A confirmed letter of credit can be an important document to those who are launching or running a business, particularly those engaging in international trade. These letters are used to help protect both the buyer and the seller in a business-to-business transaction by adding an extra guarantee that the seller will get paid. They essentially mean that a second bank will pay the seller if the first bank fails to do so, which can inspire confidence and allow a deal to go through.
Here’s a closer look at what a confirmed letter of credit is, how it works, and its pros and cons.
What Is a Confirmed Letter of Credit?
Also known as a confirmed LC, a confirmed letter of credit is an additional guarantee for a payment by a secondary bank. It states that this additional bank will be responsible for a payment being on time and in full even if the buyer doesn’t meet their contractual obligations and the first bank (called the issuing bank) defaults on the payment. You might think of it as a kind of insurance policy or Plan B if the initial bank responsible for payment fails to do its job.
This type of document can be common in international trades, such as transactions between export and import businesses. In many cases, a guarantee may be required to conduct international transactions or when a vendor or seller has reason to doubt the first bank’s creditworthiness.
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How Confirmed Letters of Credit Work
Confirmed letters of credit are commonly used as negotiable instruments, which are signed documents that promise to pay a certain sum to a specified person. They can be especially valuable in international business transactions that involve a significant payment amount for goods or services. Since the letter acts as guaranteed payment, it may take the place of a request for advance payment.
To get a regular letter of credit, the buyer will likely need to submit required documents to the first bank, including proof that certain steps have been completed. Then the bank will send appropriate documents to the seller’s bank. This paperwork shares detailed instructions on the terms and conditions, as well as how payment should be made. Depending on the agreement between the buyer and the seller, payment may be made immediately or at an agreed-upon date.
Once the letter of credit has been issued, the buyer may need the backing of a second bank, or a confirmed letter of credit. Worth noting: A fee is likely to be involved. The exact amount of this fee may depend on how good (or questionable) the first bank’s credit is. This letter usually reflects the first letter of credit and uses the same terms.
A confirmed letter of credit can protect both parties because it decreases the risk of default for the vendor or seller. Additionally, it ensures that payment is only made if all the terms are met. It can be a step to building good credit when doing a deal with a new client. It can also be helpful for a business that is just starting out and making connections, building contacts, and monitoring its credit.
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Parties Involved in a Confirmed Letter of Credit
Here’s a listing of all the parties typically involved in a confirmed letter of credit.
• Buyer or applicant: This is the party who is requesting the letter of credit and who will pay the seller.
• Beneficiary or seller: The party who is selling goods or services and is the one who receives payment.
• Issuing bank: This is usually a bank where the buyer already has a business bank account. It’s the one that issues the original letter of credit.
• Confirming bank: This is the second bank that will guarantee the funds to the seller once the terms in the letter of credit are met. In some cases, the confirming bank is from the seller’s home country (this may be called a correspondent bank) or is a bank the seller already works with.
Recommended: Guide to Irrevocable Letters of Credit (ILOC)
Confirmed Letter of Credit Example
Let’s look at a fictional example of how a confirmed letter of credit could work. Say that Pauline’s Paper Goods receives an order for 100,000 pallets of customized notebooks from JessCo, a stationery company. Pauline’s Paper Goods has never worked with JessCo before and isn’t sure that this company has the means to pay for the goods. Maybe Pauline’s Paper Goods worries that JessCo doesn’t have what is considered good credit.
In order to prevent non-payment after the notebooks are produced and shipped off to the buyer, Pauline’s Paper Goods outlines an agreement that JessCo needs to pay with a confirmed letter of credit on the date the shipment leaves their warehouse.
If JessCo agrees, it would start applying for a letter of credit at its bank, where it has its checking account, in the U.S. If the bank requires it, the company needs to provide proof it has the funds available or it will apply for financing.
As soon as the issuing bank creates the letter of credit, JessCo then applies for a confirmed letter of credit with another bank, possibly the seller’s bank. When Pauline’s Paper Goods receives the completed confirmed letter, it manufactures and ships the customized notebooks. Once Pauline’s Paper Goods provides proof of when and how the goods were shipped, the guaranteed funds are released.
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Confirmed vs Unconfirmed Letters of Credit
If you are conducting international business, you will probably hear the terms confirmed and unconfirmed letters of credit. An unconfirmed letter of credit is simply a letter of credit issued by a bank. A confirmed letter of credit, as we’ve described above, is backed by two banks. This can foster trust if, say, there’s reason to worry the payment won’t be made.
Here’s a look at some other differences between a confirmed vs. an unconfirmed letter or credit.
• Guaranteed payment: With a letter of credit, the issuing bank guarantees payment. With a confirmed letter of credit, however, two banks confirm payment.
• Cost: Unconfirmed letters of credit tend to cost less than confirmed letters of credit.
• Changes: The buyer is allowed to make changes to an unconfirmed letter of credit. With a confirmed letter of credit, both banks can modify the document.
• Issuance: The seller only has to approach one bank for an unconfirmed letter of credit, but needs to contact two with a confirmed letter of credit.
Recommended: Guide to a Commercial Letter of Credit
Advantages of Confirmed Letters of Credit
Confirmed letters of credit can have several benefits for sellers, particularly those doing business internationally and wanting to ensure smooth transactions. These advantages include:
• Protection for both the buyer and seller
• An extra layer of confidence for the seller
• A lower risk of default thanks to a reputable second bank (perhaps serving as a guarantor if the first bank has a low credit rating)
• Buyers can seem more creditworthy, which may increase the odds that a seller will do business with them
Disadvantages of Confirmed Letters of Credit
While confirmed letters of credit can be very valuable in business, there are a couple of downsides to recognize. Disadvantages of confirmed letters of credit include:
• It may take longer to get a confirmed letter of credit since an additional bank is involved
• Bank fees may be higher than with an unconfirmed letter of credit
The Takeaway
A confirmed letter of credit can be a valuable business tool, especially when conducting international business. For those importing or exporting, the letter will guarantee payment for goods a company is supplying if the buyer and the buyer’s bank can’t complete the deal. Getting a confirmed letter of credit may cost more and take longer compared to an unconfirmed letter of credit, but the effort may be worth it. It can secure a transaction and open doors to doing business with new customers in a way that communicates confidence.
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FAQ
What is an unconfirmed letter of credit?
An unconfirmed letter of credit is a letter of credit that’s only been issued by one bank, known as the issuing bank. In a transaction, the buyer requests an unconfirmed letter of credit to guarantee funds will be paid on time to the seller by the bank.
Is an unconfirmed LC safe?
Yes, an unconfirmed letter of credit is safe because there is a guarantee or confirmation from one bank that payment will be made. Assuming that the issuing bank has a high credit rating, the seller can feel confident that the funds will be paid once all the conditions in the contract have been met. If the seller wants an additional layer of security, they may request a confirmed letter of credit — which means a second bank will provide payment if the first one fails to do so.
What is the risk of an unconfirmed LC?
The risk of an unconfirmed letter of credit is that the issuing bank won’t have the funds to pay the seller. That means that even if the seller completes their end of the contract, they risk losing out on funds if the issuing bank doesn’t fulfill their promise.
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