Revocable LC goes stealth under UCP 600

It is interesting to note that the concept of ‘revocable’ has no longer exists in UCP 600 where LC now is considered to be irrevocable to further strengthen the doctrine of ‘undertaking’. This has been highlighted in few of articles:

Article 2, “Credit means any arrangement, however named or described, that is irrevocable…”.

Article 3, “A credit is irrevocable even there is no indication to that effect.”

Article 10, “…a credit can neither be amended or cancelled without the agreement of the issuing bank, the confirming bank, if any and the beneficiary…”

These articles provide a guarantee to the seller that in any event, should the buyer wish to cancel the LC that has been issued, several parties must also agree to the said cancellation; issuing bank, confirming bank if any, and the seller. In another words, if the LC is to be cancelled, all parties must be aware of it and agree to it. In the absence of such cancellation notice and agreement, the undertaking of the bank to pay, shall stand in effect. The seller need not worry about getting paid and the buyer need not worry about making payment for his purchase.

So, premised on the above, trading parties especially the sellers, can be said to be in a safe harbour.

The question now is, is irrevocability an ultimatum? Is revocable LC no longer an option because the word ‘revocable’ has been totally deleted from the revised UCP?

The very beginning of UCP 600, Article 1, which reads “The Uniform Custom Practice for Documentary Credits, 2007 Revision, ICC Publication no. 600 (“UCP”) are rules that apply to any documentary credit (“credit”)(including, to the extend to which they may be applicable, any standby letter of credit) when the text of the credit expressly indicates that it is subject to these rules. They are binding on all parties thereto unless expressly modified or excluded by the credit.”

Firstly, this article says that all parties are bound by UCP 600 when the text of the credit expressly indicated that the LC is subject to these rules. Secondly, this article does not prohibit modification to any of the articles.

Finally, this article also does not prohibit exclusion parts of the articles. This article gives us an understanding that irrevocability of an LC is not an ultimatum as it allows and provides room for revocable LC to operate. It is therefore very important for seller and buyer to fully understand the implication of this article to avoid financial loss. The contract of sales should be expressly stated that the LC is subject to UCP 600 and INCOTERMS 2000. If, however, both parties agree to modify or exclude certain article or rules, this must also be expressly stated in the contract of sale to avoid further dispute.

Principle of Autonomy

If the seller ships the goods which are not up to the buyer’s expectation, can the buyer get the bank to cancel payment under LC? For example, the letter of credit says, ‘milk powder grade A’ but seller shipped ‘milk powder grade B’. Can the buyer instruct his bank to stop payment of the LC which has been issued to the seller?

Letter of Credits are separate contract from contract of sale and other contracts existing which bind the parties involved in an international trade transactions. This is clearly stated under article 4 and article 5 of UCP600. LC is only concern with payment and absolutely has nothing to do with goods.

The dispute in any of these contracts shall not form grounds for non-payment of an LC. Regardless of any disputes, seller is still entitles to payment under LC. Disputes between parties should be settled by litigation or arbitration or otherwise as stipulated in the contract. This principle is clearly emphasized in one of the popular cases, Hamzeh Malas & Sons v. British Industries Ltd.

The plaintif, a Jordanian firm, had contracted to purchase from the defendant, a British firm, reinforced steel rods to be shipped in two instalments. Payment was to be effected by way of two LCs. The first instalment was delivered and payment was obtained by the seller. The plaintiff then complained that the first instalment was defective and sought to enjoin the defendant from drawing under the second LC.

The court commented:

“…the opening of a confirmed LC constitutes a bargain between the banker and the vendor of goods, which imposes upon the banker an absolute obligation to pay, irrespective of any dispute there may be between the parties as to whether the goods are up to contract or not…A vendor of goods selling under the insurance that nothing will prevent him from receiving the price…”

Based on the judgment passed by the court of law, it is important to understand that in LC transaction, payment is 100% guaranteed but it is not an undertaking to guarantee the goods.

Doctrine of strict compliance

If the problem of interpretation of strict compliance is regarded from importer´s, exporter´s and banker´s view, it will lead to different results. The interest of the exporter can be easily determined: he wants to receive payment against the documents, even there are (relevant) mistakes.

So, an exporter will plead for the substantial compliance which offers more tolerances to him. A bank is interested to receive its charges and commissions without or with little risk. On the other hand, it must keep its reputation which can hardly been reached if every irrelevant mistake will lead to an obligation to refuse payment.

So, the interest of a bank is to make decisions on its own. For it, the literal compliance in a wider sense offers the best possibilities: obvious typographical errors do not lead to an obligation to refuse; on the other hand it can refuse payment in cases of doubt and is not obliged to examine the documents materially or finds itself as an arbitrator between applicant and beneficiary with the risk that it pays, but is not reimbursed and must lead a process.

Regarding the importer, it is not easy to say what interpretation of strict compliance he would prefer. Of course, he would not prefer the substantial compliance because it would lead to additional risks for him if his stipulations were not exactly fulfilled and the bank took up the documents in the belief that they are substantial equal. In such a case, a huge process risk would occur for him if he refused to pay the bank. But also it is not quite clear if the strict literal compliance offers more flexibility for him: the chance to give instructions to the bank if there are typographical or irrelevant errors make it possible to exploit the situation and claim new negotiations about the price with the beneficiary.

On the other side, a situation can occur when a bank has got own interests like financing the goods by credit: in such a situation, exporter and importer perhaps both want the sale contract to be fulfilled even there is an irrelevant error, but the bank refuses to pay because for example, the interest rates for a credit have been raised or because the credit-worthiness have been changed. So it is more secure for the importer if strict compliance is interpreted as wide literal compliance.

UCP 600

Effective July 2007, UCP 500 will be no longer effective in governing the application and operations of Letter of Credit. UCP 600 will be the new governing set for all parties concerned; bankers, traders, transport operators, insurance companies, lawyer etc.

One of the major changes is article 14(b). This new article defines the number of days required to hold the documents for processing or examining by banks. The ‘reasonable time’ in article 13(b) of UCP500, as expected, has been eliminated and replaced with a definite 5 banking days in UCP600. Now, the issuing bank, nominated bank or confirming bank (if any) shall each have a maximum of 5 banking daysto process, examine and determine whether the documents are in compliance with the terms and conditions of the LC. If the documents are to be rejected, the notice to this effect must also be made within this new time frame.With this new change, trading parties, buyer and seller can expect faster payment.

In addition to this, articles 16(c)(iii)(a) and 16(c)(iii)(d) provide comfort to the seller where seller has a control over the discrepant documents.In the event the bank refuses the documents due to discrepancies, it will hold the documents pending further instruction from the presenter on how to dispose the documents. Seller may also provide such instruction at the time of tendering documents to his bank. In this condition, even if the bank has decided to refuse payment, the bank somehow will act in accordance to the instruction given by the presenter. The bank either waits for the instruction from the presenter while waiting for the buyer to waive the discrepancies or acts accordingly to the instruction given by presenter on the covering schedule. This new article however may expose buyer to a new threat or rather create an opportunity to the seller when dealing with commodities. When price has appreciated and documents are discrepant, seller may not want to release the documents to the buyer.

Some of the technical problems

If exporter load the container after “latest date of shipment” but within the expiry date and also submit the documents before expiry of 100% sight Letter of credit, what is the security of exporter shipped consignment amount is he secure?Is it possible importer quit the L/C?


Shipment made after the latest shipment date indicated in the LC is considered a discrepancy, which is late shipment. In this regards, bank will refuse payment. When bank refuses payment, normally, the issuing bank will notify the buyer whether or not the buyer will accept the rejected documents. If, subsequently the buyer accepts the rejected documents, bank will effect payment. I don’t get the meaning of ‘quit’. If it means cancellation, it is not possible for the buyer to cancel the LC if it is an irrevocable LC. But, if it means ‘reject’, yes the buyer may reject the documents and shipment. When this happens, the bank will return the documents to the seller. The seller has to arrange to dispose the cargo to another party.

Second condition is that in the L/C partial shipment allowed and importer paid one container payment. Is it possible importer quit another container and doesn’t not collect the documents therefore his bank received the second container documents.3- If in L/C partial shipment allowed exporter sends the 1st container and also send documents to his bank is it possible he collect the documents and get this container, other container on transit.

If either party would like to cancel the irrevocable Letter of Credit, he must obtain a consent form the issuing bank, confirming bank (if any) and trading party. The issuing bank, having issued the LC is bound to honour its payment undertaking whether or not the goods are in conformity to the Sales contract.

Characteristics

Credit function

The documentary credit, even it contains the word credit, is no credit in the sense of law, but still today in times of strict separation in law exists an important economic connection between letters of credit and credit transactions. Both, importer and exporter possibly needs financing for buying or producing goods, and both can be debtors or creditors to each other regarding the terms and conditions for payment. But also the banks which are involved in the letter-of-credit-transaction can be creditors next to the letter of credit.

The issuing bank could finance the price of the goods and receive the money back after sale of the goods in the home market of the importer. The bank of the exporter on the other side could finance the production of the goods in the expectancy that it receives the money back after handing-over of the documents.

A documentary credit makes it easier for banks to finance goods. In the case of an acceptance letter of credit, when a draft was signed by the issuing bank, the exporter can also sell this bill of exchange at a discount to a bank and receive immediately money instead of waiting. He needs not to finance over a long period.

Security function

If there is no reliance between exporter and importer, if they do not know each other, the seller requires security for payment. It is hard possible to claim the payment in the state of the importer.

A letter of credit is called “child of distrust between seller and buyer”. It secures the change of the performances of buyer and seller. The importer can be sure that the exporter only receives a payment if he proofs his delivery in accordance with the contract through handing-over of documents to the bank and the exporter on the other side, can be sure that he receives payment if he handed over the documents.

The contract parties are secured against solvency risks of the other side because the letter of credit makes it possible to match payment with delivery what else would be impossible. There is nearly no economic risk for the exporter. The stipulated documents can be a security for financing banks because the goods are at their disposal. In the case of an acceptance credit, the exporter can not only rely on the reputation of the bank and its promise to pay; a bill of exchange is also independent from other contracts and offers therefore and because of its binding to strict forms and rules security. The bank, if it financed goods for the importer, receives by the documents the shipped goods as security. If a letter of credit lapsed because of wrong documents or documents not presented in time, the seller could still insist on payment because of the sale contract.

A letter of credit is a second performance additionally, but not instead, of the first one. Some political risks for the exporter can be avoided by an irrevocable, confirmed letter of credit. Measures of government like a moratorium or restrictions in conversion of currency in the importer´s country do not cause losses to the exporter if he can claim payment from a bank in his own state. Currency risks caused by governmental measures can be reduced if the letter of credit is issued in a free floatable currency.

But of course, letters of credit cannot avoid of all risks: transport risks can be covered by special transport insurance, currency risks resulting from floats can be avoided with special bank transactions on the currency market like derivative currency transactions, for example swaps or currency options. Also it is possible to fix the currency rate in the contract.

One of the main risks a letter of credit cannot avoid is that a fraudulent seller delivers documents which appear clean, but delivers rubbish or goods not in accordance with the contract.

Beneficiary's veto power?

Compliance documents or now known as compliance presentation is still be the nucleus in making a payment by banks. Article 2 states that “…Credit means any arrangement, however named or described, that is irrevocable and thereby constitutes a definite undertaking of the issuing bank to honour a complying presentation”

Undertaking of the bank to pay is absolutely based on documents that comply with the terms and conditions of the LC. It is therefore, an obligation of the banks; the nominated bank, issuing bank or confirming bank, if any, to examine and check on the basis of the documents alone, whether or not they appear on their face to constitute complying presentation. This includes type of documents, number of copy, original or photocopies, issuer of a document as well as the data in a document to ensure they are consistent with each other and not to conflict with the LC. However, this does not include documents presented but not required by the LC.

What happens when the presentation is found not in conformity?

Article 16(a) says that “…when a nominated bank acting on its nomination, a confirming bank, if any or the issuing bank determines that a presentation does not comply, it may refuse to honour or negotiate”.

Article 16(b) further states “when an issuing bank determines that a presentation does not comply, it may in its sole judgment approach the applicant for a waiver…”

In the event the documents are discrepant, the bank can either:

1. refuse to take up the documents or;
2. refer to applicant for a waiver

These two options are still maintained in UCP 600 and has been the practiced for banker worldwide. What UCP 600 differs greatly from UCP 500 is the manner of refusal of discrepant documents (article 16(c)(iii)(b)).

Previously, in UCP 500, refusal of discrepant documents should not be subjected to or pending acceptance of a waiver from the buyer. This was not construed as a refusal. Refusal of this manner is considered as a bad practice and strongly discouraged.

However, drafters of UCP 600 now has interpreted differently where refusal of discrepant documents can be subjected to or pending acceptance of a waiver from the buyer. Not only this, the seller, now is given the privilege to issue instruction on how the documents should be disposed off (articles 16(c)((iii)(a), (b) and (d)). It is understandable, after going through all the articles in UCP 600, it is drafted with a main focus given to the users; traders, transport operators, insurance companies etc. with a view to reduce discrepant documents and upholding a concept of ‘payment mechanism’ of the LC. This article in particular, is seen to provide a safety cushion and more comforting to the seller instead of the buyer.

LC: Globalization

The catchword “globalization” is in public discussion often used for the closed link between the national economies. Since beginning of 1990ies, “globalization” is also used for the general increase of economic interdependence which is caused by liberalization of trade in goods, services and capital markets and by improvement of worldwide transport-infrastructure and revolution in communication and information technologies, but no general definition exists. Important for globalization is the integration of capital markets and of trade of goods, which today is in an advanced stadium. Globalization started with colonization and the process went faster with invention and development of communication and transport. A normative background has been reached with the elimination of trade barriers, caused by GATT, and the creation of an international currency system in our times.

The victory of constitutional and democratic states and market economy have been catalysts of globalization process. 70% of world trade is between industrialized states. But policy in the époque of globalization also tries to fight against poverty and to find a global structure policy for active creation of globalization. The future will show if policy will fail or have success, but it is still today quite clear that therefore trade with developing countries will increase. So the share of developing countries in global merchandise exports and imports jumped by six and five percentage points in the years 1990 – 2001; exports from those countries reached 30% of all exports, imports reached 26% of the whole world imports; also the trade between developing countries increased by 12% a year, twice as fast as global commerce generally.

History of Letter of Credit

Understanding the nature of letters of credit as an international financial device and the reason why they have become widely used by merchants all over the world requires us to find out its historical origins.

Some scholars believe that the origins of letters of credit go back to ancient Egypt and Babylon, which had an adequate system of banking. A clay promissory note of Babylon dating from 3000 B.C., is exhibited in the University Museum of Philadelphia, USA, which provided for repayment of an amount and the interest on a specific date.

Another discovery is an evidence of an obligation made in 248 B.C. in Egypt “for the repayment, in wheat, or upon default double its value, of a loan of money from one Zenon, which ends with ‘and the right of execution shall rest with Zenon and the person bearing the note on behalf of Zenon". It is also verified that banks of ancient Greece prepared letters of credit “on correspondents with the view to obviating the actual transport of specie in payment of accounts”.

With the collapse of the Roman Empire the role of the banks as well as the great extent of commerce between trading nations diminished. It was not until the 12th and early 13th century that banks in Genoa, Venice, Florence and other European cities were re-established. At this time merchants had to face two major problems:

(a) travelling with gold was very dangerous; and
(b) commerce generated currency that was not sufficient to satisfy the needs of traders.

The earliest devices with which merchants tried to solve these problems were with the bills of exchange and letters of credit. In their early history these payment instruments operated in a very similar way, and letters of credit were used to supplement the bills of exchange. There are scholars who believe that their development in Europe was inspired by the discoveries made by Marco Polo in the 13th century who reported the use of currency and other negotiable documents in China, concluding that such a measure was one of the reasons for “the ways and means by which the Great Chan can have and indeed does have more treasures than all the kings in the world”.

In any case, it was impossible to conduct commerce via caravan without some sorts of documentary letters. To explain their early operation Professor Dolan gives the following example:

“… a Florentine merchant who bought wool from an Amsterdam merchant could issue a bill of exchange to the Dutch merchant’s agent in Florence directing a third party (the drawee) to pay the sum due for the wool. The agent, having taken the bill in payment for the wool, could travel across Europe or by sea to a commercial center, where he would meet the drawee and ask the drawee for payment.The drawee would pay the draft either

(1) in gold (though such payment would be rare);
(2) by “clearing”, that is, by setting the draft off against sums due from the Dutch merchant on other drafts; or
(3) by accepting the draft and returning it to the agent.

In the third case, the holder had a readily marketable instrument, which he could use to trade or which he could take with him to other commercial centers. He could do so armed with the knowledge that such “currency”, while valuable to merchants, was of little value to the brigands who stalked the highways and the pirates who sailed the seas. It did not take long for some enterprising merchant, whose paper was suspect, and, therefore, subject to heavy discount or to outright rejection in the trade, to strengthen his bills by obtaining the drawee’s announcement that he, the drawee, would pay or accept the bills. The announcement was a letter of credit.”

De Roover also refers to letters of credit used by the Medici Bank in Bruges and in Italy between 1385 and 1401. The various provisions of the letters are strikingly similar to those of the modern letters of credit. They stated for example that

(a) payments are to be made as requested by a named beneficiary
(b) the payments could not exceed a specific sum
(c) the payor shall obtain receipts from the beneficiary
(d) the payment shall be charged to the account of the issuer with the payor; or
(e) upon receipt of a written notice from the payor that the amount has been paid, the issuer shall credit the payor’s account accordingly.

By the 17th century letters of credits were common financial instruments both in the European continent and in England. At this time they functioned more like a traveller’s cheque.

By the 19th century British banks had a virtual monopoly on the issuance of letters of credits. This was due to the fact that in world trade the Pound Sterling was the most accepted currency and the bankers of London gained a pre-eminent position in the field of international finance.

In the United States letters of credit emerged from the “competition of factorage houses for business, which led to the issuance of promises to accept drafts against shipments”. The growing number of manufacturers and their relationships with foreign traders, the specialization of banking activities and the technological development such as the more frequent use of telegraph for communicating the terms of the contracts facilitated the increasing use of letters of credit.

On the other hand, letters of credit were not used exclusively by merchants. The outbreak of World War I broke the well-established and trusted trading links that had existed between the merchants worldwide. In order to keep on trading, merchants were forced to create new links with firms often unknown or not trusted. These circumstances were favourable for the extensive use of letters of credit which invited a trustworthy paymaster, a bank, into the merchants’ relationship. By the 1950s letters of credit had earned a predominant position in domestic commerce of the United States and were also widely used in international transactions.

Since World War II the use of letters of credit in world trade remains steadfast. Although from time to time the emergence of alternative means of trade finance overshadows the use of the letter of credit, it has “proven to be a flexible instrument, which can be readily attempted to the needs of changing conditions in international trade”. In a world of shrinking distances and increasing trade there will be a continuing need for such a highly reliable and flexible means of payment and financing.