Top Tips About Revocable Letter of Credit 

Introduction

In the current era, when trade and commerce have no borders, and people buy and sell their goods and services around the world, the issue of how they can secure the payments from the buyers, which they don’t even know, that’s when the letter of credit comes into place. The instrument guarantees the parties that the payments will be made if the buyer defaults on their payments. There are various types of letters of credit, such as revocable, irrevocable, standby, deferred, confirmed, and unconfirmed LC, etc.

What is a revocable letter of credit, with an example?

A revocable letter of credit is a financial instrument that can be amended or cancelled by the issuing bank without the approval and consent of the beneficiary or trading parties. This LC does not provide any security and could be terminated at any time, resulting in financial loss for the seller.

On the other hand, the buyer is not in a safe position either, as the seller can also amend the requirements of the LC and make things in their favour, like extending the deadline for sending the shipment.

These instruments can be amended at any time between when the seller ships the products and sends the relevant document to the issuing bank(the issuing bank may also ask the seller for additional documents not initially requested and can also change the expiry date of the LC and despite that, the bank may still refuse to act as a mediator). 

Issuing this LC indicates that the bank is not ready to bear the risk or guarantee the payment associated with the contract, along with it showing the weak financial strength of the bank to make the payments.

A Russian firm named ABC limited(buyer) contracts with a US firm(seller) for 3 pieces of machinery like bulldozers and scrapers. Being an international shipment, the seller asked for a letter of credit to secure the payment, and the buyer asked his bank(issuing bank) to issue a revocable letter of credit and send it to the seller.

The seller successfully shipped the pieces of machinery, and when he asked for payment from the issuing bank, they refused. On the other hand, when he contacted the buyer, he said he didn’t have the money to pay and was dependent on LC, making the seller vulnerable to fraud.

After further inquiring, the seller discovered that revocable LC gives the bank the option to refuse the payment, and now he has to recover the payment directly from the buyer. 

Types of revocable letter of credit

There are two types of revocable letter of credit, secured and unsecured. 

For a secured revocable letter of credit, the buyer has to give a personal guarantee or mortgage security. For an unsecured revocable letter of credit, the bank checks the creditworthiness of the buyer. Please note in both instances, the bank can revoke the LC. 

What are the terms to check out while reviewing a revocable letter of credit?

Parties involved: the LC should include the parties involved in the transaction, including the beneficiary (the seller or exporter), the applicant (the buyer or importer), and the issuing bank.

Amount involved: the amounts to be relied on should be specifically spelt out in the LC, representing the maximum amount the bank is obligated to pay the beneficiary.

Expiration date: specific expiry date should also be set out in the LC, including the date by which the beneficiary must present the required documents to the bank to receive payment.

Documents required: the LC should set down the documents that the beneficiary must present to the bank, such as a commercial invoice, bill of lading, packing list, and insurance certificate.

Beneficiary’s obligations: The beneficiary’s obligations should also be specified, such as shipping the goods by a certain date or providing proof of shipment. For a comprehensive overview of securing shipments, explore our article on the various types of shipping insurance.

Applicable law: The Letter of Credit should identify the law that governs the Letter of Credit and any disputes arising from it.

Revocability: the LC may be revocable or irrevocable. The same should be included.

What is the difference between a revocable and irrevocable letter of credit?

Revocable and irrevocable letters of credit mainly differentiate in 3 ways. 

The first one is revocable. While the former can be revoked at any stage of the LC and is an unapproved instrument, the latter cannot be revoked and is a definite undertaking by the issuing bank to pay the seller.

The second one is how secure this payment method is. Revocable LC is a much riskier option for all the parties involved as it doesn’t guarantee any payment to the beneficiary. On the other, the latter confirms that the issuing bank will honour the payment, and the third and last one is about the usage, revocable LC is the least used instrument reason being how powerless this leaves both parties, while irrevocable letter of credit is used frequently. It should be noted that both LC works the same way. However, limited functionality and utilization persist with revocable LC. 

Under what circumstances may a bank revoke the revocable letter of credit?

As a ground rule, this type of revocable letter of credit can be revoked at any time by the bank. However, still, there are following circumstances where the bank has to revoke the LC:

• Political tension
• Deteriorating market conditions
• Financial crisis 

Why buyers issue a revocable letter of credit?

While it’s never advised to issue this LC, people usually use it in cases where the contract that parties have entered into doesn’t have proper conditions and terms attached to it or if either party lives in an environment of political tensions or economic crisis in this situation the bank can’t guarantee payments or the buyer doesn’t have a good credit history and even doesn’t have a guarantee or collateral to give as a security to the bank.

In addition, this LC is issued when parties feel that the price of the goods or services may increase before the contract is fulfilled. It is also issued when the buyer doubts the seller’s trustworthiness and wants an option if he observes signs of fraud. 

When does a revocable letter of credit become irrevocable?

As you have learned above, the bank can revoke this LC. However, there’s a threshold above which the bank loses this authority. Once the seller has shipped the goods and services and produced those documents to the advising bank, once the bank accepts the documents, it becomes irrevocable. 

Advantages and disadvantages of revocable letter of credit

It has no significant advantages except that it puts the buyer on the safer side. However, this also means that this becomes a risk for the seller, and if the buyer would like, he could refuse to pay through this LC.

The second benefit is that it is affordable. The banking fees associated with this transaction are considerably lower than any other. Another type of LC and for that reason, it is used between sister-concern or subsidiary companies. 

Disadvantages: Revocable LC has several negative aspects, it negates its prime responsibility of providing security and acting as an intermediary, and for these reasons, it has been removed from the UCP600, the common code for harmonizing LC published by the ICC. Some of the disadvantages are listed below:

• Can be revoked anytime
• Both parties are at a disadvantage position, and financial loss is expected
• Non-transferable instrument due to lack of authority/security related to issuing bank
• An unapproved document adds to the security risk. 

Which type of letter of credit cannot be cancelled by the bank?

The question surely occurs to you if this is an untrustworthy LC, then what should be used to ensure the parties are paid? The answer is the revocable letter of credit. This instrument cannot be cancelled or changed except in the condition explicitly mentioned in the contract. 

Frequently asked questions

When should one use a Revocable Letter of Credit?

A Revocable LC can be used where either of the parties lives in an environment of political turmoil or economic crisis or where the price of the products or services is expected to rise before the execution of the contract.

What are the risks associated with Revocable Letters of Credit?

The main risk associated with LC is that it can be cancelled or modified by the issuing bank at any time without the consent of the parties involved, meaning that the seller may not receive a payment if the bank decides to do so.

How can I mitigate the risks of a Revocable Letter of Credit?

The risk can be mitigated using a reputable trade finance provider and negotiating favourable terms and conditions in the credit letter. In addition, considering alternatives such as an irrevocable letter of credit or other payment methods can help mitigate the risk.

Conclusion

Revocable letters of credit are rarely used for international and domestic transactions. The reason remains the same: lack of security defeats the purpose of using a letter of credit, and neither banks issue it as they refrain from getting into problems after the issuance of LC.