Letter of Credit In Electronic Trade Transaction

Somewhere in 1990s some 40 bankers, carriers and multinational companies have joined together in the BOLERO project. BOLERO aims at providing an electronic Bill of Lading for use in export transactions. Banking software packages and specialized telecommunications networks such as SWIFT have already taken a lot of paperwork out of the business of preparing and transmitting letter of credit details. eUCP has been introduced by the ICC to focus on the presentation of electronic or partial electronic documents.

Internet, undoubtedly has become an important medium for business community to get connected and to carry out their business transactions safely with the help of digital signature authentication system. The internet facility also makes buying a large business abroad possible through the internet franchise service. This electronic medium has also made the status inquiry and the due diligent process completed much faster without exchanging papers back and forth. By clicking on computer franchise for example, buyer or seller can obtain information and get connected. Internet franchise or computer franchise provides a focal point for trading community in search for business diversification.

When the idea of electronic trade transaction takes a full swing, the quality of the evidence provided by the seller with regard to the goods is very important. The buyer, in his instructions to the bank, specifies what the bank is to accept as evidence. In practice, this is a set of documents issued by the seller and by the independent parties.

A letter of credit consists of a series of flows; instructions, money, evidence regarding the goods and the title to the goods. Most of the flows are already dematerialized, or could be. For example, instructions with regard to the letter of credit can be passed from buyer to bank, and from bank to seller by electronic means and many banks have implemented systems to allow this to happen. Indeed, there is even a North American Bank which is prepared to accept applications for letter of credit over the World Wide Web. Within the banking system, this type of instruction can be handled through SWIFT, using its MT700 message format.

The issues seem to be concentrated in the field of evidence and of title to the goods. If we concentrate on the evidence, there seems to be no reason why a buyer could not call for the bank to accept a certain set of electronic messages instead of the equivalent set of documents. There exist internationally accepted standard EDIFACT messages, which can carry all the data the buyer may require, and which correspond in every way to the documents normally used.

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).

SWIFT Confusion

The issuing bank is responsible to ensure not only completeness of the Letter of Credit but the most important is to make sure all the data which forms the terms and conditions of the Letter of Credit is correct, clear and does not open to multiple interpretation before it is advised to the beneficiary. Legally speaking, Letter of Credit is in fact a form of a contract that is a contract of payment. Therefore, the terms and conditions laid out in an LC should be precise and clear.

Recently, a question came from one of the readers asking about the following problem. He received an LC with the following conditions:

44E: Port of loading/Airport of departure

+Bangkok Port, Thailand

45A: Description of goods and/or services

+400metric ton abc. FOB Thailand

He wants to know whether the information in field 44E and field 45A above is correctly indicated.

Field 44E (Port of loading/Airport of departure) and field 44A (Place of Taking in Charge/Dispatch from.../Place of Receipt) are fields specifically to indicate the point of delivery. This is the point where the seller technically delivers the goods to the buyer and the buyer accepts the said delivery. At this point, the delivery by the seller is said to have been completed. In other words, the seller must ensure the point of delivery by referring to field 44E only.

Is it necessary to indicate the point of delivery in field 45A? In the above example, name of the port that is “Bangkok Port” is not indicated. Is this ambiguous?

Field 45A is specifically to describe the goods or services and to indicate the trade term agreed upon by both parties. Therefore, the name of the port need not appear again in this field. Nevertheless, it is not wrong if the buyer wish to indicate again the name of the port in this field. However, it makes no difference whether it is indicated or not as information in field 44E is already conclusive.

Discrepancy Fee: The Unnecessary "Evil"

Today, it is impossible to receive a letter of credit without a clause “…a discrepancy fee of USDxx will be deducted…”. This clause becomes popular in pursue to curb discrepant documents being presented to the banks. There was a period where discrepant documents had reached 60% of the total documents presented under letter of credit worldwide.

Most of the documents, in many cases are issued by a third party for example, Bill of Lading, Insurance Certificate, Certificate of Origin, Inspection Certificate and etc. If any of these documents is found to be discrepant, it would take some time for the seller to get it rectified and most probably would not meet the time limit for presentation or expiry date of the letter of credit. It is however agreeable, that the onus to ensure document compliance lies on the seller.

Let us see how the examination process takes place. Issuing bank will receive the documents by air courier. Upon receipt of the documents, the bank officer will retrieve the copy of letter of credit and conduct a document checking against the letter of credit. When the documents are found in compliance with the terms and conditions of the letter of credit, the applicant will be contacted by phone to notify the arrival of the documents. A good banker will send a SWIFT message to the sender bank to confirm that the documents are received and payment will be transmitted in accordance with the reimbursement clause. Consequently, a SWIFT message (MT202) will be effected to remit payment in the case where direct TT claim on the issuing bank is not allowed.

In this case, the charges incurred on phone and electronic fund transfers are debited to the applicant’s account.

The process does not change even if the documents are found to be discrepant. The bank officer must notify the applicant by phone, send a SWIFT message to the sender bank to notify rejection and reimburse the negotiating bank if the applicant accepted the discrepancy. The bank officer would not call the applicant 10 times to notify 10 discrepancies found in the documents or send 10 separate SWIFT messages to notify the sender bank of the discrepancies found in the documents. Only one phone call and one SWIFT message would put the examination process to an end. So, what is this ‘additional’ so called a discrepancy fee between USD20 to USD50 for?

If the objective of this fee is to curb or reduce discrepant documents, it has successfully proven that it failed miserably.

In view of the new UCP 600, the doctrine of strict compliance is seen going beyond 'strict' compliance and reaching the border of ‘substantial compliance’ as evidenced by article 14. From the bank’s point of view, the doctrine of strict compliance is no longer based on ‘mirror image’ but much wider. This indirectly means that the potential risks of wrongful rejection by the banks are higher. To mitigate these risks, banks eventually pass over the ‘non-mirror image’ documents to the applicant for final decision. The applicant will give a final say whether or not to take up the documents and convey the decision to the bank within 5 banking days.

Looking at article 16, it seems that UCP further reduces the risks of the banks by allowing the presenter to arrange how the discrepant documents should be disposed off. This article intentionally allows the presenter and the applicant to sort out the discrepancy problem. Not only the role of the bank has becoming lesser, but the risks in handling non-compliance documents are also reduced.

So, why would the presenter need to pay additional fee if it does not trigger any additional performance by the Issuing bank? What risk can possibly be reduced by charging a discrepancy fee?

Murabahah Trade Financing

Originally, Murabahah is a particular type of sale and not a mode of financing. However, in the perspective of the current economic set up, there are certain practical difficulties in using Mudarabah and Musyarakah instruments in some areas of financing. Therefore, the contemporary Syariah experts have allowed, subject to certain conditions, the use of Murabahah on deferred payment basis as a mode of financing. But there are two essential points which must be fully understood in this respect:

1. It should never be overlooked that, originally Murabahah is not a mode of financing. It is only a device to escape from “interest” and not an ideal instrument for carrying out the real economic objectives of Islam. Therefore, this instrument should be used as a transitory step taken in the process of Islamization of the economy, and its use should be restricted only to those cases where Mudarabah or Musyarakah are not practicable.

2. The second important point is that the Murabahah transaction does not come into existence by merely replacing the word “interest” by the words “profit” or “mark-up”. Actually, Murabahah as a mode of finance, has been allowed by the Syariah scholars with some conditions. Unless these conditions are fully observed, Murabahah is not permissible. In fact, it is the observance of these conditions which can draw a clear line of distinction between an interest bearing loan and a transaction of Murabahah. If these conditions are neglected, the transaction becomes invalid according to Syariah.

Basic Features of Murabahah Financing:

1. Murabahah is not a loan given on interest. It is the sale of a commodity for a deferred price which includes an agreed profit added to the cost.

2. Being a sale, and not a loan, the Murabahah should fulfil all the conditions necessary for a valid sale, especially those enumerated earlier in this chapter.

3. Murabahah cannot be used as a mode of financing except where the client needs funds to actually purchase some commodities. For example, if he wants funds to purchase cotton as a raw material for his ginning factory, the Bank can sell him the cotton on the basis of Murabahah. But where the funds are required for some other purposes, like paying the price of commodities already purchased by him, or the bills of electricity or other utilities or for paying the salaries of his staff, Murabahah cannot be effected, because Murabahah requires a real sale of some commodities, and not merely advancing a loan.

4. The financier must have owned the commodity before he sells it to his client.

5. The commodity must come into the possession of the financier, whether physical or constructive, in the sense that the commodity must be in his risk, though for a short period.

6. The best way for Murabahah, according to Syariah, is that the financier himself purchases the commodity and keeps it in his own possession, or purchases the commodity through a third person appointed by him as agent before he sells it to the customer. However, in exceptional cases, where direct purchase from the supplier is not practicable for some reason, it is also allowed that he makes the customer himself his agent to buy the commodity on his behalf. In this case the client first purchases the commodity on behalf of his financier and takes its possession as such. Thereafter, he purchases the commodity from the financier for a deferred price. His possession over the commodity in the first instance is in the capacity of an agent of his financier. In this capacity he is only a trustee, while the ownership vests in the financier and the risk of the commodity is also borne by him as a logical consequence of the ownership. But when the client purchases the commodity from his financier, the ownership, as well as the risk, is transferred to the client.

7. As mentioned earlier, the sale cannot take place unless the commodity comes into the possession of the seller, but the seller can promise to sell even when the commodity is not in his possession. The same rule is applicable to Murabahah.

8. In the light of the aforementioned principles, a financial institution can use the Murabahah as a mode of finance by adopting the following procedure:

(i) The client and the institution sign an overall agreement whereby the institution promises to sell and the client promises to buy the commodities from time to time on an agreed ratio of profit added to the cost. This agreement may specify the limit up to which the facility may be availed.

(ii) When a specific commodity is required by the customer, the institution appoints the client as his agent for purchasing the commodity on its behalf, and an agreement of agency is signed by both the parties.

(iii) The client purchases the commodity on behalf of the institution and takes its possession as an agent of the institution.

(iv) The client informs the institution that he has purchased the commodity on his behalf, and at the same time, makes an offer to purchase it from the institution.

(v) The institution accepts the offer and the sale is concluded whereby the ownership as well as the risk of the commodity is transferred to the client.


All these five stages are necessary to effect a valid Murabahah. If the institution purchases the commodity directly from the supplier (which is preferable) it does not need any agency agreement. In this case, the second phase will be dropped and at the third stage the institution itself will purchase the commodity from the supplier, and the fourth phase will be restricted to making an offer by the client.

Step To Mitigate Trade Risks

Since the establishment of the UCP, it has never been intentionally to address or mitigate issues on fraud. The primary purpose of formulating the UCP is to provide a set of uniformity governing the conduct of trade activity in commerce. It is aimed at ensuring smooth transition of goods, services and payment. As the life blood of commerce, money, regardless of currency is what the protection needed the most and not be compromised at any cost.

Article 4 and article 5 of UCP 600 formed what is known as the principle of autonomy where it is solely to protect the integrity of payment obligation by banks. In other words, it means the letter of credit only guarantees the payment provided that the terms and conditions of the credit are complied with.

But, what about the integrity of the beneficiary or seller? How does buyer establish the performance capability of the seller, credit standing, business history and other important aspects related to trade?

This is an issue which is not covered in the UCP and there are no official guidelines on how to go about in establishing the integrity of the seller especially when the seller is domiciled in different country.

The buyer is always advised to conduct independent checking through Chamber of Commerce or by obtaining confirmation letter from the seller’s bank before concluding any agreement. This method however, is not favourable by most traders as the turn around time to get a reply is considerably long and in most cases it is viewed as not practical. Not only time, but the genuineness and precision of information are also very important to buyers in making business decision especially in establishing a first time trade relationship. Replies received from banks in most cases are not helping the buyer in making business decision.

A reputable third party private company, American Heritage is a good source of obtaining information on companies registered in the United States. Buyers may easily access to millions of active company through their marketing list. Information like owner of the company, business type, branches, number of employees and others can be easily obtained from their mailing leads. Financial information on the other hand is available from their mortgage mailing list.

Although this may not provide a guarantee but, it gives a very good overview of who the buyer is dealing with and what is the next course of action to be taken.

Original And Copies

This is a very confusing topic for most of traders as well as bankers. The difference is only technical. In fact, I had tough time checking documents under letter of credit when it comes to establishing original or copies. 

Documents like Insurance Certificate, transport documents, official documents issued by third party do not require so much of scrutinizing as they are issued regularly on a daily basis to traders. 

These documents are always issued in original and copies. The problem is with the beneficiary or seller when issuing invoice or packing list.

What is original?

From the letter of credit point of view, original document is a document which does not bear any statement saying “copy” on the face of the invoice, for example. 

Even if the invoice is issued using preprinted stationery complete with address, contact number, seller’s trading mark and signed but bears a statement or stamp says “copy”, it is deemed to be a copy and not original. In the absence of the statement or stamp “copy”, the invoice is considered as original.

I had come across an invoice during my days way back in 1980s, from Hong Kong. It was hand written, signed and stamped with Chinese character in red. It did not bear any statement “original” or “copy”. 

This is, from the letter of credit point of view, an original invoice. An invoice which is computer generated is also original even if it is not signed by the issuer and does not bear statement “copy”. But if the letter of credit specifically requests for a signed invoice, it should be signed.

As a general rule, invoice issued using an issuer’s original stationery and does not bear any statement “copy” or computer generated or a carbon copy bearing the statement “original” is considered original. 

Take Bill of lading for example, it is always issued in multiple original, 1st original, 2nd original 3rd original and so on. The 2nd original onwards is customarily issued in carbon copies. But they are considered original because they bear the statement “original”.

To be safe and not to be caught with unnecessary discrepancy, I encourage you to issue all your invoices in original. Letter of credit may request 2 original and 2 copies. It is not a discrepancy if you present all 4 invoices in original.