Documentary Credit System & International Trade Law

Introduction:



The documentary credit system has been a cornerstone of international trade for over a century. This system continues to play a critical role in world trade today. For any company entering into the international market, documentary credit system is an important payment mechanism, which will help to eliminate risks in international trade. At least 60 percent of commodity trading is conducted through documentary credit system .

The documentary credit system was developed to include a measure of security to trade transactions, mainly between buyers and sellers from different countries, and to put sufficient pressure in case of any violation or non-performance to the trade contract. The documentary credit system calls for the involvement of a third party, which is the bank. The bank provides additional security for both parties; it plays the role of an intermediary, by assuring the seller that he will be paid if he provides the bank with the required documents, and by assuring the buyer that his money will not be paid unless the shipping documents evidencing proper shipment of his goods are presented . Their popularity in international commerce has led judges to describe them as the ‘life blood of international commerce’ .

Documentary Credit System :

A documentary credit system normally operates as follows, assuming the underlying transaction is one of sale:

1. The seller and the overseas buyer agree in the contract of sale that payment shall be made under a documentary credit.

2. The buyer (applicant for the credit) requests a bank in his own country (the issuing bank) to open a documentary credit in favour of the seller (the beneficiary) on the terms specified by the buyer.

3. The issuing bank opens credit in favour of the beneficiary, if the specified documents are duly tendered and other terms and conditions of the credit are followed.

4. The issuing bank may open the credit by sending it direct to the seller or as happens in most cases, the issuing bank may arrange for a bank in the seller’s country (the advising or correspondent bank) to advise the seller that the credit has been opened.

5. The issuing bank may ask the advising bank to add its confirmation to the credit. If the bank agrees to add its confirmation, and it may be under no obligation to do so, the advising bank (confirming bank) gives the seller a separate payment undertaking in terms similar to that given by the issuing bank and the seller benefits from having the payment obligation localised in his own country.

6. The seller ships the goods and tenders the required documents to the advising bank. If the documents conform to the terms of the credit, the advising bank will pay the contract price and seek reimbursement from the issuing bank.

7. Before releasing the documents to the buyer, the issuing bank will in turn seek payment from him.


Advantages of Documentary Credit while using as a good means of payment in a direct sale :

1. A documentary credit enables the buyer to confirm his paying capacity, which is important when establishing new trade relations.

2. By guaranteeing the payment with a documentary credit, the buyer can achieve more profitable terms of delivery and payment for the goods.

3. The buyer can be sure that the Bank will pay money to the seller no sooner than it receives the documents corroborating the delivery of the goods.

4. In case the documents submitted by the seller do not correspond to the terms of the letter of credit (the deadlines are not met; the quality, quantity, packing etc. are not in compliance with the letter of credit), the buyer can be sure that the payment under the letter of credit will not be executed.

5. Banking experience and knowledge for the implementation of complex commercial contracts can be applied.

6. A credit against goods may be obtained when using a documentary credit with deferred payment.

7. A documentary credit is a payment obligation of the Bank, and the seller can be sure of receiving the money subject to the timely submission of the documents corresponding to the terms of the letter of credit to the Bank.

8. The prompt receipt of money immediately upon delivery; payment under the documentary credit will be executed by the issuing bank subject to the submission of the appropriate documents to the bank regardless of the buyer’s wish.

9. A wide choice of financing for any terms of transaction.

10. Chances of complexities with the documents and fraud are less, numbers of parties to the contract are limited and they are well connected to each other through single contract of sale, in case of breach of contractual obligations, the aggrieved party can sue the other party in a court of law effortlessly, moreover there is only one letter credit and easy to manage in a direct sale, when compared to the chain transactions.

Documentary Credits and Chain transactions:

Chain transactions are mainly financed by Back-to-back credits. This is a new letter of credit opened, based on an already existing non-transferable credit used as a security. Traders often use back-to-back arrangements to pay the ultimate supplier. A trader receives a letter of credit from the buyer and then opens another letter of credit in favour of the supplier. The first letter of credit serves as security for second credit .

In addition, a back-to-back credit is a credit, which is issued at seller’s request to his supplier, against the letter of credit, which the seller himself has received from buyer. Back-to-back credit is essentially a mechanism by which seller’s bank, relying on the prospect of receiving on seller’s behalf payment under the letter of credit issued to him against presentation of documents, is prepared to issue a corresponding letter of credit to the seller’s supplier in fulfilment of the obligation contained in the separate sales contract between the seller’s supplier and seller himself .

When seller’s bank agrees to issue a back to back credit ,it will take possession of the letter of credit issued to seller and itself issue a countervailing letter of credit to seller’s supplier. The documents specified in this second credit must, of course, be such as can, when received by seller’s bank, be tendered on seller’s behalf in conformity with the requirements of the first credit. Thus the specification must be identical and must, of course, relate to the same goods. When the documents are tendered by seller’s supplier, seller’s bank will pay his supplier under the back to back credit, will substitute seller’s invoice for that of his supplier’s invoice and will present the documents to issuing bank pursuant to the primary credit, collecting payment in exchange. Seller’s bank will then retain the amount necessary to recoup the price paid to the seller’s supplier and seller’s bank’s own charges, and will release the balance of the sum received to the seller .

The back-to- back credit is mainly found in connection with string contracts and it is relatively uncommon, because banks dislike issuing back-to- back credit, it is too risky for them. The cover afforded by possession of the original letter of credit is weak, since apart from the risk of the issuing bank finding a flaw in the documents, seller may become insolvent before seller’s bank has collected payment under the first letter of credit, in which case seller’s bank will have made or become committed to payment to seller’s supplier under back-to-credit .



Problems related to Chain Transactions or Back-to-Back Credits :

1. If the seller becomes insolvent, then the seller’s bank will be in deep trouble.

2. Complexities with documentation.

3. Administration cost is high.

4. Delays.

5. Fraud.

6. In case of breach of contractual obligation, the legal procedures will be too complex due to the number of parties and banks involved and the number of contracts, the legal procedure will be costly and time consuming too.

7. It is necessary that the documents required under the first letter of credit will be provided by the second letter of credit. This may be difficult or even impossible where the basis of sale is different. For example, the bank’s customer is buying on FOB and selling on C & F or CIF. There is also room for differences of interpretation where the first letter of credit and second letter of credit are payable by different banks, which may create a further difficulty. If a letter of credit is not transferable, then it will be wrong for the advising bank to open a back-to-back credit at the seller’s request, because the opening of a back-to-back credit is equivalent to transfer .

Solutions to the problems of Chain Transactions:

1. Transferable credit is considered as a better alternative for the back-to-back credit. According to Article. 38 (b) of UCP 600, transferable credit means a credit that specifically states it is ‘transferable’. A transferable credit may be made available in whole or in part to another beneficiary (second beneficiary) at the request of the beneficiary (first beneficiary).Transferable credits are used, where the beneficiary wishes to pay his own supplier or is acting as an agent for an undisclosed seller. In other words the seller who contracted to sell goods to the buyer on terms that payment is to be made under an irrevocable confirmed credit, is not himself the physical supplier but is buying them from the manufacturer, who is to be paid under a same letter of credit. In this situation the seller instead of arranging for the opening of a separate letter of credit in favour of the manufacturer, may find it suitable to transfer to manufacturer, wholly or in part, the benefit of the credit that is being opened in seller’s favour at the request of buyer .

Reasons for using transferable credits as an alternative to back to back credits are :

(a). It is operating inside a recognized practice called UCP 600.

(b). The buyer is aware about the transferable credit and it is allowed by

him.

(c). As in back to back credit, there is no chance of trouble to the seller’s

bank, even if he becomes insolvent.

(d).Chances of fraud are very less.

(e). Easy to use and not much complexities.

(f). If any problem arises, the confirming bank/advising bank can always reimburse the money paid, from the issuing bank, because the whole

procedure is taking place with the knowledge of the ultimate buyer.

But in back-to-back credit the ultimate buyer will come to know

about it only at final stage. Even then, the ultimate buyer and the

issuing bank is not responsible for it.

(g). If buyer agrees to a transferable credit, he accepts the associated

risk.

2. The second solution to the problems of chain transaction is Article.39 of UCP 600. According to article.39 , a credit is not stated to be transferable shall not effect the right of the beneficiary to assign any proceeds to which it may be or may become entitle under the credit, in accordance with the provisions of applicable law. This article relates only to the assignment of proceeds and not to the assignment of the right to perform under the credit.

3. The back-to-back credit is good enough, if the parties are ready to follow all the terms and conditions of the contracts and banks, provided they all are familiar with each other. Since a transferable credit can only be transferred once, it is suitable only if there is a single middleman obtaining the goods from one or more suppliers for a single re-sale. It is not suitable for chain sales, where the same goods are sold over and over again through many intermediaries. However, back-to-back credit may be used for any number of transactions.

In Ian Stach Ltd v Baker Bosly Ltd

According to Diplock J, the reason for issuing fresh credits is that in banking practice a transferable credit is regarded as transferable once only, and also is obvious in this sort of trade where string of contracts are involved.

Conclusion:

Documentary credit system is developed as a solution to the concerns of sellers and buyers, a century ago, when they rarely meet each other. Today, the emergence of new telecommunication devices has contributed to enhance trust between global buyers and sellers. Banks and other financial service providers have developed global trade financing tools such as documentary collection and trade asset. These solutions are not replacements of documentary credit system, instead they complement it by providing additional financing resources in a more complex and demanding international trade scenario.


Bibliography:

1. Benjamin’s Sale of goods (2002), Sweet & Maxwell, London.

2. British Library Current de-duplicated serials ACE-16, 01/05.

3. Carr, I (2005) International Trade Law, Cavendish Publishing Ltd, United Kingdom.

4. Frida Youseff (2001),UNCTAD, Documentary Risk in Commodity Trade.

5. Goode,R (2004),Commercial Law, Penguin Books, England.

6. Hooley, RJA & Sealy, LS (2003), Commercial Law Text, Cases and Materials, Butterworths,UK.

7. Jack,R et al(2000),Commercial Credits, Butterworths,UK.

8. King,R (2001) ,Gutteridge and Megrah’s Law of banker’s commercial credit, Roultedge,UK.

9. UCP 600 (2007),ICC Publication.