BANK COLLECTIONS, TRADE

FINANCE,
AND LETTERS OF CREDIT
WEEK 6
THE BILL OF EXCHANGE
• A negotiable instrument is a signed writing, containing an unconditional promise or order to pay a
fixed sum of money, to order or to bearer, on demand or at a definite time.
• Common negotiable instruments include promissory notes, which are two-party instruments
containing a promise to pay, and drafts, which are three-party instruments containing orders to
pay.
• A draft is the signed order of the drawer, given to a drawee who is in possession of money to
which the drawer is entitled, to pay a sum of money to a third party, the payee, on demand or at
a definite time.
• A common check is a special form of draft, which is drawn on a bank and payable on demand.
• The three parties to a check include the drawer, who gave the order to pay, the drawee bank to
whom the order to pay is given, and the payee.
• The bill of exchange is a specialized type of international draft commonly used to expedite foreign
money payments in many types of international transactions.
• These negotiable instruments can serve two purposes:
• (1) they act as a substitute for money and
• (2) they act as a financing or credit device.
THE BILL OF EXCHANGE
• Basically, a bill of exchange or international draft is similar to a check, in that it is an unconditional order to
pay a sum of money.
• In the case of a check, the drawer orders its bank, the drawee, to pay the amount of the check to the payee.
• However, instead of being drawn against funds held on deposit in a bank (as with a check), an international
draft is an order from the seller to the buyer or buyer’s bank to pay the seller upon the delivery of goods or
the presentation of shipping documents (e.g., an ocean bill of lading or air waybill).
• Thus, the seller is both the drawer (the one giving the order to pay) and the payee (the one entitled to
payment under the instrument).
• The drawee is either the buyer or its bank, depending on the arrangements made for payment.
• The commercial use of a draft or other negotiable instrument is derived from its negotiability, the quality
that allows it to act as a substitute for money.
• Negotiation is the transfer of an instrument from one party to another so that the transferee (called a
holder) takes legal rights in the instrument.
• The correct manner of negotiation depends on whether the instrument is a bearer or order instrument.
• Most drafts used in international trade are order instruments because they are payable to a named payee.
• To negotiate an order instrument, indorsement (by signature) and delivery of the instrument to the holder
must take place.
THE DOCUMENTARY DRAFT AND THE BANK
COLLECTION PROCESS
• A draft that is to be paid upon presentation or demand is known as a sight draft because it is payable “on sight.”
• The seller prepares the sight draft and sends it to the buyer along with the shipping documents (e.g., the bill of lading) through
banking channels, moving from the seller’s bank in the country of export to a foreign correspondent bank in the buyer’s country
and city.
• The draft is sent “for collection,” known as a documentary collection. The banks act as agents of the seller for collection purposes.
A collection letter that provides instructions from the seller on such matters as who is responsible for bank collection charges,
what to do in the event the buyer dishonors the draft, and how the proceeds are to be remitted to the seller, accompany the draft
and documents.
• Thus, the collection letter may specify that in the event of the buyer’s dishonor of the draft, the seller’s agent in the buyer’s
country is to be notified, and that the goods are to be properly warehoused and insured pending resolution of the problem or sale
of the goods to another party.
• Essentially, documentary collections function like a cash-on-delivery (COD) transaction. When the buyer receives the sight draft at
its bank or place of business, the draft is paid, and the payment is remitted to the seller. Only then does the bank turn over the
shipping documents with which the buyer can claim its cargo from the carrier.
• The transaction is somewhat risky, however, because when presented with documents, there is no guarantee that the buyer will
actually pay.
• Assuming the buyer does pay, the average cycle for completing a documentary collection is approximately three weeks (although
most banks offer accelerated schedules).
• If a sales contract between buyer and seller calls for payment upon presentation of a sight draft, the contract terms commonly call
for cash against documents.
DOCUMENTARY DRAFTS USED IN TRADE
FINANCE – TIME DRAFTS AND ACCEPTANCES
• Banks and other financial institutions involved in commercial lending provide a wide range of
financing packages for international trade, commonly called trade finance.
• Trade finance not only assists the buyer in financing its purchase but also provides immediate
cash to the seller for the sale and is profitable for the lending institution.
• The documentary draft can serve as an important financing or credit device, providing the seller
and buyer with a mechanism for financing the international sale. In a competitive marketplace, an
exporter must be able to offer its customers credit or other financing for their purchases.
• Many firms consider their ability to arrange credit a crucial component of their marketing
strategies. If an exporter can prearrange financing for the buyer, it has an advantage over a
competitor who cannot.
• The use of the draft in trade finance works like this: Seller agrees to issue a draft that is due, say,
60 days after shipment of the goods. The draft states that it is due in 60 days or on a future date
specified on the instrument. A draft due at a future date or after a specified period is known as a
time draft. The time draft is sent to the buyer for its acceptance. Typically, acceptance is done by
stamping the date and the word “accepted” across the face of the draft, together with the name
and signature of the drawee, because no party is obligated on a draft unless its signature appears
on it. Under the UCC, the acceptance “may consist of the drawee’s signature alone.” The buyer
has thus created a trade acceptance. The buyer’s acceptance indicates the buyer’s unconditional
obligation to pay the draft on the date due.
DOCUMENTARY DRAFTS USED IN TRADE
FINANCE – TIME DRAFTS AND ACCEPTANCES
• A draft payable at “60 days after date” is payable by the drawee 60 days after the original
date of the instrument. A draft payable at “60 days sight” means that it is due to be paid
60 days after the date of the acceptance.
• As with a sight draft, a seller usually sends the time draft together with the shipping
documents to the buyer through banking channels with instructions to the banks that
the shipping documents should be handed over to the buyer only upon acceptance of
the draft.
• The sales contract would have indicated the parties’ agreement to this arrangement by
calling for “documents against acceptance,” or other clear language of similar meaning.
After acceptance, the draft is returned through banking channels to the seller. The seller
can then hold the draft to maturity or sell it at a discount to a local bank or commercial
lending institution for immediate cash. The commercial lender takes the acceptance by
negotiation.
• The greater the creditworthiness of the buyer, the greater the marketability of the trade
acceptance. Where the foreign buyer is unquestionably creditworthy, such as a major
multinational corporation, the trade acceptance carries little risk and is easily saleable.
DOCUMENTARY DRAFTS USED IN TRADE
FINANCE - BANKER’S ACCEPTANCES
• A banker’s acceptance is a negotiable instrument and short-term financing device
in wide use to finance international (as well as domestic) sales.
• The purpose of an acceptance is to substitute a bank’s credit for that of the buyer
to finance the sale. A banker’s acceptance is a time draft drawn on and accepted
by a commercial bank. The bank stamps its name, date, and signature on the face
of the draft to create the acceptance and thereby becomes obligated to pay the
amount stated to the holder of the instrument on the date specified. The holder
of the acceptance can convert it to cash immediately at a discounted rate or hold
it until it matures.
• Banker’s acceptances are flexible instruments, with many creative uses. Either a
buyer’s or a seller’s bank can handle the acceptance. Importing buyers can use a
banker’s acceptance for short-term borrowing until they can resell and liquidate
the goods being purchased. Sellers to export markets can use a banker’s
acceptance for short-term, pre-export financing of raw materials and production
costs until the goods are sold to the foreign customer and payment is received.
Exporters can also use acceptances to grant credit terms to foreign customers.
CREDIT RISK IN TRADE FINANCE PROGRAMS
• Institutions with regular involvement in trade lending commonly prearrange
these financing terms by agreeing in advance to purchase the trade acceptances
of the foreign buyer.
• They must first perform an analysis and evaluation of the buyer’s financial
position.
• Thorough credit checks are done on the buyer, using trade and banking
information, the reports of U.S. or foreign credit reporting agencies, and even site
visits to the foreign firm.
• Although obtaining and verifying credit information is relatively easy in the
United States, Canada, Japan, and Western Europe, it is somewhat more difficult,
and the information is less reliable, in other regions of the world.
• To reduce the credit risk and lower the cost of trade finance, several government
agencies provide credit guarantees to back trade finance lending by commercial
institutions
CREDIT RISK IN ACCEPTANCE FINANCING:
RIGHTS OF THE HOLDER IN DUE COURSE
• A holder in due course is a holder in possession of a negotiable instrument (such as a draft or acceptance)
that has been taken: (1) for value, (2) in good faith, (3) without notice that it is overdue or has been
dishonored, and (4) without notice that the instrument contains an unauthorized signature or has been
altered.
• If all of the requirements for transferring a negotiable instrument are met and the transferee qualifies as a
holder in due course, the transferee can take greater rights in the instrument than the transferor had.
• According to the holder in due course rule, the purchaser of an acceptance, or any negotiable instrument,
takes it free from most disputes that might arise between the drawer and drawee—the original parties to
the underlying transaction. The most common type of dispute that might arise is breach of contract.
• For example, assume that DownPillow sells pillows to a Japanese buyer and forwards documents and a draft
for acceptance. DownPillow discounts the trade acceptance to a U.S. bank, which then discounts the
instrument in the credit markets. If the pillows turn out to be moldy and worthless, the Japanese buyer must
still honor and pay the acceptance upon presentation in Japan. The buyer may then assert its separate claim
for breach of contract against the seller.
• This rule ensures the free transferability of commercial paper in international commerce.
• A financial institution can discount an international draft without fear that it will be caught up in the middle
of a breach of contract action between buyer and seller.
• If drafts did not come with this protection, banks might not be so willing to finance international sales.
CREDIT RISKS IN FACTORING ACCOUNTS
RECEIVABLE: THE RIGHTS OF THE ASSIGNEE
• Many firms are offering open account terms to their better, long-term
foreign customers. These sellers are giving their customers an open credit
period, typically from 30 days to several months, to pay for goods received.
• An account receivable is no more than a representation of a contract right
belonging to the seller—the right to collect money owed by the buyer
under the contract for goods shipped. Contract rights can be assigned to
another party. In a typical financing arrangement, the seller (assignor)
assigns its right to collect the account to the financial institution (assignee).
This is also called factoring, and the assignee is sometimes called the factor.
• Banker’s acceptance financing offers some advantages over accounts
receivable financing. Unlike a factor, the rule protects a holder in due
course of a banker’s acceptance. Thus, the fact that the products are
defective does not provide a defense against payment to one liable on the
negotiable instrument.
• Some insurance companies today offer commercial credit insurance to
protect against accounts receivable that become uncollectible bad debts.
THE LETTER OF CREDIT
• In broad terms, we can say that a letter of credit is an obligation of a bank, usually
irrevocable, issued on behalf of one of its customers and promising to pay a sum
of money to a beneficiary upon the happening of a certain event or events.
• In a sense, it is the substitution of the credit and good name of a bank for that of
its customer, permitting the customer to do business with other individuals or
firms on terms that otherwise might not be available to them.
• Letters of credit can be either domestic or international.
• They can be used in transactions for the sale of goods or services or to guarantee
performance of other business obligations.
• In this chapter we discuss two types of letters of credit:
• the international documentary letter of credit for use in the sale of goods and
• the standby letter of credit for guaranteeing performance or payment obligations of a bank’s
customer.
THE DOCUMENTARY LETTER OF CREDIT
• The documentary letter of credit is defined as:
• 1. The definite undertaking of a bank,
• 2. issued in accordance with the instructions of their customer,
• 3. addressed to, or in favor of, the beneficiary,
• 4. wherein the bank promises to pay a certain sum of money (or to accept or
negotiate the beneficiary’s drafts up to that sum) in the stated currency,
• 5. within the prescribed time limits,
• 6. upon the complying presentation,
• 7. of the required and conforming documents
THE DOCUMENTARY LETTER OF CREDIT
• A buyer that has committed in the sales contract to obtain a letter of credit
begins by applying to its bank for a letter of credit issued “in favor of” or “for the
benefit of” the seller.
• In this arrangement, the buyer is known as the account party, the buyer’s bank is
the issuing bank, or issuer, and the seller is the beneficiary.
• The requirement that the bank will pay the seller only on the presentation of
documents is what gives the documentary credit its name.
• The documents might differ greatly depending on whether the transaction is a
domestic or an international one, the needs of the parties, or the method for
shipping the goods.
• The letter of credit does act like a promise from an issuing bank to a beneficiary,
and it seems to be treated at times like a contract and discussed in terms of the
principles of contract law. However, the general consensus is that it is not a
contract.
STEPS OF THE DOCUMENTARY SALE WITH A
LETTER OF CREDIT
• A. Sales contract calls for L/C.
• B. Application for L/C.
• C. L/C forwarded to beneficiary through advising bank.
• D. Documents prepared according to L/C· goods shipped.
• E. Documents negotiated for payment through nominated,
negotiating or confirming bank.
• F. Payment or acceptance of draft after documents checked for
discrepancies.
• G. Negotiation of documents to buyer for reimbursement
UNIFORM CUSTOMS AND PRACTICE FOR
DOCUMENTARY CREDITS (UCP)
• UCP is a set of standardized rules for issuing and handling letters of credit that the
International Chamber of Commerce drafts and publishes with the assistance of
the international banking community.
• The UCP establishes the format for letters of credit, sets out rules by which banks
process letter of credit transactions, and defines the rights and responsibilities of
all parties to the credit.
• Because banks were the main drafters of the UCP, its provisions tend to protect
their rights in any transaction.
• The UCP is in use in virtually every nation of the world and applies to most letters
of credit issued worldwide.
• The International Chamber of Commerce is not a government or lawmaking body,
and the UCP is not law.
• The UCP “governs” a letter of credit only to the extent that it states that the letter
of credit is to be “interpreted” according to the UCP (which almost all do).
THE INDEPENDENCE PRINCIPLE AND LETTERS
OF CREDIT
• The independence principle is a general rule of law stating that the letter of credit
is independent of the sales contract between buyer and seller.
• The issuing bank does not concern itself with what the parties had promised to
do, or should do, under their contract.
• The issuing bank’s only concern is that the buyer presents to the issuing bank
certain “documents” (i.e., invoice, bill of lading, insurance policy, etc.) required by
the letter of credit. Think of it as though the bank is purchasing documents for its
customer, not goods.
• The independence principle is found in UCP 600, Article 5, stating, “Banks deal
with documents and not with goods … ”
• The banks do not concern themselves with the quality or condition of the goods.
They have no obligation to inspect goods or to investigate rumors about them.
• They do not care if the ship on which they are sailing has gone to the bottom of
the sea.
 THE BUYER’S APPLICATION AND CONTRACT
WITH THE ISSUING BANK
• Once the buyer has finalized a sales contract calling for payment to the seller under a letter of credit, it is
up to the buyer to apply for that letter of credit at a bank.
• The application for the credit, contains the buyer’s instructions and conditions upon which the issuing
bank may honor the seller’s documents. The application requests the bank to issue a letter of credit to the
seller promising to purchase the seller’s documents covering a certain quantity and description of goods,
with a value up to a certain amount of money, that are insured and shipped on or before a certain date.
• The buyer may impose almost any conditions or requirements on the seller’s performance, as long as the
conditions or requirements pertain only to the seller’s documents. For example, the buyer can prohibit the
bank from taking documents showing a partial shipment or require a document that shows a specific
method of shipping, or even name a specific vessel. However, the buyer must remember that this
information is based on the buyer’s final agreement with the seller.
• When the bank accepts it, the buyer’s application for the credit becomes a contract between them. It
states what the bank must do on the buyer’s behalf. If the bank follows the buyer’s instructions, then it is
entitled to purchase the seller’s documents and obtain reimbursement from the buyer. If it does not, or if
it violates any terms of its contract, then the buyer need not take the documents or reimburse the bank
that took them contrary to instructions.
• The buyer may not make any demands on the issuing bank that are not related to the seller’s documents.
For example, the application may not attempt to require the bank to inspect goods or to make the letter of
credit conditional on an investigative report of the seller, on a criminal background check, on the buyer’s
receipt of financing, or on a contract to resell the goods.
ADVISING THE LETTER OF CREDIT TO THE
BENEFICIARY
• The issuing bank will send the letter of credit to the seller via a foreign
correspondent bank (a bank with whom the issuing bank has a reciprocal banking
relationship) located in the seller’s country. This bank is called the advising bank.
• An advising bank merely informs or “advises” the seller that the letter of credit is
available for pick up. An advising bank has no responsibility to honor a draft or
purchase the seller’s documents. It is not liable on the credit.
• It provides the service of forwarding the letter of credit to the seller, but it has no
obligation to advise the credit and may refuse if it wishes.
• The bank’s only responsibility is to satisfy itself that the credit is authentic and
accurate as received (e.g., that there were no errors in transmission). For
example, it might compare the signature on the credit as advised to them with
the authorized signature of the banking officer at the issuing bank.
• Letters of credit are commonly transmitted between banks using the SWIFT
network.
SELLER’S COMPLIANCE WITH THE LETTER OF
CREDIT
• Until the seller receives the letter of credit and reads it carefully, he or she might not want to begin
manufacturing, packaging, arranging transportation, or preparing the documents.
• The letter of credit tells the seller what it must do to be paid. It tells the seller what to ship, how to ship,
when to ship, and more. It contains specific terms and conditions drawn from the original sales contract and
included in the letter of credit, such as the quantity and description of the goods, shipping dates, the type or
amount of insurance, markings on packages, and so on. The letter of credit also tells the seller what
documents are needed in addition to the usual ones.
• For instance, assume a buyer in California wants to import foreign-made beanbag chairs that must meet
California’s strict flammability standards for upholstered furniture. The letter of credit might call for an
inspection certificate showing that the chairs “were tested pursuant to and are compliant with California
Technical Bulletin 117.” This tells the seller that this test must be performed, probably by an independent
laboratory, and the inspection certificate obtained before the shipping date.
• The seller will want to decide if the letter of credit is in keeping with his or her agreement with the buyer in
the underlying contract of sale. If the letter of credit shows any significant differences from the sales
contract, the seller will want to contact the buyer to inquire why.
• If the seller is unable to comply with the letter of credit for any reason, the buyer must be contacted
immediately, before shipment, so that an amended credit can be issued.
COMPLYING PRESENTATION
• A presentation is the delivery of the seller’s documents and draft to the nominated bank or directly to the
issuing bank.
• A complying presentation is one in which
• 1. the seller delivers all of the required documents,
• 2. within the time allowed for presentation and prior to the expiry date of the credit,
• 3. containing no discrepancies, and
• 4. which complies with all other terms of the letter of credit, the provisions of the UCP, and standard banking practices.
• The nominated bank, usually in the seller’s country has been appointed or “nominated” by the issuing bank
to honor the documents. The nominated bank is often the advising bank that originally transmits the
documents to the seller.
• If no bank is nominated, then the letter of credit is said to be “freely available” and can be negotiated
through any bank of the seller’s choice.
• Article 14(c) of the UCP requires, in most cases, that presentation of the documents be within 21 days of the
date of shipment (determined by the date of the bill of lading) and before the expiry date stated in the
credit.
• Documents will be refused for late presentment unless waived by the buyer.
EXAMINATION OF DOCUMENTS FOR
DISCREPANCIES
• If the seller’s presentation complies, the nominating bank will purchase the seller’s documents and honor the draft. If the credit
calls for payment on sight, the nominated bank will honor and pay the seller’s draft on sight. If the credit calls for payment of the
draft at some other time, the nominated bank will honor the draft by acceptance.
• However, if the seller’s documents do not comply with the terms of the letter of credit or if they contain irregularities or
discrepancies, the documents will be held pending instructions from the buyer or rejected by the banks. If the bank purchases
noncomplying documents, it cannot seek reimbursement from the buyer.
• Article 14(b) of UCP 600 gives banks up to five banking days to examine the seller’s documents to determine if they conform to the
requirements of the letter of credit, or if they contain any discrepancies or irregularities.
• A discrepancy is any difference, no matter how minor, between the terms of a required document and the terms required by the
letter of credit.
• The discrepancy may be caused by some wording or data in a document that is not exactly what was required in the credit.
• The seller’s documents and letter of credit are literally put side by side and compared by a bank’s Professional document checker.
Each term in the documents is matched to the requirement of the letter of credit. For instance, a discrepancy exists if the quantity
or description of the goods in the invoice does not match that in the credit, if the bill of lading is dated later than required, if any
documents are missing, or if they show signs of fraud, forgery, tampering, or missing signatures.
• A bank may not try to interpret the wording of a document. The UCP permits banks only to examine the documents “on their face”
to see if they comply with the letter of credit or if there is a discrepancy. Banks may not look to any outside sources or conduct any
independent investigation to see if the seller’s shipment to the buyer is in good order. It is the documents alone that must be in
good order and compliant with the letter of credit.
COMMON DISCREPANCIES FOUND IN
DOCUMENTATION
• Bill of Lading/Air Waybill • Insurance Policy
• Incomplete set of bills (originals missing) • Description of goods differs from invoice
• Onboard notations not dated and signed or initialed • Risks not covered as required by the letter of credit
• Time for shipment has expired • Policy dated after date of bill of lading
• Unclean bill of lading shows damage • Amount of policy insufficient
• Indorsement missing • Certificate or policy not indorsed
• Evidence of forgery or alteration • Certificate presented instead of policy, if required in letter of credit
• Does not show freight prepared if required under the letter of credit
• General Discrepancies
• Description of goods differs substantially from letter of credit
• Letter of credit has expired
• Name of vessel differs from one required
• Letter of credit is overdrawn
• Shows partial shipment or transshipment where prohibited by the letter of
credit • Draft and documents presented after time called for in letter of credit
• Incomplete documentation
• Draft • Changes in documents not initialed
• Draft and invoice amounts do not agree • Merchandise description and marks not consistent between documents
• Draft does not bear reference to letter of credit
• Evidence of forgery or alteration • Commercial Invoice
• Draft not signed • Description of goods does not conform to description in letter of credit
• Maturity dates differ from letter of credit • Does not show terms of shipment
• Currency differs from letter of credit • Amount differs from that shown on draft
• Amount exceeds limits of letter of credit
• Weights, measurements, or quantities differ
THE COMMERCIAL INVOICE
• Buyers, banks, and customs authorities require the commercial invoice in every international sale.
It must be made out by the seller and addressed to the buyer and be in the same currency as the
letter of credit. It need not be signed, notarized, or verified, unless the credit requires.
• Where a commercial invoice is required, a preliminary “pro forma” invoice will not be accepted.
• Perhaps the most important requirement is that the description of the goods in a commercial
invoice must correspond to that in the credit. Most courts hold that the description must be
exactly the same.
• Where bulk items are involved, the invoice should be for the quantity of goods ordered, or within
5 percent of the amount specified in the credit. However, the 5 percent rule does not apply to
letters of credit covering a specific number of items or packages.
• In such a case, the amount of the invoice cannot exceed the amount of the letter of credit.
• For example, a seller may ship and bill for 5 percent more grain than was ordered, but not for
more cases of soft drinks, or tractors.
THE OCEAN BILL OF LADING
• For transactions in which the letter of credit calls for presentment of an “on-board” bill of lading,
the seller must present to the issuing bank a bill of lading showing the actual name of the ship
and containing the notation “on board,” to indicate that the goods have been actually loaded.
• Where the buyer and seller have agreed, and where it is approved in the letter of credit, it is
acceptable for the bill of lading to show that the carrier has received the goods for shipment (but
are not yet loaded on board). The dates of receipt or loading must be shown. The seller must
present the original bill of lading, and if it was issued in a set of more than one original, then all
originals must be presented.
• When all originals are present, this is known as a full set. The bill of lading must be dated within
the time set in the credit for shipping. It must show the name of the carrier and be signed by the
carrier’s agent or ship’s master. It must state either that the goods have been taken in charge for
shipment, or that they were shipped “on board.” It must be a “clean” bill—one that has no
wording or notations indicating that damage to the goods or packaging was apparent or visible at
the time of loading.
• In transactions where the seller has agreed to arrange and pay for the cost of international
freight, the bills of lading must be marked “freight prepaid.”
• Similar requirements exist for road, rail, inland waterway, or air transportation.
THE INSURANCE POLICY
• The insurance policy should be of the type and coverage required by the
letter of credit, and in the same currency and in the amount specified in
the credit or, if none is specified, in the amount of the invoice, plus 10
percent.
• It should be effective on or before the date of the bill of lading to show that
the goods were insured during loading.
• The policy itself should be used; alternatively, a certificate of insurance may
be used unless a certificate is not permitted by the letter of credit.
• Companies that have open policies that “float” over many shipments use
declarations. They must be signed by an agent for the company. Cover
letters from agents are not acceptable
CERTIFICATES OF ANALYSIS OR INSPECTION
• Although certificates of analysis or inspection are not required for letter of credit
transactions, they are common and deserve to be mentioned.
• Frequently, a buyer requires the seller to submit documentary proof of inspection
from an independent inspection firm.
• A seller may require submission of a certificate of inspection for merchandise, a
certificate of laboratory analysis, or a certificate of compliance with health,
safety, or technical standards from an approved testing lab.
• Analysis or inspection certificates can be required for almost any product, such as
an inspection of the sewing quality of blue jeans, an analysis of the mold content
of grain, or a laboratory analysis of the lead content of the paint on children’s
toys.
• Sellers should ensure that certificates they include with their documents meet all
the terms the letter of credit requires.
THE RULE OF STRICT COMPLIANCE
• The prevailing standard established by the courts for examining documents
is found in the rule of strict compliance. According to this view, the terms
of the documents presented to the issuing bank must strictly conform to
the requirements of the letter of credit and the UCP.
• Some typographical errors are excusable, of course. But the thrust of the
rule is that every provision of the bill of lading, invoice, insurance policy,
and any other required shipping documents must match the letter of
credit.
• Even a small discrepancy can cause the bank to reject the documents.
• The reason for such a harsh rule is simple: it relieves bankers from the duty
of interpreting the meaning of the discrepancy or its possible impact on
their customers, and it relieves them of the liability of interpreting it
incorrectly.
UCP 600 RULES ON COMPLIANCE
• The general principles of letter of credit law that we have discussed up to this point have been developed by
courts in countries around the world. Often, these decisions are based on the courts’ interpretation of the
UCP because the UCP contains its own standards for gauging when documents comply with the letter of
credit.
• Article 14(d) of UCP 600 takes a modified strict compliance approach by stating that, while “data in a
document” (here “data” means such things as the description of the goods, names of the parties, quantities
and weights, addresses, and similar relevant terms) does not have to be “identical” to other data in the same
document, or to data in any other required document, or data in the credit itself, it may not conflict with it.
• The UCP has specific provisions regarding the description of the goods—one of the key terms in any letter of
credit. The UCP states that a document (other than an invoice) may describe the goods “in general terms not
conflicting with their description in the credit.”
• However, the rule of strict compliance is retained in Article 18(c) with regard to the invoice, which states,
“The description of the goods … in a commercial invoice must correspond with that appearing in the credit.”
• The UCP also requires that the name, address, and contact details for the consignee or notify party on the
transport documents must appear exactly as in the letter of credit.
• Thus a warning to export managers and to bankers who advise them: Be certain that you describe your
goods in your invoice in the exact wording and form that is used in the letter of credit. Be consistent in your
data throughout all documents, and conform your data and wording to that used in the credit itself.
ENJOINING BANKS FROM PURCHASING
DOCUMENTS IN CASES OF FRAUD
• Letters of credit are independent of the underlying sales contract. An issuing bank is responsible only for the seller’s documents
and is not concerned with the quality of the goods or whether the seller shipped the correct goods. If the goods are defective or
nonconforming, the buyer’s remedy is against the seller for breach of contract.
• What if the buyer’s problem is not that the quality or condition of the goods is defective, but that he or she has fallen victim to a
fraud or a scam? What good would a breach of contract suit be against the perpetrator of a fraud who disappears with the cash?
• To address these situations, a partial exception to the independence principle exists where documents presented by the seller (the
beneficiary of the credit) are fraudulent, or forged, or if fraud in the transaction exists in the underlying sales contract.
• For instance, suppose that the buyer in a letter of credit transaction learns, almost too late, that the purported bill of lading is
actually a fake, that no ship or carrier by that name exists, and that the goods the buyer was awaiting do not exist. Here the issuing
bank would be justified in refusing to pay for fraudulent documents.
• Similarly, consider the case where an unscrupulous seller places worthless junk into a sealed ocean container and delivers it to an
ocean carrier, obtains a bill of lading, and presents it to the issuing bank for payment under a letter of credit. Here too, the issuing
bank would be justified in dishonoring the letter of credit because of fraud in the transaction. Of course, banks do not want to
refuse documents without cause (especially where they have already been purchased by a nominated bank that is looking for
reimbursement). After all, their international reputation is at stake, and no bank wants to be known for refusing to honor its letters
of credit. One solution that will preserve the reputation of the bank is for the buyer to obtain a court injunction stopping the bank
from honoring its letter of credit.
• The UCP is silent on the question of when a court may enjoin a letter of credit for fraud. This is left to the law of individual
jurisdictions.
CONFIRMED LETTERS OF CREDIT
• In most cases, a letter of credit is adequate assurance for payment. In certain instances,
however, a seller may want an additional layer of security. Where a seller is uncertain
about the soundness of an issuing bank in a foreign country, or of the integrity of the
banking system there generally, or the stability of the government, the seller may want
to request that a bank in its own country confirm the letter of credit.
• A confirmed letter of credit is one in which a second bank, usually in the seller’s country,
agrees to purchase documents and honor drafts on the same terms as the original
issuing bank.
• Suppose a seller is shipping to a country that has a shortage of foreign currency, large
foreign debts, and a poor balance of payments record. It is always possible that foreign
government currency restrictions, imposed between the time the contract is agreed to
and the time the drafts are tendered for payment, could prevent the issuing bank from
honoring its letter of credit in dollars. A letter of credit confirmed by a bank in the seller’s
country will ensure prompt payment regardless of financial or political instability in the
country where the issuing bank is located.
STANDBY LETTERS OF CREDIT
• A standby letter of credit (also called a standby credit, or simply a standby) is one in which the issuer is obligated to pay a
beneficiary upon the presentation of documents indicating a default by the account party in the payment of a debt or the
performance of an obligation. The documents might be as simple as a notice of default by the account party, signed by the
beneficiary, and accompanied by a demand for payment.
• A standby letter of credit is a backup payment mechanism that the parties hope they will never have to use. It can be used to
guarantee performance under a service or construction contract, to guarantee repayment of a loan, or as security for almost any
other type of contract.
• The standby works much like the “performance guarantee” used by banks in other countries (or the “performance bond” in the
UK) but is legally different. A standby is subject to the International Standby Practices (ISP 98), a set of rules and standards
published by the International Chamber of Commerce.
• A standby letter of credit is flexible and can be tailored for almost any use. Most are used in large, complex transactions.
• Assume that a construction firm enters into a contract with a foreign government to construct a public Works project. The
government wants assurances that the firm will complete the work as promised by being named as beneficiary of a standby credit.
The credit could be payable upon the government’s presentation of a written demand for payment and a notice of default to the
issuing bank stating that the construction firm has failed to complete the required work in the manner and within the time called
for in the contract.
• In the sale of goods, a standby can be used in lieu of a conventional letter of credit. Assume that a seller agrees to grant 30-day
open account terms to a buyer. In a standby credit, the bank is “standing by” as a backup, ready to purchase the documents if the
buyer does not remit payment within 30 days. A standby can also guarantee the seller’s performance, that is, that the seller will
ship conforming goods within the time called for.
OTHER SPECIALIZED USES FOR LETTERS OF
CREDIT
• Transferable Credits
• International traders usually use transferable credits.
• Traders buy and sell goods in international trade quickly and with no view to actually using
the goods themselves.
• Red Clauses in Credits.
• The red clause is a financing tool for smaller sellers who need capital to produce the products
to be shipped under a letter of credit.
• A red clause in a letter of credit is a promise (usually written or underlined in red ink) by the
issuing bank to reimburse the seller’s bank for loans made to the seller.
• The loan, then, is really an advance on the credit. Loans can be used only for purchasing raw
materials or for covering the costs of manufacturing or shipping of the goods described in the
credit.
• Ultimately, the liability will fall on the buyer if the seller defaults on shipment or repayment
of the amounts taken under the credit.
• This form of financing is risky for the buyer and its bank.
OTHER SPECIALIZED USES FOR LETTERS OF
CREDIT
• Revolving Credits and Evergreen Clauses.
• When a buyer is planning on purchasing from a foreign seller on a regular basis, the buyer may use a revolving letter of
credit.
• Instead of having to use several different credits, one may be used with a maximum amount available during a certain
period.
• As the draws against the credit are paid, the full amount becomes available again and continues until the expiration of the
credit.
• An evergreen clause provides for automatic renewal of the letter of credit until the bank gives “clear and unequivocal” notice
of its intent not to renew.
• Back-to-Back Letter of Credit Financing
• A back-to-back letter of credit is a special type of financing arrangement in which the proceeds of one credit serve as
security to obtain a second credit.
• It might be used where a manufacturer or other exporter has a contract to sell finished goods to a buyer but needs financing
to purchase needed component parts or raw materials from a supplier.
• The exporter, as beneficiary of a letter of credit from its buyer’s bank, can assign the proceeds of that credit to its bank as
security for a separate letter of credit being issued to the exporter’s supplier.
• Thus, a back-to-back credit is really two credits, one issued in favor of the exporter that serves as security for a second issued
in favor of the exporter’s supplier.
• Many banks will issue the second credit only if they had issued the first one (known as a countercredit).
• Back-to-back credits are also used as a financing arrangement by traders with minimal capital resources.
ELECTRONIC DATA INTERCHANGE AND THE
eUCP
• Like funds transfers, letters of credit have been issued and transmitted to advising banks electronically for
many years (and from advising bank to beneficiary usually by mail).
• The use of electronic documentation has increased over time, and beneficiaries are presenting documents
electronically to banks for payment.
• In 2002, the International Chamber of Commerce published the eUCP, a set of rules that extends the UCP to
electronic documents.
• When documents are submitted electronically, eUCP rules apply by agreement of the parties.
• The eUCP addresses the format for electronic documents (the rules are flexible and include signed e-mail
attachments or secured transfer), authentication and digital signatures, transmission errors, the manner of
presentation, and other issues.
• Bolero is a technical infrastructure created by the world’s banking and logistics firms for exchanging
electronic documents in a common format, including bills of lading, letters of credit, and other bank
documents.
• Identrus is a private company founded by a small consortium of the world’s largest banks to provide secure
“digital identities” or signatures for confidentiality and authentication of financial and legal documents.
• Both Identrus and Bolero represent technological innovations necessary to move the centuries-old banking
and shipping industries to the paperless age
CONCLUSION