BUSINESS FRAMEWORK OF THE CREDIT DEVICE
1.01 From very early times, mercantile custom and practice common to all legal systems evolved alternative methods of payment of the purchase price of goods in foreign sales transactions. In settling the provisions of a sales transaction contemplating, for example, large-scale, long-haul shipments, the seller can stipulate for an advance payment, due from the buyer upon closing the negotiations; or may content himself with selling the goods to the buyer on open account terms; or agree to employ a bill of exchange; or request the buyer to furnish a letter of credit to cover the price. Each of these options involves different levels of risks; whichever alternative the parties’ agreement eventually selects is often the result of their individual bargaining strengths, an expression of a willingness on the part of one person to run a certain risk in order to reap the benefit of a potentially lucrative deal, rather than allow the business to pass him by and not take a chance at all. What are the possible risks associated with opting to pay or to receive payment by a particular mode?
(1) Advance payment
1.02 It is possible for a seller, in proposing a sale transaction, to demand an advance payment of the price, and promise to deliver the goods by a stated date. Other than the occasional cases where, for instance, the sum will facilitate the production or procurement of the intended goods, the buyer usually eschews a contract requiring payment upfront. In the first place, he often lacks the wherewithal to make the advance, and taking out a bank loan attracts prohibitively high interest rates, including complex conditionalities. Second, even if the money is readily obtainable and remitted, the remittance to the seller effectively renders the capital unavailable for a significant period. Third, the buyer constantly faces the prospect of the goods failing to materialize, and the amount he had paid irrecoverable: the seller’s insolvency or financial difficulties may supervene. Notably, though, in the few transactions in which the parties agree the proposed stipulation, prudent buyers are wont to safeguard their interests against the likelihood of such untoward events occurring by requesting the seller to furnish an advance payment bond or on-demand guarantee.
(2) Sales on open account
1.03 Under a foreign sale on open account, the buyer receives the merchandise at the destination named in the contract and effects payment immediately or at some future time. Ordinarily, however, sellers loathe such arrangements. Goods can take several months to reach the point of delivery, and as much length of time to clear customs. Those periods effectively shut the seller out of the capital invested in procuring the cargo from some third-party suppliers, diminishing the funds he needs to satisfy his commitments to them. A sale on credit also means that the seller relies on the creditworthiness and personal integrity of the buyer. By such reliance, he runs the risk of losing a huge investment of time, effort, and money in the event of the buyer’s insolvency. Where the market for the goods has fallen considerably, this stands to influence the buyer to demand a substantial cut in the initially agreed price. A refusal to oblige the buyer can translate to the seller having to scout around for a new customer in a possibly unfamiliar market, or force the seller to commence an action for damages for breach of contract against him. Regrettably, pursuing such a claim could become a protracted legal battle, spanning a couple of years in a number of countries. The experience would be financially devastating for the seller, not least because the damages which the court or arbitrator might ultimately award in his favour are, in the nature of things,1 unlikely to adequately compensate him for the disruption caused to his business by the litigation. Quite understandably, therefore, significant volumes of international sales seldom occur on open account terms.
(3) Employing a bill of exchange
1.04 With an advance payment unforthcoming from the buyer, and transacting on open account basis being generally unacceptable to the seller, both parties will stipulate that the seller shall draw on a named noticeably solvent financial institution (traditionally the buyer’s bankers as opposed to the relatively unreliable credit reputation of its customer, the importer) a bill of exchange2 for the agreed price of the goods. The stipulation normally obligates the buyer to secure the drawee’s acceptance of the bill against presentation to the drawee of the documents required in the sales contract.3 The documents commonly include a bill of lading4 representing the merchandise, invoice, insurance policy,5 and a certificate of quality6 or an inspection report.7 A bill of exchange of the kind indicated, on occasion referred to as a time or usance draft to distinguish it from a bill drawn payable at sight, is customarily made out payable to the seller’s order. Compared with sight drafts, a usance bill has long been the most frequently and widely employed means of payment in mainstream international sales arrangements. The explanation for its predominant use lies in its ability to enable buyers to purchase goods, and defer actual payment of the price until a stated period (in many cases 180 days after its date8) has elapsed, while simultaneously ensuring that the seller, upon dispatching the cargo to the contractual destination, gets paid his money when he pleases.
(a) Manner in which the bill performs its role
1.05 Following completion of shipment, the seller draws up the bill of exchange in accordance with the terms of the sales contract, attaches the proper documents, and then tenders the documents, normally to his bank in the locality, with a request for a discounted payment of the amount of the draft. In practice, the tenderee will expect the presentation where it had acted as the financier of the shipment covered by the documents.
1.06 Prior to financing the deal, or deciding to grant the seller’s request for a discounted payment, the bank will have meticulously evaluated certain business risk factors and considered the overall picture of the transaction positive. Among the factors are the current status of the seller’s bank account; the invoice value; the nature and destination of the goods involved; the international financial standing of the bank on whom the bill is to be drawn; the relative stability of the currency in which the bill of exchange is denominated; the political situation existing in the country to which the currency belongs, along with the likelihood that the government there might impose or increase restrictions on foreign exchange dealings; the relations between the country and the other members of the global community, including the UN; and the substantive character of the country’s law, as well as the quality of its administration of justice.
1.07 The tenderee bank effects the desired payment in one of two ways. It may send the documents through its correspondent or branch operating in the buyer’s location with instructions to present them to the drawee for acceptance, a process known as collection.9 The drawee accepts the draft at the instance of the buyer, returns it via the banking channels or directly by courier to the seller’s bank. By this acceptance, the drawee acceptor promises10 to pay the sum on the draft at the maturity date, namely, on the 180th day from the date of the instrument. The bank then credits the seller’s account with a discounted amount of the accepted bill, the sum credited depending on the applicable discount rates, which largely depend on the weight of the risks earlier adverted to and the length of time the acceptance will take to mature. At all events, the discounting creates an avenue for the seller to circumvent having to wait 180 days for the draft to reach maturity before encashing it, thereby assisting him with solving certain of his immediate cash flow needs.
1.08 The alternative course which the bank may adopt to meet the seller’s request is to pay the discounted sum at the time of the seller’s demand, have the seller endorse the bill of exchange and the attached bill of lading in its favour, and afterwards transmit the documents to the drawee for acceptance. The payment so made gives rise to certain legal consequences.11 It suffices here to point out that the bank’s purchase (negotiation) of the presentation prima facie goes to constitute the bank, a holder of the draft for value and in due course, with a security interest in the goods represented by the accompanying bill of lading to the extent of the sum advanced by way of the discount. On the other hand, by reason of the purchase, the seller’s ownership of the merchandise passes to the buyer by virtue of the contract of sale.12 Upon the drawee taking up the documents and sending back the accepted bill, it acquires a limited proprietary interest in the cargo, and that of the bank ceases.13
1.09 After the acceptance and the dispatch of the bill to the seller’s bank, the drawee delivers the shipping documents to its customer, the buyer, to take delivery of the goods at the port of discharge and, if appropriate, arrange resale to sub-buyers. For its services, the drawee charges an acceptance commission. As the maturity date of the bill is the 180th day from the date of the draft, the obligation of the buyer to put the drawee in funds to meet its liability arising out of the acceptance to the discounter or eventual bona fide holder of the draft for value, only matures or crystallizes on that 180th day; thenceforward the sum due, if unpaid, metamorphoses into a loan and would naturally be subject to the prevailing interest rates, both of which the drawee may recover through the comparatively easy self-help remedy of realizing the asset pledged as security for the obligation.14
(b) Reciprocal rights and obligations of the parties in a nutshell
1.10 A distinguishing characteristic of the sales transaction affords the buyer two successive rights against the seller, namely, the right to conforming documents and the right to the goods that form the subject matter of the sale agreement.15 However, payment or acceptance of a draft by the drawee on behalf of the buyer against an unimpeachable set of documents is to occur earlier in time than when the goods reach the port of discharge. But the payment does not preclude his right to reject or to claim damages in respect of the goods if, upon discharge and reasonable inspection, he discovers that they do not correspond with the specifications in the contract as to description, quality, or quantity.16 On the other hand, rejection of the documents constitutes a repudiatory breach of the contract, entitling the seller to consider himself relieved of any further obligation owed to the buyer and to recover the loss he sustained because of the rejection. Prosecuting a lawsuit to vindicate that entitlement carries with it serious financial hardship for the seller.
1.11 Bills of exchange as a mode of payment tend to work to the seller’s disadvantage. When the documents from the seller’s bank come forward for acceptance (or payment in the case of a sight draft), the drawee does not normally accept the bill until it has given the buyer a chance to examine them and confirm they are in every respect what the sales contract entitles him to. It often happens that an intervening change in economic conditions renders the contract an entirely unprofitable business for the buyer. Almost entirely on this basis, he no longer wants the goods he engaged to buy, so that well ahead of the documents’ arrival he will have made up his mind to get rid of the bargain. An invitation to call at the drawee’s premises to check the regularity of the tender would therefore merely provide him with an opportunity to assert a deficiency in comparatively faultless and adequate documents, and press the bank to decline acceptance of the presented draft. Perhaps anxious to avert a threatened or potential lawsuit and foster a mutually beneficial future relationship with the customer-buyer, some drawees would yield to the pressure exerted on them and accordingly refuse to accept the tendered draft. In the absence of exceptional circumstances,17 the drawee will not be liable to the seller qua drawer, nor to his bank qua endorsee of the instrument for withholding its acceptance.18 Instead, the dishonour by non-acceptance triggers the seller’s liability19 to his bank, the endorsee holder of the unaccepted draft and documents, in that the seller, being drawer of the bill, engages that on due presentation to the drawee, it shall be accepted and paid according to its tenor, and that if it be dishonoured, he will compensate the holder of the bill.20
1.12 Even if the acceptance had been given and subsequently discounted, the drawee acceptor may decline to honour the bill at the maturity date, claiming certain defences, some urged on it by the buyer, others of its own initiative. Very often, the grounds for complaint are wholly centred on the quality of the goods and doomed to defeat as a matter of negotiable instrument law. In the first place, the dishonour by non-payment ex hypothesi runs afoul of section 54 (1) of the Bills of Exchange Act 1882 or, in the US, UCC Article 3–413. Second, an acceptance creates a separate contract from the sales agreement between the merchants; the contract admits of limited defences such as fraud on the part of the seller seeking to enforce it, and no defence at all to a bona fide holder of the draft for value.21 Nevertheless, when the drawee dishonours the bill by non-payment, an immediate right of recourse against the seller as the drawer accrues to his bank, the holder. Under the statute, therefore, the bank can recover the payable amount on the accepted but dishonoured draft plus interest from the drawee in an action or by way of set-off of the sum against the funds that it holds in an account of the dishonouring acceptor. In the ordinary case, however, set-off is inapplicable because no such funds are at hand; and it would, as a matter of prudence, choose to save itself the trouble of litigating the dishonour by simply debiting the seller’s account with the discounted sum paid previously,22 leaving the seller to sue the drawee on the acceptance or the buyer under the sale contract.
1.13 A sales contract, which stipulates for payment by means of a sight or usance draft, involves the contracting parties’ agreement that the drawee will accept the seller’s bill drawn in accordance with the provisions of the contract against complying delivery of the specified documents. The working out of the agreement usually exposes the seller and the potential discounter of his draft to major risks. There is no cast-iron guarantee that the drawee will perform the expected act upon receipt of the documents; a refusal to carry out the task ordinarily founds no cause of action at the suit of the presenting party. Nevertheless, the non-acceptance practically leaves the drawee on a par with the seller whose hopes are disappointed in a sale on open account transaction: it might eventually compel him to sue the buyer for the price in respect of goods discharged long ago and accumulating substantial warehouse charges. In the case where the drawee accepts a presentation, but subsequently dishonours the acceptance, the discounting bank normally exercises its right of recourse against the seller. In that event, the seller suffers the misfortune of proceeding against the drawee acceptor, typically abroad, to seek enforcement of the acceptance. Overall, then, the seller constantly runs two types of risk under a sale transaction which entails the use of a bill as the contractual method of payment: he faces the likelihood of the drawee refusing an otherwise apparently regular tender of documents without incurring liability for the refusal. The drawee’s failure to honour an accepted draft at maturity obligates him to repay the advance he received from the discounting banker; moreover, the repayment may well plunge him into liquidation or bring his business to the brink of collapse.
(4) Mercantile cure for the risk of non-payment
1.14 Since the mid-nineteenth century, or thereabouts, down to the present day, only one instrument has emerged to make it possible for the seller to contract in terms that tap the bill of exchange method of payment and nevertheless free him from becoming entangled in the risks attendant on the use of the bill. The mechanism is widely known in the mercantile and international banking world as a letter of credit. It extracts the drawee’s engagement to take up the conforming documents and, on the other hand, often eliminates the possibility of the seller being required, after obtaining payment, to refund money already ploughed back into his business. In defined contexts,23 the obligation also runs to the seller’s banker or some other discount house: by its nature, in such an event, it authorizes either party to purchase (i.e. negotiate) the seller’s draft with the accompanying documents covering the merchandise involved in the sale contract; upon effecting the envisaged negotiation, the purchasing party becomes possessed of the right24 to demand the drawee’s acceptance of the draft to recoup its cash advances to the seller. As will appear in the next section, a letter of credit provides a range of additional benefits for the parties and can assume different forms. But whatever its shape in any particular transaction, current banking practice and usages understand a letter of credit25 to mean an irrevocable promise by a bank (‘the issuing bank’ or ‘issuer’26) at the request of a party (‘the applicant’27) in favour of another party (‘the beneficiary’28) to honour29 a presentation of documents which complies with the terms of the promise. The fact of issuance of the undertaking together with its requirements is usually notified to the beneficiary in the form of a letter, hence the expression ‘letter of credit’. Considering the condition for acceptance of documents, whether the seller gets paid or not, principally lies within his power—an ability which the bill of exchange lacks the means to confer on him. If his presentation adheres to the stipulations of the credit, ‘nothing will’ ordinarily prevent him from receiving the amount of the instrument, the price of the goods articulated in the sales contract.30 If not, the bank is entitled to reject the tender unless it omits to follow a stipulated contractual course in communicating the rejection.31 What the beneficiary’s or other presenting party’s right to payment and the presentee bank’s right of rejection covers, runs through subsequent chapters of this book.
1.15 Unlike the bill of exchange, which the law of negotiable instruments controls, the letter of credit enjoys the protection of that law, and has an entire article devoted to it in the American Uniform Commercial Code (Revised Article 5–Letters of Credit).32 Furthermore, it forms the subject of constant regulation of the Uniform Customs and Practice for Documentary Credits (the UCP) to ensure its provisions keep abreast of the latest developments in associated business transactions. The device also occupies the careful attention of International Standby Practices (ISP98) and a United Nations convention.33
1.16 ISP98. Drafted by the American Institute of International Banking Law & Practice Inc (IIBP), adopted and published in 1998 by the International Chamber of Commerce as ICC Publication No. 590 with 1 January 1999 as the effective date, the International Standby Practice (ISP98) codifies certain banking practices relating to standby letters of credit thought to be generally accepted. Unlike the UCP, ISP98 has yet to gain popularity among non-American banks. Standby credits issued outside the US occasionally express themselves subject to it. This is, however, hardly surprising. Its development and eventual adoption faced fierce opposition from the vast majority of the national committees and direct members of the ICC’s Commission on Banking Technique and Practice. The principal grouse was that standby credit, whatever its peculiarities might be, did not require a fresh, separate regime. The dissentient considered the UCP adequate for the instrument.34
1.17 The UCP. This code is a product of the International Chamber of Commerce (ICC).35 ICC’s membership includes banks and trading companies in over 120 countries and territories; but periodic revision of the UCP falls to the organization’s Banking Commission.36 The code is easily the most effective in the annals of privatively drafted international rules for trade, presumably because its formulation usually undergoes extensive consultation with the ICC’s national committees and member companies. The UCP comprises a unique set of precepts and requirements aiming to harmonize, clarify, and standardize the almost endless variety of municipal banking and related commercial practices touching on letter of credit operations around the world. Originally launched in 1933,37 following the conclusion earlier in that year of the Seventh Congress of the ICC in Vienna, Austria, the code has thus far seen six revisions.38 The prevailing edition is the Uniform Customs and Practice for Documentary Credits, ICC Publication No. 600 (often referred to as ‘the UCP 600’).
1.18 At present, banks customarily incorporate by express reference the UCP 600 into their letters of credit and the applicant’s application for the issuance of the credit in virtually every part of the world. We shall have occasion in Chapter 2 to look in depth at the legal nature and effect of such incorporation on certain disclaimer clauses. In the meantime, it is worthwhile to note