A letter of credit is an irrevocable undertaking for the payment of money, issued by a bank (known as an issuing bank) at the request of its customer and in favor of a third-party beneficiary. Letters of credit are divided into two broad categories:

Standby letters of credit are common in financing transactions, where the borrower can obtain letters of credit from its lender as a utilization of either an existing:

Letters of credit share equally in the collateral and guarantees that support the loans made under the credit facility and are subject to the terms of the loan agreement. Letters of credit that are outstanding and have not been drawn by their beneficiaries reduce the available revolving credit commitments under the loan agreement because they must be funded by the lenders if they are drawn by their beneficiaries. This is the case regardless of whether the borrower could, at that time, satisfy the conditions precedent in the loan agreement and borrow new loans under its credit facility. The loan agreement under which letters of credit can be obtained will contain terms for issuing and repaying letters of credit.

Beneficiaries of letters of credit are often third parties with which the borrower has business dealings. The purpose of the letter of credit is to assure the beneficiary that the borrower will honor its contractual obligations. The main difference between a commercial letter of credit and a standby letter of credit is that a commercial letter of credit is drawn on as a means of payment in the ordinary course of a transaction. A standby letter of credit is only drawn on by the beneficiary if the borrower defaults on its obligations to the beneficiary. A standby letter of credit is more like a cash guarantee of specified obligations of the borrower, rather than a means of payment of those obligations.

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