A clean letter of credit allows for payment without additional documentation, commonly used in international trade. Applicants provide documentation to demonstrate creditworthiness and negotiate a contract with sellers. The credit limit may be renewable each year, and companies must protect the document from counterfeit drafts.
A clean letter of credit allows the applicant to issue drafts that must be paid by the bank on demand, without the additional documentation required. Such documents are frequently used in international trade to provide a mechanism for importers to pay exporters for their products. They can also arise in other business and commercial contexts. This is in contrast to a documentary letter of credit, where supporting material is needed before a bank will pay a letter of credit.
The process of obtaining a clean letter of credit begins with an application to a bank that offers this service. Applicants provide documentation to demonstrate their creditworthiness and explain how they plan to use the letter of credit. The bank can review this information to determine if it wants to grant the request and how much credit to offer. This is generally based on a reasonable ability to repay, and the letter of credit may be renewable each year to allow the bank to periodically review the customer to confirm that the credit limit is still appropriate.
Once merchants have a clean letter of credit in hand, they can begin to approach sellers. They negotiate a contract, basing the sale price and other arrangements on the existence of the letter of credit to finance the purchase. After completion of the contract, the buyer can write a draft demanding payment and send it to the bank. The buyer’s bank, in turn, informs the seller that his client has resorted to the letter of credit, and funds will arrive to cover the purchase. They may be held until the goods arrive to protect the buyer.
Clean letters of credit are irrevocable within the issuance term. They will remain in effect until the review period arrives. Because banks don’t want to put themselves in jeopardy, they can keep the credit limit low for the first year, until they are sure the customer can pay the drafts against the clean letter of credit. In the second year, the bank can increase or decrease the limit, and can also adjust it thereafter.
Companies that use a clean letter of credit in trade must protect the document well. The counterfeit drafts would allow the bank to issue cash to a beneficiary without any supporting information, in accordance with the terms of the letter of credit. Banks typically examine money orders for signs that they are fake or altered in some way, but they can’t always spot problems, and a snarl can be created as the bank recovers the funds and presses charges against the parties involved. During this time, the letter of credit may be temporarily inaccessible.
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