Letters of Credit

Guide to Letters of Credit

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Revocable vs. Irrevocable Documentary Credits

Documentary credits may be issued by the buyer and issuing bank as revocable or irrevocable. (The buyer must indicate either revocable or irrevocable on the application form to the issuing bank.) Each has a distinct advantage for buyers and sellers.

Revocable Credit

A revocable documentary credit gives the buyer and/or issuing bank the ability to amend or cancel the credit at any time right up to the moment of intended payment without approval by, or notice to, the seller. Revocable credits are, therefore, of great advantage to the buyer.

Revocable credits are, conversely, of great disadvantage to the seller as the credit may be canceled at any time, even while the goods are in transit, giving the seller no security whatsoever. Although revocable credits are sometimes used between affiliated firms, sellers are advised never to accept a revocable credit as a payment method.

Irrevocable Credit

An irrevocable documentary credit constitutes a firm contractual obligation on the part of the issuing bank to honor the terms of payment of the credit as issued. The buyer and issuing bank cannot amend or cancel the credit without the express approval of the seller.

Irrevocable credits are of advantage to the seller. As long as the seller complies with the terms of the credit, payment will be made by the issuing bank. Virtually all documentary credits issued today are irrevocable and so state on their face (on the face of the documentary credit itself). Sellers are advised to insist upon an irrevocable credit from the buyer.

Confirmed vs. Unconfirmed Documentary Credits

Payment under an irrevocable documentary credit is guaranteed by the issuing bank. However, from the seller's perspective, this guarantee may have limited value as the issuing bank may be (1) in a foreign country, (2) beholden to the buyer, (3) small and unknown to the seller, or (4) subject to unknown foreign exchange control restrictions. The seller, therefore, might wish that another, more local bank add its guarantee (confirmation) of payment to that of the issuing bank.

Within the category of irrevocable credits there are two further options for the buyer and seller. These are the irrevocable unconfirmed credit and the irrevocable confirmed credit. Once again, each has a distinct advantage for buyers and sellers.

Unconfirmed (or Advised) Documentary Credit

Under an unconfirmed documentary credit only the issuing bank assumes the undertaking to pay, thus payment is the sole responsibility of the issuing bank. An unconfirmed documentary credit will be communicated (advised) to the seller through a bank most likely located in the seller's country, and the related shipping and other documents will usually be presented to that bank for eventual payment. However, the final responsibility for payment rests with the issuing bank alone. The advising bank may or may not negotiate the seller's draft depending on the degree of political and financial risk anticipated in the issuing bank's country, as well as the credit standing of the issuing bank. In dealing with a readily identifiable issuing bank in a developed country, an unconfirmed documentary credit is very probably an acceptable, safe instrument for most sellers. If you have any doubt about the issuing bank and its standing, you can check the name through a local bank with an international department.

Note: Some countries (most notably China) do not permit confirmation of letters of credit issued by their banks, deeming that the credit of their national financial institutions should not be questioned by others.

Confirmed Documentary Credit

Confirmed letters of credit carry the commitment to pay of both the issuing and the advising banks. The advising bank adds its undertaking to pay to that of the issuing bank, and its commitment is independent of that of the issuing bank. Therefore, when documents conforming to the requirements of the confirmed documentary credit are presented in a timely manner, the payment from the advising bank to the seller is final in all respects as far as the seller is concerned.

Confirmed, irrevocable letters of credit give the seller the greatest protection, since sellers can rely on the commitment of two banks to make payment. The confirming bank will pay even if the issuing bank cannot or will not honor the draft for any reason whatever. In accordance with the additional risk assumed by the banks, however, confirmed, irrevocable letters of credit are more expensive than unconfirmed letters of credit. Confirmed, irrevocable letters of credit are used most frequently in transactions involving buyers in developing countries.

Special Letters of Credits

There are several special credits designed to meet the specific needs of buyers, suppliers, and intermediaries. Special credits involve increased participation by banks, so financing and service charges are higher. Each of the credits listed below is explained in greater detail in the pages that follow.

Standby Credit

Standby credits are often called nonperforming letters of credit because they are only used if the collection on a primary payment method is past due. Standby credits can be used to guarantee repayment of loans, fulfillment by subcontractors, and securing the payment for goods delivered by third parties.

Revolving Credit

This is a commitment on the part of the issuing bank to restore the credit to the original amount after it has been used or drawn down. This credit is used in cases where a buyer wishes to have certain quantities of the ordered goods delivered at specified intervals, such as in a multiple delivery contract.

Red Clause Credit

A red clause credit has a special clause (red clause) that authorizes the confirming bank to make advances to the beneficiary (seller) prior to the presentation of the shipping documents. In this credit the buyer, in essence, extends financing to the seller and incurs ultimate risk for all sums advanced under the credit.

Transferable Credit

A transferable credit is one where the original beneficiary transfers all or part of the proceeds of an existing credit to another party (typically the ultimate supplier of the goods). It is normally used by middlemen as a financing tool.

Back-to-Back Credit

This is a new credit opened on the basis of an already existing, nontransferable credit. It is used by traders to make payment to the ultimate supplier. A trader receives a documentary credit from the buyer and then opens another documentary credit in favor of the ultimate supplier. The first documentary credit is used as collateral for the second credit. The second credit makes price adjustments from which comes the trader's profit.