What Is an Irrevocable Letter of Credit?

A letter of credit (LC) is a financial instrument providing a payment guarantee in commercial transactions, especially in international trade. It introduces a bank as an intermediary, assuming the buyer’s payment risk to the seller. LCs are used globally to build trust between unfamiliar parties. Their primary purpose is to assure the seller that payment will be received on time and for the correct amount, provided the credit’s terms and conditions are met.

Understanding Irrevocable Letters of Credit

An irrevocable letter of credit (ILOC) is a formal bank commitment guaranteeing payment for goods or services. It cannot be canceled or modified without the explicit consent of all involved parties. Once issued, an ILOC’s terms are binding on the issuing bank, the buyer, and the seller. This provides high security for the seller, as the bank’s undertaking to pay is firm, reducing the risk of non-payment.

In contrast, a revocable letter of credit, though rare, could be amended or canceled by the issuing bank without the beneficiary’s consent, offering less security. The irrevocability of an ILOC assures the seller of payment upon fulfilling stipulated conditions, even if the buyer faces financial difficulties. This stability makes ILOCs a preferred choice for international transactions, particularly in high-stakes deals where trust between parties might be limited.

Roles of Parties Involved

Parties in an irrevocable letter of credit transaction each have specific responsibilities.

The Applicant, typically the buyer or importer, requests their bank to issue the letter of credit in favor of the seller. This party reimburses the issuing bank for payments made under the LC.
The Beneficiary, usually the seller or exporter, receives payment upon complying with all specified terms and conditions. The LC provides payment assurance to the beneficiary.
The Issuing Bank, typically the buyer’s bank, issues the letter of credit and commits to pay the beneficiary. This bank assesses the buyer’s creditworthiness and honors payment if documents are compliant.
An Advising Bank, often in the beneficiary’s country, authenticates the letter of credit and informs the beneficiary of its terms. This bank acts as an intermediary, forwarding documents and payments.
A Confirming Bank may add its guarantee to the issuing bank’s commitment, providing additional payment security, especially when the issuing bank’s creditworthiness is unknown or perceived as risky.

The Process of an Irrevocable Letter of Credit

The irrevocable letter of credit process begins when the buyer and seller agree to use an LC for their transaction. The buyer, as the applicant, submits an application to their bank, the issuing bank, requesting the ILOC. This application includes specific transaction details, such as the amount and beneficiary information. The issuing bank evaluates the buyer’s financial standing and, if satisfied, issues the ILOC.

Once issued, the ILOC is transmitted to an advising bank, usually in the seller’s country. The advising bank authenticates the LC and notifies the seller, the beneficiary, of its issuance and terms. Upon notification, the seller ships the goods or provides services as agreed in the underlying contract. After shipment, the seller prepares and presents all required documents to the advising bank within the stipulated timeframe.

The advising bank examines these documents for strict compliance with the LC’s terms. If compliant, the advising bank forwards them to the issuing bank. The issuing bank then reviews the documents for compliance. Upon successful verification, the issuing bank releases payment to the advising bank, which remits the funds to the seller. This structured process ensures payment is made only when documentary conditions are met, providing security to both parties.

Essential Features

Irrevocable letters of credit are governed by core principles ensuring their reliability.

The independence principle dictates that the bank’s payment obligation under the LC is separate from the underlying sales contract between the buyer and seller. Banks deal only with documents, not the goods or services themselves, and cannot refuse payment due to commercial transaction disputes, unless fraud is evident. This principle ensures the seller can rely on the bank’s promise of payment, provided they present conforming documents.
The strict compliance rule requires all documents presented by the beneficiary to precisely match the LC’s terms and conditions. Any discrepancy, even a minor one, can lead to the issuing bank refusing payment. This rule protects banks by limiting their liability to a straightforward documentary check and places the onus on the seller for meticulous document preparation.
The documentary nature emphasizes that banks operate solely on the basis of documents. Banks are not concerned with physical inspection of goods or performance of services. Their role is to examine presented documents against the LC’s terms to determine if a valid payment claim exists. This focus on documentation streamlines the payment process and provides a clear, objective standard for payment release.