Documentary credits law depends on the principle of autonomy or independence of the credit and the doctrine of strict compliance. The principle of autonomy protects the beneficiary (exporter) while the doctrine of strict compliance protects the issuing bank and the applicant (importer).
According to the World Trade Organization, Some 80% to 90% of world trade depends on trade finance. This is why it is described as the “lifeline of trade”, a method to facilitate international commerce.
International trade involves risk, and needs for capital. There is some uncertainty in relation of the timing of payments between the seller and the foreign buyer. Both parties are willing to evade or reduce their risks. But it is also a matter of capital needs.
Exporters may need capital in order to buy the products or the raw material to produce the products ordered by the importer. Not always the products are on stock, and it depends on an order to put them on production line, or to obtain them from a big supplier. This is a rule in stock management. The exporter will need to use its own funds, or arrange special credit for exporters in his country or require payment / credit arrangements to the buyer. This is different when the exporter has enough stock. He may want to have this products sold as soon as possible, and will prefer to facilitate sales transactions, even with direct credit to long term buyers via an open account. At some moments, exporters may agree to have goods consigned in other country where a selling force can be activated. With this method, he will maintain the property of the goods and the cost of storage will be passed to the consignee.
Documentary credit is the option to secure payment from importers. It involves the participation of banks. It is important for exporters to verify the nature of documentary credit for the business they are conducting. Documentary credits are currently ruled by the International Chamber of Commerce Uniform Customs and Practice for Documentary Credits, 2007 Revision, ICC Publication no. 600 (“UCP”) , which entered into force in July, 1, 2001 . The first version was issued in 1933.
According to Article 1 of UCP 600 these rules apply to any documentary credit “when the text of the credit expressly indicates that it is subject to these rules.” Credit is defined as “any arrangement, however named or described, that is irrevocable and thereby constitutes a definite undertaking of the issuing bank to honor a complying presentation.”
Letters of Credit are Documentary credits. They are the one of the most secure methods of payment available to international traders. Letters of Credit are considered as the “lifeblood” of international trade. This term comes from the case The Bhoja Trader [1981] 2 Lloyd’s Rep 256.
A Letter of credit (LC) is a commitment by a bank of payment which is fulfilled against the presentation of documents previously determined. This is how it is possible to execute long distance payments, with the assistance of a main bank and a correspondent bank. The documentary credit allows the parties to reduce their respective risks. The buyer opens a documentary credit in favor of the seller, who will only recover upon presentation of the documents that represent the goods sold. The participation of the banks leads also to a financing of the sales transaction.
Documentary credits law depends on the principle of autonomy or independence of the credit and the doctrine of strict compliance. The principle of autonomy protects the beneficiary (exporter) while the doctrine of strict compliance protects the issuing bank and the applicant (importer).
English Law recognizes the independency of documentary credits from the main contract. The bank may honor its obligation even when a claim arises between the buyer and the seller. Both English law and the UCP recognize this principle . This principle can be difficult to understand in countries with Civil Law system, which follows the principle: “accesorium sequitur principale”, that means “the accessory follows the principal.” It is always an option that Civil Law systems judges will apply this principle, denying independence to a documentary credit that depends from a contract of sale. This would happen when it does not appear a specific submission to the UCP and / or English Law. In fact, Roberto Frias, in his article The Autonomy Principle of Letters of Credit criticizes judges in Civil Law systems to go apart from the principle of autonomy recognized by the rules of the UCP and English Law.
Banks are only aware of documents, and not with the goods or services related. If the documents are completed according to the terms and conditions of the credit, the bank will have to pay. This is the Doctrine of Strict Compliance. The bank has to honor its obligation according to the terms of a guarantee or a letter of credit. unless there is a strong belief that documents submitted are false.
Normally the documentary credit is irrevocable unless the contrary is stipulated in the credit document. It means the possibility of having the credit to be revocable if it is so stated in the credit. A revocable credit brings insecurity to the transaction.
For cases the open account is executed, the Stand-by credit is a valid option to be asked by importers. The issuing Bank takes the commitment to pay instead of the importer if he fails to comply. Open Account method of payment means that goods are going to be shipped and delivered before payment is due. Therefore the invoices can be paid in a fixed term. This is a great advantage to the importer; it is a faster option and reduces administrative work. Without a bank as a guarantor it involves a higher risk option to the exporter, who depends solely on the importer for payment.
On deferred Credits, the exporter has to submit all documents but the bill of exchange to the Bank, and the payment for the goods will be executed at the date agreed.
Credits are also subject to be transferred, if it is so stated. The transfer can be partial or total, to a second beneficiary, by request of the beneficiary. Once the transfer is executed to the second beneficiary it is not possible to make a new transfer, with the exception to the first beneficiary.
With the arrangement of documentary credits, the exporter or middleman can obtain a credit solution in his way to find the big supplier. This can happen when a big export order appears. The middleman, based on the letter of credit he has been granted as collateral, will request the bank to issue a second letter of credit. This is called “back-to-back” letters of credit. Also known as “primary” and “secondary”, or “mother” and “baby.” In this context there take place 2 different credits.
These are examples of credit arrangements that can be undertaken in international trade. It is supremely important for the actors in the international trade arena to be informed of their pros and cons before applying them in an international transaction.
Bibliography
Roberto Luis Frias Garcia, The Autonomy Principle of Letters of Credit. Biblioteca Virtual del Instituto de Investigaciones Juridicas de la UNAM. http://info8.juridicas.unam.mx/pdf/mlawrns/cont/5/arc/arc4.pdf
Marc Auboin, Boosting Trade Finance in Developing Countries: What link with the WTO? Since more than 90% of trade transactions involve some form of credit, insurance or Guarantee, one can reasonably say that trade finance is the lifeline of trade. http://www.wto.org/english/res_e/reser_e/ersd200704_e.pdf
Roy Goode, Commercial Law. Third Edition
Saboor H. AbdulJaami, Esq. of AbdulJaami, PLLC Basics of Trade Finance “ A Legal Perspective 2006 http://www.hg.org/article.asp?id=6187
K. Michael Fingerand, Ludger Schuknecht. Trade Finance and Financial Crisis. Special Studies. World Trade Organization. http://www.wto.org/english/res_e/booksp_e/special_study_3_e.pdf
WTO Website. World The Challenges of Trade Financing
http://www.wto.org/english/thewto_e/coher_e/challenges_e.htm
United Nations Convention on Independent Guarantees and Stand-by Letters of Credit
Marcela Pizarro Amigo, Claudio Barroilhet Acevedo, Uniform Customs and Practice for Documentary Credits UCP 600Revista de Derecho de la Pontificia Universidad Católica de Valparaiso XXX (Valparaiso, Chile, 1er Semestre de 2008) [pp. 155 – 181]
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