Irrevocable Letter of Credit

Irrevocable Letter of Credit

An irrevocable letter of credit (ILOC) is a bank-issued guarantee that a buyer’s payment to a seller will be made on time and for the agreed amount. Once issued, it cannot be canceled or changed without the consent of all parties involved (applicant/buyer, beneficiary/seller, and the issuing bank). ILOCs are commonly used in international trade to reduce payment risk between parties that may not know or fully trust one another.

How an ILOC works

• The buyer (applicant) asks its bank (issuing bank) to issue an ILOC in favor of the seller (beneficiary).
• The issuing bank guarantees payment to the beneficiary if the beneficiary presents documents that comply with the ILOC’s terms.
• If the buyer fails to pay, the issuing bank must pay the beneficiary up to the guaranteed amount.
• ILOCs typically expire on a specified date; they can be amended only with agreement from all parties.
• ILOCs can be:
• Confirmed — the seller also receives a payment guarantee from its own bank (advising/confirming bank), adding protection against the issuing bank’s default.
• Unconfirmed — the seller relies solely on the issuing bank’s obligation.

Key specifications and mechanics

• Transmission: Commonly transmitted through SWIFT as message type MT700.
• Legal framework: Often subject to rules such as the Uniform Customs and Practice for Documentary Credits (UCP 600).
• Use cases: Widely used for large or cross-border transactions (e.g., construction, manufactured goods) where payment risk is significant.
• Bankruptcy protection: Payment claims under many ILOCs are treated differently in insolvency contexts, increasing seller protection.

Information typically included in an ILOC

• Issuing bank’s name and contact details
• Applicant (buyer) name and contact details
• Beneficiary (seller) name and contact details
• Maximum guaranteed amount (currency and numeric limit)
• Expiration date and place for presentation of documents
• Detailed commercial and documentary requirements (e.g., commercial invoice, bill of lading/airway bill, certificate of origin, inspection certificates)
• Shipping terms and whether partial shipments are allowed
• Port of loading and discharge and any applicable Incoterms
• Insurance requirements, if any
• Governing rules and jurisdiction (e.g., UCP 600)

Steps to acquire an ILOC

1. Confirm both parties agree to use an ILOC.
2. Select a bank with experience in documentary credits and international trade.
3. Provide the bank with transaction details: amount, beneficiary, expiry, required documents, shipping terms.
4. The bank evaluates the applicant’s creditworthiness and the transaction.
5. If approved, the bank issues the ILOC and forwards it (often via SWIFT) to the beneficiary’s bank.
6. Review the issued ILOC promptly and request amendments immediately if terms differ from the agreement.
7. Ensure documents are presented within the validity period to receive payment.

Tip: The issuing bank’s creditworthiness matters—the ILOC’s value depends largely on the bank backing it.

Alternatives to an ILOC

• Cash-in-advance — buyer pays upfront; high protection for seller, less attractive for buyer.
• Open account — goods shipped and payment due later; relies on trust, higher seller risk.
• Documentary collection — banks handle documents and collection but do not guarantee payment.
• Bank guarantee — bank promises compensation only if the applicant defaults on obligations (can be tailored for payment, performance, bid bonds).
• Escrow — a third party holds funds until contractual conditions are met.

Practical example (concise)

A buyer purchases goods from a foreign supplier. The buyer’s bank issues an ILOC guaranteeing payment up to $500,000 if the supplier presents the agreed documentation (e.g., invoice, bill of lading, inspection certificate) by the expiry date. If the buyer fails to pay, the issuing bank pays the supplier on presentation of compliant documents. If the seller requires extra security, the seller’s bank can confirm the ILOC, adding its own undertaking to pay.

Roles and benefits

Issuing bank: Issues the ILOC and undertakes payment upon presentation of compliant documents. Its reputation and financial strength are critical to the ILOC’s credibility.

Benefits for buyers:
* Demonstrates creditworthiness and can facilitate procurement.
* Ensures payment is made only against required documentary proof, protecting against non-conforming goods or services.

Benefits for sellers:
* Provides a reliable payment guarantee independent of the buyer’s solvency.
* Reduces risk of non-payment or delayed payment in cross-border transactions.

Amendments and expiration

• An ILOC can be amended (e.g., to extend expiry or change terms) only with the agreement of all parties, including the issuing bank.
• If required documents are not presented by the expiration date, the ILOC typically becomes void and the beneficiary may lose the right to draw.

Conclusion

An irrevocable letter of credit is a widely used financial instrument in international trade that balances risk between buyer and seller. It guarantees payment by a reputable bank when documentary conditions are met, giving sellers payment assurance and buyers assurance that funds will be released only for compliant deliveries. Choosing a strong issuing bank and carefully drafting and reviewing the ILOC’s terms are essential to avoid disputes and ensure smooth settlement.