A Letter of credit is a form of undertaking given by an issuing bank in favor of the beneficiary against the creditworthiness of the applicant. In the modern trading world, we commonly treat any letter of credit as irrevocable unless otherwise stated explicitly.
An irrevocable letter of credit is a formal contract between the issuing bank and the applicant. The contract guarantees the trade payments to the beneficiary (exporter or seller). The terms of such a contract are irrevocable unless all three parties involved in the contract agree on any amendments.
According to the ICC rules any letter of credit is:
- Irrevocable even if does not state so
- For a revocable letter of credit, it must state the revocability clause explicitly to inform all three parties
- The terms of revocability should be incorporated into the credit terms
The terms of a letter of credit (LC) are agreed between the issuer bank and the applicant. The prime feature of any letter of credit is the payment confirmation. An irrevocable letter of credit follows the basic principles of the working mechanism of letters of credit.
What is an Irrevocable Letter of Credit?
It is a form of guarantee that the bank issues in favor of the seller. The letter or contract defines the trade contract terms and payment mechanisms. With an LC, the seller gets the payment from the bank instead of the buyer. In a sense, once the issuer bank issues an LC, the seller can still receive the payment even if the issuer defaults.
Irrevocable letters of credit are dominantly used in international trading. These contract forms eliminate the trust deficit between the two new trade partners. For exporters, it offers confirmed payment. The importers can add an additional layer of security for deliverables with a condition of goods receipt certification.
How Irrevocable Letter of Credit Works?
The working mechanism of an irrevocable letter of credit is similar to a standard LC working. The terms and conditions specified in the letter can vary according to the trade contract. The prime feature distinguishing an irrevocable letter is that its terms once agreed and issued cannot be amended or canceled.
A simple working mechanism of an irrevocable letter of credits flows as:
- The applicant (buyer) approaches the issuing bank for a bank guarantee in the form of a letter of credit.
- The issuer bank assesses the creditworthiness of the applicant and issues a letter of credit. The terms specified decide the nature of the letter which is called an irrevocable letter of credit.
- The credit letter specifies the date, supplies, location, and duration of the trade contract.
- The seller needs to present the verified documents of supplies dispatching to the location specified in the contract.
- The buyer may ask for a goods receipt confirmation letter before the bank releases the letter of credit amount to the seller.
The process of an irrevocable letter of credit completion may take a phase-wise approach. The buyer and the seller may agree to verify the shipment, receipt, and conditions of the ordered supplies on a step-by-step approach. However, once the issuing bank issues, the correspondence takes place through the issuer and verifying bank rather than directly.
Purpose of Irrevocable Letter of Credit
The primary function of an irrevocable letter of credit is to ensure the payment of the trade contract. Its irrevocability clause makes it a more secure contract than a revocable letter of credit. Once agreed, both parties and the bank cannot amend any terms specified unless all three parties agree.
Even in large domestic contracts, both parties may require substantial bank guarantees in the form of letter of credit. It secures the payment for the supplier of goods or services and work completion (supplies of goods) for the buyer.
Irrevocable Vs Revocable Letter of Credit
Under the ICC rules currently in place, all letters of credit issued are irrevocable. The UCP 600 code doesn’t take into account the revocability clause. Hence, the revocability clause in the letter of credit must explicitly be specified if needed.
Some key differences and features of both types of letters of credit are:
- An Irrevocable letter of credit terms cannot be amended or cancelled.
- A Revocable letter of credit terms can be altered or cancelled without the consent of other party.
- The issuing bank can cancel both types of letters of credit under certain conditions. However, the revocable letter of credit takes the form of an unsecured guarantee issued by the bank.
- The buyer may require higher creditworthiness to issue a revocable letter of credit than an irrevocable letter of credit.
Both types of letters of credit need some specified verification mechanism to release the funds. Usually, the seller needs to present the shipment documents in accordance with the letter of credit or trade contract terms. The issuer of the LC (buyer) needs to inform the bank of the receipt of shipped goods. Often the document verification takes time, hence provides ample time to both parties to verify the trade contract terms too.
Although considered more secure, an irrevocable letter of credit can also be put on hold under certain conditions. The issuing bank controls the irrevocable letter of credit procedure with communication from both parties. The issuing bank upon certain conditions can refuse the payment.
Some common reasons for an irrevocable letter of credit refusal:
- The seller may not be able to present goods shipment documents according to the contract terms.
- The shipment date does not meet the deadlines
- The issuer of LC (buyer) may approach the bank with damaged or wrong goods delivered complaints
- Any documentation error on goods shipment invoicing, bills, etc.
Types of Irrevocable Letter of Credit
As stated above, all letters of credit issued by default are irrevocable in nature, unless specified otherwise. Some key features combined with the revocability clause make different types of letters of credit.
It can take any of the following forms.
Irrevocable and Confirmed/Non-Confirmed
In this form of a letter of credit, another bank acts as a confirming bank. It confirms the credit of the irrevocable letter of credit presented. Sellers of large trade volumes usually request such additional confirmations.
A non-confirmed letter of credit does not offer additional confirmation from any third bank. The issuer bank remains liable only to the extent of applicant’s creditworthiness and bears no responsibility for the default.
Irrevocable and Transferable/Non-Transferable
A transferable letter of credit accommodates two sellers instead of one. The beneficiary of an LC can transfer the receivable credit to another seller. The specific form of an irrevocable letter of credit usually works where the buyer contacts sellers working together. For example, a raw material supplier and the factory owner.
The non-transferable clause prohibits the pledge of a letter of credit to be transferred to any other party than the beneficiary.
Irrevocable letters of credit are the most widely used form of documentary credits. The irrevocability clause offers greater protection to both the buyers and the sellers. The seller may reduce the risk of buyer default by meeting the terms and conditions of the trade contract.