LETTERS

OF CREDIT


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.


INDEPENDENCE PRINCIPLE

> 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.

6. INSURANCE

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