It’s Good to Have a Backup Plan: Can a Letter of Credit Help Keep Your Contracts Secure?
In uncertain times, it’s important to know what tools are at your disposal to help you keep your business stable. One such tool is a Letter of Credit, a product that Grasshopper offers. This resource helps you to mitigate risk in the event that parties don’t live up to their obligations. Read on to find out more about letters of credit and if they may be right for you and your business.
What is a letter of credit?
A letter of credit can be issued by a bank to guarantee that a buyer’s payment to a seller will be made. If, for any reason, the buyer defaults on the agreement/contract, the letter of credit ensures that the bank will cover the payment. The bank’s obligation is outlined in the terms of the letter of credit.
Two commonly used letters of credit are commercial and standby. Commercial letters of credit are commonly used in international transactions, where the bank is the primary mechanism of payment, essentially acting as a middleman in the transaction. The buyer’s bank makes the payment on behalf of the buyer, and the buyer pays the bank back. Standby letters of credit are a bit different as the bank is the secondary mechanism of payment, basically acting as an insurance policy in the event that the buyer/bank’s customer cannot meet their financial obligations. In both instances, the contracts/agreements are independent and thus outside of the letter of credit terms. The bank’s authority to step in to issue full or partial payment is governed by the terms in the letter of credit.
Why are letters of credit particularly important in today’s climate?
A feeling of financial insecurity is resonating around the world due to an erratic stock market, escalating unemployment rates, and the fact that dozens of industries are currently at a standstill. Business owners need to protect their credit, make their payments, deliver the goods and services they’re contracted for, plus ensure that the suppliers they’re relying on can meet their obligations. It’s no small task.
The number one advantage of a letter of credit is the minimization of risk. There are endless things to consider when it comes to running a business. With instability stemming from a global pandemic, it makes sense to minimize your risk as much as possible. A standby letter of credit can be structured to provide the beneficiary assurance of payment in case of a default in financial obligations.
You, as a business owner, can request a letter of credit from your vendors, making you the beneficiary and protecting your interests in the event that a supplier is unable to meet their financial obligations.
You can also request a letter of credit from your bank to protect yourself. This ensures that if one party defaults under the terms of a contract but other aspects of the agreement are fulfilled, the bank can step in to help. What help the bank provides is pursuant to the terms outlined in your letter of credit.
What are the pros of using or requesting a letter of credit?
International transactions utilize commercial letters of credit all the time to mitigate the risk associated with navigating the laws of different countries, challenges posed by the physical distance between transacting parties, and cases where the international parties may not know each other personally. As such, letters of credit are a long-standing, proven method of doing business.
Letters of credit are fairly flexible. You may assign any entity as the beneficiary, including an individual, a company or their bank; or you may choose to make the letter of credit transferable so that the beneficiary can assign it to another entity of their choosing.
The security of the applicant is enhanced as the bank takes on the financial risk. This offers those suffering financial hardship a way to stay afloat and continue transacting confidently, even in tough economic times.
A letter of credit guarantees payment, even when cash flow for your business may be uncertain, offering you and your stakeholders peace of mind.
What are the cons of using a letter of credit?
As with any document, there is always the potential of a fraudulent claim if the letter of credit is drawn improperly by the beneficiary, so it’s important to be thorough and detail oriented when reviewing.
Letters of credit may require a pledge of collateral in the form of securities or cash, so this resource may not be a viable option for everyone.
Recourse for an issue with a letter of credit is generally handled outside of banking channels. Again, be thorough before accepting or requesting a letter of credit and don’t be afraid to loop in your legal counsel to stay ahead of any potential problems.
What is the process to secure a letter of credit? How long does it take?
Step 1: Reach out to our team to request an application for a letter of credit
Step 2: Letter of credit application to be completed by the customer.*
Step 3:Terms for the letter of credit will be agreed upon by the bank and the customer upon
Step 4: The letter of credit will be issued within 2–3 business days and becomes immediately viable upon issuance**
* Please note that all Letters of Credit (regardless of the security/collateral) require an underwriting and Credit approval
** Letters of Credit are only available to existing customers, if you are not a customer yet and qualify, we will need to open an account for you first.
Grasshopper is here to help you
If you need a letter of credit, other financial resources or are feeling isolated and simply want to chat or have a virtual coffee, we are here for you. Please don’t hesitate to contact us at banking@grasshopper.bank.
We’ve been compiling and regularly updating a list of resources to help our community navigate COVID-19 together. Please check out our Resource Guide and revisit it frequently for updates.
Want to share? We’d love for you to join our virtual events, where we collectively share various difficulties, opportunities, strategies and tips for being a business owner during this global health crisis.
Together, we can fight this virus and come out stronger.
Stay safe, stay healthy.
Grasshopper Bank
