Letters of Credit, Bills of Lading & International Trade Finance Documentation Issues Important in Litigation
The author explains from a banker’s and financial professional’s point of view factors that must be taken into account by attorneys handling litigation involving letters of credit, bills of lading, documentary collection, international trade finance documentation, offshore transactions, offshore finance, transfer pricing, international business entities, multinational business entities, and other related subjects.
International Trade finance
International trade finance deals with money lent to sellers, i.e., exporters, and buyers, i.e., importers. In international trade transactions, there is always the “chicken and egg” question of payment to the seller versus shipping and delivery of the goods to the purchaser. If a seller requires payment in advance, then their sales may suffer since purchasers would rightfully fear that they might pay in advance and the seller not ship the goods. Likewise, if the seller ships the goods and trusts the buyer to pay, then the seller runs the risk that the purchaser may not pay.
In order to address this recurring situation, banks step in as an intermediary and provide various types of financing that attempt to address the concerns of both the buyer and the seller. For example, the buyer's bank may provide a letter of credit to the seller, or the seller’s bank, providing for payment upon presentation and approval of certain specified documents, such as a bill of lading, et al. The Seller's bank may make a loan by advancing funds to the seller on the basis of the sales contract.
Other forms of intermediary-assisted trade finance include trade credit insurance, export factoring, forfaiting (the purchasing of receivables from exporters) and many other methods.
There are four basic methods of trade finance:
1. Advance Payment - The buyer pays up front and trusts that the seller will forward the goods. This method is the most secure for the seller and the least secure for the buyer.
2. Direct Payment - The Seller ships the goods and the Buyer pays the Seller directly. This offers the most security for the Buyer and the least security for the Seller.
3. Documentary Collection - An international trade financing procedure in which a bank in the buyer’s country acts as a fiduciary on behalf of the seller in collecting and remitting payment for a shipment of goods. The seller presents the required shipping and collection documents to his local bank which sends them to its correspondent bank in the buyer's country. The seller’s bank (also known as the presenting bank) delivers the required documents to the importer in exchange for payment - in the case of a “documents against payment” transaction - or a firm commitment to pay on a fixed date - in the case of a “documents against acceptance” transaction. The banks involved in the transaction act only in a fiduciary capacity to collect the payment but make no guaranties. They are liable only for correctly carrying out the exporter's collection instructions and may, if so instructed, sue the non-paying or non-accepting importer on the exporter's behalf.
Documentary collection transactions, also known as “Cash Against Documents” transactions, are subject to the ICC's URC 525, sight and usance (The length of time that is allowed for the payment of a foreign bill of exchange.), for delivery of shipping documents against payment or acceptances of a draft, where the shipment of the goods comes first, and then the title documents are sent by the seller's bank (known as the “remitting bank”), to the buyer's bank (known as the “collecting bank”), for acceptance and payment.
4. Documentary Credit - This covers letter of credit transactions wherein the buyer has his bank provide a letter of credit that effects the payment for the goods purchased. In effect, the seller is comforted by substituting the credit worthiness of the bank for the creditworthiness of the buyer. These transactions are subject to UCP 600 and are more fully explained in the following section.
How Letters of Credit Work
The first thing to understand about Letters of Credit is that there are many different variations that have been crafted over the years to meet the requirements of Buyers and Sellers. However, there is a generally accepted format that permeates all Letter of Credit transactions, and that framework will be explained here.
The basic purpose of a Letter of Credit is to comfort buyers and sellers in an international trade transaction by essentially replacing the credit of the buyer with the financial backing of the bank that issues the letter of credit. Two basic types of letter of credit are used:
1. Commercial Letter of Credit - This is the basic payment document guaranteeing the payment for the goods that are being sold and shipped. Also called a Documentary Letter of Credit.
2. Standby Letter of Credit - This is a secondary payment device.
Both types of Letters of Credit will be explained:
1. Commercial Letter of Credit
An issuing bank issues (or opens) a commercial letter of credit at the request of one of its customers, authorizing the advising or confirming bank, to make a specified payment to the seller or shipper, known as the beneficiary. The letter of credit is the bank’s commitment to fund draws covered by the credit. In effect, the credit of the issuing bank replaces the credit of the bank's customer as the party obligated to make the payments under the letter of credit.
Binding guidelines for the issuance and operation of letters of credit used in international transactions are governed by the International Chamber of Commerce Uniform Customs and Practice for Documentary Credits.
Letters of credit that are issued and used solely within the United States are governed by and subject to the Uniform Commercial Code.
Components of a Letter of Credit
• A payment obligation on the part of the issuing bank.
• To facilitate a purchase by the bank’s customer.
• To pay a specified amount of money.
• To the beneficiary seller or shipper.
• Upon the receipt of specified goods.
• In acceptable condition.
• And upon the receipt of specified documents.
• All received according to a specified timing schedule.
• All in compliance with the terms of the letter of credit.
• And received at a certain place.
Parties to a Letter of Credit
It is important to note that the letter of credit transaction is actually a separate contract from the sales contract between the buyer and the seller. The letter of credit transaction deals in documents and not in the handling of goods, and the bank that issues the letter of credit is not liable for the performance of the sales contract between the buyer and the seller. The bank that issued the letter of credit is obligated to pay the specified amount to the seller/beneficiary if it produces the documentation required by the letter of credit. The issuing bank's obligation to its customer, the buyer, is to examine thoroughly all of the documents to insure that they meet all the terms and conditions required by the letter of credit. When the beneficiary presents the documents for payment, the beneficiary guarantees that all of the conditions of the letter of credit have been met. Then if the issuing bank’s examination of the documents confirms this fact, then the issuing bank makes the specified payment to the beneficiary/seller.
Once the issuing bank has received the documents and approved them as complying with all of the requirements specified in the letter of credit, the bank is obligated to make payment to the beneficiary. The Uniform Customs and Practice for Documentary Credits allow the issuing bank a reasonable amount of time after receipt of the documents to examine them and to honor the letter of credit by making the specified payment to the beneficiary. Then the issuing bank completes the transaction by receiving reimbursement from the bank customer for whom the letter of credit was issued.
A letter of credit typically will require at a bare minimum documents such as an official invoice, a bill of lading or airway bill, and an insurance document. However, letters of credit may require additional documentation depending upon the nature of the transaction.
An advising bank is usually a bank located in the beneficiary’s city. The advising bank’s role is to advise the beneficiary and insure the beneficiary that the letter of credit is valid, usually accomplished by having a relationship with or simply by knowing of and communicating with the issuing bank. Also, it is the responsibility of the advising bank to make sure that the appropriate documents are collected and sent to the issuing bank.
Irrevocable letters of credit may be confirmed or unconfirmed. An issuing bank that issues a confirmed letter of credit may require that a confirming bank confirm the letter of credit for the beneficiary, which means that the confirming bank obligates itself to insure payment to the beneficiary under the letter of credit. Before a confirming bank confirms a letter of credit, it performs an evaluation of the issuing bank and the documentation requirements of the letter of credit. Typically, the confirming bank is also the advising bank, but this is not a requirement, and the functions may be separated.
Documents that May Be Required in a Letter of Credit Transaction
This is a sample of documents that may be required in a letter of credit transaction:
• Financial Documents – For example, a Bill of Exchange or a Co-accepted Draft.
• Commercial Documents – For example, Invoice, Packing List.
• Shipping Documents – For example, Transport Document, Insurance Certificate, Commercial, Official or Legal Documents.
• Official Documents – For example, License, Embassy Legalization, Certificate of Origin, Inspection Certificate , Phyto-sanitary Certificate, Agricultural Certifications.
• Transport Documents – For example, Bill of Lading (ocean or Multi-Modal or Charter party), Order Bill of Lading, Through Bill of Lading, Airway Bill, Trucking Receipt, Railway Receipt, CMC Other than Mate Receipt, Forwarder Cargo Receipt, CIM Rail Consignment Note, CMR Road Consignment Note, Consignment Instructions, FIATA Warehouse Receipt, FIATA Negotiable Multi-Modal Bill of Lading, Non-Negotiable Multi-Modal Transport Waybill, FIATA ,Delivery Receipt.
• Insurance documents – For example, Insurance Policy, or Insurance Certificate.
There are many other documents that may be required in a letter of credit transaction.
How the Letter of Credit Process Works
There may be variations in this process based upon the customary practices in different geographical areas, different industries, etc.; but the basic process usually looks like this:
1. A Seller (Beneficiary) requires a Buyer to provide a letter of credit to guarantee payment.
2. The Buyer requests that his bank open a letter of credit in favor of the Seller.
3. Buyer's bank approves the letter of credit and forwards it to its correspondent bank (Advising or Confirming Bank) in the Seller’s area and that will do the advising or confirming function.
4. The Advising bank advises or confirms the letter of credit and forward the original to the Seller (Beneficiary).
5. The Seller (beneficiary) ships the sold goods and the other documents required by the letter of credit to the Buyer.
6. The Seller (Beneficiary) presents the documents required by the letter of credit to the advising or confirming bank to be examined for compliance and approved.
7. The advising or confirming then forwards the payment to the Seller.
8. Advising or confirming bank forwards the documents to the Issuing (Buyer’s) bank.
9. Issuing bank examines the documents for compliance. If they are in order, the issuing bank will debit the buyer's account and send the funds to the advising or confirming bank.
10. Issuing bank forwards the documents to the buyer.
To obtain the final payment, various means may be used by the advising or confirming bank including direct payment by the issuing bank, a transaction in a correspondent bank account, reimburse from another bank, or various other means that effect a transfer of funds from the issuing bank to the advising or confirming bank.
Letter of Credit Characteristics
Generally, letters of credit are negotiable instruments. The beneficiary may direct the issuing bank to pay another bank named by the beneficiary. In order to be considered a negotiable instrument, a letter of credit must include an unconditional promise to pay a specified amount on demand or at some specific time. The new bank named by the original beneficiary bank becomes a holder in due course of the letter of credit, and accepts the letter of credit for the specified value and in good faith and without notice of any claims against it. All of this assumes that the letter of credit is in order and that the documents are present and acceptable to the issuing bank.
An exception to this procedure is if the parties choose enter into a straight negotiation which means that the obligation of the issuing bank to pay is exclusively to the beneficiary of the letter of credit. In order to be considered a straight negotiation, the letter of credit must carry the language "we engage with you" or "available with ourselves." In a straight negotiation, the issuing bank’s obligation to pay does not extend to a party that purchases the draft as a holder in due course.
Revocable or Not
Letters of credit may be structured as either revocable or irrevocable instruments, and this status is usually indicated on the face of the letter of credit document.
You may never see a revocable letter of credit. Revocable letters of credit are seldom used, and they may be revoked or modified by the issuing bank at any time and for any reason and without notification to the beneficiary. Therefore, this means that a revocable letter of credit cannot be confirmed.
However, once the documents have been presented to the issuing bank, examined, and found to be acceptable, a revocable letter of credit cannot be revoked, and it becomes final, and the letter of credit and draft must be honored at that point.
Irrevocable letters of credit are by far the most common form and may not be revoked or modified without the unanimous agreement of the issuing bank, the confirming bank, and the beneficiary / seller. An irrevocable letter of credit from the issuing bank insures the beneficiary that if the required documents are presented and that all of the terms and conditions and timing requirements are met, then the issuing bank will make the specified timely payment to the beneficiary.
The proceeds of an irrevocable letter of credit must be made available to the Beneficiary if the documents presented meet all of the stated requirements of the letter of credit, UCP 600, and other international standard banking practices, according to the following:
• Sight Payment – by payment at sight upon the presentation of acceptable documentation.
• Deferred Payment – by payment on the maturity date in compliance with the requirements of the letter of credit; and of course undertaking to pay on due date and confirming maturity date at the time of presentation of acceptable documentation.
• Acceptance by the Issuing Bank – by acceptance of a Draft drawn by the Beneficiary on the Issuing Bank and payment at maturity of the draft.
• Acceptance by Another Drawee Bank – by acceptance and payment at maturity of a Draft drawn by the Beneficiary on the Issuing Bank in the event the drawee bank stipulated in the letter of credit does not accept the Draft drawn on it, or by payment of a Draft accepted but not paid by the drawee bank at maturity.
• Negotiation by Another Bank – by payment of a Draft, without recourse, to drawers or holders, of a Draft drawn by the Beneficiary or documents presented under the letter of credit and properly negotiated by the nominated bank. Negotiation means the giving of value for Draft or documents by the nominated bank.
Transferable and Assignable
In order for a beneficiary to transfer or assign its right to receive the specified funds under a letter of credit, the letter of credit must be structured so that it is clearly transferable or assignable. There is no limit on the number of times that a domestic letter of credit issued under the Uniform Commercial Code may be transferred. However, international letters of credit issued under the Uniform Customs Practice for Documentary Credits may be transferred only once. Nevertheless, even if a letter of credit specifies that it is not transferable or assignable, the beneficiary still may transfer their rights to another party so long as the transfer takes place prior to the performance of the conditions of the letter of credit.
Payment through a letter of credit typically is through a draft. All letters of credit require that the beneficiary present a draft as well as certain specified documents in order to receive payment from the issuing bank. A draft is similar to a check and is a written payment order by which the party creating it orders another party to pay money to a third party. A draft is sometimes referred to as a bill of exchange.
There are two types of drafts - sight draft and time draft – and both are used in letter of credit transactions. A sight draft is payable on sight, i.e., as soon as it is received – seen - by the bank. Still, the bank is allowed a reasonable period of time to review and approve the attached documents before they are required to make payment.
A time draft is payable after a time period specified on the time draft. The bank is required to accept a time draft as soon as it has received the specified documents and accepted them as meeting the requirements of the letter of credit. Again, the bank is allowed a reasonable time to examine the attached documents.
2. Standby Letter of Credit
Whereas a commercial letter of credit is a payment mechanism for a particular international trade transaction, a standby letter of credit serves as a secondary or back-up means of payment. Issuing banks issue standby letters of credit in order to provide comfort to other parties that the bank’s customer can perform some financial obligation to the beneficiary. Usually, it is not expected that the issuing bank will ever be called upon to fund the standby letter of credit.
Domestic standby letters of credit are governed by the Uniform Commercial Code. They are generally less complex transactions than are commercial letters of credit, and they do not require a correspondent bank to carry out the advising or confirming functions.
A standby letter of credit can only be drawn on if the customer has failed to perform some required action, as specified in the letter of credit, and before the letter of credit’s expiration date. To draw on the letter of credit, the beneficiary presents evidence that the customer has not performed some required action and may include copies of various documents depending on the transaction, invoice copies, and a draft for the amount due under the letter of credit. Under the Uniform Commercial Code, a bank is allowed until the close of the third banking day after the receipt of the required documents to honor the draft.
Standby letters of credit often are used as a credit enhancement or to guarantee a beneficiary that payment will be made. They can also be used for any situation where a future payment needs to be guaranteed.
The most common documents that are required to accompany a draft are a commercial invoice. bill of lading, warranty of title, and an indemnification letter.
A commercial invoice typically includes at least a generic description of merchandise, price, FOB origin, buyer’s name, address, and contact information, and the seller’s name, address, and contact information.
Bill of Lading
A seller consigns goods to a carrier in exchange for a bill of lading. The seller then provides the bill of lading to the bank in exchange for payment. The seller's bank exchanges the bill of lading for payment from buyer's bank. The buyer's bank exchanges the bill of lading for payment from the buyer. The buyer then provides the bill of lading to the carrier and takes delivery of the goods.
The bill of lading confirms that a carrier has received the goods for shipment. It is also a receipt for the merchandise turned over to the carrier, and states the destination of the goods.
Main Types of Bills of Lading
● Straight Bill of Lading
This bill states that the goods are consigned to a specified entity or person and it is not negotiable free from existing equities, i.e. any endorsee acquires no better rights than those held by the endorser. So, for example, if the carrier or another holds a lien over the goods as security for unpaid debts, the title received by the endorsee is subject to that lien. Although, if the endorser wrongfully failed to disclose the charge, the endorsee will have a right to claim damages for failing to transfer a clean and unencumbered title.
Also known as a non-negotiable bill of lading; and from the banker's point of view this type of bill of lading is not safe.
● Order Bill of Lading
This bill uses express words to make the bill negotiable, e.g. it states that delivery is to be made to the further order of the consignee using words such as "delivery to ABC Ltd., or to its order, or its assigns." Consequently, it can be endorsed by ABC Ltd., or the right to take delivery can be transferred by physical delivery of the bill accompanied by adequate evidence of ABC Ltd.'s intention to transfer.
● Bearer Bill of Lading
Just like any other bearer document, this bill states that delivery shall be made to whosoever holds the bill. A Bearer Bill of Lading may be created explicitly or it is an order bill that fails to nominate the consignee whether in its original form or through a blank endorsement. A bearer bill effectively can be negotiated by physical delivery.
● Surrender Bill of Lading
Under a term import documentary credit, the bank releases the documents upon receipt from the negotiating bank, but the buyer does not pay the bank until the maturity of the draft under the credit. This direct liability is called Surrender Bill of Lading (SBL), i.e. when the bill of lading is handed over, you surrender title to the goods and power of the sale over the goods.
Warranty of Title
A warranty of title confirms that the title to the goods being conveyed from the seller to the buyer is valid, and that the seller indemnifies the buyer and the bank.
Indemnification letters are sometimes used to provide protection that is deemed to be needed in specific circumstances. For example, an indemnification letter may be used to guaranty that certain shipping documents will be provided.
Letter of Credit Documentation Problems
Letter of credit documentation problems are common due to the great variety of workable practices that are possible, documentation practices that vary among geographical regions, etc. However, it is a standard practice that the documentation requirements contained in a letter of credit may not be modified or waived without the approval of the customer.
Some typical documentation variations between the letter of credit and the transaction documents include:
• Date problems, for example the letter of credit expired before the draft was presented, some of the documents may have a stale date, delivery of goods before or after the specified date range, etc.
• Embarkation and debarkation ports and actual destination variations.
• Changes included in the invoice not authorized in the credit.
• Inconsistent or inaccurate description of goods.
• Invoice amount different from draft amount.
• Beneficiary name different from documents.
• Insurance documentation inconsistencies.
• Unsigned documents.
• Missing documents.
Sometimes, a documentation discrepancy can be corrected while the document is still in the control of the negotiating bank. The seller should request that the negotiating bank return the documents for corrections, if time will permit.
If time will not permit, then the seller may ask that the negotiating bank send the documents to the issuing bank for pre-approval or else notify the issuing bank of the problem and request authority to waive the problem and fund. When all parties have agreed to waive the problem, then the letter of credit may be funded.
Keep in mind that there are many different ways to finance an international trade transaction, shaped by financial considerations, product considerations, different practices in different geographical areas, practices that may vary due to different shipment modes, and many other nuances that man affect how an international trade finance transaction is structured. The key is to look past all of the documentation to make sure that the potential financial exposures of all of the parties are addressed and covered by the proposed international trade financial transaction.
ABOUT THE AUTHOR: Expert Witness Consultant Don Coker
Expert witness and consulting services. Over 480 cases for plaintiffs & defendants nationwide, 116 testimonies, 12 courthouse settlements, all areas of banking and finance. Listed in the databases of recommended expert witnesses of both DRI and AAJ.
Clients have included numerous individuals, 60 banks, and governmental clients such as the IRS, FDIC. Employment experience includes Citicorp, Ford Credit, and entities that are now JPMorgan Chase Bank, BofA, Regions Financial, and a two-year term as a high-level governmental banking regulator.
B.A. degree from the University of Alabama. Completed postgraduate and executive education work at Alabama, the University of Houston, SMU, Spring Hill College, and the Harvard Business School.
Called on by clients in 30 countries for work involving 61 countries. Widely published, often called on by the media.
Copyright Don Coker
Disclaimer: While every effort has been made to ensure the accuracy of this publication, it is not intended to provide legal advice as individual situations will differ and should be discussed with an expert and/or lawyer.For specific technical or legal advice on the information provided and related topics, please contact the author.