What Is Irrevocable Letter of Credit (ILOC)?
An irrevocable letter of credit (ILOC) is an official paper from a bank that promises payment for goods or services bought by the person or business that asks for the letter of credit from the issuing bank. This person or business is called the applicant.
A letter of credit that can’t be changed or canceled can only be canceled with the explicit permission of all three parties: the buyer, the seller, and the bank that issued the letter of credit. One example is that once an ILOC is granted, the bank that issued it cannot change its terms.
How to Understand Irrevocable Letters of Credit
A commercial bank sends a letter of credit to a seller to ensure that they will get paid by a buyer on time and for the right amount. Should the buyer not be able to make a payment on the purchase, the bank will have to pay the total or leftover amount.
International trade is complicated by distance, different rules in each country, and the inability to know each other well. Because of these issues, letters of credit have become essential to international trade.
An ILOC can’t be revoked while it’s in effect, which is usually when a planned transaction is expected to be completed. However, an ILOC expires at a particular time, written in the letter of credit.
Details about ILOC
Official bank letters called irrevocable letters of credit are sent and verified through the Society for Worldwide Interbank Financial Telecommunications (SWIFT) banking system. An ILOC is sent as MT700, “message type 700.” This is a world system for making it easier for banks and other financial institutions to do business with each other.
The person who receives the letter (usually the seller in a deal) has a better chance of getting paid with an ILOC. People often look for ILOCs for big building projects since they can’t be claimed as preferred in bankruptcy.
It is most common for ILOCs to help with foreign trade. This is because there is more credit risk when two people who don’t know each other do business across national borders. When someone issues an ILOC, the buyer’s bank promises to pay the seller if the buyer doesn’t. This gives the seller peace of mind that they will get paid. An ILOC helps the buyer make a deal with a seller who might not be willing to do business with them otherwise by giving the seller a guarantee of payment.
The Way an ILOC Works
In a deal between a buyer and a seller, an ILOC helps the deal go through with the help of both parties’ banks. At first, the buyer asks his bank for an ILOC, which is then sent to the seller’s bank. An ILOC usually spells out essential aspects of the deal, like the price, payment terms, and when and where the goods will be delivered, and protects the lender from credit risk.
If the buyer doesn’t pay when they agreed to, the buyer’s bank pays the seller’s bank, which then pays the seller, who is the receiver of the ILOC.
ILOCs can also be confirmed or not confirmed. A certified ILOC protects the seller even more from risk by giving a promise of payment from both the buyer’s and seller’s banks. With an unclear ILOC, the seller’s bank doesn’t have to pay anything and acts as a middleman to get the money from the buyer’s bank to the seller.
It is possible to change or reverse an ILOC, but everyone involved must agree to the change.
What’s in an ILOC
Each letter of credit that can’t be changed can be written to a different creditor or case. In general, all irrevocable letters of credit will have the exact details. This information includes the following but is not limited to:
Information about the Issuing Bank: The ILOC should clarify what bank issued the letter by listing its name, address, and phone number.
Information about the Buyer or Applicant: The ILOC should have the buyer or applicant’s name, address, and contact information so that it can be found. The person who wants the ILOC to be given out is called the application.
Information about the recipient: The ILOC should list the seller’s or recipient’s name, address, and phone number. The recipient is the person or group that will get the money after the ILOC’s conditions are met.
Dollar Amount: The ILOC should list the exact dollar amount that the giving bank is guaranteeing. This amount is the most cash the beneficiary can get from the bank after meeting the ILOC standards.
Expiration Date: The ILOC should say what date the beneficiary must send in the required paperwork to get paid.
Other Conditions and Terms: The ILOC will list the conditions the recipient must meet to get paid. These criteria could say that goods must be shipped, inspected, adequately recorded, and in line with all applicable laws and rules.
Documents Needed: The ILOC will spell out exactly what documents the recipient needs to give the sending bank to get paid. Some common types of papers are commercial contracts, transportation records (like airway bills or bills of lading), origin-certification records, and inspection records.
Currently In Effect Rules: The ILOC may list the rules that apply to the deal, like the Uniform Customs and Practice for Documentary Credits (UCP 600).1
Items Sent in Parts: The ILOC may say if items sent in parts are allowed. If part-shipments are allowed, the rules and limits that apply to them should be made clear.
Port of Loading/Discharge: To ensure the items are carried as promised, the ILOC may ask the recipient to name the planned port of loading and discharge for the shipment. This could also include International Commercial Terms (incoterms), which say how the goods should be delivered and how the buyer and seller should share the risk.
Needs for Insurance: The ILOC could say what kind of insurance is needed for the goods, how much insurance is needed, and any other specific rules.
How to Get an ILOC
The buyer and the seller must agree to use an ILOC as payment. Before you receive it, ensure both parties are ready to move forward with this financial instrument and know all the terms and conditions in the letter. A lawyer is often hired to ensure the terms are correct and easy to understand.
If you want an ILOC, you might choose a bank with a good reputation and experience with ILOC deals and international trade. Some things that might affect your ability to believe and receive in the ILOC process are the bank’s financial stability, global reach, and experience with handling credit. Many times, the ILOC not only shows what kind of person is applying or buying, but it also shows how trustworthy the bank is in giving the loan. If it applies, make sure the letter is written following the rules of foreign trade.
Banks usually have a method for approving ILOCs that includes asking for information about the amount you want, who the ILOC is for, when it expires, what documents are needed, and any other terms and conditions. This information is looked at, and not only is the deal looked at, but also the requestor’s creditworthiness. The letter is ready once it has been accepted.
Once the ILOC is sent out, it must be carefully checked to ensure it accurately reflects the agreed-upon terms and conditions. Any problems or mistakes should be reported immediately to the granting bank to avoid problems during payment. Keep an eye on the ILOC’s end date to ensure all the necessary paperwork is turned in and payment is requested before the deadline. If this isn’t done, the letter might not be valid anymore.
An ILOC’s hidden value comes from the fact that it is usually given by a bank that the Federal Government insures. A seller can’t always get this amount of protection on their own.
Things besides an ILOC
Sometimes, the buyer or applicant may be able to use something other than a permanent letter of credit. The buyer may pay the seller in full before getting the goods or services. It might not be the best deal for the buyer because they have to pay a lot of money upfront, but it gives the seller a lot of safety when they need cash in advance.
When an open account is used for a trade, the buyer and the seller agree not to pay until the goods or services have been received. Because it is based on trust, this method works great for long-term relationships that are already established. This means the seller is taking on more risk because payment depends on the buyer’s desire to pay.
In a documentary collection, the buyer and seller trade papers and use a bank to pay each other. This type of e-banking differs from letters of credit in that it acts as a go-between but does not promise payments. They help exchange documents and get the money from the buyer for the seller instead.
When a buyer asks a bank to promise something, the bank does so on behalf of the buyer. It tells the seller that if the buyer doesn’t do what they agreed to, the bank will pay the seller up to a certain amount. You can change the terms of bank guarantees like bid bonds, payment guarantees, and performance guarantees to fit your needs.
Finally, some require a trustworthy third party to hold the money through escrow services until certain conditions are met. The buyer gets paid for the goods or services they bought once the buyer says they are happy with them. Both the buyer and the seller can feel safe with escrow services, but the deal has to be finished by one party before the other can do the same.
A case of an ILOC
The following is an example of an ILOC from the General Services Administration of the United States government. The following confirmation may be added after specific information is given, and the granting bank may sign it.
Remember that this format is usually acceptable and can be used for many deals. It’s possible to use a specific template for an ILOC and fill in specific fields or add essential data bits. This ILOC example shows when it expires, what rules it may follow, and the signature blocks that different groups need.
What does the issuing bank do in a letter of credit that can’t be changed?
The bank that issues the ILOC on behalf of the buyer is called the issuing bank. If the beneficiary shows the proper paperwork, it agrees to pay the beneficiary. The issuing bank’s creditworthiness and image are essential in determining whether the ILOC is acceptable.
Why is it good for buyers to use an irrevocable letter of credit?
Buyers can be sure they will only be paid after all the paperwork is complete and all the rules are followed. An ILOC lowers the risk that the seller won’t do what they agreed to and adds a layer of security to foreign trade deals.
Why is it a good idea for sellers to use an irrevocable letter of credit?
The payment guarantee offered by the producing bank is good for sellers. The ILOC gives them peace of mind that they will get paid by the bank as soon as they meet the standards. This lowers the risk of not getting paid or getting paid late.
Can a Letter of Credit That Can’t Be Changed Be Amended?
It is possible to change an ILOC if both the buyer and the recipient agree to the changes. Changes to the ILOC can change its rules, make the expiration date longer, or change other conditions. The issuing bank and everyone else concerned must agree with and support the change.
Conclusion
- A bank issues an irrevocable letter of credit (ILOC) as a promise to pay for goods and services, and the buyer can’t back out of the deal for a certain amount of time.
- Most of the time, ILOCs are used to make foreign trade easier.
- A certified ILOC protects the seller even more by giving them a promise of payment from both the buyer’s and seller’s banks.
- When a buyer takes out an ILOC, the trustworthiness of their position is improved by the institution’s creditworthiness.
- An ILOC may include detailed details about insurance needs, incoterms, government rules, or paperwork needs.
