment. Standby letters of credit typically require less documentation than a commercial letter of credit, but standby letters of credit are not normally used for export sales transactions - so their usefulness to many credit managers is limited.

© 2011 by Michael C. Dennis.  All Rights Reserved.  Michael is the author of "Credit and Collection Handbook."  He is a consultant and can be reached at mcdennis13@yahoo.com

Edited by:  Michael Zininberg