Letter of Credit vs. Promissory Note

Attribute	Letter of Credit	Promissory Note
Definition	A financial document issued by a bank guaranteeing payment to a seller	A written promise to pay a certain amount of money to a specified party
Parties involved	Buyer, seller, issuing bank, advising bank	Maker (borrower), payee (lender)
Usage	Primarily used in international trade transactions	Used for borrowing money or as a form of payment
Payment guarantee	Bank guarantees payment to the seller	Maker promises to pay the specified amount to the payee
Transferability	Can be transferable or non-transferable	Generally non-transferable

Introduction

When it comes to financial transactions, two common instruments used are the Letter of Credit (LC) and the Promissory Note. Both serve as a form of guarantee for payment, but they have distinct attributes that make them suitable for different situations. In this article, we will compare the attributes of Letter of Credit and Promissory Note to understand their differences and similarities.

Definition

A Letter of Credit is a document issued by a bank on behalf of a buyer that guarantees payment to a seller upon the completion of certain conditions. It acts as a form of security for the seller, ensuring that they will receive payment for the goods or services provided. On the other hand, a Promissory Note is a written promise from one party (the maker) to pay a specified amount of money to another party (the payee) at a certain date or upon demand.

Usage

Letters of Credit are commonly used in international trade transactions where the buyer and seller are located in different countries and may not have an established relationship. The LC provides assurance to the seller that they will receive payment once the conditions of the agreement are met. Promissory Notes, on the other hand, are often used in domestic transactions between parties that have a pre-existing relationship. It serves as a formal acknowledgment of debt and a promise to repay the amount owed.

Parties Involved

In a Letter of Credit transaction, there are typically three parties involved: the buyer (importer), the seller (exporter), and the issuing bank. The buyer requests the LC from their bank, which then issues the document to the seller's bank. The seller presents the required documents to the bank to receive payment. In a Promissory Note transaction, there are two parties involved: the maker (borrower) and the payee (lender). The maker signs the note, promising to repay the specified amount to the payee.

Risk

One of the key differences between a Letter of Credit and a Promissory Note is the allocation of risk. In an LC transaction, the risk is primarily on the issuing bank, which guarantees payment to the seller. The buyer's bank assumes the risk of non-payment by the buyer. On the other hand, in a Promissory Note transaction, the risk is on the maker (borrower) who is obligated to repay the amount specified in the note. The payee (lender) may face the risk of non-payment if the maker defaults.

Flexibility

Letters of Credit are often seen as more rigid compared to Promissory Notes. The terms and conditions of an LC are set by the issuing bank and must be strictly adhered to for payment to be made. Any discrepancies in the documents presented by the seller can lead to delays or non-payment. Promissory Notes, on the other hand, can be more flexible in terms of repayment terms. The parties involved can negotiate the terms of the note, such as interest rates, repayment schedule, and collateral.

Legal Enforceability

Both Letters of Credit and Promissory Notes are legally binding documents that can be enforced in court if necessary. In the case of an LC, the terms and conditions outlined in the document must be followed for payment to be made. If there are disputes, the parties can seek resolution through arbitration or litigation. Promissory Notes, on the other hand, are more straightforward in terms of enforcement. If the maker fails to repay the amount specified in the note, the payee can take legal action to recover the debt.

Conclusion

In conclusion, both Letters of Credit and Promissory Notes serve as important financial instruments in different contexts. While an LC provides security for international trade transactions, a Promissory Note is a formal promise to repay a debt in domestic transactions. Understanding the attributes and differences between these two instruments is crucial for businesses and individuals engaging in financial transactions.