Mr Ismail1 had earlier written on Seller’s Interest Insurance and this is his secound guest article. We hope to see more guest posts2.
- Letters of credit have been the linchpin of commerce for well over a century, with the seller having the assurance that his payment is secured and the buyer having the assurance that the goods or services purchased will be delivered as per the terms of the documentary credit. In the hands of an expert, the letter of credit is a fail-safe mechanism. The same however cannot be said for a novice or a first-time trader. A Letter of Credit (“LC”) is a complicated document and even a small error can result in grave consequences.
- This article attempts to highlight a few of the challenges that an inexperienced trader may face when trading on LC terms. A typical textbook explanation of a LC is a document from a bank guaranteeing that a buyer’s payment to a seller will be received on time and for the correct amount. However, the word guarantee is highly subjective. In actual fact, the payment is only guaranteed if and when all of the documents requested for in the LC are not only complete, but also accurate. Along with this the LC must also be confirmed for payment by the issuing bank, if issued by a bank/country with poor financial standing. The reason for this is that the issuing bank may delay or renege their payment and in which case the seller would be deprived of payment.
- LC’s are governed by rules set out by the International Chamber of Commerce through a document called Uniform Customs and Practice for Documentary Credits or UCP in short. This ensures that the interpretation of the terms remains constant no matter where they are used. UCP was first published in 1933 and has since undergone five revisions to accommodate the changes in the banking and finance sector, the latest edition being UCP 600 .
- A LC is based on documents only and has nothing to do with the sales contract proper. This means that if the seller or beneficiary, as they are called in the LC, supplies the wrong products either intentionally or unintentionally, the banks have no power to refuse payment as long as the beneficiary has submitted all the documents required under that particular LC. On the same note if the seller whilst having supplied the correct contractual goods or services but submits either incomplete or wrong documents to the bank, the seller may not be able to obtain the payment for the goods or services supplied.
- Most LC’s at least have five parties in the transaction. They are
- issuing bank
- confirming bank
- nominated bank
The applicant here is the buyer whilst the beneficiary is the supplier. The issuing bank is the bank issuing the letter of credit on behalf of the buyer. There are times where the issuing bank is from another country. The confirming bank is a second bank bound to honor and make the payment to seller so long as the conditions stated on the LC are fulfilled (even if the issuing bank fails to honor the payment). Such instances can arise when banks become insolvent. Last, but not the least, the nominated bank is the financial institution which receives the funds from the issuing bank. The selection of the nominated bank is done by seller (beneficiary).
- A common mistake that any supplier may make is to overlook the transshipment condition. While it is safe to prohibit transshipment for bulk shipments, it will be unwise to do so for containerized trade. Almost all container carriers use the hub and spoke method to benefit out of economies of scale. Hence, save for very short voyages like Port Klang to Singapore or Chennai to Colombo, invariably, shipments are subject to transshipment. If there is a prohibition for transshipment in the LC and in actual effect, there is a transshipment, then the documents will be considered discrepant. This means the seller will only receive his money if the buyer agrees to overlook the error and which may happen if the buyer is in need of the goods. Otherwise, the seller is either at the mercy of the buyer or left with an option to re-export the goods supplied and which in many countries are a challenge. Hence, in many cases, the seller will neither receive his goods or payment for the same.
- Some unscrupulous buyers may include onerous conditions that will make performance of LC impossible. Such clauses are commonly called “Jokers clause” as their main aim is frustrate the negotiation of the LC. Examples of such Jokers Clause are:
- Payment to be made only after customs clearance at the destination port: In this case, the seller may loose total control of the goods. As mentioned above, in the absence of payment, bringing back the goods to the country of origin is a herculean task and in some countries may be next to impossible.
- Bill of exchange must be endorsed by buyer or applicant: If the intention of the buyer is to renege on the contract, then they will never endorse the documents.
- Export invoice must be endorsed by applicant: This situation is similar to the earlier situation i.e. bill of exchange, however, in this case the export invoice would need to be endorsed by buyer.
- Certificate of inspection of goods to be issued by a particular inspection agency: A fraudulent buyer will make sure that such an agency doesn’t even exist and therefore may nominate agencies who are similarly named but do not exist.
- Export clearance certificate issued by a particular country’s embassy: A fraudster will ensure that such an embassy won’t exist in the particular country. This being the case the condition can never be fulfilled. Unscrupulous buyers are well aware that the beneficiary will never be able to obtain the documents stated in the above examples. They may then use the discrepant documents to obtain hefty discounts or at times even renege a sales contract involving price sensitive goods.
- In conclusion, the terms of the LC’s are indeed important which the exporter should carefully consider and if in doubt, seek professional assistance before accepting any onerous conditions. Otherwise, the exporter will be exposed to issues rearing up at a later date and which may lead him to incur avoidable losses.
1This guest article has been written by L M Mohamed Ismail,a marine insurance broker employed with Acclaim Insurance Brokers Pte Ltd, involved in various classes of marine insurance and with a strong following in the cargo business. He can be reached at firstname.lastname@example.org
2We welcome all such articles on Marine Insurance, International Shipping, Transportation & Trade and Dispute Resolution and which may be of interest and hope to see more such posts.