Documentary Credits and Their Variations
Documentary Credits Explained
The independence principle: Central to documentary credit business is the independence of the bank’s undertaking to pay from the underlying contract between the buyer & seller. This means that the bank’s undertaking to pay the beneficiary is not dependent on the seller performing under the contract. The bank’s undertaking to pay is independent on the beneficiary presenting documents, which comply with the terms & conditions of the credit.
Documentary credits are a separate transaction from the sale contract on which a commercial credit may be based.
If the documents do not comply with the term & conditions of a documentary credit the documents can be rejected, which means that the bank’s undertaking to pay will b lapse.
The typical documents requirements under a documentary credit can be seen in this extract from a SWIFT documentary credit
Six original signed invoices marked ‘Goods tested & screened’
Certificate of origin signed by the Chamber of Commerce evidencing goods country of origin.
3/3 full set of marine bill of lading, consigned to the order of issuing bank notify consignee, marked freight paid.
- The role of confirming bank
Confirmation of a credit removes the financial & political risk of the importers country & provides a bank, which is conveniently for the exporter.
How does the exporter obtain a confirmed documentary credit?
If agreed & authorized between the applicant, issuing bank & the beneficiary it is possible to have a definite undertaking of another bank in addition to that of the issuing bank.
To achieve this additional definite bank undertaking the issuing and must authorize or request another bank, usually in the exporters country to add their confirmation to the documentary credit.
The confirming is promising to pay the beneficiary to provide the terms & conditions of the credit are complied with regardless of whether payment is forthcoming or not from the issuing bank.
- The role of advising bank
The act of passing the credit on the beneficiary is known as advising the credit & this bank becomes & advising bank.
If a bank does not want to advise a credit it does not have to but in such circumstances, the bank requested to advise the credit must inform the issuing bank without delay.
If a bank agrees to advise a credit to a beneficiary it must take reasonable care to check that the documentary credit appears genuine.
If a bank cannot establish the apparent authenticity of a documentary credit it must inform the issuing bank without delay.
The advising bank may decide to advise a credit even if it cannot be established that the credit is genuine. In such circumstances, the advising bank must inform the beneficiary that it has not been able to establish the authenticity of the credit.
- Revocable & irrevocable Credit
A revocable credit may be amended or cancelled by the issuing bank at any moment & without prior notice to the beneficiary.
If the credit is cancelled or amended before the beneficiary presents documents, the bank’s undertaking to pay no longer exists & consequently the beneficiary may not be paid.
If the documents complying with the credit are presented at the place stipulated for presentation of documents before the credit is cancelled or amended, the issuing bank must honour it’s undertaking in the documentary credit.
- Date & Place of Expiry
A beneficiary must present documents complying with a documentary credit before the expiry date & during banking hours.
It can happen very easily that a documentary credit has an expiry date which falls on a day on which the bank to which presentation of documents has to be made is closed.
The most common reason for this is when the expiry date falls on a weekend. It can also happen due to a bank, national or other local holidays.
In such circumstances, documents can be presented on the next day on which the bank in question is open.
Should it happen that the bank where the credit expires be closed due to exceptional circumstances such as strikes, riots, or other causes beyond their control the expiry date will not be extended to the first following day on which such bank is open.
Documentary Credit Variants
Transferable Documentary Credit
Commercial Documentary Credits
All the commercial Documentary Credits we have seen so far were issued as a method of payment or as a method of payment & finance in favour of a supplier of goods known as the exporter.
A Transferable Documentary Credit is also issued as a method of payment or as a method of payment & finance.
A Transferable Documentary Credit is not issued by the issuing bank in favour of the supplier of goods known as exporter.
A Transferable Documentary Credit is issued by the issuing bank in favour of another party commonly known as Middleman who buys from one party & sells to another.
A Transferable Documentary Credit is typically in the following circumstances:
- The middleman has identified a specific need of a buyer for goods or services.
- The middleman knows where to obtain the goods or services needed by the buyer.
- The middleman calculated that a middleman ‘s profit margin could be added to the cost of the goods provided by the supplier.
- The middleman needs to provide the supplier with a promise of payment by the documentary credit so that the supplier will ship the goods to the buyer.
- The middleman has not got enough collateral or does not wish to use up the collateral by requesting a bank to issue a documentary credit on his behalf.
Key points regarding transferable documentary credit
- The middleman is known as the first beneficiary. The first beneficiary may request the bank to transfer the credit in favour of one or more suppliers, otherwise known as the second beneficiary.
- When the credit is issued by the issuing bank it must be clearly designated as transferable so that it may be transferred in favour one or more second beneficiates.
- Just because a credit is designated as transferable does not mean that the bank requested to transfer a credit has to comply with such request. If for any reason the bank does not wish to transfer the credit it can be refuse to do so.
- If a documentary credit is transferred to one or more second beneficiaries then the first beneficiary must irrevocably instruct the transferring bank whether or not he (first beneficiary) retains the right to refuse to allow the transferring bank to advise amendment to the second beneficiary (ies).
This is because once the credit is transferred then the first beneficiary & one or more second beneficiaries having an interest in the credit. It is important that all the parties with an interest in the terms & conditions of the credit are clear regarding to the position of amendments.
- In any case a second beneficiary cannot be forced to accept an amendment to which he has not agreed. If there are more than one second beneficiary some may accept amendments as issued, others may refuse to accept such amendment s. If any second beneficiaries refuse to accept amendments to the credit the transferred portion of the credit will not be amended.
- The transferring bank should get payment of the transfer fees at the time of credit transferred. Transfer charge are usually for account of the first beneficiary. This is important as if for some reason the transaction does not proceeds after the credit are transferred then it can be difficult for the transferring bank to obtain payment of other transfer charge.
- A transferable documentary credit can only be transferred once. The transfer of credit can be made in favour of one or more benefices.
- When a transferable documentary credit is transferred there is still only one documentary credit. If the credit is not confirmed the second beneficiaries are promised payment only by the issuing bank. If not confirmed the transferring bank is not obligating itself to make payment to the first or second beneficiaries.
It is obvious that in order to facilitate the middleman certain terms & conditions of the credit as originally issued can be changed.
Further important points
Rights of transferring bank.
When the documents have been received by the transferring bank from the second beneficiary the first beneficiary must supply his own invoice(s) on first demand.
If the first beneficiary does not supply his own invoices on first demand then the transferring bank has the right to deliver the issuing bank the documents received under the transferred credit.
Rights of first beneficiary
The beneficiary may request the payment or negotiation under a transferable credit is effected at the place to which the credit has been transferred up to an including the expiry date of the credit.
The transferring bank is only ever obliged to transfer a transferable credit on terms to which it agrees. In most cases the transferring bank will want the place for negotiation or payment to remain with the transferring bank.
Advantages of transferable credit.
The main advantage of transferable credit rests with middleman. In the case we have examined the middle man was able to finance a large transaction without any bank lines of credit or without providing any collateral to the bank.
At the same time the beneficiary had a promise of payment before shipment & the applicant would only have to pay if documents evidencing that the correct goods had been shipped were presented.
Transferable credit involves little risk for the transferring bank but often involves a lot of work & administration. That is why it is a good idea for the transferring bank to take it’s transfer charges at the time of transfer.
- Back to Back Documentary credit
Back-to-back documentary credits like transferable credit s relates to the transaction is involving middleman.
Transferable credit & Back to bank credits enable the middleman to, but from one & sell to another & make a profit.
Back to Back Documentary credits – Terms & conditions
When a bank issues a second credit on behalf of the middle man it will ensure that the terms & conditions of the second credit reflects the terms & conditions of the first credit with following exceptions:
- Back to back credit usually expires at the issuing bank. The applicant for the second credit will be the beneficiary of the first credit.
- The amount of second credit will be less than the amount of the first credit.
- Unit price of the second credit (if any) will be less than unit prices of the first credit.
- The insurance percentage of the second credit (if any) will have to be increased so that the insurance document presented under the second credit will satisfy the insured value for the first credit.
- Expiry date of the second is brought forward.
- Latest shipment dates (if any) is brought forward.
- The period for presentation of documents can be reduced.
Banks are very much cautious about opening back-to-back credits.
Bank’s needed to be confident that the terms of the first credit can be fully met by the beneficiary. Where possible, the middleman’s bank would prefer to see this type of transaction undertaken on a transferable credit basis.
The big risk for a bank issuing a second credit in back to back operations is that the bank issuing second credit or back to back credit will have to honour it’s obligations und3r the second credit & due to non – payment performance by the middleman be unable to obtain.
Advantages of back-to-back credit
The main advantage of a back-to-back credits rest with middleman. In the case we have examined the middleman was able to finance /a large transaction by using documentary credit issued in favour to get a bank to issue another documentary credit on his behalf without providing collateral to the bank.
Back to back credit s involve considerable risk for the bank issuing the second credit. The bank issuing second credit or back-to-back credit will have to honour it’s obligations under the second credit if the supplier presents complying documents.
If documents are not presented by the middleman in compliance with the terms & conditions of the first credit the bank that issued the second credit may not be reimbursed.
- Stand by documentary credits
Commercial documentary credits are issued with the objectives of payment an exporter on performance of a commercial contract, but the stand by documentary credits are issued with the objectives of paying the beneficiary in the event of non-performance under a contract.
Stand by documentary credits are issued with the intention that the credit will not be drawn under to provide security to the beneficiary in the even of non-performance by the applicant or another party.
Some interesting points about the stand by documentary credit:
- The credit is issued for almost one year to provide ‘standby’ security for ongoing trading requirements
- The documents required are not the standard shipping documents required under a commercial documentary credit. This is because in this case the standard documents will have been sent direct to the applicant.
- The operation of standby documentary credit does not depend on the issuance of transport document, so article 19-24 of UCPDC 600 does not apply.
- Revolving documentary credits
A documentary credit, which states that the amount of the credit is renewed upon drawing, is called a Revolving documentary credit.
The revolving documentary credit is suitable for trading partners who have ongoing or repeated transactions i.e. when there are likely to be regular future shipments of the same type of goods. It can revolve in relation to time or value.
If a documentary credit stipules drawing or shipments by installments within given period then article 32 UCP 600 applies.
- Documentary credits can be issued with shipments or drawings by installments
- Installments means that shipments / drawings within given periods are stipulated in the credit.
- If installment is not drawn then the credit ceases to be available for the installment or subsequent installments, unless the credit stipulates otherwise.