Documentary Credits

Information

Introduction

The Basics

The Specifics

An Irrevocable Credit

An Irrevocable Confirmed Credit

Guiding Principles

Information

Read Fraud and Letters of Credit

Read Documentary Letters of Credit and the Lending Banker

Access Uniform Commercial Code – Article 5 – Letters of Credit

Some noteworthy titles yo include in your banking library are –

Jack, Malek & Guest – Documentary Credits, 3rd edn, Butterworths

Letters of Credit, michael rowe, euromoney

Bills of Exchange & Bankers’ Documentary Credits, 4th edn, william & richard hedley, llp

Bills of Lading and Bankers’ Documentary Credits, paul todd, llp

Read Letters of Credit and the Fraud Exception – A Comparative Analysis of the Laws of the United States of America, England and South Africa

Read Role of Letters of Credit in Payment Transactions

Introduction

English Judges have termed LCs or Documentary Credits, the “life blood of International Commerce”

If the buyer and seller of goods are commercially acquainted or located in the same country, there is lesser anxiety than in international transactions. Payment can be made –

by mail

by telegraphic transfer

cash with order or cash with delivery

DAP (delivery against payment) or DAA (delivery against acceptance)

by documentary collection

The situation in trade is however complex. Parties are located in and governed by different systems of law and unaware of the financial standing, credibility, goodwill, reputation and solvency. Economic conditions and political risk of the respective countries assume importance. Rules, regulations and exchange-controls have also to be considered. The mode of carraige of goods needs to be considered

The buyer desires contracted goods on time. He does not desire to pay in advance or on shipment but only after he has satisfactory evidence that the seller has shipped the goods on time and that they are now beyond the seller’s physical control

The seller, on the other hand, wants payment in advance, before commencing manufacture or purchase (of raw material or the goods on resale) – arranging to get the goods, already on high seas, if the buyer were to refuse to pay on some flimsy reason would be commercially damning

A conflict thus persists between the interests of the parties

It is to assist trade in such situations and to harmonise the conflict between the seller’s desire for swift payment and the buyer’s desire of goods first as also to represent and protect the interests of participating banks and standardise banking practice that the International Chamber of Commerce (ICC) has developed Documentary Credits

Nearly all the credits are subject to the Uniform Customs and Practices for Documentary Credits (UCP) published by the ICC. The latest is the 1993 revision

In this writing, I discuss the working of Documentary Credits, using an Irrevocable Confirmed Credit as the base with shipping of goods as the mode of transportation

The Basics

Apart from the buyer and seller a credit involves banks, the shipowner/carrier and a variety of intermediaries –

Underlying transaction – the documentary credit is concerned with documents and not goods. The actual contract of purchase and sale of goods between the buyer and seller is known as the underlying transaction and should not be confused with the credit, contract of carraige, contract of insurance etc.

Applicant for the credit – it is the buyer of the underlying transaction who initiates the credit – he applies to a banker in his country to open a credit on in favour of the the beneficiary (seller)

Issuing bank – the buyer’s bank in the buyer’s country. On the latter’s request and instructions and as his agent, the Issuing bank issues notice to the seller that an Irrevocable credit has been opened in his favour. It also intimates the terms to be satisfied by the seller to become entitled to the benefit of the credit. By giving such notice, the Issuing bank undertakes to irrevocably pay to the seller as a “reliable and solvent paymaster” and takes over the buyer’s liability to pay Correspondent (and then Confirming) bank – a bank in the seller’s country which acts on the instructions/request and as the agent of the Issuing bank when merely advising (informing) the seller. It however acts as a Principal when it confirms the credit. On confirming to the Issuing Bank’s undertaking, the Confirming bank is adding its own independent undertaking to ultimately pay the seller Beneficiary to the credit – the seller, being the person entitled to payment under the credit on complying with the conditions of credit

Document of title – A document which enables the possessor to deal with the property described in it as if he were the owner

The Specifics

Documentary credit is the more organised and efficient manner of saying, “My banker will pay you $X if you perform conditions A and B”

In other words, it implies payment against documents (which transfer title to the goods) instead of against the goods themselves. Payment is thus made on constructive delivery and not on their actual physical delivery

Article 2 of the UCP provides that Documentary credit means any arrangement whereby a bank (Issuing bank), acting at the request and on the instructions of a customer (applicant for the credit) is to make payment to or to the order of a third party (the beneficiary) or is to pay or accept or negotiate Bills of Exchange (drafts) drawn by the beneficiary authorises another bank to effect such payment or to pay, accept or negotiate such bill of exchange, against stipulated documents, provided that the terms and conditions of the credit are complied with Thus, in the process of banks acting as financers to international trade –

there is a guarantee to the seller that he will be paid the agreed sale price on tendering credit documents. The payment may be either immediate or by the bank accepting a Bill of exchange drawn on it by the seller or by negotiation. The seller may hold on or discount the bill. The documents pass on to the bank

The seller can utilise this guarantee (from the buyer’s bank) to obtain credit from his own bank to finance his trading or manufacturing activity, until he is paid the price

As payment is agreed to be made by the buyer’s bank, the buyer gets a specified credit period, before he actually becomes liable to pay for the value of the goods

Often when the goods have already reached the destination, the buyer can procure the documents representing the goods from his bank, before payment by executing a trust receipt, take delivery from the ship, sell the goods and then pay of the bank

The bank holds the documents of title and therefore has interest in the goods until paid by the buyer

All parties benefit –

the seller, before performing his part of the contract gets an assurance that he will be paid by the buyer’s bank and (in a confirmed credit) get paid by a bank in his own country, if he completely and correctly fulfills the terms of the credit

the buyer gets a period of credit from his own bank and maintains an insurable interest in the goods throughout the transaction

the buyer’s bank gets doucments of title to the goods in exchange to its exposure, an effective control over the goods

if there is a confirming bank, it has the Issuing bank’s assurance that it will be paid

the carrier has the physical possession/custody of the goods until payment

An Irrevocable Credit

There are two primary types of credits –

An Irrevocable Credit – when one bank irrevocably guarantees payment to the seller – the Issuing Bank in the buyer’s country

An Irrevocable Confirmed Credit – when two banks guarantee payment to the seller – the Issuing Bank in the buyer’s country and the Confirming Bank in the seller’s country

In an Irrevocable credit, the parties are the Applicant, the Issuing Bank and the Beneficiary

The document elaborating the underlying transaction the mode of payment (i.e. Documentary credit) and the exact documents to be tendered by the Beneficiary as evidence fulfilling his part of the contract

The Applicant shall instruct the Issuing bank to open an Irrevocable credit in favour of the Beneficiary in confirmity with the underlying transaction

Being satisfied that its customer (the Applicant – Buyer) is creditworthy, the Issuing Bank opens the credit in favour of the Beneficiary and informs him (“Notify”) about the period of its validity. This intimation sets the Beneficiary to manufacture or procure contracted goods and (in terms of underlying contract) book shipping space, insure the goods, obtain statutory clearances etc. The Beneficiary ships the goods and gets the Bill of Lading from the Carrier. The goods are now in transit

Possessed with agreed documents, the Beneficiary forwards them to the Issuing Bank signalling compliance with the credit. These documents invariably are the Bill of Lading, the Policy of Insurance, Invoice, Certificate of Origin, Certificte of quality/quantity/inspection, Certificate of Shipment etc.

On receipt, the Issuing bank checks them against the credit and satisfies itself that they conform precisely

Upon satisfaction, the Issuing bank either pays the Beneficiary immediately or accepts a Bill of Exchange drawn on it by the Beneficiary or negotiate it (i.e. buys it). At this stage the Beneficiary can discount the Bill of Exchange or hold it till maturity and then present it for payment. The Issuing Bank has all documents giving effective control over the goods (then on the high seas) and can take actual delivery, should the Applicant fail to reimburse it

By now, the goods are nearing the port of discharge. The Applicant desires delivery of the goods on board the ship. The Issuing Bank may give up its control on the documents in its possession either reimbursement by the Applicant or on the Applicant executing it the Bank’s favour a trust receipt. The Applicant undertakes to receive the goods from the carrier and sell them on behalf of the Issuing Bank, hold the goods and the sale proceeds as trustee for the Bank

An Irrevocable Confirmed Credit

In an Irrevocable Confirmed Credit, the parties are the Applicant, the Issuing Bank, the Confirming Bank and the Beneficiary

In an Irrevocable Credit, the Beneficiary is protected from the Applicant’s insolvency or inability to pay as contracted

The Beneficiary therefore substitutes debtors – the Issuing Bank instead of the Applicant. The Applicant is more secure if the “reliable and solvent paymaster” is not located in a foreign country but in his own jurisdiction governed by his system of law. The involvement of a Confirming bank (at an extra commission) helps localise the export transaction

Again, the Applicant instructs the Issuing Bank to open an Irrevocable credit in favour of the Beneficiary, specifying the documents to be tendered to entitle payment

The Issuing Bank sends the credit to the Confirming Bank with a request to confirm it. By adding its own confirmation, the Confirming Bank adds its own independent commitment and engagement to pay the Beneficiary on tendering agreed documents. The Confirming Bank is reimbursed by the Issuing Bank. A vendor of goods selling against a confirmed credit is selling under the assurance that nothing will prevent him from receiving the price

The Confirming Bank intimates the Beneficiary of opening the Irrevocable Confirmed credit and forwards it to him

The Beneficiary forwards a Bill of Exchange (for the credit value) drawn by him on the Confirming Bank for acceptance, simultaneously preparing the required shipping documents and tendering them later (but within the credit period). Alternatively, he may forward all the documents together (including the Bill of Exchange) at the same time. He shall, if the documents are in order receive the Bill from the Confirming Bank or be paid

The Confirming Bank exchanges the shipping documents with the Issuing bank for the agreed price (which it is reimbursed)

The Issuing Bank exchanges the shipping documents with the Applicant in return for the price (which it is reimbursed). The Applicant collects the goods from the master of the ship on arrival at the port of discharge.

Guiding Principles

Articles 3 and 4 of the UCP propound the doctrine of autonomy of the credit Credits, by their nature, are seperate trasactions from the sales or other contract(s) on which they are based and banks are in no way concerned with or bound by such contract(s), even if any reference whatsoever to such contract(s) is included in the credit (Article 3)

In credit operations all parties concerned deal in documents and not in goods, services and/or other performances to which the documents may relate (Article 4)

In other words, banks are concerned only as experts of documents and interested in security for the price. The letter of credit is only a paper transaction. Further, where the transport documents consist of Bills of Lading, the bank(s) invariably ask for the delivery of a full set of the original bills

Opening the credit should be made an express condition precedent before the Beneficiary-seller is required to perform his part of the contract. The credit is regarded as “opened” when the advice or the confirmation, as the case may be, is communicated to the Beneficiary

Generally, neither party to the credit can unilaterally withdraw from the credit, once it is agreed that payment is to be by documentary credit

The Confirming Bank’s undertaking to pay is enforceable independently of the position taken by the Issuing bank – the former’s obligation to pay the Beneficiary will not cease simply because, say the Issuing Bank fails to reimburse it

In the absence of negligence, a bank is entitled to take documents that are apparently correct (The Galatia (1980) 1 Weekly Law Reports 495). Also, if the credit instructions are ambiguous or unclear, the bank should ask for clarification, but if that is not possible, it is protected if it has acted reasonably (see Commercial Banking Co. of Sydney Ltd. v Jalsard Pty. Ltd. (1973) Appeal Cases 279)

When a correspondent bank takes incorrect documents and having sent them to the Issuing Bank hears nothing for an unreasonably long period of time, it is entitled to assume that the latter has no objection to them. By not commenting in good time, the Issuing Bank’s right of rejection is lost and it must reimburse the Confirming Bank without question (Bank Melli Iran v Barclays Bank DCO Ltd. (1951) 2 Weekly Law Reports 367)

An Issuing Bank has a lien over the documents till it is paid by its customer (the Buyer). Similarly, the Confirming Bank has a lien till it is paid by the Issuing Bank (Aschkenasy v Midland Bank Ltd. (1954) 51 TLR 34)

Payment by documentary credit is only a conditional undertaking by the banks – conditional upon the Beneficiary fulfilling the requirements of the credit. In the similar vein, it is conditional and not absolute payment for the seller. If the bank wrongly refuses or fails to pay the seller or becomes insolvent, the seller can look directly to the Buyer for payment and the Buyer would be obliged to pay, whatever the reason for the Bank’s non-payment (W J Allan & Co. Ltd. v El Nasr Export & Import Co. (1972) 2 Queens Bench 189)

The general rule however is that once it has been agreed that payment shall be by documentary credit, it is not open to the seller to short circuit the credit, tender documents directly to the Buyer and demand payment from him (Soproma SPA v Marine & Animal By-Products Corpn. (1966) 1 Weekly Law Reports 367)

Banks must ensure that documents tendered to them under the credit precisely conform to the credit – they have no authority to interpret them nor should they concern themselves with the legal significance or value of the documents called for by its customer, the Buyer

Also, in the absence of instructions to the contrary, it is sufficient if all the documents (Bill of Lading, Invoice, Insurance Policy etc.) taken together contain the particulars required by the bank’s mandate. It is not necessary that every document should contain them (except the Invoice, for the full description of the goods)

The nature of the credit (revocable/irrevocable/revocable and confirmed/irrevocable and confirmed etc.) should be agreed upon and specified in the underlying transaction. Preferably, even the identity of the Issuing and Confirming Banks must be decided

The documents which are tendered to the Bank(s) have to be taken up or rejected promptly and without opportunity for prolonged inquiry

Lastly, both the UCP and various decided cases have propogated what has come to known as the Doctrine of Strict Compliance. Its effect is that the Beneficiary must tender the exact documents stipulated in the credit, and that Banks must accept only those exact documents – banks are entitled to reject documents which do not strictly conform with the terms of the credit. This position is similar as regards the relationship between the Confirming Bank and the Issuing Bank and between the Issuing Bank and its Customer (Equitable Trust Co. of New York v Dawson Partners Ltd. (1926) 25 Lloyds’Reports 903)