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.

Reasonableness of 'reasonable time'

Prior to the revision of article 13, UCP 500, the period within which the documents should be check for conformity by banks is set at maximum of 7 banking days. Banks, must exercise ‘reasonable care’ and take ‘reasonable time’ not to exceed the time limit given and provided for in the article.

Effective July 2007, article 13 of UCP 500 is revised (article 14, UCP 600) with a slight different wording where the words ‘reasonable care’ and ‘reasonable time’ are deleted.

The word ‘reasonable time’ has caused many disputes among traders as to what is ‘reasonable time’. How does it determined and who is to determine the number of days so called ‘reasonable’. But of course, this ‘reasonable time’ must not exceed 7 banking days. The maximum number of days, which is 7 banking days is not much of an issue of dispute. The centre of dispute is, is it deemed ‘reasonable’ for banks to consume 2 days, 3 days, 4 days or more within that given maximum period to decide whether or not the documents are compliance. The same applies if bank refuses to take up the documents.

The question now is, is the article 14(b), UCP 600 totally eliminates the same disputes triggered by article 13 of UCP 500? This change, the deletion of the words reduces the disputes among traders. But there is another problem arises which come to almost the same issue caused by article 13 of UCP 500.

The dispute on ‘reasonableness’ again surfaces by virtue of article 1 of UCP 600. The article states that:

“…they are binding on all parties thereto unless expressly modified or excluded by the credit”.

This article causes another debate, what if a bank decides on the second day that the documents are compliant. Can the seller insist on payment on that second day or must he waits until the fifth day for payment?

Can the seller request to modify the clause by inserting words, for example, “…providing for payment within 3 banking days of presentation of the following documents…” in the credit? Is it deemed reasonable to demand payment say, on the second day, third day or forth day?

The survey of court decision on ‘reasonable time’ suggests that depending upon the circumstances, a court’s interpretation of a reasonable time could be firstly, the day of receipt of the documents by the bank, if that were the day when the bank made, or should have made, the decision to reject and dishonour or secondly, a period of time ranged from three days in some decisions, to more than three years in another decisions, regardless of when the decision to accept or to reject the document was made by the bank

Among other criteria on which reasonableness depends are the circumstances of presentation, the type and the value of documents. At one end of the spectrum one may encounter an examination of hundreds of documents. This examination could consume every hour of the five-day period. At the other end, a simple statement of indebtedness of principal or interest concerning a financial Standby Credit may consume no more than a few hours of the examination period.

Premised on the above, banks have the advantage to determine what is the ‘reasonable time’ based upon the circumstances of their operations. If it is customary for that particular bank to process on average, say, 50 documents per day and takes 3 days to decide whether to honour or to refuse, therefore 3 days is deemed “reasonable”. Other banks may take up lesser time or more time to complete checking and to decide. Whatever the case may be, banks should not exceed the time limit given that is 5 days, maximum.

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.

Presentation of documents

A freely negotiable LC with the expiry date on the 01st of December, 2007. Beneficiary presents the documents to his bank in his country on 30th of November 2007. The documents are not negotiated but instead redirected to the issuing Bank by courier service and reached the issuing Bank on the 05th of December, 2007.

Is the LC deemed to be expired? Is it a discrepancy?

One participant from India suggested that it is a discrepancy because the LC reached the Issuing Bank after the 01st of December, 2007.

Article 2 of UCP600 states that “presentation means either the delivery of documents under a credit to the issuing bank or nominated bank or the documents so delivered”.

In layman term, the beneficiary has the option, either to send the documents to his bank or to the issuing bank if the issuing bank is also in his country. In the case where trading parties domicile within the same country or within the same vicinity, the beneficiary may send the documents directly to the issuing bank. For example, the LC is issued by Maybank, in Kuala Lumpur that is the buyer’s bank and the seller is also in Kuala Lumpur where he maintains an account with Stanchart which also in Kuala Lumpur. The beneficiary may either send the documents directly to the issuing bank, that is Maybank or he may also send the said documents to his bank that is Stanchart. When the documents reached the counter either one of these banks, he is said to have made a ‘presentation’ and therefore, he owes no further obligation as far as presentation is concerned.

Article 6(d)(i) of UCP 600 clearly states that "...an expiry date stated for honour or negotiation will be deemed to be an expiry date for presentation..." Article 6(d)(ii) further states "...the place for presentation under a credit available with any bank is that of any bank..."

From this point onwards, responsibility shifts to the nominated bank to examine the documents to determine whether or not the documents comply with other terms and conditions of the LC. It may take 1 day, 2 days or more but not to exceed 5 banking days.

To escape refusal by bank, the beneficiary must also ensure that the documents reach the bank within the validity of the presentation period which is within the expiry date of the LC.

Upon receipt of the said documents from the nominated bank, the issuing bank must first establish the date on which the presentation was made at the nominated bank. This is only a matter of checking the date on the covering schedule provided for by the nominated bank. The date indicated on the covering schedule is deemed to be the date on which the presentation is made at the nominated bank. This is the routine process in checking the documents by banks. If the indicated date is before the expiry of the LC, it is not a discrepancy.

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Examination of documents under LC

The principle of strict compliance is ruled by articles 14, 15 and 16 of the UCP 600. Article 14(a) obliges the bank to examine all documents stipulated in the credit to ascertain on the basis of the documents alone, whether or not they appear, on their face, to constitute a complying presentation. That is in compliance with the terms and conditions of the Credit. Compliance of the stipulated documents on their face with the terms and conditions of the credit shall be determined by international standard banking practice as reflected in the UCP 600. Therefore documents which appear on their face to be inconsistent with one another will be considered as not appearing on their face to be in compliance.

That standard is applicable only for stipulated documents; documents which are not stipulated will not be examined and shall be returned to presenter or be passed without responsibility. Banks shall have reasonable time for examination, not to exceed five banking days following the day of receipt of the documents, and for determination whether to take up the documents or to refuse payment. Banks will deem conditions as not stated and disregard them if a credit contains such conditions without stating the documents to be presented.

Banks, which can be the issuing bank, the nominated bank or the confirming bank, must determine of the documents alone whether or not they appear on their face to be in compliance with the terms or not. If they appear not to be in compliance, banks may refuse to take up the documents. The bank hereby has got latitude when judging, which it need because not every error leads to a rejection and many problems can be solved by communication between bank, applicant and beneficiary. But the bank is obliged to decide on its own. If the issuing bank determines documents to be not in compliance, it may in its sole judgment approach the applicant for a waiver of the discrepancies.

Article 16(f) rules that if the issuing or the confirming bank fail to act in accordance with the provisions provided for in Article 16, they shall be precluded from claiming that the documents are not in compliance with the terms and conditions of the credit.

The issuing bank and a confirming bank are not relieved from any of their obligations or provisions of article 16. Banker´s examination consists of three steps:

the completeness of the stipulated documents,
the compliance on their face and if they are in accordance with each other and
the terms and conditions of the letter of credit.

Documents are complete if all stipulated documents are presented and if each document contains the stipulated number of duplicates. The compliance ‘on their face’ means that there must not be obvious falsifications and errors. The documents are in accordance with each other if they do not contain contradictions.

Risks mitigation

The question arises why contract parties are willing to pay so much money for bank commissions instead of paying directly to the other contract party. To give an answer to this question, it is first necessary to take a look at the risks of worldwide trade today.

Risks associated with trade

“The truth is that risk is a derivative, and essentially negative, concept – an elliptical way of saying that either or both of the primary obligations of one party shall be enforceable, and that those of the other party shall be deemed to have been discharged, even though the normally prerequisite conditions have not been satisfied.” (goode)

Business outside of the home country bears greater risks than inside; wide distance, different law and business practices, different currencies, different political systems and communication problems caused by different languages and technical standards are typical problems in international business. If contracts are ruled by foreign law, it is often hard to estimate the legal situation of the foreign contract party. Another problem is the performance of the contract; matching payment with physical delivery is not possible, therefore also no control. To take a party to court can be difficult because of foreign language, foreign law, foreign process law or the need of a foreign solicitor. There are mainly four risks to face when trading worldwide: economic risks, political risks, payment risks and transport risks.

Economic risks

Economic risks results from a lack of quality, solvency or credit-worthiness of a contract party. Exporter’s risks are the manufacturing risk, that means that the importer could get insolvent or breaches the contract while producing the goods; the risk that the importer do not take the goods delivered, and the delcredere risk, which means that the importer do not pay, for example because of delay or unwillingness or incapability to pay. In a wider sense, economic exporter risks are includes the risk of bankruptcy of the importer, the risk of arbitrary cancellation of the contract, the risk of compositions / arbitration or the risk that an execution does not compensate a payment claim. But there are also importer´s risks: the order risk, that means that the exporter cannot deliver promised goods, and the delivery risk, which means that the exporter fails in performance caused by delay or lacks in kind, quality or quantity of the goods.

Political risks

Political risks, also called “state risks”, are caused by measures of governments or authorities or are results of war, rebellion or revolution. These risks can concern goods, which can be confiscated, expropriated, destroyed or damaged, or can concern assets or payments caused by confiscation, prohibition of payment, a moratorium or restrictions of conversion or transfer of money. Perhaps each party wants to perform, but caused by such political circumstances that is impossible. In some cases, for example war, the whole contract is regarded as being frustrated if one of the parties acquiring the status of an enemy. Or the performance can be disturbed by war.

A contract can also regarded as frustrated if legislation of one country after conclusion of it prohibits its performance by placing an embargo. An important and usual risk is the risk of a moratory; a state prohibits payments because of the incapability of the state to pay.

Currency risks

Currency risks are caused by floating exchange rates of the home currencies of each party and generally include the danger of losses. The exporter who signs a contract which includes payment in foreign currency bears the risk that he receives less money than he has calculated. The importer who has to pay in foreign currency bears the risk that he has to pay more money for buying foreign currency than he has calculated. Such currency risks can be caused by economical and / or political reasons. Another risk occurs if the currency of a state is not convertible or payments in this currency are not allowed. Even this is more a political risk, caused by measures of a state, it can also include a currency risk if the payment was said to be made in this currency.

Transport risks

Import and Exports include a transport risk; goods can get lost or damaged on the transport way. The question arises from which point on the importer has to bear a risk and has to pay even he never received goods. Another problem occurs if the property in the goods has passed, but the buyer justifiably rejects the goods; it is then not always clear who has to bear the risk of any loss, damage or deterioration of the goods if they must be stored or transported back.

Letters of credit can be used for risk-minimization of some, but not all of the above mentioned risks.