Countries faced a major stumbling block occasioned by conflict of different laws due to the intensive growth of international trade in the early 20th century. It was at this period that letters of credit were adopted as a main mode of steering a uniform way of carrying out international trade in different countries. The 1933 International Chamber of Commerce conference was held to give the letter a valid legal position.
The member state meeting had various objectives (Hinkelman and Karla 26). The main aim of their meeting was to come up with a ‘Uniform Customs and Practice for Documentary Credits’ (Dabydeen 41). These rules were later narrowed down to rules that are used to govern letters of credit. The rules have been revised to capture the new developments due to growth in international trade and the banking sector.
Letters of credit have had effective application due to the existence of uniform regulations among major countries. The set framework has made international trade easy. Banks and traders have conducted business without fear of being defrauded. Assurance of security has been the main impetus towards a better playing ground for all concerned parties. The popularity of credit letters has been growing throughout the years and more people are picking consistent interest in their use.
The operation of letters of credit is not basically based on one type of a document. The letters are in numerous occasions in two types (Dabydeen 41). This paper will critically analyze the effectiveness of letters of credit in facilitating international trade.
A letter of credit is a document that shows an importer’s commitment to make payment to an exporter once goods are received. The precondition of payment is that the exporter must present all the necessary documents and conditions set out in the letter of credit. The conditions of payment stipulated in the document must be strictly followed.
It is possible to have a letter of credit that can be repealed and one that cannot be revoked. The distinction is based on the fact that the revocable letter may be revoked without first seeking the consent of the exporter (Bertrams 46). The foregoing literary means that the documents may be cancelled or challenged before the other documents are presented to the exporter.
The letter is rarely used, considering its limited protection to the exporter. On the contrary, an irrevocable letter of credit is not revocable without issuance of consent by all parties in the transaction. The general rule on the letters of credit is to the effect that all letters are irrevocable, unless there is a document stating otherwise within the knowledge of the parties.
The rationale behind making letters of credit to be irrevocable is to guarantee protection to all parties in the transaction. W distinction that is based on the payment terms is made on understanding their operation.
A ‘sight letter of credit’ is evident when the importer is allowed to see the documents before effecting payment. On the hand, if the payment is to be completed at a later fixed date it follows that the document will be known as deferred payment letter of credit (Bertrams 46).
To maintain gradual uniform, the International Chamber of Commerce reviews and subsequently publishes the agreed rules that are geared towards governing letters of credit in several banks in the world. The standardization of letters of credit has played a critical role in ensuring that banks subscribe to uniform standards. The International Chamber of Commerce continuously revises the rules from time to time.
From the making of the letters of credit rules, there are certain steps that are essentially followed by the persons and institutions in transactions involving letters of credit. To start with, the importer and exporter reach an agreement that their purchase and sale respectively will be through a letter of credit.
Secondly, the importer is required to fill in an application form asking his bank to issue a letter of credit in favour of the exporter. At this point, the importer must be in possession of a line of credit with the issuing bank. Thirdly, the issuing bank is duty bound to transmit the letter of credit through the convenient means possible. In many occasions, this is done through telecommunication or registered mail.
Fourthly, the authenticating bank must receive the letter in due time to authenticate it and communicate to both the importer and exporter. Fifth, the exporter goes through the letter diligently upon receipt of the letters of credit. This is done to establish whether there is compliance to the terms as they are stated in the initial contract.
On the same vein, the exporter checks the document to ascertain whether the documents can be produced and whether the terms and conditions in the letter of credit can be fulfilled. Sixth, the exporter is expected to act expeditiously when he notes that some of the conditions or terms may not be fulfilled (Hinkelman and Karla 26).
This affords the exporter an opportunity to request the importer to amend the conditions or terms in the letter of credit. Seven, the new conditions are incorporated in the letter of credit when all parties are in agreement on the amendments. At this point, the exporter is advised against any goods shipment until the amendments are received and accepted.
Eighth, the exporter makes physical arrangements on how the goods will be shipped. At the same time, the exporter prepares letters of credit. Upon completion, the letters are forwarded to the confirming bank. The drawing in the issuing bank is paid or accepted depending on the circumstances (Dabydeen 46).
Ninth, the issuing bank has an obligation of examining the letter of credit before hand. This is mainly done to safeguard the interest of the importer. Finally, the documents are forwarded to the importer for permitting possession of goods. There is a shift of possession of merchandise from the exporter to the logistics company.
The transaction is deemed fit when the importer receives goods and the exporter has received payment. Banks deal with documents and not goods as it has been noted from the afore-discussed steps. The precondition pegged on payment is based on the fact that the documents presented appear to be in compliance with the terms and conditions of the letter of credit.
Possession in these circumstances is the possession of documents (Winston and Winston 47). It is highly impractical to talk about dealing with goods since the seller and the buyer are far from each other. The letter of credit depends on the integrity of the seller and the buyer. Documents related to the transactions must be inspected with due diligence.
There are numerous merits and demerits for the exporter and importer in the use of the letter of credit. First, the importer is guaranteed that the exporter will be paid upon adhering to all terms and conditions in the letter of credit. In addition, this moment presents a viable chance for the importer to review his negotiation for better terms at a stage when the credit has not been offered.
The letter of credit may be to the disadvantage of the importer in that there is no protection against the exporter shipping goods of low quality (Winston and Winston 48).
The letters of credit if not carefully followed with supporting documents seem to be offering more protection to the importer at the expense of the exporter. The importer is required to do a thorough research on the nature and reputation of the exporter. It is imperative to note that some of the details may not be discovered during the research, thus putting the exporter at a greater risk.
Further, it is a requirement that the importer ought to have a line of credit before the issuing bank can commit to issue letters of credit. The final payment is grossly affected by the line of credit a party has applied for. There are several advantages to the exporter. First, the risk payment may be interfered with by the political risk where the issuing bank domiciles. The letter of credit presupposes an agrement.
The exporter may be required to execute his obligation. In addition, the exporter may reduce credit risk at any given time he deems fit. On the disadvantageous side, the exporter has the obligation of preparing all the necessary documents. The documents must be in strict compliance with the letter of credit. Due to lack of credit facilities, some exporters may lack credit facilities, thus preventing export.
There are broad categories of impacts presented by the use of a letter of credit. Substantial discrepancies in the negotiating bank may not be detected. It is recommended that once the discrepancy is detected, there is room for correction before the other documents are returned. It is possible to have the documents sent back to the bank if there are errors.
The only disadvantage is that there could be no time for such documents to be returned, which is disadvantageous to one party in the transaction (Bertrams 61). Waiver in cases of discrepancies in the contract is allowed.
This can be done whereby the parties agree that the payment and transportation of goods to the buyer will take place even after the discrepancies have been discovered. The parties to the agreement or their agents must reach a consensus about the waiver.
There are numerous characteristics that make a letter of credit favourable. Its negotiability makes it convenient and practical to the exporter and the importer. It is mandatory for the issuing bank to pay the beneficiary any arrears. The payment is made through the bank where the beneficiary holds an account. It is the negotiable character that makes the transaction flow in a similar was as if money was used.
The promise to pay in the letter of credit makes the document a negotiable document. This can be on demand or at any other time as stipulated by the agreement. The nominated bank in this case becomes the holder in due course, waiting for the remaining requisites to be fulfilled.
The holder of letters of credit is supposed to take the face value. Any party with a claim on it is defeated. Straight point negotiations may arise bearing in mind that the beneficiary of the credit is covered. Under the foregoing condition, the promise does not pass to the purchaser in due course (Grath and Anders 50).
The instrument is negotiated on the basis that it can be revoked. A revocable letter of credit is not subject to confirmation. The advising bank in such cases engages in correspondence transaction for the parties in the contract. All requirements must be met as demanded by the transacting parties.
Revocability is a salient element of credit letters. However, documents of such a nature are mostly used when providing crucial guidelines as to shipment (Grath and Anders 51). Worth noting is the fact that an irrevocable letter of credit may not be amended without consent from the issuing bank. Equally, the beneficiary and the confirming bank must provide their consent.
It is possible to transfer ‘letters of credit’, just the same way they can be assigned. Upon reaching the negotiations the beneficiaries are free to deal with the property in the desired way, including assigning. There is a limitation imposed under the international control. The transfer is only possible at once.
In instances whereby the instrument is not transferable, parties to the transaction may transfer their rights before the performance of conditions commences. It should be noted that letters of credit are applicable where there is a contract of sale of goods. In addition to the requisite documents, the transaction must be evidenced by a written contract. There are two types of drafts in regard to the letter of credit.
A draft created by the beneficiary may also be termed as a bill of exchange. The drafts are based on time and sight. They are distinguishable depending on the time they are presented for payment. In some instances, the time draft may rely on a condition of payment after the lapse of some time. The credit terms will predict the use of the documents depending on the terms earlier agreed on.
It is clear that the most fundamental steps concerning the transaction between the exporter and the importer are handled by banks (Bertrams 63). This is because the transactions are international in nature and the two parties may meet. The banks in this case act to the best interest of the parties.
The fact that the documents are not a substitute to the goods is worth critical examination. The buyer of the goods in one country is sure that the documents will arrive in the bank before the money is paid. The buyer is, however, not certain on the condition of goods.
Actual possession of the goods comes earlier when the payment has been effected. The issuing bank acting in the best interest of the buyer and the seller should make sure that the documents are examined. The appropriate bank is advised to pay against the documents once they are authenticated and said to be mature. The ‘standby letter of credit’ can be used in places that the ‘commercial letter of credit’ is no applicable.
The ‘standby letter of credit’ is the second preferred payment method. This type of letter has greatly fostered international trade by ensuring that the customer is able to fulfil his or her obligations. This provides security to the beneficiary. When the parties enter into such arrangements, there are no guarantees that drawing of the letter of credit will be done.
The standby letter is the only document that is designed to provide assurance to parties in the agreement of sale. Standby letters, as the name suggests, are used to stand behind monetary obligations by providing assurances to other people. The letter is used as a guarantee since it acts to inform either party in the transaction on the nature of credit they have.
The holder of the letter in this case is the supplier, while the bank is the issuing authority. The seller pursues the seller directly, but if the customer is unable to pay the seller presents copies of the draft to the bank which should be paid immediately (Schaffer et al. 75).
In international trade, the most essential step to follow is assuring security to both the buyer and the seller. The distance between the two makes them unable to carry out the transaction differently. Both the issuing and confirming banks ensure that the buyer and the seller are compliant. The banks steer the contract of sale of goods. There are other obligations that rest on the exporter and the importer.
For instance, there is the risk of damage since the goods are mostly shipped. Any damages occurring in the course of transporting the merchandise are not borne by the exporter. The liability shifts when the exporter prepares all the necessary documents and forwards them to the bank. The exporter’s obligations are extinguished upon payment.
The transport company that is in contract with the importer is expected to safely transport the goods to the importer (Grath and Anders 55). The buyer is encouraged to enter into a contract of insurance to safeguard the safety of the goods in transit.
The contract is at some instances entered into by the importer and the exporter for the benefit of the exporter. The cost of insurance is paid by the exporter. The documents indicating that the goods on transit have been insured should be given to the confirming bank.
The documents in international trade are the crux of the transaction. The transaction cannot be effectively achieved without the document. It would be cumbersome to transport the document from one country to another without consideration. The letter of credit comes in to strengthen the security of the contract.
The payment is only secure in an event that documents are presented to the bank, which has the sole duty of confirming compliance. Handling of the letter of credit backs up the reputation and creditworthiness of the bank. The bank will assume the responsibility of paying the exporter within the prescribed period.
In essence, the contract is between the bank and the importer, but the exporter is paid upon meeting given conditions as per the contract of sale. The documentary collection method lacks the required degree of security to facilitate smooth running of international trade. The letter of credit fills that loophole by detailing the conditions (Grath and Anders 56).
As mentioned before, the banks in such transactions heavily rely on the exporter reputation in issuing the credit. Arguably, this is a major disadvantage to new exporters who have not built any reputation. However, the bank’s preconditions before payment may be used to cure that.
The bank may impose conditions stating the nature of the goods to be received before payment is effected and the time when the documents will be received. The bank is under obligation to pay the exporter, despite the importer’s breach.
The letters of credit have gained their popularity for their ability to offer unique and a universally accepted mode of payment that satisfies the exporter and the importer. They make international trade transactions smooth in that the documents have to be received and not the merchandise. In order to protect the importer, shipment of goods may be postponed up to a time when payment is done.
This means that the importer is protected against being provided with goods of poor quality. The exporter remains with a draft in the bank that has been requested to effect payment. The letter is the most efficient mode of payment today due to its universal acceptance. Banks all over the world find it safe to associate themselves with letters of credit.
The International Chamber of Commerce has strengthened the acceptability of the letters of credit. The industrial utilization and strict conformity with the ‘International Chamber of Commerce Customs and Practice Publication No.
600’ has made letters of credit a preferable mode of payment as opposed to other means. Although there are many safeguards to protect transactions through a letter of credit, it is clear that neither the exporter no the importer is protected from fraud. The risk of fraud still remains unchecked (Grath and Anders 54).
In the transactions that the mode of payment is by letters of credit, banks confine themselves to the face value of the document. The practice in international trade is that documents of international trade are acceptance without actual verification of the merchandise. The duty of safeguarding the transaction from fraud rests on the exporter and the importer to act on the reputation of the each other.
The parties to the transaction take over the responsibility of exercising diligence, a rule that would have been executed by the bank. This is one of the main draw backs of the letters of credit. It should be noted that the security of payment does not depend upon the importers financial status. The exporter is allowed to continue controlling the title until the payment for the goods has been effected or documents are accepted.
On the other hand, the importer gains several advantages. The importer will only be required to pay when the documents providing shipment are presented. The letter of credit being a document of payment should specify the type of payment and the mode. This means the timing of payment as well as the timing of the payment. There should a clear specification on the manner in which the payment is to be made.
The face of the letter specifies the availability of payment. In circumstances whereby the payment is on the tenor, it means that the payment will be effected at the sight of the document. Payment at sight greatly favours the exporter since the payment is received immediately (Schaffer et al. 74).
The importer must evaluate his or her ability to pay for the merchandise. This should be done before remitting the payment. The letter of credit has a time frame in which acceptance is deemed to be effective. It requires the exporter to be paid after a given period of time. The wording of the letter of credit ought to be understood in the context of the contract terms. The word acceptance is very common in the letter.
It means that payment will be effected at a future date. The date in the ordinary contract of sale is specified. If the letter of credit is indicated on its tenure at sight, this means that payment has to be made six months after sight. The letters of credit have made transactions in the international trade become more flexible (Hinkelman and Karla 26).
A basic letter of credit may address special considerations, which create a flexible way of effecting transactions. The bank may settle on a special letter of credit to enhance flexibility. A revolving letter of credit allows reinstatement of credit without amending the letter of credit every time. This is used to maintain constant control on the shipment schedule.
The letters of credit may adopt the cumulative or non cumulative mode. This means that goods that would have been shipped in the previous periods are carried forward to future shipping periods. This also includes carrying forward the value of the delayed goods to be considered for shipment at a future date. On the contrary, a non-cumulative revolving credit prohibits shipment of merchandise to a future date (Winston and Winston 42).
The letter of credit may also take the red clause credit. This allows the exporter to receive the payment in advance. This happens prior to the presentation of the necessary documents. The transferable credit enables the exporter to act as an agent or in some instances as the middle man. The proceeds may subsequently be transferred in another payment option.
The option given by the importer in relation to the goods is optional to the exporter as far as there is prove showing that all other terms have been met. The role of the bank at this point is to engage in a serious undertaking. A letter of credit once issued becomes a pending liability to the bank. The state of the importer or goods is not a factor to consider when there is a clear indication that the documents are in good order.
An advising bank in such a case is not required to effect any payment, but to forward the letter of the credit to the exporter without any responsibility. The overall effectiveness is enhanced when the confirming bank forwards the document to the other bank in a move to accept payment. The letter of credit in simple words is treated by a bank just the same way a loan is treated.
The bank introduces a clause for its protection once the owner of the goods refuses or is unable to pay. This clause expressly stipulates that the documents that are to take part in the negotiations are to be issued under the banks orders. There is a massive evaluation by the bank to ascertain the capacity to pay by the parties in the contract.
The financial stability of the importer and the proof of his capacity to pay are of grave importance to the bank. The issuance of letters of credit should not be understood to mean that the bank is ready to pay.
The financial history of the importer is very essential as a condition before issuing the letter of credit. In addition, the importer is required to accept certain conditions before the bank permits the issuance of letters of credit. The proof agreement is reached by signing the letter of credit agreement (Bertrams 64).
The agreement with the bank by the importer is to the effect that the importer should reimburse the bank all the payments under the letter of credit. This condition is dependent on the fact that the bank will pay the exporter. The bank also acknowledges the fact that it has the sole right to deal with the title of the goods.
The responsibility of the validity of the documents is covered in the agreement between the importer and the bank (Grath and Anders 56). The dealings between the importer and the bank are that the information presented in the credit application acts as the instructions to the bank at a later date. The importer should be having sufficient knowledge of the requirements of the contractual agreement with the bank.
The applications for letters of credit have various conditions to facilitate secure transactions. First, the amount of credit for the importer is a requirement that banks consider before they agree to transact with the exporter. The total amount of credit and the mode of payment should be indicated.
In some instances, the mode of currency is required. It has been observed that trading overseas is based on various factors, the major issue to deal with being that the exporter and the importer should have confidence in the transaction.
Letters of credit are legally binding, thus the importer is assured of payment. Secondly, the importer only pays for the goods agreed; hence the exporter makes sure that the goods conform to the conditions. This reduces the risk of not being paid (Mugasha 34).
Conclusion
International trade has many challenges that emanate from the nature of the transactions that constitute it. There are documents that are used in securing safe transfer of title in goods from the exporter to the importer. The complexity of cross-border trade is compounded by the fact that the importer does not get the chance to check the goods. The transactions rely on documents.
One of the main documents that have gained popularity throughout time is the letter of credit. Its credibility is derived from the fact it has the recognition of the International Chamber of Commerce. The document has gained universal applicability due to its advantages. Letters of credit are reliable since they are issued to a person with the credit line.
It is not possible to get letters of credit void of credit. Letters of credit are issued by the bank upon confirmation of certain conditions. The legal binding of the letters makes them essential when engaging in business. International transactions largely depend on the reputation of the exporter and the importer.
A bank will be very reluctant to issue letters of credit when the importer has a history of defaulting payment. A clause in the contract of sale may be invoked in instances whereby the bank is not sure about the payment by the importer, thus postponing payment. Payment of goods in the international sphere would be very hard without letters of credit.
Works Cited
Bertrams, Roeland I. V. F. Bank Guarantees in International Trade: The Law and Practice of Independent (first Demand) Guarantees and Standby Letters of Credit in Civil Law and Common Law Jurisdictions. Paris: ICC Publ., 2004. Print.
Dabydeen, Sally R. UK Steel Industry & International Trade. New York, NY: iUniverse, Inc, 2004. Print.
Grath, Anders. The Handbook of International Trade and Finance. London: Kogan Page, 2012. Print.
Hinkelman, Edward G, and Karla C. Shippey. Dictionary of International Trade: Handbook of the Global Trade Community Includes 19 Key Appendices. Novato, CA: World Trade Press, 2004. Print.
Schaffer, Richard, Filiberto Agusti, and Beverley Earle. International Business Law and Its Environment. Mason, OH: South-Western Cengage Learning, 2009. Print
Mugasha, Agasha. The Law of Letters of Credit and Bank Guarantees. Sydney: Federation Press, 2003. Print.
Winston, Jay, and Winston, Arthur. Complete Guide to Credit and Collection Law: 2010-2011. Aspen Pub., 2010. Print.