The letter of credit is the best way for exporters to receive payment in an international sale (apart from cash in advance). As we wrote in our article what buyers must know about letters of credit, the letter of credit is designed to assure payment to the seller, and will favor this latter even in case of dispute between the parties.
However, this is a general principle, and, as we all know, the devil is in the details.
There are different types of letters of credit, and exporters should know that one of them is definitely to be avoided, because it does not assure payment at all; essentially, this type of letter of credit does not assure that the letter that the credit transaction will be carried out. Instead, it can be revoked; this is why it is called revocable letter of credit.
The revocable letter of credit has been eliminated under the UCP 600 (the common rules for harmonization of letters of credit published by the ICC), but it is still regulated under the previous version, UCP 500 (article 8).
The Problem With Revocable Letters Of Credit
Under a revocable letter of credit, the issuing bank or the buyer can revoke the promise to pay the seller and the advising bank. Moreover, they are not obliged to inform the seller and his bank of the decision to revoke the credit.
Even worse for the seller is that his bank is also not obliged to inform him of the decision of the issuing bank to cancel the credit. If the seller’s bank is informed that the credit has been revoked, but for any reason decides or forgets to inform the seller, this latter cannot claim payment or damages on the bank.
Essentially, under a revocable letter of credit, the seller is not sure of receiving payment, which somehow distorts the main function of a letter of credit, that is to assure payment to exporters. For this reason, it should never be used between unrelated parties, especially when knowledge of the counterparty is limited.
Advantages Of A Revocable Credit
The only advantage of a revocable letter of credit is that banking fees to process the transaction are way lower than for an irrevocable letter of credit. For these reasons, the revocable letter of credit is used only in transactions between sister companies, or parent and subsidiary.
Because of the lack of assurances to an exporter, the use of a revocable letter of credit in an international sale must be clearly specified in the contract; otherwise, the letter of credit will be deemed to be irrevocable.
When Does An Irrevocable Credit Becomes Irrevocable?
An interesting question is at what point a revocable credit becomes irrevocable, i.e. after which point the bank cannot refuse payment.
The UCP 500 fails to address this issue clearly, but it is common practice that when the seller presents the documents to the advising bank and this latter accepts them, then the credit is deemed to be irrevocable and the seller can cash his credit.
The problem is that, in order to present the documents, the seller must already have shipped the goods; therefore, the uncertainty of a revocable letter of credit remains with the seller from the moment he ships the goods until the documents are accepted, which entails a great amount of risk.
For all of the reasons we mentioned, apart from transactions between related parties, exporters should always avoid a revocable letter of credit.
Globartis Research Center