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Letters of Credit

J.F. (Jim) Straw
by J.F. (Jim) Straw

Although the term “Letter of Credit” (or “L/C”) has a specific meaning, the term has been so abused and misused by con-men and assorted fools even some bankers don't know what a Letter of Credit is.

A TRUE STORY — only the names have been withheld to protect the guilty:

In the early 1970s, I was able to set-up a deal to buy frozen seafood (lobster & shrimp) overseas at a very attractive price. — I, in turn, offered to sell that seafood to a buyer in Florida at a nice profit; saving the buyer money as well.

The buyer went to his bank and had a Letter of Credit issued to my company in the amount of $120,000 for the first monthly shipment of seafood.

Fearing loss in the mail, the buyer's bank asked for the name of my bank, so they could transmit the Letter of Credit by courier to my banker. Upon receipt, my banker was to do nothing more than turn the Letter of Credit over to me, so I could proceed with arranging the delivery of the seafoods to the buyer.

Upon receipt of the Letter of Credit by courier, my banker REFUSED to turn the Letter of Credit over to me. — His comment was, “I can't turn this over to you until you deposit $120,000 with our bank.”

At that time, I was banking with the ‘oldest' bank in the State; established before the Civil War (notice I didn't tell you what State). And, the banker who made the comment and held my Letter of Credit was the President of the bank; well over 60 years of age; with nearly 40 years experience in banking.

It took 5 lawyers and 10 days for the banker to turn the Letter of Credit over to me … and … I had to publicly apologize to the banker for what I had called him in front of his personnel.

By the way, although that happened a good many years ago, I find even today many bankers still don't really know what a Letter of Credit is. That's why you scare them to death when you ask them to issue a Letter of Credit for you.

If you think the misunderstanding on the part of some bankers is ridiculous, consider this. — All too many otherwise intelligent people envision a Letter of Credit as some mystical piece of paper; writ in Old English form, that magically opens the door to the international financial markets. And, they honestly believe that Letters of Credit can be bought, like any other commodity, on the open market for any intended use.

Anyone who offers to ‘sell' you a Letter of Credit is a con-man or worse (unless, of course, they are selling “banker's acceptances;” which is a completely different financial game).

So …

What is a Letter of Credit?

To best answer that question, it will be easier to break that question down into two other questions. — What is a letter? … and .. What is Credit?

A ‘Letter' is a piece of written correspondence from one party to another. — ‘Credit' is confidence in the ability of a person to fulfill financial obligations.

Therefore, a Letter of Credit is a ‘letter' from one party to another expressing confidence in (giving ‘credit' to) a person to fulfill a financial obligation.

Although there are a wide variety of generally accepted forms of Letters of Credit used in the banking industry, a Letter of Credit can take any form; as long as it is a written document (letter) expressing confidence in someone to faithfully fulfill a financial obligation.

You could write a Letter of Credit yourself, for someone else. A very simple form might be:

“TO WHOM IT MAY CONCERN: I know John Doe. He's a good old boy. I trust him. You can sell him up to $1,000 worth of goods on credit. If he doesn't pay you, I will.”

That is a Letter of Credit.

Now, John Doe has a Letter of Credit. But, if the merchant doesn't know you, John Doe still won't be able to buy anything on credit from the merchant.

On the other hand, if the merchant knows you and trusts you to pay the bill, John Doe will be able to buy up to $1,000 worth of goods from the merchant against your reputation (credit).

When a bank (or other financial institution) issues a Letter of Credit for you, it is exactly the same as your simple Letter of Credit for John Doe. — The bank is saying that, under the terms and conditions expressed in their letter, they will guarantee that you will fulfill your financial obligation to some third party; or they will fulfill that obligation for you to some third party and collect the money from you.

Since all of the banks in the world are connected (directly or indirectly) through their various corresponding relationships, the bank issuing the Letter of Credit is replacing your credit (because the receiving bank doesn't know you) with the bank's credit which is known in the industry. But, if the bank issuing the Letter of Credit isn't known to the receiving bank, it may be necessary for the receiving bank to ‘confirm' the credit of the issuing bank through another bank (or banks) who does business with both the issuing and receiving banks.

Now …

How do you get a Letter of Credit to use as collateral for your Loan?

Simple. — Let's say, you are trying to get a Letter of Credit for $1,000,000. –All you have to do is prove to some bank that YOU can be trusted $1,000,000 worth. But, since the issuing bank will be putting their credit on the line for you, you will have to provide the issuing bank with at least $1,000,000 worth of collateral. That means YOU have to have $1,000,000 worth of collateral to pledge to the bank, so that bank can issue a Letter of Credit for $1,000,000 as collateral for your loan from another bank.

There … ain't that simple?

Having spent over 50 years in business, doing business successfully, J.F. (Jim) Straw now shares “Practical Instruction in the Arts & Sciences of Making Money” at the Business Lyceum. —