Collections: Collection Instructions

When the seller presents the relative documents to the remitting bank for collection of proceeds, the documents are invariably accompanied by a covering schedule in which the seller fills the relevant details as to the name of the drawee, nature/type of documents and instructions on the disposal of the documents and collection of the proceeds, known as a Collection Instruction. For standardization and ease of reference, and to prevent misunderstanding, thereby leading to inconvenience and complications, the seller is required to complete the standard Collection Instruction furnished by the remitting bank.

The seller is required to give full and clear instructions in the Collection instruction to the remitting bank to avoid unnecessary misinterpretation, inconveniences and enquiry which would result in delays. The following points should be noted:

1. The full name and address of the buyer/drawee should be correctly stated
2. The seller should correctly stipulate the following in the Collection instruction:
a. The tenure (Sight/Acceptance), the reference number, date and value of the Bill of Exchange
b. The nature and number of copies of the relative documents in the form of commercial invoice, insurance policy, certificate of origin, bill of lading or multimodal transport document or etc
c. How the documents to be released to the buyer/drawee that is whether against payment or upon acceptance of the bill of exchange
d. The name of the presenting bank in the country of the buyer to present the documents, other than the remitting bank’s correspondent/agent bank, if it is so required by the seller or buyer

Besides the above mentioned, generally the Collection instruction contains a set of standard instructions with appropriate boxes for the seller to mark and with extra boxes for the seller to include other additional specific instructions, where appropriate. Listed below is a typical list of such instructions:

1. Release documents against payment
2. Release documents against acceptance
3. Payment may be deferred until arrival of goods
4. Acceptance may be deferred until arrival of the goods
5. Collect all charges and expenses from drawee
6. Waive charges/expenses if refused by drawee
7. Collect interest at the rate of…….% from the drawee from…….until………
8. Advise Acceptance and due date by airmail/telex/SWIFT
9. Advise Non-Acceptance by airmail/telex/SWIFT
10. Remit proceeds by airmail/telex/SWIFT
11. Advise Non-Payment by airmail/telex/SWIFT
12. If dishonoured by non-acceptance/non-payment, please protest
13. If dishonoured by non-acceptance/non-payment, please do not protest
14. In case of need, refer to…………, who will assist in securing payment, but who has no authority to amend the bill or terms of payment
15. If documents are not taken up on arrival of carrying steamer, please arrange for goods to be stored in bond and insured, under advise by airmail/telex/SWIFT to us
16. Other specific instructions, where deemed appropriate.

Collections: Documents against acceptance (D/A)

Under the documents against acceptance (D/A) the buyer does not have to pay immediately. The buyer is given a credit period. He only pays on the maturity date of the accepted Bill of Exchange, which may be 30 days, 60 days, 90 days later or even longer. This method offers greater flexibility to the buyer in his cash flow and liquidity management as by the time he is required to pay, he should be able to sell the goods and secure payment from his debtors.

Under this method, the seller is required to ship the goods first to the buyer. Upon shipment, the seller will obtain all the necessary documents like Bill of Exchange, Invoice, Bill of Lading (or other transport documents), Insurance Policy, Certificate of Origin and etc. He is also need to complete a collection order (furnished by his bank) with the appropriate instruction.

The documents then will be presented to his banker (Remitting bank) where the documents will be checked to ensure they tally with the collection order. These documents will be air couriered to the buyer’s bank (Collecting bank).

Upon receipt of the said documents, the collecting bank will present the Bill of Exchange to the buyer for acceptance. Acceptance means the buyer has to endorse on the back of the Bill of Exchange with a company seal. Upon acceptance, the Bill of Exchange will be returned to the collecting bank for safe keeping and the rest of the documents are delivered to the buyer to take possession of the goods.

The collecting bank will notify the remitting bank of the acceptance as well as the maturity date. On maturity, the collecting bank shall debit the buyer’s account and remit the proceeds via MT202 to the remitting bank.

What if the buyer fails to pay on maturity? In the first place, can the buyer refuse to pay under documents against acceptance? This is in fact the biggest risk faced by the seller under this method of payment. When the buyer refused to pay, the collecting bank will not pay the remitting bank which means that the seller will not receive his payment.

In this case, the seller has to resolve the problem with the buyer. The remitting bank and the collecting bank are only acting as an agent and can not enforce any legal avenue to obtain payment from the buyer. Collections is not governed by the UCP but by another set of rules known as Uniform Rules for Collections (URC).

Transferable Letter of Credit: Is It Really "Transferable?"

Letter of credit can be qualified in a number of ways and it is well recognized that a transferable credit is no different from any other apart from the fact that it enables the beneficiary of the credit to “transfer” the benefit to a third party. Where the credit itself is not stated to be transferable, no transfer of the credit is permitted because to do so would defeat the purpose of the credit.

The transferable credits are commonly used where the beneficiary contracts with a third party in order to obtain goods which are necessary to fulfill his obligations to the issuing bank’s customer. In such a case, the beneficiary will often be required to transfer the benefit of the credit to the third party in order to fulfill his obligations to that party.

Article 54 of UCP 400, Article 48 of UCP 500 and Article 38 of UCP 600, incorporated the relevant provisions relating to the transfer of a letter of credit. However, its interpretation has long troubled bankers, particularly with regard to the obligations placed upon the issuing or confirming banks.

A decision of the Privy Council considered this issue, and held that, although a beneficiary had the right to instruct the bank, which issued a transferable letter of credit, to make the credit available to one or more third parties, by Article 54(c) of UCP 400, no bank asked to transfer the credit was obliged to do so except to the extend and in the manner to which the bank expressly agreed. Furthermore, the designation of a letter of credit by the issuing bank as transferable was insufficient to constitute consent to a subsequent transfer request by the beneficiary.

The brief facts of the case were that Lariza (Singapore) Pte Ltd had agreed to sell crude palm oil to Bakrie Brothers (Singapore) Pte Ltd. It was a term of the contract that payment for the oil was to be made by means of a transferable irrevocable sight letter of credit to be opened in favour of Lariza, the opening of which was to be advised through the Bank of Canton Limited. In order to fulfill its agreement with Bakrie, Lariza entered into an agreement with Ban Lee oil Mill Co for the purchase of a corresponding quantity of crude palm oil which would be passed on to Bakrie. Payment of the Ban Lee contract was also to be made by an irrevocable sight letter of credit opened in their favour.

On 27 February 1980 (UCP 400 was in forced), a transferable irrevocable sight letter of credit was opened by Bank Negara Indonesia in favour of Lariza for the account of Bakrie and in due course Lariza requested Bank Negara Indonesia to transfer part of the letter of credit to Ban Lee, but the bank persistently refused to effect the transfer. As a result Lariza failed to perform its obligations under its agreement with Ban Lee and were sued by Ban Lee for damages for breach of contract.

Lariza subsequently brought an action against Bank Negara Indonesia claiming damages for breach of contract arising from the issuing and opening by the bank of the letter of credit. That claim was resisted by the bank, which contended that it was not under any obligation to effect the transfer of the letter of credit as requested by Lariza.

The case eventually reached the Privy Council , which held that under Article 54 of UCP 400, a bank which issued a transferable letter of credit could not, without more, be taken to have consented in advance to any request by the original beneficiary to transfer the credit to a third party. The consent contemplated by paragraph (c) of Article 54 was held to be a consent to effect the transfer to the particular extend in issue, and in that particular manner. Such a consent cannot be given in blanket form in advance, so as to apply to any request for transfer which may subsequently be made, whatever its extend or manner may be. Any consent given by the issuing bank must be an express consent which is made after the request by the beneficiary and it has to cover both the extent and the manner of the transfer requested.

It is submitted that if the view of the Privy Council is correct the whole purpose of the transferable letter of credit is effectively destroyed. A transferable credit should be transferable at the instance of the beneficiary and neither the issuing nor confirming bank should be able to refuse to transfer the credit, for otherwise the commercial purpose of such instruments would be defeated. Such restriction clause which appeared in UCP 400 and UCP 500 is still maintained in UCP 600 today.

Bank Guarantee: Part 2

Bid Bond (Tender Bond)
This guarantee is required in connection with public tenders. If a company participates in such a tender, it must submit a bid bond together with its offer. Bid Bonds therefore secure payment of the guarantee amount:

1. in the event of withdrawal of the offer before its expiry date
2. if the contract, after being awarded, is not accepted by the tenderer
3. if the bid bond, after the contract has been awarded, is not replaced by a performance bond

As a general rule, the guarantee amount is normally within 1% to 5% of the amount of offer. The validity period of the guarantee is until the signing of the contract or the issue of a performance bond, usually between three and six months.

Performance Bond
The bank undertakes, at the request of the seller, to pay the beneficiary the guaranteed amount in the event the supplier has not met or insufficiently fulfilled his contractual delivery obligations. The guarantee amount usually 10% of the contract amount. The bond remains valid for the full amount until complete performance of the contract. Where contracts for works and materials are concerned, this generally includes the warranty period for the correct functioning of a machine or system. The period of validity of performance bonds may be two years or longer.

Advance Payment Guarantee (Letter of Indemnity)
The terms of payment for major export orders generally stipulate that the buyer pays an installment for the purchase of raw materials and for the cost of production. However, such a down payment will only be agreed to by him after receipt of so called advance payment guarantee which ensures repayment of the advance by the seller in the event of non-performance of his contractual obligations. The amount guaranteed is 100% of the advance payment. In contrast to the performance bond, the advance payment guarantee should stipulate that the guaranteed amount be automatically reduced in proportion to the value of any partshipments made. A utilization of the related documentary credit is usually recognized as avidence of delivery. The validity of the advance payment guarantee should be limited in such a way that it expires on the date the covered performance is made.

The advance payment guarantee must usually be issued before prepayment is made, but should enter into force only after receipt of such payment. Therefore a clause to this effect should be included in the guarantee whenever possible.

Bank Guarantee

In international trade, it is difficult for the buyer to accurately assess the professional ability and financial position of a supplier or seller. The situation is worst when both parties are domiciled in different countries. The buyer therefore, quite rightly, demands that the seller’s ability to perform be secured and for this purpose a Bank Guarantee (BG) is arranged. In general, the use of the BG as an instrument for securing payment is restricted in international trade to non-payment guarantees used for the “open account” mode of payment.

A BG may be defined as the "irrevocable obligation of a bank to pay a sum of money in the event of non-performance of a contract by a third party". Similar to Letter of Credit, the guarantee is a separate obligation independent of the principal debt or the contractual relationship between the creditor and the principal debtor. Under the terms of the guarantee, the bank has to pay on first demand provided that the conditions contained in the guarantee are fulfilled. Guarantees are, as a rule, subject to the laws of the country of the issuing bank. Meaning to say, when a BG is issued by a bank in Malaysia, it is governed by the Malaysian laws. Under Swiss law, the parties are free to determine the contents and form of a guarantee. Generally, the contents of a BG more or less is standardized to suit to the issuing bank’s laws. However, minor adjustment is permissible subject to approval of the issuing bank. Issues or clauses not provided for would be adjudicated on basis of Article 111 of the Swiss Code of Obligations.

There are few example of related guarantees for securing performance or payment namely, the ‘simple’ guarantee (Swiss Code of Obligations, Art 495) and the ‘Joint and several’ guarantee (Swiss Code of Obligations, Art 496); by the contract of guarantee, the guarantor is obligated to make payment if the principal debtor becomes insolvent and goes bankrupt. The contract of guarantee presupposes a valid principal debt and also become void if the principal debt ceases to exist. In Switzerland, contracts of simple and/or joint and several guarantees are used almost exclusively for securing claims of domestic creditors.

The confirm payment order (Swiss Code of Obligations, Art 468); As in case of the guarantees, the irrevocable confirmed payment order includes an irrevocable, not accessory obligation to pay. Payments under this instrument can be subject to the fulfillment of the special conditions of this order. The documentary credit is an important case of application of the irrevocable, confirmed payment order.

As in the case of the documentary credit and the documentary collection, the International Chamber of Commerce in Paris has issued ‘Uniform Rules for Contract Guarantees’. But these guidelines issued in 1978 have not been generally accepted.

Red Clause Credit

The purpose of red clause in a documentary credit is to enable the beneficiary to obtain pre-shipment advances from the advising or confirming bank, at the expense of the beneficiary, but under the responsibility of the issuing bank. This red clause is so termed because it is usually printed in red on the credit to draw attention to this special feature of the credit terms.

Red clause has been used traditionally, in certain countries where goods, such as wool, cotton, meat, rubber etc, need to be purchased by a beneficiary who requires advances in order to pay for goods either directly or at auctions. Under the terms of the credit, an intermediary bank is authorized by the issuing bank to make advances to the beneficiary so that he may pay in this way. When in due course the goods are shipped and complying shipping documents presented, the proceeds are used to liquidate the pre-shipment advances, proportionate interest being taken or claimed.

Advances are usually made in local currency to avoid any fluctuation in exchange rates between the time of the advance and the time payment or negotiation is effected. If the credit is expressed in a currency other than local currency, it should stipulate for whose account any exchange difference will be.

If a red clause credit is available for negotiation rather than payment, it need not be restricted to the intermediary bank responsible for providing the advances as long as the eventual proceeds of the credit are made available to that bank. There are two main types of red clause:

1. The unsecured or clean red clause, under which the advances are authorized against the beneficiary’s statement that they are required to pay for pre-shipped goods.

2. The secured or documentary red clause, under which advances are made against presentation of warehouse receipts or similar documents together with the beneficiary’s undertaking to deliver the bill of lading and/or other documents required upon shipment (The warehouse receipts are usually returned to the beneficiary in trust so that he may then obtain the bill of lading). Here, the beneficiary may also be required to insure the goods while they are in store.

In the event of subsequent default by the beneficiary, including failure to present documents in compliance with the terms and conditions of the credit, the intermediary bank has the right to claim refund of its advances, together with interest and any other charges, from the issuing bank.

There is a third type of clause which may be used, the ‘receipt and undertaking’ or ‘invoice and undertaking’ clause, which differs from both the above in that the intermediary bank makes advances against the beneficiary’s receipt or invoice together with his undertaking to refund the advance in the event of failure to present complying documents under the credit.Advances under the ‘receipt and undertaking’ clause are not normally made from the intermediary bank’s own fund but against immediate reimbursement from the issuing bank, with the beneficiary being responsible to the issuing bank in the event of default.

Clean red clause:
"As the accredited may have to pay for the wool before shipment, kindly grant him advances to enable him to make such payments agaisnt his statement that the money is required for the purpose of the aforesaid. We accept responsibility for the repayment of anticipatory advances granted by you within the credit limits."

Documentary red clause:
"As the accredited may have to pay for the goods before shipment please grant him advances for the purpose of making such payments against Warehouse Receipts or other documents evidencing the right to claim possession of the goods and the undertaking to deliver the relative Bills of Lading in due course. Such Warehouse Receipt or other documents may be entrusted to the accredited in exchange for his acknowledgement that the documents are held by him as trustee for you and as your agent to obtain for you in exchange the relative Bill of Lading. The goods, whilst in the warehouse pending shipment are to be insured by......................... . We accept responsibility for the repayment of anticipatory advances granted by you within the credot limits."

Invoicing and undertaking clause:
"As the accredited will have to pay for the goods, processing and ancillary charges before shipment, negotiation may be made to the beneficiary against invoices evidencing firstly cost of goods and/or processing and ancillary charges and the beneficiary's undertaking to produce the relative shipping documents in due course. We accept responsibility for meeting such payments under the terms of the credit."

Revolving Letter of Credit

A revolving credit (RC) is one that is available for an amount that remains constant for a given period of time so that whenever it is drawn upon, it becomes available again for the full amount, either immediately or as soon as advice is received from the issuing bank that earlier presentations are acceptable to them. Alternatively, it may be made available for a reducing sum during a given period of time, to become automatically available again for the original sum at the end of the period. If the renewal of amount is not automatic but subject to reinstatement instructions after each drawing, it is not strictly a true RC but rather one of fixed amount which has to be increased by means of amendment.

RC may be renewable as to amount and time as follows:

· RC may be available for up to, say USD10,000 at any one time, and as soon as a drawing is made the amount drawn immediately becomes available gain. Often there is no limit to the number of drawings that may be made of up to USD10,000 each, except perhaps a qualification as to how much may be drawn per day; such RC continues to be drawn upon and reinstated until it expires.

· RC may be available for up to USD10,000 per week or per month. The amount is automatically available each week or month irrespective of whether any sum has been drawn during the previous week or month. This can be on a cumulative or non-cumulative basis, cumulative being more common, i.e. un-utilized amounts are carried forward and added to the total amount available for the following week or month.

RCs that revolve around amount, as in the first example, are rarely confirmed since it is virtually impossible to establish the total liability that may be incurred during the life of the RC. RCs that revolve around time (example 2) are more likely to bear confirmation since the overall amount of liability is ascertainable.

RCs should not be confused with LCs available by instalments. If an LC has an overall limit as to amount and validity and permits specified drawings or quantities of goods to be shipped at appointed periods of time during that validity, it is an LC that is available by instalments and as such is subject to UCP 600 article 32, “if a drawing or shipment by instalments within given periods is stipulated in the credit and any instalment is not drawn or shipped within the period allowed for that instalment, the credit ceases to be available for that and any subsequent instalment.”

Shipping Guarantee: Part 2

In international trade, banks deal with documents and not with physical goods although these documents represent goods and movement of goods. The regulatory and commercial requirements of international trade have resulted in the use of many and varied documents. It is not unusual to see exports department and imports department staff of banks buried under huge mass of documents. You will appreciate that due to this inherent characteristic of international trade shipping documents through delays, losses in the mail and bureaucratic procedures may arrive after the goods have reached their destination. Non-arrival of shipping documents may result in the importer facing a loss should he not be able to take delivery of goods and sell them especially if they are perishable goods. To assist the importer to take delivery of the goods a Shipping Guarantee (SG) is issued in favour of the carrier of the goods.

In general, SGs only relate to bills of lading that have been delayed, lost, mislaid, stolen or destroyed.

SG is an indemnity given by the consignee to which the bank jointly indemnifies the carrier of goods so that the consignee so named can take delivery of the goods without production of the relevant bills of lading. The consignee and the bank jointly undertake to indemnify the carrier against all liabilities relating to the delivery and undertake to surrender the bill of lading duly endorsed to the carrier on receipt of it.

On receipt of notice of arrival of ship bearing the goods, the consignee will ascertain whether the bank has received the relevant shipping documents, particularly the bill of lading. If the shipping documents are not on hand, the consignee will then request the bank to issue a SG.

The normal prudent consideration for a banking facility is applied. If the consignee is someone who is not known to the bank or who has had minimal dealings with the bank, a deposit varying in amount up to the full invoice value of the imports normally required by the bank. This deposit is commonly known as a margin and provides the requisite security should the consignee turn out to be someone who is not entitled to the goods. A counter indemnity is also taken whereby the consignee undertakes to indemnify the bank against all losses, damages and expenses in relation to the issue of the SG and at the same time undertake to deliver the bill of lading duly endorsed on receipt or obtain a discharge of the bank’s liability under the indemnity. Having satisfied that all precautions have been taken the bank will then issue the SG and forward it to the carrier or his representative for the goods to be released.

On receipt of the shipping documents, the bank will extract the bill of lading and after having obtained the required endorsements forward it to the carrier to redeem the SG.

Standby LC and Principle of Autonomy

The traditional LC for import and export transaction is issued to provide the exporter with a guarantee of payment when performance has occurred by submitting documents in accordance with the terms and conditions of the LC. However, the standby LC (SBLC) for import and export transaction is issued to provide the exporter with a guarantee which is only activated in the case of non-performance of another pre-arranged activity. The development of SBLC took place in the United States where the banks do not have the power to issue performance bonds and first demand guarantee.

SBLC can be issued in lieu of performance guarantee in construction contracts, as a guarantee to loan repayment or as a guarantee to a seller as a back-up to some other pre-arranged method of finance. In transactions involving the manufacturing and the sale of goods, SBLC can also be used to secure payment of the price; the payment of liquidated damages for faulty performance; and to cover a deposit repayable in the event of the non-performance of the underlying contract. Losses which could be incurred in a take-over of a company and arising from the non-payment of a promissory note, the payment of rental and the payment of an amount can be, likewise, secured by SBLC.

The beneficiary can usually draw under the SBLC on the basis of providing a certificate or statement that a specific agreement has not been complied with. Given that specified documentation is presented, the bank called upon will be required to pay, regardless as to whether or not the applicant of the LC considers he has performed. Just as in the case of commercial LCs, the payment of a SBLC is subject to the tender of a fully complying set of documents by beneficiary.

The autonomy of a SBLC leads to certain problems. As the bank’s undertaking frequently assumes the form of a promise to accept a bill of exchange accompanied by a default certificate or statement, the beneficiary, who executes the two documents, is in a position to abuse the rights conferred on him.

For example, in the case of Intraworld Industries Inc vs Girard Trust Bank, a SBLC was issued by a bank in order to cover annual rentals due under a lease of a hotel. Payment was to be effected against the beneficiaries’ sight draft, accompanied by their written statement confirming the non-payment of the rent. As the account party (the lessee) mismanaged the hotel to such an extent as to seriously damage its international reputation, the beneficiaries cancelled the lease. They made a demand under the SBLC in order to recover an amount of liquidated damages due under the terms of the lease in lieu of rent.

The account party brought an action for an injunction to restrain the bank from paying. He alleged that the beneficiaries’ demand for fraudulent because it did not involved a genuine claim for rent, as represented in the default notice, but a “stipulated penalty”. Dismissing this action, the Supreme Court of Pennsylvania observed that the circumstances which would justify the granting of an injunction were limited to situations of fraud in which the “wrongdoing” of the beneficiary had vitiated the entire transaction.

In another case, Bossier Bank & Trust Company vs Union Planters National Bank, the Circuit Court of Appeals emphasized that an injunction could be granted only if the alleged fraud related to the relationship between the issuing bank and the beneficiary and not the underlying contract between the beneficiary and the account party.

Shipping Guarantee

Shipping Guarantees are issued by banks to enable importing customers to effect clearance of goods in circumstances where the bill of lading covering the cargo has not come forward or may be missing. In doing so, the bank incurs liability in respect of the goods. Also, of course, it may involve loss of control of the goods, the documents for which the bank has been entrusted to handle.

Shipping guarantees are only issued in respect of missing bill of lading where the guarantees relate to documents which are definitely expected to come forward through the bank. In the absence of already approved credit facilities under which a shipping guarantee may be issued, all applications for shipping guarantees are subject to a credit appraisal of the applicant. Where the standing of an applicant does not justify clean credit facilities, a cash margin (normally 100%) is taken. In all cases, it is essential that banks satisfy themselves from appropriate and reliable documentation regarding the value of the cargo prior to the issue of the guarantee. Shipping guarantees may not be issued in respect of cargo under lien to another bank.

Upon clearance of goods, the guarantee must be returned to the issuing bank for cancellation. It should not remain outstanding for more than one month from the date of its issuance. It is customary, where bank would initiate an enquiry into the reason for its non-return immediately after expiry date of the guarantee.

Nomination Without Obligation

The word ‘available’ as used in LC operations, ranks high on the list of terms that confuse exporters. An LC should clearly specify how it is available; by sight payment, deferred payment, acceptance or negotiation [article 6(b), UCP 600]. It is preferable for exporters that LCs be advised available with a local bank, or at least with a bank in the exporter’s own country. For instance, if the LC is available at the counters of a local advising bank by sight payment, deferred payment, acceptance, where confirmation is added, then the exporter will, in the normal course of events, receive payment or have a bank acceptance or a deferred payment commitment a few days after presenting documents complying with the terms of the LC. Such commitments are definitive and without recourse to the exporter. However, if LC is not confirmed, such advising bank may decide not to pay, accept or issue a deferred payment commitment at the time documents are presented, even if they are presented in order [article 12, UCP 600]. There can be many reasons for this, but the most common is that the advising bank where the LC is available is not satisfied with the bank risk or country risk.

If on the other hand, the LC was confirmed, such advising/confirming bank would have no option but to take up documents which comply with the terms and conditions of the LC and honour its commitment to the exporter.

Negotiation deserves a special mention. Negotiation is a term which regularly confuses exporters and perhaps even some bankers. If an LC is available by negotiation with an advising bank and not confirmed, that bank has the option to pay to the exporter, remit the documents and claim payment from the issuing bank. The exporter must realize that the final decision as to whether or not documents meet the terms and conditions of the LC, and consequently as regards payment, rests with the issuing bank. The negotiating bank will request repayment from the beneficiary (with interest) if payment is not received from the issuing bank. Negotiation without confirmation is with recourse.

An LC available by negotiation and confirmed by the negotiating bank means that the negotiating bank has no option but to negotiate documents presented complying with the terms and conditions of the LC. Such negotiation under a confirmed LC is without recourse. Where an LC is only available by negotiation and not confirmed, many banks which have been nominated as negotiating banks are not prepared to take the risk of paying the exporter for fear they may not get reimbursed. Exporter should appreciate the service provided by a bank when it negotiates documents, and also understand why a bank is not always prepared to negotiate.

Part two: Letter of Credit defined

What is letter of credit? To understand what letter of credit is, we should first know the standard international rules that governed the operation of letter of credit which is known as Uniform Customs and Practice for Documentary Credits or in short, UCP.

The current UCP is known as Uniform Customs and Practice for Documentary Credits, 2007 Revision, ICC Publication no 600 or in short, UCP600. This is the sixth revision of the rules since they were first circulated in 1933. The primary objective of UCP is to alleviate the confusion caused by individual countries’ promoting their own national rules on letter of credit practice. UCP was established to create a set of contractual rules that would establish uniformity so that practitioners would not face national regulations conflict.

Under the current UCP600, letter of credit is defined in article 2 which reads as follow:

“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…”

In international trade community, letter of credit is known as ‘credit’ or popularly known as ‘LC’. There are few important criteria need to be highlighted from the definition above because they form the basic principle of letter of credit.

Irrevocable – In letter of credit transaction, they are three important parties involved namely, bank, buyer and seller. The letter of credit is issued by a bank which is known as ‘the issuing bank’ which acts on the instruction or at the request of the buyer. The buyer is the party who provides the instruction to the bank via a standard format form. Based upon the instruction or application form received from the buyer, the issuing bank issues the letter of credit to the seller.

Irrevocable here means, in any event, should any of the parties; buyer, seller or bank wishes to cancel the LC that has been issued by the issuing bank, a mutual agreement or consent in writing must first be obtained from the rest of the parties involved in the transaction. In the absent of such agreement or consent in writing, the LC cannot be cancelled or revoked and it stands as an operative instrument.

The LC, once issued, is said to be a definite undertaking of the issuing bank where it encapsulates the ‘guarantee’ or ‘promise’ of the issuing bank to the buyer that payment will be made to the seller. This ‘guarantee’ or ‘promise’ to make payment to the seller by the issuing bank is based on the presentation of the documents (invoice, packing list, Bill of Lading/Air waybill etc) within the stipulated time period as expressly stated in the LC by the seller. Failure to comply with the requirements (terms & conditions) of the LC, the seller would not entitled to the ‘guarantee’ or ‘promise’ of the issuing bank or in other words, he would not get his payment.

This is the first important basic principle on which the LC operates.

Understanding Letter of Credit for beginners (Part One)

In trade transaction, there are two main objectives to be achieved; consideration for payment and consideration for the goods. Buyer wants to be assured that he received his goods and on the other hand, the seller would like to ensure that he would receive the value for his goods.

Let say, Sharif is a small trader in Malaysia operating his business in a shop lot in Kuala Lumpur selling canned food. He wants to buy a large quantity, one full container load (FCL) of canned sardine from Abdul, who is a food manufacturer residing in Singapore.

Shariff informs Abdul that he will list down important details like quantity of the canned sardine, brands, the place to deliver, time to deliver, amount and so on to show his intention to buy and to engage in this trade. The total value is, say, USD100,000.00. Abdul on the other hand, needs some time to prepare the delivery where he needs to process the sardine, to label the can, to pack and to contract for the transport before the goods can be delivered.

Now, there is one major problem. How can Abdul be sure that this list is coming from Shariff and Sharif would honour his word to pay him for USD100,000.00?

To ensure that this request is genuine and not a fake order, Abdul requires a third party, a bank, the organization recognized by law to give a confirmation or some kind of guarantee to ensure that Sharif would take the delivery of the goods on the agreed date and pay him the agreed amount. Without this confirmation or a guarantee by a bank, Abdul would refuse to prepare the goods for deliver.

So, Sharif goes to his bank, Maybank, and discusses this matter with his bank. His bank agrees to provide confirmation as well as a guarantee to Abdul provided that Shariff deposits USD100,000.00 equivalent sums with Maybank. Sharif agrees and hands over the list he made to Maybank and requests Maybank to issue the same instruction to Abdul in Singapore.

Maybank prepares the list based on the list which Sharif made with the inclusion of a few additional instructions where among others, Abdul is required to produce documentary evident for the delivery and how to obtain his payment. This list is sent through Abdul’s Bank in Singapore, DBS Bank. Upon receipt of the same, DBS Bank notifies Abdul and hands over the said list to him incorporating a guarantee for payment from Maybank.

Having received this list from Maybank in Malaysia, Abdul is assured that he will receive his payment from Maybank, not from Sharif provided that documentary evident must be sent to Maybank as evident that the delivery has been made on the agreed date to Sharif.

Upon making of the delivery, he sends the required documents to DBS Bank where they will be sent to Maybank for examination and when all the documents are presented as required, Maybank will debit Sharif’s account for USD100,000.00 and pay to Abdul through DBS Bank in Singapore.

Upon remittance of the money, Maybank will deliver the said documents to Sharif to enable him to collect the goods and pay the necessary duties and taxes.

The list issued by Maybank to Abdul through DBS Bank is called Letter of Credit. It contains the details like issuing date, expiry date, name of the buyer, name of the seller, address of both buyer and seller, type of goods, amount, documents required, shipment date, place of delivery and other important details related to this particular trade. All these details which are expressly stated are called ‘terms and conditions’.

In layman term, a Letter of Credit is a piece of list or letter incorporating terms and conditions for the seller to fulfill in order for him to obtain payment for goods he sold to the buyer.

Collections: Documents Against Payment

“Please advise what is the difference between L/C and D/P payment ? Thanks in advance”.

A question received from Helen Jolee, China.

LC, as we all know, is a written undertaking by the issuing bank to guarantee that the payment will be honoured upon presentation of documents and in compliance with the terms and conditions of the LC.

DP or Documents Against Payment or Collections does not constitute an undertaking to make payment by presenting bank or accepting bank. The movement of the documents from the seller to the buyer under DP is quite similar to those documents drawn under the LC. The seller will prepare all the necessary documents and present them to his bank for onward redirection to the buyer’s bank. The seller’s bank or the collecting bank, upon receipt of the documents, is not obligated to examine the said documents to establish compliance.

Unlike LC, Collections is governed by separate standard international rules called Uniform Rules for Collections (URC 522). Under these rules, collecting bank is merely acting as an ‘agent’ for the seller where its’ responsibility is only restricted to ‘handling’ the documents and ‘collecting’ proceeds. In doing so, collecting bank must take necessary steps to provide full information pertaining to the documents it receives to the paying bank. This includes, type of documents, number of pieces of each document, how payment should be transmitted, amount, currency and so on. The documents than are couriered the paying bank for presentation to the buyer.

The paying bank will notify the buyer and make presentation by obtaining payment for the documents value, that is switching documents for payment. The paying bank is also merely acting as and ‘agent’ to collect payment from the buyer and deliver the documents. If the buyer fails to pay on first presentation, the paying bank has no authority to demand neither can it enforce any legal mechanism to obtain payment from the buyer.

The ‘ownership’ of the documents under Collections is held by the seller. The seller is the party in this operations who makes a call. The paying bank only acts according to the instruction of the seller via instructions provided for by his bank (Collecting bank).

This method of trade settlement is much riskier as compare to LC. However, it is also widely used in international trade especially involving parties of the same group of companies. First time traders are not advised to resort to this method as the probability of non payment is very high.

LC: Negotiation under reserve

Negotiation under reserve is sometimes resorted to by a bank only when it is convinced that the nature of discrepancies are not of any serious consequences and which in the bank's experience have not materially affected the LC terms but would nevertheless negotiate the documents under reserve. At the time of making payment under reserve, both the negotiating bank and the seller believe that the documents will be taken up by the issuing bank despite the discrepancies. The negotiating bank will draw the attention of the issuing bank by listing all the discrepancies on the remittance schedule. If, however, the documents are rejected, the seller will reimburse the bank for the amount and the interest from the date of negotiation to the date of repayment.

Nevertheless, the fact remains that the documents are not in complete conformity with the LC. A bank makes payment under reserve only to a seller who is a valued client of the bank and whose integrity is beyond doubt. By understanding all types of negotiation (without recourse, with recourse, against indemnity & under reserve), I hope all traders are aware of the risks and the roles of buyer, seller as well as functions of the issuing bank and negotiating bank in LC operations.

LC: Negotiation against indemnity

In LC operations, the seller is entitled for payment only against documents in strict compliance of the terms and conditions of the LC. This is the basic principle on which the LC operates. But, it often happens that the documents tendered are not always in conformity with the terms and conditions of the LC. According to a study conducted by the International Chamber of Commerce (ICC), Banking Commission, it shows that two-thirds of presentation of the documents against LC deviate from the terms and conditions of the LC on first presentation. Under this situation, negotiating banks may decide whether:

• to refuse the request for payment by the seller
• to pay under reserve to the seller
• to pay against indemnity from the seller.

It is easy for a bank to refuse to pay against non-confirming documents but this will have negative consequences especially if the seller is a valued customer of the bank. Therefore, banks do negotiate documents against an indemnity from the seller. The bank's decision to negotiate the documents against an indemnity is dependent mainly upon evaluation of the credit risk of its customer. When negotiating documents against indemnity, the discrepancies in the documents are listed in bank's standard indemnity form and executed by the seller. By doing so, the seller has full knowledge and aware of the discrepancies, possibility of rejection by the issuing bank and his obligation to refund the negotiating bank in the event the issuing bank refuses to take up the documents and pay the negotiating bank.

LC: Negotiation with recourse

If the seller presents the documents to his bank, which is not the issuing bank and also not the confirming bank, then that bank negotiates the documents with recourse to him. This is because the seller's bank does not hold an undertaking to pay even though it is authorized to negotiate the documents.

The seller's bank on the other hand, may refuse to negotiate or give value of the documents to the seller. The principle of negotiation with recourse arises in a situation when:

• the negotiating bank is not able to obtain reimbursement from the issuing bank or from the applicant, that is the buyer because they have become insolvent
• rejection of documents as a result of discrepancies in documents for which the negotiating bank is either holding an indemnity or has negotiated under reserve.

It is a norm within banking industry worldwide that banks other than confirming bank, upon receipt of the documents from the seller, would redirect the said documents to the issuing bank for payment. Once the documents are found to be in order, the issuing bank will reimburse the negotiating bank and the seller will be paid. This may take some time before the seller could get his payment because the payment is made by the issuing bank in the country of the buyer.To cut short the traveling time of the documents as well as to avoid negotiation with recourse, the seller could ask for confirmation to be added to the said LC. By doing this, seller is entitled for his payment by tendering the documents to the confirming bank in his country.

LC: Negotiation

Negotiation means the standard procedures that bank performs which includes checking of the documents and giving value to the seller. The issuing bank may issue the LC available by negotiation with a nominated bank or it may allow the LC to be freely negotiated with any bank.

In the first case, the beneficiary, that is the seller, has to present the documents only to that bank, which is the nominated bank. Nevertheless, the nominated bank is not bound to negotiate if it has not undertaken a separate payment obligation to the seller. The nominated bank may simply refuse to negotiate the documents drawn under the LC. This is because, by having been nominated by the issuing bank, it does not constitute and undertaking to negotiate. If, however, the nominated bank has added its confirmation to the LC at the request of the issuing bank, thereby undertaking a separate payment obligation to the seller, then it has to honour its undertaking and pay for the documents drawn under the LC if they are in order . LC which does not nominate any bank is normally available for negotiation with any bank in the country of the seller which is willing to negotiate the documents. For the information of all traders, there are 4 types of negotiation practiced by banks around the world. They are:

1. Negotiation without recourse

2. Negotiation with recourse

3. Negotiation against indemnity

4. Negotiation under reserve

Let me explain Negotiation without recourse first and the rest at a later posting. A seller may present his documents drawn under LC directly to either:

a) The issuing Bank (bank that issues the LC) or

b) The confirming bank (bank that adds its confirmation at the request of the issuing bank) or

c) To his own bank

If the seller chooses to present the documents directly either to the ISSUING BANK or to the CONFIRMING BANK, these banks make payment WITHOUT RECOURSE to him. Meaning, the payment that has been paid to the seller shall not in any way become claimable by these banks in the event the documents are found not in order after making such payment. These banks cannot have recourse to the seller because by issuing or confirming the LC, they have taken upon themselves the risk that the party from whom reimbursement is to be obtained may become insolvent.

I hope this would give traders a general idea of how the LC operates and the implications to buyer and seller.

Basic Operations

The documentary credit is the “traditional form of letter of credit created as a payment and financing mechanism for international sale of goods”. A typical documentary credit operates in the following way.

Suppose a seller in Malaysia wishes to sell some goods (e.g.: Palm Oil) to a buyer in Russia. Suppose further that the parties have not previously entered into any business relationship, thus they do not know each other. Although both parties are willing to enter into a relationship, they are very concerned about the other party’s financial reliability.

The seller wishes to get paid as soon as he has shipped the goods. He is afraid that, after shipping the goods the buyer may refuse to pay the purchase price, or even become insolvent. In both cases, the seller may have to engage himself into lengthy negotiations, or sue the buyer to seek enforcement of payment by the court, which will certainly incur great expenses. Not to mention the costs of shipping back the goods or storing them in the original country of destination until further actions.

On the other hand, the buyer is concerned that he may not get the goods in the agreed quality and/or quantity, thus he is not willing to pay unless he inspects the goods.

In a situation like this, where the buyer and the seller are distant from each other and transportation of goods is inevitable, it is impossible to have the seller paid upon shipment and at the same time allow the buyer to pay only upon inspection of the goods.

When difficulties such as distance, different currency (fluctuation of currencies), culture and foreign laws have to be dealt with, the parties are most likely willing to fall back on legal instruments, which reduce the risks both seller and buyer have to face in an international sale of goods.

One of these instruments created by the international trading community is the commercial letter of credit. By agreeing to a commercial letter of credit the parties invite a third, trustworthy party – a bank – into their relationship. Upon the buyer’s request, the bank will open a letter of credit in favour of the seller, agreeing “to assume the primary, direct and independent obligation to honour the seller’s draft presented under the letter of credit provided that complying documents specified in the letter of credit are tendered”.

This way the seller is assured that he will receive payment from an individual “paymaster” regardless of the financial situation of the buyer. On the other hand the buyer is also assured that payment will only be effected if the conditions, set by the buyer and appearing in the credit, are completely fulfilled.

In a basic letter of credit transaction three parties are involved: the buyer (usually referred to as the “Applicant”), the bank and the seller (usually the “Beneficiary”).

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.