What Is a Documentary Letter of Credit?

A documentary letter of credit is a type of financial instrument that is used to guarantee delivery of payment to a specific bank or other financial institution at an agreed upon future date. The detail included in this particular type of letter of credit (LC) is usually very comprehensive in terms of identifying the responsibilities that the seller must fulfill before the payment will be tendered. Issues such as the type of documentation that must be prepared and presented to the buyer, the date that the goods will be shipped, and even what type of shipping methods will be employed are often addressed. The purpose of a documentary letter of credit is to clearly identify all the terms that must be completed before the payment will actually be issued to the exporter’s bank.

The use of a documentary letter of credit does not take the place of a sales contract, although the two documents will often include much of the same detail. While the contract focuses on the specifics of what items are ordered and how much the buyer will pay for those items, the documentary letter of credit will typically address additional issues such as the mode of shipment, the charges involved with the shipping, and the preparation of proper documents to allow the goods into the country where the buyer resides. Essentially, this type of letter of credit spells out everything that must be done before the actual payment is tendered.

There are several benefits associated with the use of a documentary letter of credit. Since it serves as a guarantee of payment to the exporter’s bank, it is not unusual for banks to extend loans to the exporters, tailoring the terms of those loans to match with the terms in the LC. Doing so allows the exporter to make use of the loan proceeds to manage the manufacturing and delivery of the order without using other financial resources. The bank holds the LC in check as a guarantee that the payment will be tendered once the terms of the sale are completed, often serving as the recipient of the payment, deducting the amount due on the loan, then depositing the rest into the exporter’s bank account.

Lenders also benefit from accepting a documentary letter of credit as security for a loan. Since these letters of credit are virtually guaranteed for payment, the risk to the lender is relatively low. By loaning the money to exporters based on the terms of the letters of credit, it is possible to charge interest in the form of a percentage of the total amount of the order, and generate revenue for the bank.

When there is no loan arranged between the seller and his or her bank, the buyer will sometimes remit the amount named in the documentary letter of credit directly to the exporter’s bank. The funds are then held in check until the bank is satisfied that the seller has fulfilled his or her commitments to the buyer, and only then release the funds to the seller’s bank account. Should the buyer claim that the terms of sale were not fulfilled, the bank may hold the funds pending an investigation. If the bank finds that the seller did not fulfill the terms of sale, the funds from the documentary letter of credit are generally returned to the buyer or held until the seller does finally complete his or her commitments.