What Is an Irrevocable Letter of Credit?
An irrevocable letter of credit is a guarantee from a bank, issued in the form of a letter. These letters allow companies (and individuals) to do business with confidence. Letters of credit are often found in international trade, but they can also be used for domestic transactions. The details of each deal are not as important as the concept of a bank promising to pay a “beneficiary” once something happens.
That something might be: An exporter ships goods, a customer fails to pay on time, a contractor does not complete a project, or somebody, somehow, does not perform whatever obligation they agreed to. When you do business with somebody in a foreign country (or even with a brand new customer or vendor in your home country), you have to trust them to some degree. Perhaps you've never met the person you're dealing with, and you might not know much about their company.
If you're selling something to that company, will they ever pay for it? If you're buying something and you send money, will they ever deliver the goods? Without some guarantee, doing deals is risky. Irrevocable letters of credit can reduce risks for both buyers and sellers.
The Purpose of an Irrevocable Letter of Credit
To understand irrevocable letters of credit it's important to understand two components: They are letters of credit, and they are irrevocable, meaning they can’t be changed or canceled unless everybody agrees to it. Let’s explore both of those components, review some advantages and disadvantages, and look at an example of a letter of credit in action.
Letters of Credit
Letters of credit are agreements between a buyer (often an importer) and the buyer’s bank. The bank agrees to pay the seller (the exporter) as soon as certain conditions are met. To meet those conditions, the seller typically needs to ship the buyer's goods on time and meet any other requirements listed in the letter.
This agreement provides security to both parties, the buyer and seller: The buyer knows that she won't pay anything until goods have been shipped or services have been performed, and the seller knows that she will get paid as long as she does everything specified in the letter. However, letters of credit don’t completely eliminate problems. Buyers and sellers are always taking risks, even with an irrevocable letter of credit.
For sellers, letters of credit are especially beneficial because the seller gets to rely on the strength of the bank, not the strength of the buyer. When you sell something, how do you know you’ll get paid, especially if you’ve never done business together before (and how many customers overseas are willing to pay you in advance)? Even if you trust that your buyer intends to pay, bad things can happen, and your buyer might not have cash on hand when it’s time for you to get paid.
With an irrevocable letter of credit, you don’t have to worry about the buyer’s financial situation. Once the letter has been issued, you’ve got a promise from the bank that issued it. The bank will pay you as soon as you prove that you’ve met the conditions spelled out in the agreement, so you need to evaluate how stable and reputable the bank is (as opposed to evaluating every single potential buyer in every single country).
However, you have to meet the requirements of the letter (with 100% compliance) to get paid. If anything is off, the bank can refuse payment. That includes everything from major problems (sending the shipment early or late) to seemingly minor problems (typographical errors in the agreement, or substituting the word "Suite" for "Unit" in your address). The bank is in the business of verifying documents, and they don't care about anything else.
For buyers, letters of credit can help ensure that something has been done. The seller didn't just accept your payment and fly the coop – he shipped something. However, an irrevocable letter of credit is about documents and has nothing to do with the quality of goods shipped. Your bank will make payment once your seller provides documents showing that a shipment was made. You won't know what's in the shipment until it arrives (and the money will be gone). To manage risk, you can require that an inspection certificate be one of the required documents.
The easiest way to understand a letter of credit is to look at an example. You can see a visual example of the process, or you can read through the example below. This is a general example to illustrate the concept, and any deals you do will certainly look different. There might be more steps (and intermediaries) involved.
- Sally, in Country X, wants to buy widgets from George, in Country Z.
- Sally does not want to pay upfront, and George does not want to build the widgets until he’s confident that he’ll get paid.
- Sally and George agree on price, quantity, shipment date, and other terms.
- Sally asks her bank for a letter of credit and provides details about her agreement with George to the bank.
- Sally's bank forwards the letter to a bank in Country Z. (we’ll call that bank George’s bank)
- George’s bank provides the letter of credit to George, who reviews it to make sure he can meet the requirements.
- George produces the widgets and ships them to Sally.
- George provides documents to his bank to prove that he has made shipment.
- George's bank reviews the documents to make sure they meet the requirements in the letter of credit and forwards the documents to Sally’s bank. (at this point, George might get paid, or he might have to wait)
- Sally’s bank reviews the documents to make sure they meet the requirements, and if they do, Sally’s bank sends payment to George’s bank.
- Sally’s bank provides the documents to Sally, including documents she’ll need to claim the shipment when it arrives in Country X.
- George’s bank pays George.
When does Sally pay her bank? It depends. She might have to provide the funds up front (but she’s not sending the money to George, she’s just letting the bank hold onto it until the documents arrive). Or, if she has sufficient credit and collateral, her bank might wait and ask for the money after the letter of credit comes back with the required documents. Finally, Sally’s bank might issue a loan to Sally as part of the letter of credit, and she’ll repay the loan over time.
The Irrevocable Letter of Credit
Letters of credit, in general, work as described above. But what about irrevocable letters of credit? An irrevocable letter of credit is simply a letter of credit they cannot be changed or canceled without the permission of everybody involved: the buyer, the seller, and any banks involved.
It is extremely difficult to find a letter of credit that is not irrevocable. However, it's always worth verifying whether or not you have an irrevocable or a revocable document. It is difficult to plan when things can change at any time.
Sellers generally want letters of credit to be irrevocable because they can get burned if they produce and ship goods without any guarantee of payment. But buyers may also want things set in stone: they don't want sellers to ship goods late or change order quantities without discussing things first. Ultimately, the greatest risk falls on sellers, and you should avoid selling anything with a revocable letter of credit.
How to get an Irrevocable Letter of Credit
If you need to obtain a letter of credit, talk with your bank. You’ll probably need somebody in the international trade (or similar) department. Don’t try to craft a letter of credit yourself, and don’t “adapt” a letter of credit that somebody else used.
What’s the big deal? If any detail is off, you risk an expensive legal battle (possibly overseas, where laws may be different from what you’re used to), and you might not get paid for shipments you send. You might save a few bucks by doing it yourself, but the risks are significant. For sellers, it's a good idea to look at alternatives to letters of credit, including trade credit insurance, which might be less expensive, and different types of letters of credit.