LETTERS OF CREDIT- Negotiable Instruments
NATURE AND IMPORTANCE
> A letter of credit is a financial device developed by merchants as a convenient and relatively safe mode of dealing with sales of goods to satisfy the seemingly irreconcilable interests of the seller, who refuses to part with his goods before he is paid, and a buyer, who wants to have control of the goods before paying
> To break the impasse, the buyer may be required to contract a bank to issue a letter of credit, the issuing bank can authorize the seller to raw drafts and engage to pay them upon their presentment simultaneously with the tender of documents required by the letter of credit. The buyer and seller agree on what documents are to be presented for payment, but ordinarily they are documents of title evidencing or attesting to the shipment of the goods to the buyer
> Once the letter of credit is established, the seller ships the goods to the buyer and in the process secures the required shipping documents and documents of title. To get paid, the seller executes a draft and presents it together with the required documents to the issuing bank
> The issuing bank redeems the draft and pays cash to the seller if it finds that the documents submitted by the seller conform with what the letter of credit requires. The bank then obtains possession of the documents upon paying the seller. The transaction is completed when the buyer reimburses the issuing bank and acquires the documents entitling him to the goods. The seller gets paid only if he delivers the documents of title over the goods while the buyer acquires the said documents and control over the goods only after reimbursing the bank.
> What characterizes letters of credit, as distinguished from other accessory contract, is the ENGAGEMENT OF THE ISSUING BANK TO PAY THE SELLER ONCE THE DRAFT AND THE REQUIRED SHIPPING DOCUMENTS ARE PRESENTED TO IT. In turn, this arrangement ASSURES THE SELLER OF PROMPT PAYMENT, INDEPENDENT OF ANY BREACH OF THE MAIN SALES CONTRACT.
LAWS GOVERNING A LETTER OF CREDIT TRANSACTION
> Uniform Customs and Practice for Documentary Credits (UCP) issued by the International Chamber of Commerce
PARTIES TO A LETTER OF CREDIT TRANSACTION
1. Buyer—procures the letter of credit and obliges himself to reimburse the issuing bank upon receipt of the documents of title. He is the one initiating the operation of the transaction as buyer of the merchandise and also of the credit instrument. His contract with the bank which is to issue the instrument and is represented by the Commercial Credit Agreement form which he signs, supported by the mutually made promises contained in the agreement
2. Opening bank—usually the buyer’s bank which issues the letter of credit and undertakes to pay the seller upon receipt of the draft and proper documents of titles to surrender the documents to the buyer upon reimbursement. As it is the one issuing the instrument, it should be a strong bank, well known and well regarded in international trading circles.
3. Seller—in compliance with the contract of sale, ships the goods to the buyer and delivers the documents of title and draft to the issuing bank to recover payment. He is also the beneficiary of the credit instrument because the instrument is addressed to him and is in his favor. While the bank cannot compel the seller to ship the goods and avail of the benefits of the instruments, however, the seller may recover from the bank the value of his shipment is made within the terms of the instrument, even though he hasn’t given the bank any direct consideration for the bank’s promises contained in the instrument
4. Correspondent bank/advising bank—to convey to the seller the existence of the credit or a confirming bank which will lend credence to the letter of credit issued by the lesser known issuing bank or paying bank which undertakes to encash the drafts drawn by the exporter. Furthermore, another bank known as the negotiating bank may be approached by the buyer to have the draft discounted instead of going to the place of the issuing bank to claim payment
RESPONSIBILITIES OF BANKS IN COMMERCIAL CREDIT TRANSACTIONS
> If the beneficiary is to be advised by the issuing bank by cable, the services of an ADVISING OR NOTIFYING BANK must always be utilized
> The responsibility of the NOTIFYING BANK is merely to convey or transmit to the seller or beneficiary the existence of the credit. However, if the beneficiary requires that the obligation of the issuing bank shall also be made the obligation of the bank to himself, there is what is known as a CONFIRMED COMMERCIAL CREDIT and the bank notifying the beneficiary of the credit shall become a CONFIRMING BANK. In this case, the liability of the confirming bank is primary and it is as if the credit were issued by the issuing and confirming banks jointly, thus giving the beneficiary or a holder for value of drafts drawn under the credit, the right to proceed against either or both banks, the moment the credit instrument has been breached.
> The paying bank on which the drafts are to be drawn it may be the issuing bank or the advising bank. If the beneficiary is to draw and receive payment in his own currency, the advising bank may be indicated as the paying bank also. When the draft is to be paid in this manner, the paying bank assumes no responsibility but merely pays the beneficiary and debits the payment immediately to the account which the issuing bank has with it. IF THE ISSUING BANK HAS NO ACCOUNT WITH THE PAYING BANK, the paying bank reimburses itself by drawing a bill of exchange on the issuing bank, in dollars, for the equivalent of the local currency paid to the beneficiary, at the buyeing rate for dollar exchange. The beneficiary is entirely out of the transaction because his draft is completely discharged by the payment, and the credit arrangement between the paying bank and issuing bank
doesn’t concern him.
> If the draft contemplated by the credit instrument, is to be drawn on the issuing bank or on other designated banks not in the city of the seller, any bank in the city of the seller which buys or discounts the draft of the beneficiary becomes a negotiating bank. As a rule, whenever, the facilities of an advising or notifying bank are used, the beneficiary is apt to offer his drafts to the advising bank for negotiation, thus giving the advising bank the character of a negotiating bank becomes an endorser and bona fide holder of the drafts and within the protection of the credit instrument. It is also protected by the drawer’s signature, as the drawer’s contingent
liability, as drawer, continues until discharged by the actual payment of the bills of exchange.
LIABILITY IN COMMERCIAL CREDIT TRANSACTIONS
> A commercial bank which departs from what has been stipulated under the letter of credit, as when it accepts a faulty tender, acts on its own risk, and it may not thereafter be able to recover from the buyer or issuing bank, as the case may be, the money thus paid to the beneficiary
> In the case of a discounting arrangement, wherein a negotiating bank pays the draft of a beneficiary of a letter of credit in order to save such beneficiary from the hardship of presenting the documents directly to the issuing bank, the negotiating bank can seek reimbursement of what has been paid to the beneficiary who as drawer of the draft continues to assume a contingent liability thereon. Thus, the negotiating bank has the ordinary right of recourse against the seller or beneficiary in the event of dishonor by the issuing bank.
PROTOTYPE EXPORT TRANSACTION
1. PROFORMA INVOICE—all the particulars for the proposed shipment which are then known to the buyer
2. PRICE QUOTATION FAS AND CIF—FAS stands for “free along side” which means that the seller will be responsible for the cost and risks of the goods “along side” an overseas vessel at the stated location: the buyer bears the costs and risks from that point. CIF on the other hand means “cost, freight and insurance”, that in exchange for this stated price, the seller undertakes not only to supply the goods but also to obtain and pay for insurance and bear the freight charges to the stated pointy.
3. BUYER’S PURCHASE ORDER
4. LETTER OF CREDIT
a. One way for a seller to be assured of payment is to ship goods under a negotiable bill of lading and arrange for a bank in buyer’s city to hold the bill of lading until the buyer pays the draft in the usual foreign sale this arrangement for securing payment of the price is not adequate
b. In some situations, sellers may need assurance of payment even before the time of payment. This problem arises in contracts which call for the manufacture of goods to the buyer’s specifications.
c. Although the proforma invoice may not specify, the seller will expect the letter of credit to be confirmed by the local bank in its location. But why does a local bank confirm rather than issue a letter of credit? The bank that issues the letter of credit needs assurance that it will be reimbursed by the buyer, on whose behalf it pays the seller. The buyer’s bank can take steps to minimize or
remove the hazards. It will receive the negotiable bill of lading controlling the goods which will provide security for the customer’s obligation to reimburse the bank; in addition, the buyer’s own bank can judge in the light of its knowledge of his financial standing whether added security is needed and can insist on such security before it issues the letter of credit
d. To meet the seller’s letter of credit requirements, the buyer will request its bank to arrange for the issuance of a letter of credit which will comply with the terms of the proforma invoice. The buyer will then sign a detailed application and agreement for commercial credit prepared by the bank. The issuing bank, after approving the buyer’s credit standing transmits a letter of credit by cable to the confirming bank. This confirming bank will then deliver to seller a document advising the latter that the issuing bank opened a letter of credit in its favor and adding the confirming bank’s confirmation. In this arrangement, the seller is assured of payment of its sight drafts drawn on the confirming bank in the amount of the total amount of the sale, provided it presents the documents called for in the letter of credit. An examination of the letter of credit will also reveal that the bill of lading is to be consigned to the order of the buyer’s bank, thereby giving the bank control over the goods, with the consequent security for its claim against the buyer.
5. ACCEPTANE; SHIPMENT
a. On the receipt of the confirmed letter of credit, the seller will send the order acknowledgment. This document will repeat the description and price of the goods which has also appeared on the proforma invoice and states the number and expiration date of the letter of credit.
b. Further, the arrival of the letter of credit is the go-signal for the seller to send the goods. The seller then prepares the COMMERCIAL INVOICE which provides a complete record of the transaction and is an important source of information to such interested parties as a bank discounting a draft or an underwriting extending issuance.
c. As the time of shipment approaches, the seller will contact its forwarder and give its shipping instructions. It will inform that to comply with the requirements of the letter of credit, the bill of lading must be made to the order of the issuing bank. It will also send copies of the commercial invoice, a packing list, and a Shipper’s export declaration. When the forwarder receives these documents, he takes over all further documentation as the agent of the shipper, the latter merely has to dispatch the goods from the factory in accordance with the forwarder’s instructions.
d. The seller will then send the truck to the pier where they are delivered to the ocean carrier’s receiving clerk who signs the dock receipt. The dock receipt is a form supplied by the ocean carrier which contains information relevant to the shipping of the bearings such as the number of the pier, and the name of the ship. The dock receipt is NON-NEGOTIABLE and serves as a temporary receipt for the goods until they are loaded on board.
e. The ocean carrier is soon ready to receive the cargo. When the goods are loaded on board, the steamship line issues a bill of lading which, to comply with the letter of credit, is CONSIGNED TO ORDER OF THE ISSUING BANK. The bill of lading is initially prepared by the forwarder on a form supplied by the ocean carrier, it sets forth the markings and numbers of the packages, description of the goods, and the number and weight of the packages. On its dorsal side, it will state that the goods are received for shipment, but a statement FREIGHT PREPAID ON BOARD is initiated by a representative of the steamship line after loading. The forwarder then delivers the bill of lading and the commercial invoice to the seller.
7. PAYMENT; THE DRAFT.
a. The confirming bank stated in their letter that the estimated CIF price would be “available by your drafts on us at sight” when accompanied by the listed documents
b. Seller accordingly draws a sight draft on the confirming bank. The sight draft together with the commercial invoice, insurance certificate, full set of bills of lading, and the packing list are presented to the confirming bank. When the bank receives these documents, it issues its bank draft to seller’s order and transmits the documents by air mail to issuing bank, which will
reimburse the confirming bank.
c. The documents, sent by airmail, will reach the buyer’s bank well ahead of the ocean shipment. The time for release of the documents to buyer and reimbursement to the bank will depend upon the arrangement which was made between the bank and buyer when the letter of
credit was initially established.
d. If the buyer plans to resell the goods, he may not be able to reimburse the bank until the goods arrive and he resells the goods. In this event, the issuing bank may need to take further steps to secure its claim against the buyer.
STANDBY LETTERS OF CREDIT OR GUARANTEES
HISTORY AND PURPOSE
> Sometime ago, it is common in international dealings to require the furnishing of a cash deposit as security, but with the expansion of international trade this became prohibitively expensive for the counterparty and in due course gave way to a more convenient safeguard, the provision of a written undertaking by a bank in favor of the buyer or employer payable on demand
> Demand guarantees as substitute for cash are designed to provide the beneficiary with a speedy monetary remedy against the counterparty to the underlying contract and to that end are primary in form and documentary in character.
> The demand guarantee is expressed to be payable solely on presentation of a written demand and any other specified documents. Accordingly, any demand within the maximum amount stated must in principle be paid by the guarantor, regardless whether the underlying contract has in fact been broken and regardless of the loss actually suffered by the beneficiary
A CONCISE DEFINITION: DEMAND GUARANTEES
> Undertaking given for payment of a stated or maximum sum of money on presentation to the party giving the undertaking of a demand or payment and such other documents as may be specified in the guarantee within the period and in conformity with the other conditions of the guarantee
> Procured by the seller in favor of the buyer for the latter to be paid in case the seller doesn’t comply with contract provisions. The economic burder is upon the party who breaches the contract
> Employed typically in construction contracts and contracts for international sale of goods
> Demand guarantees are intended to safeguard the other party against non-performance or late or defective performance by the supplier or contractor
GUARANTEE STRUCTURES AND TERMINOLOGY: DIRECT (3RD PARTY) GUARANTEES
> Involves a minimum of three parties
1. Account party/principal—party to the underlying contract whose performance is required to be covered by the guarantee and who gives instruction for its
2. Issuer/guarantor—the bank or other party issuing the guarantee on behalf of the customer the principal
3. The beneficiary—the other party to the underlying contract, in whose favor the guarantee is issued
> Usually the guarantee in the 3-party structure is the principal’s bank and carries on business in the same country as the principal, whilst the beneficiary carries on business in a foreign country
> Known as direct guarantees because the guarantee is issued to directly by the principal’s bank, not by the local bank in the beneficiary’s country
PRINCIPAL TYPES OF DEMAND GUARANTEES
1. Tender or bid guarantee
a. Where tenders are invited it is often a condition of consideration of the tender that the tenderer undertakes to sign the contract if its awarded to him, to procure the issue of any performance or other guarantee required by the guarantee and not to modify or withdraw his tender in the meantime
b. Purpose—safeguard the beneficiary against breach of such an undertaking
c. If the tenderer is successful and fails to sign the contract and to furnish the requisite performance or other guarantee, or withdraws his tender before its expiry, the beneficiary can call upon the guarantor to pay a specified sum designed to compensate him for the trouble and
expense he suffered in reawarding the contract, as well as any additional cost of the contract
2. Performance guarantee
a. Guarantee of the central performance of the contract from commencement to completion
b. Given for a specified percentage of the contract sum
c. But there are stages in the relationship between the parties which precede and follow the central performance, and there may be distinct segments of liability to be covered within that performance
3. Advance payment or repayment guarantee
a. Underlying contract may entitle the principal to payment of stated sums in advance of performance
b. The advance payment guarantee is designed to secure the beneficiary’s right to repayment of the advance if the performance to which it relates is not furnished
4. Retention guarantee
a. Construction contracts usually provide for stage payments against architect’s or engineer’s certificate and for a specified percentage of the amount certified in each certificate to be retained by the employer for a specified period of time as safeguard against defects
b. The employer may be willing to release such retention moneys against a retention guarantee securing repayment of the released retention moneys if defects are later found or if the contractor fails to complete the contract
5. Maintenance or warranty guarantee
a. Construction contracts usually provide that on completion part of the retention moneys are to be retained for a specified period to cover the cost of any defects or malfunction which become manifest during that period
GUARANTEES NOT GUARANTEED BY UNDERLYING CONTRACT
> Not all guarantees are meant to be in favor of a party in the underlying contract
> For example are customs guarantees which are issued to the customs to cover any duty that may become payable when imported goods which would be exempt from duty if reexported within a specified time are not in fact reexported within that time
THE LEGAL NATURE OF A DEMAND GUARANTEE
> A demand guarantee is an abstract payment undertaking that is, a promise of payment which, though intended to preserve the beneficiary from loss in connection with the underlying transaction is detached from the underlying contract between principal and beneficiary and is in form a primary undertaking between the guarantor and beneficiary which becomes binding solely by virtue of its issue
> A secondary guarantee is both secondary in form and intent. The intention of the parties is that the guarantor will be called upon to pay only if the principal defaults in performance, and then only to the extent of the principal’s liability and subject to any defenses available to the principal
> A documentary credit is both primary in intent and form. The parties to the underlying contract intend that the bank issuing the credit is a to be the first port of call for payment, and this is the effect of the agreement between them. Whereas in the case of a suretyship guarantee, the beneficiary cannot look to the guarantor without establishing default by the principal, the reverse is true of the documentary credit. The parties have designated payment by the bank as the primary payment method and only if it fails without fault on the part of the beneficiary is entitled to > DEMAND GUARANTEE STANDS BETWEEN THE SURETYSHIP GUARANTEE AND THE DOCUMENTARY CREDIT—SECONDARY IN INTENT AND PRIMARY IN FORM. Performance is due in the first instance from the principal, and the guarantee is intended to be resorted to only if the principal has failed to perform. But though this is the intent of the parties, the guarantee isn’t in form linked to default under the underlying contract, nor there is any question of performance to hold the beneficiary harmless up to the agreed maximum; and the sole condition of the guarantors payment liability is the presentation of a demand and other documents specified in the guarantee in the manner of and within the period of the guarantee
> THE GUARANTOR HAS NO CONCERN WITH THE UNDERLYING CONTRACT AND IF DEMAND IS DULY PRESENTED, PAYMENT MUST BE MADE DESPITE ALLEGATIONS BY THE PRINCIPAL HAS FULLY PERFORMED THE CONTRACT—IN THE ABSENCE OF ESTABLISHED FRAUD OR OTHER EVENT CONSTITUTING GROUND FOR NON-PAYMENT
STANDBY LETTERS OF CREDIT
> Undertaking primary in form but intended to be used only as a fallback in the event of default by the principal under the underlying contract
> Standby credit in legal perspective is simply another term for demand guarantees
> The standby credit has developed into an all-purpose financial support instrument embracing a much wider range of uses than the normal demand guarantee. Thus, standby credits are used to support financial and non-financial obligations of the principal and to provide credit enhancement for the primary financial undertaking
KEY ELEMENTS IN A DEMAND GUARANTEE
1. The parties
2. A reference to the underlying contract
3. The amount or maximum amount of the guarantee and any agreement for reduction or increase
4. The currency of payment
5. The documents, if any, to be presented for the purpose of a demand or of reduction or expiry
6. The expiry date or other expiry provisions as well as any agreement for extension
> Where it is intended that the guarantee shall not commence until presentation of a particular document, this fact should be specified
> Direct guarantee: principal, guarantor, and beneficiary should be identified
> Indirect guarantee: principal, instructing party, beneficiary, and counter-guarantee
> Central to the demand guarantee is its documentary character: the rights and obligations it creates are to be determined solely from the terms of the guarantee and from any document presented in accordance with the guarantee, without the need to ascertain external facts
DISTINCT NATURE OF CONTRACTUAL RELATIONSHIPS
> Guarantor’s commitment to the beneficiary arises solely by virtue of the issue of the guarantee and his duty to pay is conditioned only on presentation of demand and other specified documents in conformity with the terms and within the duration of the guarantee
> Principal is not concerned with the contract between the guarantor and beneficiary
> Beneficiary has no concern with the contract between the principal and guarantor
> The relationship of principal and guarantor has an internal mandate—the guarantor is obliged to act in accordance with the terms of the contract, failing which he may forfeit his right to reimbursement but those terms are of no concern to the beneficiary, whose right to payment depends solely on his acting on conformity with the terms of the guarantee
> In indirect contracts, there is an additional mandate which has 2 facets—the mandate from the instructing party to the guarantor as to the issue of the guarantee, which the guarantor as mandatory must comply with if he accepts the instruction; and two, the counter-guarantee which the guarantor exacts from the instructing party as a precondition of issuing the guarantee and which is separate from the mandate
1. Abstract character of the payment undertaking—binding solely by virtue of issue of the guarantee, subject to the beneficiary not rejecting it
2. Independence of the guarantee from the underlying transaction
> Guarantee is separate from that contract and the rights and obligations created by the guarantee are independent of those arising under the underlying contract
> In the absence of established fraud by the beneficiary, the guarantor is not entitled to refuse payment and the principal is not entitled to have payment restrained merely because of a dispute between the principal and beneficiary
3. Independence of the guarantee from the principal-guarantor relationship—the guarantee is separate from the contract between the principal and the guarantor is not entitled to invoke a breach of that contract
4. Documentary character of guarantee—amount and duration of the duty to pay, the conditions of payment and termination of payment obligation depend solely on the terms of the guarantee itself and presentation of required documents
5. Requirement of compliance of the demand with the terms of the guarantee
6. Guarantor’s duty of examination limited to apparent good order of the document
7. Guarantor’s duty limited the exercise of good faith and reasonable care
8. Independence of counter-guarantee from guarantee
9. Independence of counter-guarantee from mandate received from instructing party