The classic situation in which a letter of credit is used is something like this. The San Tomé Mining Company, located in Ecuador, wants to purchase a piece of mining equipment from San Francisco Equipment Company, located in California. San Francisco Equipment Company is unwilling to ship the equipment without being paid in advance. It is concerned that San Tomé Mining Company might be unable to pay for the equipment, and it is not willing to trust credit reports from Ecuador. It might ship on a COD basis, but that would leave it in a position that if the equipment were rejected on delivery in Ecuador, San Francisco Equipment Company would have to try to re-sell it in Ecuador or ship it back to the United States. In either case, it would take a big loss that it could only recoup if it were able to successfully recover in a foreign court system from the possibly insolvent buyer. The San Tomé Mining Company is unwilling to pay in advance because it has similar concerns. San Francisco Equipment might become insolvent, or it might just fail to ship, leaving the buyer to attempt to recover under a foreign legal system.
A letter of credit gives both parties some of the assurance they need. The buyer will get its bank to issue a letter of credit. This letter will state that the bank will honor a draft drawn against the bank in the agreed amount, if the draft is accompanied by certain specified documents, one of which will be a bill of lading showing that the equipment has been loaded on a ship bound for a specified Ecuadorian port and which will entitle the buyer to possession of the equipment upon arrival. With assurance from a reputable, solvent entity that it will be paid as soon as the goods are shipped, San Francisco Equipment Company can ship with minimal risk.
San Tomé Mining Company is similarly protected. It doesn't have to pay until the equipment has been shipped and is out of the seller's control. The bank that issues the letter of credit (known as the issuer; see U.C.C. Section 5-102(a)(9)) can protect itself several ways. The simplest is simply to have San Tomé Mining Company (the applicant; see U.C.C. Section 5-102(a)(2)) place the face amount of the letter of credit in a blocked account from which the bank can withdraw funds when the letter is drawn upon. Alternatively, it can issue the letter of credit on the same basis it would make San Tomé Mining Company a loan, satisfying itself as to the applicant's credit and perhaps taking collateral. In this case, funds disbursed under the letter of credit would accumulate interest at the normal rate of loans until repaid.
If San Francisco Equipment Company (the beneficiary; see U.C.C. Section 5-102(a)(3)) is unwilling to trust the buyer's bank (of which it may never have heard) it can require that a bank which it does trust act as confirmer (see U.C.C. Section 5-102(a)(4)) of the letter of credit. The confirmer will be a bank that knows and trusts the issuer and perhaps has a correspondent banking relationship with it. The confirmer will obligates itself on the letter of credit. It will check the documents the beneficiary (the seller of the equipment) presents and if they are satisfactory, pay the funds to the beneficiary. It will then transmit the documents to the issuer and receive reimbursement.
The transaction described in above is commonly referred to as a commercial letter of credit. Although commercial letters of credit were once common in domestic transactions, their use is now generally limited to international transactions. For a long time, the only lawyers who dealt with letters of credit were a few specialists who in international transactions. Letters of credit regained importance when lawyers discovered that they could be used as credit support rather than merely as a device for payment. This gave rise to the standby letter of credit. The standby letter of credit performs a function similar to that of a guaranty, but, as we shall see, it is technically not a guaranty. In fact, it's better than a guaranty.
Here is an example of the way a standby letter of credit might be used. Jay Gatsby organizes a partnership to invest in an oil exploration venture. Each investor must agree to contribute $100,000 for his or her share in the venture. The $100,000 per share is designed to cover all of the costs of exploration and drilling, right up through the time the wells begin producing. Not all of the money is needed in the beginning, so each investor is required to contribute only $10,000 to get the venture started. As additional expenditures occur, Gatsby will call on the investors to come up with additional funds. To make sure that none of the investors will back out, leaving the venture underfunded, the partnership agreement will require that each investor post a letter of credit in the amount of the unpaid portion of her contribution. If the investor fails to provide the additional funds when called upon to do so, the partnership can draw on the letter of credit to satisfy the investor's obligation pay in the money.
Daisy Buchanan invests in Gatsby's partnership. In accordance with the partnership agreement, she posts a letter of credit from Princeton Bank & Trust Company.
The term the UCC uses to describe Daisy is