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Guide to International Trade Finance CITF
 9789284212576, 9789284201891, 9789284211840, 9789284200368, 9789284201846

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Guide to International Trade and Finance Paul Cowdell Peter McGregor Siraj Ibrahim (Chapter 10) Neil Chantry (Chapter 14) David Hennah (Chapter 15)

The London Institute of Banking & Finance is a registered charity, incorporated by Royal Charter. The International Chamber of Commerce (ICC) is the largest, most representative business organization in the world.

The London Institute of Banking & Finance is a registered charity, incorporated by Royal Charter. The London Institute of Banking & Finance believes that the sources of information upon which the book is based are reliable and has made every effort to ensure the complete accuracy of the text. However, neither The London Institute of Banking & Finance, the author, nor any contributor can accept any legal responsibility whatsoever for consequences that may arise from errors or omissions or any opinion or advice given. All rights reserved. This publication is for the personal use of the individual studying for the relevant London Institute of Banking & Finance qualification and may not be offered for sale to or by any third party. Apart from any fair dealing for the purposes of research or private study, or criticism or review, as permitted under the Copyright, Designs and Patents Act 1988, this publication may not be reproduced, stored or transmitted in any form or by any means, except with the prior permission in writing of the publisher or, in the case of reprographic reproduction, in accordance with the terms and licences issued by the Copyright Licensing Agency. Enquiries concerning reproduction outside those terms should be addressed to the publisher at the address below: The London Institute of Banking & Finance 4–9 Burgate Lane Canterbury Kent CT1 2XJ T 01227 818609 F 01227 784331 E [email protected] W www.libf.ac.uk Warning: the commission of an unauthorised act in relation to a copyright work may result in both a civil claim for damages and criminal prosecution.

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Captured, authored, published, delivered and managed in XML CAPDM Limited, Edinburgh, Scotland www.capdm.com

Printed and bound in the UK by Latimer Trend & Co, Plymouth First published 2007 by ifs School of Finance Reprinted with revisions 2016 by The London Institute of Banking & Finance © The London Institute of Banking & Finance 2016

Author information Paul Cowdell worked for many years at Midland Bank dealing with the

international trade needs of corporate clients. Now a Senior Lecturer at Sheffield Business School in Risk Management, Corporate Treasury Management and Derivatives, Paul has authored and co-authored several texts and articles on international trade facilities and foreign currency risk exposure management. Paul is an Associate and a Fellow (ACIB & FCIB) of the Chartered Institute of Bankers, and also holds the Institute’s Diploma in Financial Services (Dip.FS). Paul also holds the Membership Diploma of the Association of Corporate Treasurers (MCT). He is currently a project supervisor for the Association of Corporate Treasurers on the Membership Diploma. Peter McGregor spent over twenty years as a practising domestic and

international banker, both in the UK and overseas, followed by a similar period as an academic at Sheffield Business School/Sheffield Hallam University. His main areas of teaching expertise were international trade finance, corporate treasury management, lending and risk management, banking and financial services law and regulation. Peter has also been involved in writing several books and articles on financial matters. Peter is now the Managing Director of the financial and business education consultancy, The McGregor Education Consultancy Ltd, with clients throughout the UK and overseas. He undertakes several roles with The London Institute of Banking & Finance in the UK. Peter is an Associate and a Fellow (ACIB & FCIB) of the Chartered Institute of Bankers, and also holds the Institute’s Diploma in Financial Services (Dip.FS). He is a Fellow of the Higher Education Academy (FHEA). Additional contributors Siraj Ibrahim works as a banker within FI and Trade Finance for Qatar

Islamic Bank (UK). In a career spanning over ten years largely within two global banks, Siraj has worked in the FI, Treasury and Corporate coverage sectors. In addition, he sits on the UK Technical Committee for the international Islamic Finance Qualification (IFQ), administered by the CISI, and is the joint editor/other contributor for the IFQ Workbook. He is also the UK correspondent for the Islamic Finance News. David Hennah MIFS is Head of Trade at Misys, a leading service provider

of banking software solutions. He is now enjoying his second stint at Misys having previously worked for Barclays, ICL/Fujitsu Services UK and SWIFT. David is credited with launching the world’s first international direct debit service. He also played a leading role in the establishment of the bank payment obligation (BPO) as an accepted market practice in international trade. He was a member of the ICC Drafting Group on URBPO and is the author of the ICC Guide to the Uniform Rules for Bank Payment Obligations.

The reviewers David Meynell is the founder of TradeLC Advisory, an advisory and consultancy service. He previously worked for Deutsche Bank for over 30 years in a number of international locations, his most recent role having been Global Head Trade Product Management for Financial Institutions. David is Chief Examiner for the Certificate in International Trade Finance. Gary Collyer is Managing Director of Collyer Consulting Global Ltd,

a company that provides trade advisory, consultancy and training services. He previously worked for Midland Bank/HSBC, Citibank and ABN Amro in a banking career spanning over 30 years. In his last position at ABN Amro, he was the Global Trade Product Head based in London. Gary is a Visiting Professor for The London Institute of Banking & Finance and author of the fifth edition of the Guide to Documentary Credits.

Copyright acknowledgements

ICC Uniform Customs and Practice for Documentary Credits ICC Publication N° 600 − ISBN 978-92-842-1257-6 Copyright © 2007, International Chamber of Commerce (ICC), Paris − All rights reserved. ICC Uniform Rules for Bank Payment Obligations ICC Publication No. 750 − ISBN 978-92-842-0189-1 Copyright © 2013 − International Chamber of Commerce (ICC), Paris − All rights reserved. ICC Uniform Rules for Collections ICC Publication No. 522 − ISBN 978-92-842-1184-0 Copyright © 1995 − International Chamber of Commerce (ICC), Paris − All rights reserved. ICC Uniform Rules for Demand Guarantees ICC Publication No. 758 − ISBN 978-92-842-0036-8 Copyright © 2010 − International Chamber of Commerce (ICC), Paris − All rights reserved. ICC Uniform Rules for Forfaiting ICC Publication No. 800 − ISBN 978-92-842-0184-6 Copyright © 2012 − International Chamber of Commerce (ICC), Paris − All rights reserved. Available at store.iccwbo.org/ Extracts from ISP 98 © 1998 Institute of International Banking Law & Practice, Inc. All Rights Reserved. Reproduction of any part of this work by any means without express written permission is prohibited. For further information about ISP98 or its Official Commentary, see www.iiblp.org © The London Institute of Banking & Finance 2016

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Guide to International Trade and Finance

Note to students For the purpose of consistency this study text refers to ‘documentary credit’. However, ‘DC’, ‘letter of credit’, ‘LC’ or ‘credit’ are also widely used in the same context as ‘documentary credit’. Students should decide on their own preference for describing the product.

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Contents

1

Introduction

2

The international trade environment

19

3

Contracts

41

4

Intermediaries and how they operate

55

5

Documents used in international trade and the Incoterms® 2010 rules

75

6

Methods of settlement

105

7

Documentary collections

113

8

Documentary credits

131

9

Short-, medium- and long-term trade finance

161

10

Islamic trade finance

191

11

Guarantees and standby letters of credit

207

12

Export credit insurance

227

13

Foreign currencies and the exchange risk

235

14

Financial crime

249

15

Bank payment obligations (BPOs)

269

Bibliography

287

Answers to review questions

289

© The London Institute of Banking & Finance 2016

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© The London Institute of Banking & Finance 2016

Chapter 1

Introduction

Learning objectives By the end of this chapter, you should have an understanding of: u what is meant by international trade; u the concept of comparative advantage; u why international trade differs from domestic trade; u the different types of business entity; u the ways in which the risks in international trade can be reduced (risk mitigants); u the effects of the global financial crisis on world trade; u the role of the World Trade Organization (WTO) and of the International Chamber of Commerce (ICC).

1.1

What is international trade?

International trade is the exchange of goods, services or performance and capital across international borders or territories. In many ways it is similar to domestic trade. The motivation of all parties is to gain, by exchanging something that is surplus to requirements for something that is scarce or unavailable. That ‘something’ could be a physical good, or it may be a service or performance or a skill. Originally, the exchange was goods for goods or service for service − basically a form of barter. Obviously, money comes into play nowadays, but the principle of all trade remains: that each party should gain from the transaction.

© The London Institute of Banking & Finance 2016

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To illustrate how pervasive international trade is today, next time you open your computer, think about the sources of some of the components and how interdependent the countries of the world have become. If you investigated the source of the various components of your computer, you might find, for instance, that: oil from the Middle East may have been used to manufacture the plastic; the components could have been produced in China; the programs could have been written in India; the gold could have been mined in Africa; and the patent may have been drawn up in the USA.

1.1.1 Why do businesses trade internationally? First, we must ask why a business would wish to trade internationally, despite the additional problems and risks. In today’s global economy, where consumer demands are far-reaching, companies need to produce their goods and services as quickly and efficiently as possible to meet that demand. In addition, they must do so as competitively as possible. Not doing so would result in a loss of competitive advantage and business failure. A company may require raw materials or components for their product that cannot be sourced from the domestic market. They would need to look to overseas markets and buy the product from overseas suppliers. This is known as ‘importing’. Another example would be when a company is unable to manufacture or purchase the product in the domestic market and, for reasons of cost, it is cheaper to have it manufactured overseas. A business that imports may purchase goods for its own sales, or it may be acting as an agent or distributor for a foreign supplier. This is covered in more detail in Topic 2. On the opposite side of an international trade transaction is the seller. The reasons why businesses enter the export market are different. There may simply not be a domestic market for their product or service, or they may find that an export market offers them an additional customer base, from which they can generate additional income for the business.

1.1.2 Comparative advantage as a reason to trade internationally In some countries of the world, it would be possible, at least in theory, for most of the population to practise self-sufficiency. This involves people providing everything they need through their own labour. Thus they could, in theory, grow their own food, make their own clothes, and provide the necessities of life. However, this would not appeal to most people, because they would find their consumption confined to a narrow range of goods.

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What is international trade?

Thus individuals in modern economies do not try to produce exactly what they consume; instead, individuals work for money, which is then used for consumption purposes. This specialisation and division of labour provides a higher standard of living than can be achieved by self-sufficiency. What applies at the level of an individual also applies at the level of different nations. International trade is simply a logical development from specialisation and division of labour, as is the concept of comparative advantage. The theory of comparative advantage is one of the most widely accepted theories among economists. It is attributed to David Ricardo, who wrote about it in his 1817 book On the principles of political economy and taxation. Ricardo gave the example of England and Portugal. At the time, Portugal was able to produce wine and cloth with lower labour costs than it would take to produce the same quantities in England. However, Ricardo examined and compared the relative costs of producing wine and cloth between the two countries. He found that in England, although it could produce cloth relatively easily, it was very difficult to produce good-quality wine at a reasonable price. In Portugal, however, although it was able to produce both wine and cloth quite easily, it was more beneficial to produce excess wine and trade that for English cloth. England benefited from this trade, as it was able to buy wine at a lower price and finer quality for less than it could produce itself, and its cost for producing the cloth had not changed. In a highly simplified illustration, let us assume that: u Portugal can produce 1 litre of wine from 1 unit of production and 1 roll of cloth from 1 unit of production; u England can produce 1 roll of cloth from 1 unit of production, but requires 3 units of production to produce 1 litre of wine. The position can be summarised as shown in Table 1.1. If England devoted 4 units of production to cloth and Portugal devoted its 2 units of production to wine, England would produce 4 rolls of cloth and Portugal would produce 2 litres of wine. Thus the total output of the two countries is now greater than before for the same total number of units of production. England could then exchange 2 rolls of cloth for 1 litre of wine from Portugal and the net outcome would be as shown in Table 1.2. This simplified example relies on many assumptions that may not hold good in the real world, such as the following: u The wine and cloth are identical, whichever country produces them. u A unit of production is identical in both countries and for the production of both goods. © The London Institute of Banking & Finance 2016

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Table 1.1

Using Ricardo’s theory of comparative advantage Wine

Cloth

Total production units for 1 litre / wine and 1 roll / cloth

Portugal: number of units of production required to produce 1 litre / wine or 1 roll / cloth

1

1

2

England: number of units of production required to produce 1 litre / wine or 1 roll / cloth

3

1

4

Table 1.2 A simplified illustration of Ricardo’s theory of comparative advantage

Total number of units of production used Total output produced Net output after exchange of 2 rolls of cloth by England for 1 litre of wine from Portugal Net gain from comparative advantage

Portugal

England

2

4

2 litres of wine

4 rolls of cloth

1 litre of wine and 2 rolls of cloth

2 rolls of cloth and 1 litre of wine

1 roll of cloth

1 roll of cloth

u There are no transaction costs in connection with the trade. u The gains from comparative advantage are split evenly, as each country gains the same, ie 1 roll of cloth. u There are no foreign exchange rate complications. u The wine producers in England and the cloth producers in Portugal will not object to being ‘closed down’. Nevertheless, the example demonstrates the basic principle that the concept of comparative advantage is simply a logical extension of the principles of specialisation and division of labour that results in higher overall output and hence higher overall wealth. 4

© The London Institute of Banking & Finance 2016

Business organisations

1.2

Business organisations

A simple definition of a business organisation is that a business is involved in buying and selling goods and services, with the aim of making a profit. Business organisations are generally formed to provide a product or service for their customers with the aim of generating a profit for their owners or investors. There is an exception to this in the form of not-for-profit organisations such as charities, which do not share this aim. The profit is achieved through the trading activity and it is basically the net result of all of the income achieved by the business minus the expenditure incurred. This study text will explore the implications for those organisations that trade internationally. It will examine the various products, services and risks associated with international trade, and how those risks might be mitigated. As a starting point, it is useful to look at what businesses do and the different types of business entities.

1.2.1 Goods and services Both goods (products) and services are something that a business provides to its customers. A product is generally something tangible that can be seen, such as a pair of shoes, a table, a car, etc. A service is more intangible − it can be described as an experience that a customer feels. It can be a piece of advice given to a customer by a service provider, or something a little less intangible, such as a barber cutting and styling a client’s hair.

1.2.2 Buyers and sellers A buyer, often referred to as ‘the customer’, is a person or organisation that wants the business to provide the goods or services in exchange for a payment. A seller is a person or organisation that provides the goods or services. In international trade, buyers are normally importers and sellers are normally exporters. However, some international trade is undertaken by businesses that act as intermediaries, bringing buyers and sellers together in exchange for a fee. © The London Institute of Banking & Finance 2016

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1.3

The different types of business entity

When deciding which entity to form when setting up a business, an important factor is the concept of liability. There are two forms that the business can take − limited and unlimited. u Limited − the owners of the company have limited responsibilities for any debts outstanding, which are equal to the value of the shares they have in the company. u Unlimited − the owners of the company have unlimited liability. This means that if the company is unable to pay its creditors, the creditors can pursue the owners for repayment. Sole traders and partnerships fall into this category.

1.3.1 Sole proprietor / trader This type of business has no separate legal identity from its owner. It is very easy to set up, with little capital required. All the profits go to the owner and all decisions are made by the owner. A major disadvantage of this type of entity is that a sole trader has unlimited liability, so in the event of a creditor being owed money that the business cannot repay, a creditor has the right to pursue the owner’s personal assets for repayment. Another disadvantage is that if the owner falls ill, the business can be put at risk.

1.3.2 Partnership Partnerships are when two or more individuals go into business together, with a view to making a profit. The owners are referred to as ‘the partners’ (or ‘general partners’) and they are usually equally responsible for the debts of the partnership − unlimited liability − although partnerships limited by liability are becoming more common. The advantages associated with partnerships are as follows: u They are relatively easy to set up. u There is no legal formality to formation, although it is good practice to enter into a partnership agreement. u Partners’ skills and expertise can be pooled together. 6

© The London Institute of Banking & Finance 2016

The different types of business entity

u All the profits are shared among the partners. u All decisions are made by the partners. Disadvantages include the following: u As mentioned above, partnerships are usually unlimited, so personal assets of the partners are at risk, should the partnership be unable to pay its creditors. u Disputes between partners can sometimes put the business at risk. u If one partner decides to leave or if one partner dies, problems may arise in taking their share of the capital out of the partnership.

1.3.3 Limited liability partnership (LLP) Limited liability partnership shares many of the features of a partnership; however, it offers reduced personal liability for some or all of the individual partners − it is the LLP that takes responsibility for the debts of the business, not the partners. Some countries, such as the UK, treat a limited liability partnership as an incorporated body and not as a partnership at all. In these instances, the LLP is not covered by partnership legislation.

1.3.4 Limited partnership Another variation is the limited partnership, which exists in some countries and is quite different from a limited liability partnership. A limited partnership must have at least one general partner, whose personal liability for partnership debits is unlimited. The partnership can also have one or more limited partners, whose personal liability is similar to that of a shareholder in a limited company. Limited partners are only liable for debts incurred by the partnership up to their ‘registered investment’, that is the amount they have agreed to contribute to the partnership’s capital. Once limited partners have paid in the registered investment amount to the partnership, they have no further personal liability.

1.3.5 Limited company / corporation A limited company is a separate legal entity in its own right and, as such, has its own privileges, rights and liabilities that are distinct from those of its owners. © The London Institute of Banking & Finance 2016

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The owners of a limited company are known as the ‘shareholders’ or ‘members’. The day-to-day running of the business is conducted by its directors. These companies can be distinguished by the letters after their name, for example Limited or Ltd (in the UK), Inc (USA), SA (France), GmbH or AG (Germany). The advantages of a limited company / corporation are as follows: u It is a distinct legal entity, totally separate from the people who own or run it. u It has limited liability, so the owners are not responsible for the debts of the company. The exception here is where a personal guarantee has been given or if a fraud has been committed. u Ownership is transferable, simply by selling the shares to someone else. u There may be certain tax advantages for the owners. u Any losses incurred by the business can be carried forward and offset against taxable profits in future years. There are also a number of disadvantages: u It is more expensive to set up than for a partnership or sole trader. u It is governed by laws and regulations. u It has more complicated procedures in terms of account reporting.

1.3.5.1

Private limited companies

Private limited companies are companies whose shares are not traded on the open market, which can be disadvantageous as it prevents a company from raising capital through the sale of its shares to the general public. Private limited companies can be: u limited by shares, whereby the members’ liability is limited to the amount unpaid on shares they hold; u limited by guarantee, whereby members’ liability is limited to the amount they have agreed to contribute to the company’s assets if it is wound up. A private company has some legal obligations, such as the publishing of the accounts, although some privacy can be maintained by publishing the accounts in a summarised form.

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What makes international trade different from domestic trade?

1.3.5.2

Public limited companies

With public limited companies, the company’s shares may be offered for sale to the general public and are traded on the open market. For example, in the UK, public limited companies have the designation ‘plc’ after their name. An individual shareholder has the right to sell shares on the open market to the general public. In addition, when a company’s shares are dealt with on a recognised stock exchange, the term ‘listed’ or ‘quoted’ is used, so you may see the terms ‘listed company’ or ‘quoted company’ applied in such cases. All companies whose shares are traded on a stock exchange must be public limited companies, but not all public limited companies are listed / quoted. The affairs of quoted public companies are governed by by-laws and managed by a board of directors. Laws in different countries will vary; however, they usually determine how many directors are required and whether they must be stockholders. The board of directors will act on behalf of the stockholders and they can be held accountable for failure to abide by the by-laws. Shareholders have the right to attend, vote and speak at the company’s annual general meeting (AGM). It is at this meeting that all board directors are elected. There is a potential conflict of interest for larger incorporated companies such as plcs, in that day-to-day running of the company is in the hands of the directors, as opposed to being managed by the owners (shareholders). Thus, directors may wish to pursue their own interests, rather than those of the shareholders. This is sometimes referred to as ‘agency theory’.

1.4

What makes international trade different from domestic trade?

There are many risks and problems in international trade. These, along with risk reduction techniques, are analysed in some detail in subsequent chapters. For the purposes of this chapter, a brief overview of the problems and risks will suffice. u There may be language differences, time zone differences, cultural differences − all of which can make communication difficult and can cause additional delays, costs and misunderstandings. u Documentation may be more complex. u There is always counterparty risk in any commercial contract, but enforcing contractual rights against a business located in another country can be more difficult than in the case of a domestic counterparty. © The London Institute of Banking & Finance 2016

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u The laws and regulations will be different between the countries, and smaller businesses may not have the resources to employ legal expertise to deal with this. u Foreign currencies may be used for settlement, which can lead to unexpected financial gains or losses, unless managed very closely. u Overseas governments could intervene by introducing new legislation or taxes, which could make the deal uneconomic. u There may be complex formalities in relation to the movement of goods. u It may take additional time to ship goods from one country to another, and additional costs relating to transport and insurance could be incurred. u Political considerations inevitably can be a significant factor in international trade, as governments may seek to impose tariffs or quotas, and may pass laws that hinder trade. u Sadly, international trade can sometimes act as a front for money laundering, or the avoidance of sanctions, and there are many regulations in place that seek to prevent this from happening. u There is a greater probability of operational risk (such as employee error, employee fraud, failed systems, poor communication) in international trade, unless stringent precautions are taken. u Fraud is easier to commit: for example, forged documents or money may be sent to bank accounts under the control of fraudsters instead of to the seller’s bank. These aspects are discussed in detail at various stages in the text.

1.5

Risk mitigants

While there are a number of risks and problems in international trade that do not apply in domestic trade, there are also a number of risk mitigants that are available to international traders. These risk mitigants are analysed in some detail in this study text, but here is a brief list of some of the main ones: u Local chambers of commerce can provide services and point to other service providers that can help with communication, translation, documentation, legal advice, etc. u There are standard protocols and interpretations of legal issues, often published by organisations such as the chamber of commerce, covering 10

© The London Institute of Banking & Finance 2016

The effects of the global financial crisis on world trade

areas such as who pays for what on transport of goods, advice on documentation requirements, etc. u Banks provide derivatives such as forward exchange contracts to help reduce the effect of unexpected changes in foreign exchange rates. u Banks can provide specific undertakings or guarantees to cover counterparty risk (for example, documentary credits, and indemnities for release of goods without bills of lading). u Specialist freight forwarders exist to help to transport goods safely. u There are various versions of marine and cargo insurance available, to reduce the exposures incurred while goods are in transit. u Government or quasi-government sources can provide insurance against buyer default, and can provide guarantees to help sellers to obtain finance that may not be available on normal commercial criteria. The above are just some of the risk mitigants that will be covered later in this text.

1.6

The effects of the global financial crisis on world trade

Many countries have seen domestic demand shrink because of the global financial crisis, which began in 2007/08. As a result, governments have wished to encourage exports to help boost gross domestic product (GDP) and bring about an export-led recovery. In addition, businesses will consider whether they could boost export sales to compensate for static or reduced domestic turnover. Unfortunately, if domestic demand is shrinking in many countries, then it is very difficult for exports to increase. However, there are still some fast-growing economies and there is potential demand for exports to those countries. For example, in July 2012 the value of UK exports to non-EU countries exceeded the value of its exports to the EU for the first time since the 1970s. Commentators tended to view this as a result of the comparatively faster growth of some non-EU countries, such as China, when compared to the economies of the EU. Economists’ opinions inevitably differ, but in a number of countries at least there seem to be signs that growth is beginning to return.

© The London Institute of Banking & Finance 2016

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1.7

The World Trade Organization (WTO)

When countries get together and agree the rules and terms on how they are to trade with each other, they form multilateral or bilateral agreements. Multilateral agreements will be agreed by many countries; bilateral agreements will be agreed by a smaller number or groupings, such as the European Union. The largest multilateral agreement is the World Trade Organization (WTO), which was formed in 1995 and arose from the General Agreement on Tariffs and Trade (GATT). As of 2 March 2014 the WTO had 159 members. The WTO’s goal is: ‘to help the producers of goods and services, exporters and importers conduct their business’. Its members are government and country officials for the majority of the world’s trading countries. According to its website (WTO, 2016a): The WTO provides a forum for negotiating agreements aimed at reducing obstacles to international trade and ensuring a level playing field for all, thus contributing to economic growth and development. The WTO also provides a legal and institutional framework for the implementation and monitoring of these agreements, as well as for settling disputes arising from their interpretation and application. The current body of trade agreements comprising the WTO consists of 16 different multilateral agreements (to which all WTO members are parties) and two different plurilateral agreements (to which only some WTO members are parties). The WTO, therefore, acts as a negotiating forum for member governments to try to sort out the trade problems they face with each other. In particular, it acts as mediator in the event of disputes. Trading nations often find that they have conflicting interests. Interpretation is needed for agreements to be reached and the WTO will step in to help the disputing parties reach an agreement. There are a number of ongoing disputes where the WTO is mediating (WTO, 2016b). As mentioned above, the WTO is an example of a multilateral agreement. In December 2013, the WTO reached an agreement, known as the ‘Bali Ministerial Declaration’, on ‘trade facilitation’, or measures to reduce trade costs by cutting red tape in customs procedures. It will be some time before anyone can assess how significant and beneficial the deal is, and various estimates have been made as to the amount by which global trade costs could be reduced. Indeed, some commentators speculated that the deal could cut global trade costs by more than 10 per cent. You should follow this development in the financial press. Subsequent decisions related to the Bali Ministerial outcomes were adopted on 27 November 2014. 12

© The London Institute of Banking & Finance 2016

The International Chamber of Commerce (ICC)

1.8

Bilateral trade agreements: the European Single Market Programme (SMP)

Bilateral agreements have a common objective: to provide preferential trade status to member nations or trading groups in relation to certain goods or services, by removing or reducing tariffs and other trade barriers between the signatories. The European Single Market Programme (SMP) is a bilateral agreement, which began with an agreement by EU member states, signed in February 1986, containing around 270 measures to create a single market. The measures currently adopted relate in the main to: u the liberalisation of public procurement, which involved making the rules on works and supplies contracts more transparent, stepping up checks and extending the rules to important new areas such as transport, energy and telecommunications; u the harmonisation of taxation, which meant aligning national provisions on indirect taxes, VAT and excise markets, and financial services; u recognition of the ‘equivalence of national standards’; u harmonisation of safety and environmental standards; u the removal of technical barriers; u the creation of an environment that encourages business co-operation, by harmonising company law and approximating legislation on intellectual and industrial property; u the removal of the automatic need for customs clearance when goods cross EU boundaries, although customs authorities have a right to check goods if there are any suspicious circumstances. There are many other examples of bilateral agreements. See ‘Further resources’ at the end of this chapter.

1.9

The International Chamber of Commerce (ICC)

The International Chamber of Commerce (ICC) was founded in 1919. Today its global network comprises over 6 million companies, chambers of commerce and business associations in more than 130 countries. National © The London Institute of Banking & Finance 2016

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committees work with ICC members in their countries to address their concerns and convey to their governments the business views formulated by the ICC.

1.9.1 The ICC at a glance The ICC calls itself ’The world business organization’, a representative body that speaks with authority on behalf of enterprises from all sectors in every part of the world. The fundamental mission of the ICC is to promote open international trade and investment and to help business meet the challenges and opportunities of globalisation. The remainder of this section outlines the way in which the ICC describes its role and activities (ICC, 2012). The ICC Banking Commission has three main activities: 1. rule setting; 2. dispute resolution; 3. policy advocacy. Because its member companies and associations are themselves engaged in international business, the Banking Commission has unrivalled authority in making rules that govern the conduct of business across borders. Although these rules are voluntary, they are observed in countless thousands of transactions every day and have become part of the fabric of international trade. The ICC also provides essential services, foremost among them the ICC International Court of Arbitration, the world’s leading arbitral institution. Another service is the World Chambers Federation, the ICC’s worldwide network of chambers of commerce, fostering interaction and exchange of chamber best practice. The ICC also offers specialised training and seminars and is an industry-leading publisher of practical and educational reference tools for international business, banking and arbitration. Business leaders and experts drawn from the ICC membership establish the business stance on broad issues of trade and investment policy as well as on relevant technical subjects. These include anti-corruption, banking, the digital economy, marketing ethics, environment and energy, competition policy and intellectual property, among others. The ICC works closely with the United Nations, the WTO and intergovernmental forums, including the G20.

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© The London Institute of Banking & Finance 2016

Chapter summary

Chapter summary In this chapter, you have learned: u what a business is and what it does; u about the liability of the owners for business debts and how this differs between sole traders, the various forms of partnership and the various types of limited company; u what is meant by international trade; u the reasons why businesses trade internationally; u the differences between bilateral trade and multilateral trade; u about the role of the World Trade Organization (WTO); u about the role of the International Chamber of Commerce (ICC).

© The London Institute of Banking & Finance 2016

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Further resources There are many other examples of bilateral agreements, including the following: u North American Free Trade Agreement (NAFTA) (Canada, Mexico and USA). See: NAFTA Secretariat (2014) Overview [online]. Available at: https://www.nafta-sec-alena.org/Default.aspx?tabid=88&language=en-US [Accessed: 10 August 2016]. u Association of Southeast Asian Nations (ASEAN). See: ASEAN (no date) About ASEAN [online]. Available at: http://asean.org/asean/about-asean/ [Accessed: 10 August 2016]. u The following countries are currently Southern African Development Community (SADC) member states: Angola, Botswana, Democratic Republic of Congo, Lesotho, Malawi, Mauritius, Mozambique, Namibia, Republic of South Africa, Seychelles, Swaziland, Tanzania, Zambia and Zimbabwe. See: SADC (2012) About SADC [online]. Available at: www.sadc.int/about-sadc [Accessed: 10 August 2016]. u The EU has a list of all ongoing bilateral trade agreements between itself and other trading blocs or nations. See: Europa (2013) The EU’s bilateral trade and investment agreements − where are we? [online]. Available at: http://europa.eu/rapid/press-release_MEMO-13-734_en.htm [Accessed: 10 August 2016]. u The web page ‘bilaterals.org’ gives details of many of the bilateral trade agreements that currently exist. See: Bilaterals.org (no date) http://www.bilaterals.org/spip.php?rubrique113%20 [Accessed: 10 August 2016].

References ICC (2012) ICC commission on taxation [pdf]. Available at: http://www.iccwbo.org/AdvocacyCodes-and-Rules/Document-centre/2014/ICC-Commission-on-Taxation-Handbook-(2012)/ [Accessed: 10 August 2016]. Ricardo, D. (1817) On the principles of political economy and taxation. London: John Murray [online]. Available at: www.gutenberg.org/files/33310/33310-h/33310-h.htm [Accessed: 10 August 2016]. WTO (2016a) About the WTO: Overview [online]. Available at: www.wto.org/english/thewto_e/whatis_e/wto_dg_stat_e.htm [Accessed: 10 August 2016]. WTO (2016b) Current status of disputes [online]. Available at: https://www.wto.org/eng lish/tratop_e/dispu_e/dispu_current_status_e.htm [Accessed: 10 August 2016].

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Review questions

Review questions The following review questions are designed so that you can check your understanding of this chapter. The answers to the questions are provided at the end of these learning materials.

1.

‘Agency theory’ may apply in the case of public limited companies, but it cannot apply to a sole trader or a small partnership. True or false?

2.

Foreign currencies may be used for settlement in international trade. Why is this a risk?

3.

Suppose cars can be produced in Canada at a much lower cost than in China and that the cost of producing clothing is about the same. In theory, Canada should switch resources from production of clothing to production of cars and China should switch resources from production of cars to production of clothing. The two countries should then trade cars and clothing to increase overall wealth. True or false?

4.

In December 2013, the WTO reached an agreement on ‘trade facilitation’. What was the main area to which the agreement relates?

5.

Name the three main activities of the ICC.

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Chapter 2

The international trade environment

Learning objectives By the end of this chapter, you should have an understanding of how to: u assess the external factors that affect international trade markets (using the PESTEL model); u appraise the risks inherent in international trade; u research potential export markets or where new overseas supplies may be sourced; u select buyers or sellers in foreign markets; u make use of the trade promotion services available and of credit enquiries on overseas businesses selected as potential trading partners; u formulate an export strategy on entering an overseas market.

2.1

The external factors faced in international trade markets

The PESTEL model is a well-known tool that is often used to assess the impact of external factors − political, economic, social, technological, environmental, legal − that affect a business and the market in which it operates. There are a number of factors that a business must contemplate before entering into an overseas market, which will be covered later in this chapter. However, we will first examine the main issues and factors that relate to the two countries, which businesses need to consider before deciding whether to trade with each other. © The London Institute of Banking & Finance 2016

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2.1.1 Political u To what extent are the countries influenced by multilateral or bilateral agreements? u Are there any historical relationships between the countries that would benefit or hinder the relationship? u What is the political regime of the country that the business will be trading with? u Does the domestic country have any sanctions in place with the country where the business wishes to trade?

2.1.2 Economic u Is the country affected by a high level of industrial growth? u What is the impact of currency fluctuations between the two countries’ currencies? u Do the two countries share the same currency or are their currencies pegged, for example the Hong Kong dollar and the US dollar? u How will levels of inflation between the two countries affect trade? u How will employment levels in the two countries affect trade?

2.1.3 Social u Are there any religious or cultural differences that need to be considered? u Are there any cultural customs that may differ between the two countries? How is etiquette different? u Will language be a barrier? u Are negotiation styles between the two countries different? It may be customary to haggle in one country, whereas this would be seen as offensive in another.

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2.1.4 Technological u How can a company protect copyright or intellectual property rights? u Does technology conform to local legislation or does it need to be modified? u Does the country have certain safety standards that must be adhered to?

2.1.5 Environmental u Some countries demand that the goods they consume are produced in an environmentally friendly manner. Is this an issue? u What are the policies of the countries on climate change and global warming? u What are the policies in the trading countries on protecting the environment? u What are the policies on child labour?

2.1.6 Legal u Will patents that protect technology in some countries be respected in other countries? u Will different laws between the countries affect the way the underlying contract is interpreted? u Will the employment laws of certain countries, which may restrict the minimum wage or number of hours worked, affect the price of goods manufactured?

2.2

Considerations of the risks involved in international trade

Before deciding whether to enter into a foreign market either as a buyer or a seller, the business must first consider the risks to which it will be exposing itself. Many of the risks will be the same, regardless of whether the business is buying or selling abroad; the main risks are outlined in section 2.2.1−section 2.2.7. © The London Institute of Banking & Finance 2016

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2.2.1 Language and culture While English is considered the standard language of international trade, its use is not universal and the level of understanding will vary greatly from country to country and business to business. Cultural differences and sensitivities are equally likely to provide potential traps. Does the name of the product cause offence or give the wrong image, for example?

2.2.2 Legal issues We have already mentioned some of the legal issues above. The legal system and laws of countries vary immensely. Many English-speaking markets use a legal system based on common law, similar to that in England. Other countries, particularly in continental Europe and the former colonies of European countries, use a legal system based on a civil code such as the Napoleonic Code. Each country will have its own range of consumer protection laws and institutions, and may also be subject to law laid down by bodies such as the European Union. Even within a trading bloc, such as the Association of Southeast Asian Nations (ASEAN), legal differences may exist that have a direct impact on international trade; for example, the regulations relating to electrical devices, including the standard electrical current with which they may be used, may vary from country to country.

2.2.3 Buyers and sellers Exchange and currency can present a huge risk for a company. If a company agrees to buy or sell a product overseas priced in a foreign currency, it must agree on the price at the outset − the overseas party will not tolerate the business wanting to change the price down the line because the exchange rate is less favourable. Over the years, currencies have fluctuated greatly, strengthening and weakening against other currencies. A movement in exchange rate can very easily create an unexpected profit or loss in a transaction. It is largely down to relative bargaining power and custom and practice as to the choice of currency used to settle the transaction. If the seller is in a strong bargaining position, payment may well be settled in the seller’s currency; but the opposite will apply, if the buyer is in a strong bargaining position. For some commodities, for example oil, the custom and practice is that the pricing is denominated in US dollars. Thus even if neither the buyer nor the seller were US-based, the price would be denominated in US dollars and both parties would face the exchange risk. 22

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Considerations of the risks involved in international trade

2.2.4 Financial risks The working capital cycle for an international trade transaction is usually a great deal longer than that for a domestic transaction. The working capital cycle to the production of the finished product will be the same as for the domestic market if the identical goods are sold on the home market. However, once the goods are assembled, it could then take a number of weeks for them to be shipped before they arrive at their destination. In addition, in order to secure an export sale, the seller may have to grant extended sales terms. This additional time may put a strain on the working capital facility of a business and it may need additional finance in order to fund the time gap between shipment and receipt of payment. Ideally, a seller would wish to obtain a deposit up front, before commencing manufacture of the goods. This could be anything between one and three months in advance of shipment. However, it would depend on the relative bargaining positions of the two parties as to whether the buyer would agree to make such a deposit.

2.2.5 Credit risks Credit risk will not only include the risk of the buyer not paying for the underlying goods, but can also incorporate the country of the buyer’s government. For example, a country with a poor credit risk rating may have difficulties in its ability to make funds available to buyers to pay for goods or services purchased from overseas. From the point of view of the seller, the extent of the buyer risk obviously primarily depends on the creditworthiness and integrity of the buyer. However, subject to that point, the method of payment also has an influence. The methods are usually shown as: u open account; u documentary collection; u documentary credit; u payment in advance. From the seller’s point of view, open account is most risky, since the goods are despatched directly to the buyer, and the seller simply invoices for payment. Thus, the seller loses all control of the goods at the time that it ships them, trusting the buyer to effect payment. Payment in advance is least risky for the seller, but it is not easy to persuade buyers to agree such terms. Sometimes, a down payment of an © The London Institute of Banking & Finance 2016

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agreed proportion of the whole sale price is agreed, depending on relative bargaining power. In between open account and payment in advance lie documentary collection and documentary credit. The documentary collection method aims to ensure that the buyer can only obtain the goods by payment in full, or by signing a document, such as a bill of exchange, which makes the buyer legally liable to pay at a set future date. Documentary credit involves a conditional bank guarantee of payment to the seller, provided the stipulated documents in correct form are submitted within the time limit stated. For a documentary credit, the standing of the bank issuing the credit (guarantee) is vital. From the buyer’s point of view, the risk is that payment may be made but the goods or services prove to be faulty, defective or even missing. Hence the buyer’s perception of relative riskiness of payment methods is the exact opposite to that of the seller. Thus, for the buyer, the relative riskiness (highest risk first) is: 1. payment in advance; 2. documentary credit; 3. documentary collection; 4. open account. There are various bank mitigants, often governed by International Chamber of Commerce Uniform Rules, which aim to protect / compensate buyers against this risk. Sometimes buyers may be able to stipulate that payment will only be made if a third-party inspection certificate is produced. Terms of payment have to be mutually agreed between the buyer and seller, and details must be incorporated into the sales contract. This is a very brief outline of some of the considerations relating to credit risk. These points are considered in more depth at various stages later in this study text.

2.2.6 Transport risk Inevitably, the length of time the goods will need to travel to get to their final destination will be much longer than for a domestic transaction. This poses the additional risk that there will be more chance of the goods being damaged or being tampered with while in transit. Appropriate insurance is available to cover such risks, and the agreed Incoterm, which should be incorporated into the sales contract, will decide which party is responsible 24

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for insuring which part of the journey for goods in transit. Incoterms are internationally accepted terms that set out the responsibilities of the two parties as regards responsibility for transport and insurance. These terms are covered in full detail in Topic 5.

2.2.7 Risks relating to financial crime In international trade, there is an ever-present risk that the transaction could contravene anti-money-laundering regulations or could be in breach of sanctions or fraudulent. As a very simple overview, the following are examples of the types of question that need to be considered by all parties involved in any transaction. Any ‘wrong’ answers would necessitate further investigation. u Is the transaction consistent with other regular business activities? u Are the goods of a type commonly traded between the two countries? u Are any of the countries involved ‘high risk’, in other words subject to sanctions? u Is the invoice price consistent with pricing for the goods / services involved? u Are the goods ‘dual use’, ie could they be used either for military or non-military purposes? u What is known of the background of the two companies? Are they related in any way? If they are, checks are needed to confirm that the price is one that a business would pay another in a freely negotiated deal when there was no relationship between them. u Are the documents relating to the transaction free from anomalies? Is non-standard terminology used? u Does the transaction seem to be structured in an unusually complex way? The issues relating to the above questions are covered in detail in Topic 14.

2.3

Researching the market

In the first instance, the business needs to research its potential market. Research is vital to import or export success, and there are a number of places to go for information.

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2.3.1 Government departments Many governments have specific departments that can assist a company to trade internationally. Although many of these can − and will − provide some advice to a buyer, generally they are geared towards helping to promote exporting businesses in their countries. Each country will have its own government department (you should refer to your relevant government department’s website, where vast amounts of information can be found). In addition, most countries will have embassies in overseas territories that, again, can be a good source of information for the prospective buyer / seller. Examples of such government or quasi-government departments are provided in the further resources at the end of this chapter.

2.3.2 Chambers of commerce Like government departments, many countries will have their own chambers of commerce. Some of the chambers have regional offices in that country to help businesses in their area and in addition will work with overseas chambers to promote international trade. They will often run training courses for customers in areas such as transport and logistics, trade finance, international documentation, etc. They will provide translation services and country reports, and many will, for a fee, conduct market research on behalf of the customer, highlighting and matching buyers and sellers. In addition, many will organise overseas trade missions and give details of international exhibitions and trade shows (see below). In many countries there are specialist chambers, for example the Franco-British Chamber in France, which provide a range of services including networking, introductions to lawyers and accountants, and publications. Chambers of commerce usually specialise in the products of the local area, often advising on the technical requirements of local products exported to particular markets. The aim of the chamber of commerce is to act as a local first point of contact for sellers.

2.3.3 Trade missions, exhibitions and shows Trade missions are co-ordinated overseas visits by a group of business individuals representing their company. The aim is for them to meet potential overseas buyers or sellers. A company will usually attend a trade mission after it has completed its initial market research and identified its potential new market. Trade missions are often organised by chambers of commerce, industry bodies or local trade associations. The 26

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delegation that goes out would involve a mixture of businesses and some representation from the organisers. Sometimes companies that provide services in international trade, such as banks, freight forwarders or lawyers specialising in international law, will attend. In some cases, grants are available for companies wishing to attend trade missions. Trade missions are co-ordinated to coincide with trade exhibitions or trade shows. An exhibition or trade fair / show, sometimes referred to as an ‘expo’, is an exhibition where companies can exhibit their latest products and services to potential buyers. They can be general, where a number of sectors are displayed, or industry-specific. Trade shows will usually be held every year, with many being held twice a year, and many attract visitors from all over the world. For example, the Canton Fair is China’s largest trade fair; it is held every April and October and displays a complete product range of Chinese commodities.

2.3.4 Banks Most banks have trade finance operations and some have managers who specifically focus on helping their customers with international trade ventures. Although their main aim will be to assist in advising how to finance an international trade transaction, some banks will provide a wide range of assistance. u Banks may produce economic reports on individual countries, giving information about the standard of living, consumer expenditure, and the state of the country’s foreign exchange reserves, indicating the degree to which it might be difficult to get paid and other regulations and controls that apply to imports into the country. u Through the bank’s correspondent network (banks in overseas countries with an established relationship with their bank) or the bank’s overseas branches or subsidiaries, the bank can provide leads, giving names of possible businesses that might be interested in becoming a distributor or agent. u Through the same network, the bank can obtain credit information and reports on both potential customers and suppliers. u The bank may be able to suggest companies that provide third-party inspection and quality-control services, so that a buyer can ensure that a supplier is meeting contracted standards. u The bank can advise the buyer or seller on all aspects of making and receiving payments overseas, the risks involved and the mechanisms it can offer to minimise risk.

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u Some banks will also provide advice about the types of trade documents that are required, transport documents, types of invoice and insurance documents. It must be stressed that the majority of banks would not give this information directly; however, their international staff are usually happy to refer their customers to professionals in these areas. u Banks may advise their customers about currency risks and how they may be covered. u Banks may provide details on the various trade finance products that may be available, and advice and literature on how these work. Many banks have a trade finance section on their business / corporate websites, which are again a good source of information for customers (and for students studying this course).

Search the websites of your local banks to see what help they can give to sellers.

2.3.5 Status enquiries and credit control All businesses are concerned with the risk that they may not get paid, and this risk is higher when trading internationally. A buyer will also face the risk that their supplier may not fulfil their part of the contract. They might pay for goods that do not arrive or might be let down by late delivery or poor quality, resulting in a loss of business and income. A status enquiry or credit reference is a report that is collated from all of the information and history available on a company and made available to the enquirer, often for a fee. It is an historic look at how a company has traded. Although these reports cannot say how the company will trade in the future, they are a good indicator of how it has traded so far. Status enquiries and credit references are easily available from a number of sources. u Banks − the prospective customer’s or supplier’s bank may be willing to provide a status enquiry for a nominal fee. The information contained in the report will vary between the countries where they are issued. It may contain just a few lines that comment on the creditworthiness of its customer or it may be in more depth, commenting on the length of time the business has been in operation, the names of directors

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or principals, its business reputation or standing, and any known detrimental information such as litigation for debt, etc. u Credit reference agencies − each country or region has its own credit reference agencies. For example, in the UK, Experian and Dun & Bradstreet are commonly used to provide a range of credit reference and research services. u Credit rating agencies − Fitch, Moody’s and Standard & Poor’s are some of the big names in this market. They provide ratings on the credit standing of any large business that has raised capital on international markets. u Credit insurers − providers of credit insurance will also provide credit reports, either through themselves or a sister company. They will provide credit limits that they deem appropriate for the company under consideration. This is a good indicator for a seller when they are assessing the size of a contract. For example, if they receive a USD500,000 order from a customer who is only given a credit limit rating of USD20,000, then they should proceed with caution − will the customer be able to pay for the goods? Common providers of credit insurance are Aon, Euler Hermes and Atradius. Further details on credit insurance are given in Topic 12.

2.3.6 The internet and the media Most businesses have websites that will give some information as to the size of the company, its history, its product range and even testimonials. Caution is advised − you cannot believe all that you read. However, you can often get a feel for a company by examining its website. More generic information, such as country or sector reports, can be found too: by typing in ‘country reports’, you will find government departments or media agencies that will provide such reports. Trade journals and magazines will provide sector-specific information; potential buyers or sellers may be featured, as well as interesting articles on specific countries or policies. Journals and magazines with a focus on business and economics may also yield useful information, as might the business pages of quality newspapers. For a business wishing to promote its exports, a website can be a very useful additional support tool. Search engine optimisation (SEO) techniques should be used to ensure that the site features prominently in searches. Social media, or business-related media such as LinkedIn, can provide opportunities for low-cost promotion.

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2.3.7 Networking Other people who have recent experience in international trade are often an excellent source of advice and information. Local chambers of commerce or trade associations will often arrange functions such as seminars, where businesses can network and share experiences. Speakers may include a company that will talk about its experience of how it penetrated a market and about the pitfalls and its successes.

2.4

Methods of entering an overseas market

Once a potential new market has been identified and researched, a seller must decide on an appropriate entry strategy, or route to market. The research that may have been done so far may have identified demand for its product, barriers to entry and potential buyers; it may not have highlighted how best to enter the market with the product or service. The first step in this process is to decide whether to export direct to the end user or indirectly via an intermediary. The entry routes available to a seller are: u direct through to the end user; u via appointment of an agent or distributor; u through a joint venture; u through international licensing or franchising.

2.4.1 Direct exporting v indirect exporting Direct exporting is when a company sells direct to the end user. If you have ever personally purchased something on eBay from an overseas seller, then the seller has engaged in direct exporting to you. The advantages for a company that decides to go via the direct exporting route is that it has more control over the whole export process, potentially higher profits, and can build a closer relationship with its overseas customers, which can help with future marketing efforts. The downside to direct exporting is that the company would need to invest more time, which − depending on the scale of the company and export sales − may mean employing more staff with specialist experience.

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Methods of entering an overseas market

Indirect exporting is where the company would engage the services of an intermediary that specialises in finding foreign markets and buyers for its products. The main advantage for the seller in adopting this approach is that it provides a route to entering an overseas market without the risks and complexities of direct exporting, as the intermediary will basically provide all of the export services. The main disadvantage is that control is lost over how your goods are sold and marketed as well as the potential cost incurred; this must be weighed, however, against the level of potential new sales that the intermediary has generated. Intermediaries that can assist a seller in indirect exporting are outlined below.

2.4.1.1

Export management companies

Export management companies will act as the export department for the exporting company and are set up to provide a whole range of services. They will act on behalf of the exporting company, acting either in the name of the company or in its own name for a commission, salary, or retainer fee plus commission. Some of the larger export management companies can provide immediate payment for the exporting company, by either arranging financing or by directly purchasing the product. Typically, the export management company will have expertise either by product or by market, which is one of the main advantages to the exporting company. The main disadvantage of using such a firm is that the exporting company can potentially lose all control over the marketing and sale of its products.

2.4.1.2

Export trading houses

Export trading houses will purchase the goods directly from the manufacturer and sell them on in an overseas market. They are often product-specific or market-specific. Once they have purchased the goods from the manufacturer, they are then able to sell them to whoever they wish − and at whatever price they choose. Again, the manufacturing company will lose all control; however, the upside is that additional sales are generated.

2.4.1.3

Confirming houses

Confirming houses are not, strictly speaking, a route to entry for an exporting company. They are basically firms commissioned by an overseas buyer to find products for the foreign firms that want to purchase products from their country. They will seek to obtain the product at the lowest price and will be paid a commission by their foreign client. In some instances, confirming houses may be foreign government agencies or quasi-government firms that are tasked with promoting export trade for © The London Institute of Banking & Finance 2016

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their country. They offer a guarantee of payment to the seller from the buyer, which is useful if the buyer has a poor credit rating.

2.4.1.4

Buying agent (based in the home country)

Many large overseas companies or buying agencies will employ agents whose responsibility is to look for products and buy for their respective companies or clients. Their position is usually to source the product and negotiate the sales contract; however, because they are based in the home country, the sales contract would be subject to the home country’s law.

2.4.1.5

Co-marketing

Co-marketing is an arrangement in which one manufacturer agrees to distribute a second overseas firm’s product or service. A typical example would be when a company has a contract with an overseas buyer to provide a wide range of products or services. The supplying company may not have the capability to fulfil the whole of the contract, so it will turn to other domestic companies to provide the remaining products. This second company is then able to export its products to the international market. This has the advantage to the second company that it is often able to export its product, sharing the marketing and distribution costs associated with exporting.

2.4.1.6

Key factors in decision-making

The factors that will influence a company’s decision to export directly or indirectly include: u the size of the firm; u the level of resources available within the company to devote to its international marketing effort; u the nature of the product being sold; u any previous experience or expertise in exporting; u general conditions in the selected overseas market.

2.4.2 Appointing agents or distributors An agent is a third party appointed by the exporting company to act on its behalf to market and sell its product or service in a particular geographical territory or industry sector. They are often employed on a commission basis and usually work for a number of non-competing companies. Often 32

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Methods of entering an overseas market

they will negotiate a retainer fee and any subsequent sales would generate a commission. Because they are self-employed, the more sales they can generate, the more they can earn. Agency agreements are drawn up between the exporting company (the principal) and the agent, so some control can be assured to the exporting company as to who their goods are sold to and at what price. The agreement would also define the territory where the agent would be allowed to market its product, so in any one country it would not be unusual for a company to employ the services of several agents. A distributor fulfils a similar role to an agent; however, the main difference is that the distributor will usually make an outright purchase of the goods and then sell them on, again in a specified territory, at a profit. This provides an advantage to the seller, as they are not usually responsible for any losses or claims incurred by the distributor. However, the main disadvantage is that as the goods have been sold to the distributor, the seller has less control over where and how they are sold. The distribution agreement can provide some protection. Distribution agreements can either be sole distributorships, where the sole rights to sell the product or service in a particular market are granted, or a selective distributorship, where restrictions are applied as to whom (and under what conditions) the product or service can be sold. Table 2.1 highlights the main differences between agents and distributors. Table 2.1

The main differences between agents and distributors

Agent

Distributor

Does not take ownership and control of the goods, therefore is not assuming risks

Purchases the goods outright, taking ownership and control, assuming all risks

Negotiates the sale of the goods on Sells the goods on to customers, behalf of the exporting company for making a profit a commission Has no authority to agree the sale price

Usually has the authority to set the selling price of the goods

Would not usually provide after-sales Quite often provides after-sales support support Can be selective or sole distributorships

2.4.3 Joint ventures A joint venture (JV) is generally a legal entity formed between two or more parties, sometimes referred to as a ‘co-operative agreement’. A JV can also be © The London Institute of Banking & Finance 2016

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established via an agreement between two existing legal entities, without the creation of another legal entity; this is known as a ‘contractual joint venture’. The company wishing to export would find a local overseas company with which it would look to work together in the targeted country. Each party involved in the JV would bring different skills and expertise to the newly formed entity. The parties reach an agreement on the share of the revenues, expenses, assets and the control of the newly formed enterprise. Equity in the new company would be split between the parties, and any profits and losses would be shared on the same basis. A JV approach is attractive when countries impose high tariffs or quota restrictions in order to protect their domestic manufacturers. In some territories, the country’s laws may not permit foreign nationals to operate alone; for example, in some Arab countries it is not normally legal to carry out business without finding a national partner to work with in the form of a JV. A JV can also be an easier first step in working towards franchising, as McDonald’s and other fast food companies found out when they first entered the Chinese market. Other reasons for forming a JV are as follows: u Entry risks to the overseas market are greatly reduced by using the local partner. u The local partner will have greater understanding of the legal framework and business culture of that country. u Once established, labour and overhead costs may be lower than manufacturing in the domestic country and exporting to the overseas target country. Disadvantages of forming a JV include the following: u There may be an imbalance in the levels of investment and expertise provided by one party. u There are potentially conflicting management styles, business cultures and operational styles. u There may be different strategic objectives for the involved parties. u They are complex to set up, and a great deal of time and money may be needed to invest in finding the right partner. Once formed, JVs will define the responsibilities and goals for each organisation. Taxes will be paid in the country where the JV is set up to trade from, and any profits must be expatriated back to the exporting company’s country.

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Methods of entering an overseas market

Banks may be able to help with JVs. Some banks can provide advice on: u whether an equity stake or a loan capital injection is better (some overseas countries tax interest more favourably than dividends, and vice versa); u whether there are any overseas exchange controls that could affect remittance of dividends or capital back to the home country; u the likelihood of expropriation or country default (based on bank political and economic reports). In addition, banks may be able to provide letters of introduction to a reputable local lawyer or accountant. As an alternative, it is feasible to establish a contractual joint venture agreement that allows two parties to carry out a joint enterprise without creating another legal entity.

2.4.4 International licensing and franchising International licensing is when a company makes a decision that it does not wish to export directly or to do its own manufacturing in the overseas market. Instead it will grant its intellectual property rights − trademarks, patents, etc − to an overseas manufacturer in exchange for a fee. The overseas company is known as ‘the licensee’ and the granting company is known as ‘the licensor’. The license agreement will set out the terms and conditions that the licensee must adhere to. The licensee will agree to pay a fee or commission on its sales. The advantage to the licensor is that they are able to establish a presence in the overseas market, with the licensee committed to developing the market. The main disadvantage to the licensor is that they lose control over the manufacture of their product and, as such, run the risk that an inferior product in their name / brand will be sold in the overseas market. An international franchise is where a company permits an overseas party to use its business model or brand in a specified territory for a given period. The word ‘franchise’ derives from the word franc, meaning ‘free’, and is of Anglo-French origin. The exporting company would become the franchisor, and the overseas company the franchisee, which would pay a licence fee or royalty for the privilege of using the franchisor’s name and business model. International franchising has been very successful for many of the fast food outlets, such as McDonald’s, Subway and Starbucks, to name but a few. It is often said that the franchisee has a greater incentive than a direct employee in the company, as they have invested a direct stake in the business. International franchising is similar to international licensing; however, the overseas party is subject to greater controls in the use of the products. © The London Institute of Banking & Finance 2016

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The franchisee would usually pay a lump sum up front and then a royalty on subsequent sales. The franchisee effectively becomes a controlled outlet of the franchisor. The franchisor will often provide training and business advice for its franchisees as well as assistance in marketing and promotion. A further advantage of franchising is that it allows a company to expand rapidly through its network of franchisees. Although franchising is recognised worldwide, some countries have specific laws governing it. Brazil, for example, regulates franchises more closely than many other countries. Franchising is attractive for businesses with a good track record of profitability, and for businesses whose model is easily duplicated.

2.4.4.1

The advantages of franchising or licensing

From the point of view of a franchisor, advantages of franchising or licensing are that: u there is greater commitment on the part of licensees than is found among traditional agents or distributors; u there is greater control over presentation and pricing of products; u there are lower start-up costs compared with JVs or traditional selling techniques; u there is closer involvement with the overseas marketplace.

Chapter summary In this chapter, you have learned: u that there are many external factors that influence the international business environment, including political, economic, social, technological, environmental and legal factors; u that there are many risks associated with trading overseas: cultural, legal, currency, non-payment, cash flow, economic, political and the physical risk of loss of a cargo; u that research is vital to a successful venture, but there are many sources of help − government bodies, the bank, chambers of commerce and the media;

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Chapter summary

u that checking the credit standing of an overseas business can be effected through the bank, a credit reference agency and providers of credit insurance; u about formulation of an entry strategy to foreign markets.

Further resources Government and quasi-government departments providing assistance with international trade (all websites accessed 10 August 2016): u Australia − Austrade (www.austrade.gov.au/export-assistance) u France − Coface (www.coface.com/) u Germany − Germany Trade & Invest (www.gtai.de/GTAI/Navigation/EN/Meta/about-us.html) u Republic of Korea − The Export-Import Bank of Korea (https://www.koreaexim.go.kr/site/main/index002) u South Africa − Department of Trade and Industry (www.southafrica.info/business/trade/export/incentives.htm) u UK − UK Trade & Investment (www.ukti.gov.uk/home.html?guid=none) u USA − US Small Business Administration (SBA), Department of Commerce (www.sba.gov/content/us-exports-assistance-centers)

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Review questions The following review questions are designed so that you can check your understanding of this chapter. The answers to the questions are provided at the end of these learning materials.

1.

Give a specific example to illustrate what is meant by foreign exchange risk in international trade.

2.

Why is the working capital cycle longer for goods sold in international trade, as opposed to goods sold on the domestic market?

3.

What is a trade mission?

4.

What information can a bank produce to advise a seller about the likelihood of non-payment by the buyer?

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Review questions

5.

A business has decided that there is a potential opportunity to sell its products abroad. Name four possible entry routes.

6.

Briefly explain what is meant by a joint venture.

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Chapter 3

Contracts

Learning objectives By the end of this chapter, you should have an understanding of: u what makes a valid contract; u offer, counter-offer and acceptance; u the order process; u contract management; u the 1980 United Nations Convention on Contracts for the International Sale of Goods (CISG); u dispute handling and arbitration.

3.1

The contract

A definition of a contract will differ depending on the country in which you are resident and the law which applies. However, in general terms a contract can be described as an agreement between two or more persons or entities, which may or may not contain specific terms, in which there is a promise to do something in return for a consideration. Once the negotiation process is completed between the parties, the next stage is to draw up a contract. The first and most important question that arises in any international trade transaction is what law will govern the contract. The contract should always specify the applicable law, as each legal jurisdiction from around the world will have different laws and interpretations, each of which will have their own advantages and disadvantages. For example, under English law, for a valid contract to exist © The London Institute of Banking & Finance 2016

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there must be ‘consideration’, whereas French law recognises as a contract any agreement between parties who have negotiated in good faith. In general terms, for a valid contract to come into effect, the following conditions must have been met: u there must be a firm offer and an acceptance of that offer; u there must be an intention to create a contract; u there must be consideration − each party provides something to the other; u there must be capacity to contract − for a limited company that means that the nature of the business is within the objectives set out in the company’s memorandum and articles; u consent must be freely given without duress or based on false information; u the purpose must be legal. The requirement for formal validity of a contract will differ in each different jurisdiction around the world. Local legal advice should always be taken, as sometimes local laws will apply, irrespective of the governing law chosen in the contract. When the parties involved are frequent and experienced traders, they will usually each have a standard set of contract terms that they would like to impose on any orders. The International Chamber of Commerce (ICC) Commission on Commercial Law and Practice develops model contracts and guides to international contracting, published by the ICC (see: www.iccwbo.org/products-andservices/trade-facilitation/model-contracts-and-clauses/[Accessed: 10 August 2016]). The ICC’s series of model contracts is a unique set of trade tools, invaluable for practitioners and lawyers. They are succinct and practical, fair and balanced for all parties, clearly setting out comprehensive sets of rights and obligations. However, there will often be some need to vary any standard terms to meet local legal requirements or to suit specific circumstances and to reflect the relative commercial strengths of each side’s position. Once a seller has produced the contract, it will constitute their offer to the buyer, who may respond in one of the following ways. u Give acceptance as presented − if a verbal agreement to the contract has been reached, then this constitutes acceptance. Additionally, acceptance may also occur by action of the parties beginning to perform the contract. u Give acceptance, but with reservations or conditions. This represents a counter-offer. This counter-offer will have to be considered by the seller, 42

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The contract

who may then accept the amendments proposed or go back with a further offer for the buyer to consider. u Reject the offer entirely. Offers and counter-offers may flow backwards and forwards between the parties until, eventually, mutual agreement is reached or final rejection and abandonment of the negotiation process, perhaps to be resumed at a later date. Once final agreement is reached and signed by, or validly on behalf of, both parties, the contract will be binding on both seller and buyer, and any further amendments will require consent of both parties, preferably evidenced in writing. Once a contract is in place, all terms must be complied with or there is a breach of contract, unless there is some event that under the law of the contract brings it to an end, such as force majeure (ie an event beyond the control of either party, for example, riot, war, or natural disaster). Typical breaches would include delivery of substandard goods, late shipment, or failure to carry out what was promised. A breach of contract by one party usually entitles the other party to make a legal claim for any losses suffered and, in some cases, to void the contract, ie walk away from their obligations. However, in most commercial arrangements the parties will attempt to resolve their differences themselves and, if they cannot do so, will take the dispute to arbitration or some alternative dispute resolution or mediation. Only as a last resort will the party facing an actual and significant loss go to the courts for redress, which is potentially expensive, time-consuming and uncertain of outcome.

3.1.1 Information included in an international sales contract For each shipment it would be usual for the contract to state the: u currency to be used applicable for payment; u exact nature and quantity of the goods; u price; u packing requirements; u inspection and quality control requirements; u insurance requirements;

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u shipping terms to be applied − who arranges and pays for carriage, freight and all other costs, duties and taxes at each stage of the goods’ journey; u date by which goods must be dispatched / delivered; u method and timing of payment, and at what point risk to, and ownership of, the goods shipped passes from the seller to the buyer.

3.2

The ordering process

The following outlines in general terms how an order may be processed between an exporter and an overseas buyer. Note that this is only a guide and does not include financial instruments such as documentary credits or bills of exchange. u An enquiry is received from an overseas buyer. u The seller determines whether they are able to fulfil the order and whether any modifications are required, etc. u An export-costing exercise is carried out, to verify whether the transaction is commercially viable. u Due diligence may be carried out by the seller at this point, to establish the creditworthiness of the buyer. u A written quotation is submitted to the buyer. u If the buyer accepts the quotation, they place an order. u The seller accepts the order. u The order is processed by the seller and arrangements are made for shipment of the goods. u Goods are shipped. u Any relevant documents are forwarded to the buyer or through the banking system for presentation to the buyer. u Goods are received and payment is made. Where there is an established relationship, email / fax or electronic documentation may be used. For some countries, the seller has to provide the buyer with a pro forma invoice, giving all the details of the proposed shipment. This may be required by the buyer to comply with local import controls, or for an application to the central bank for a release of foreign exchange, or to obtain approval for the issue of a documentary credit. An example of a pro forma invoice is shown in Figure 3.1. 44

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Contract management

Figure 3.1

An example of a pro forma invoice

Where there is no agreement such as a distribution contract, a seller may receive a pro forma invoice following a trade enquiry or even quite unexpectedly. In that case, it represents a contractual offer from a potential buyer. The seller would need to make all necessary enquiries of the buyer and then decide whether to accept the pro forma invoice as submitted, to negotiate changes or to refuse it.

3.3

Contract management

The process − from potential order to a firm contract and finally to delivery − will often be time-consuming and may involve several departments from the exporting company. At pre-contract stage, the seller will have to liaise with its sales department and the production or supply department to be able to quote potential delivery dates and prices. The accounts or © The London Institute of Banking & Finance 2016

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3: Contracts

export department will have to become familiar with, and prepare, export documentation. The credit control manager must understand how to manage the risks and consider the most appropriate method of settlement. That could be payment by open account, documentary credit, payment in advance or by bill for collection, depending on the new customer’s credit standing and status report. To fulfil the contract, team effort is required and everyone involved must handle their part of the transaction with care, to ensure that the export of goods is made in accordance with the relevant contract. u Supplies need to be ordered or labour arranged. u Goods must be manufactured. u Packaging must be arranged. u Transport and shipping space must be booked. u Goods will have to be dispatched to the port, airport or place of destination in time, or services delivered in a timely manner. u All necessary documentation should be obtained and supplied by the export documentation department. u The buyer should be advised of shipping details. u All necessary documents must be submitted for payment directly to the buyer or via the banking system as quickly as possible. Effective export order management will be required to oversee all these functions and to periodically check progress. Changes in costs between the dates of order and final completion are not unusual and such risks must be allowed for, whether in raw materials, labour costs, insurance and freight costs, or the ever-present factor of fluctuating exchange rates. The seller will need to monitor all of these issues if the contract is to be profitable and viable.

3.4

UN Convention on Contracts for the International Sale of Goods (CISG)

The 1980 United Nations Convention on Contracts for the International Sale of Goods (CISG) is an agreement under international law that provides a code 46

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UN Convention on Contracts for the International Sale of Goods (CISG)

of legal rules governing the formation of contracts for the international sale of goods. The CISG was developed by the United Nations Commission on International Trade Law (UNCITRAL) and although it was signed in Vienna in 1980 it did not come into force until 1 January 1998, when it was ratified by 11 countries. It is sometimes referred to as ‘the Vienna Convention’. As of June 2015 it had been ratified by 83 countries, which accounts for a significant proportion of world trade. A full list of signatories and their current status can be found at: http://www.uncitral.org/uncitral/en/uncitral _texts/sale_goods/1980CISG_status.html [Accessed: 10 August 2016]. Countries that have ratified the treaty are referred to within the treaty as ‘contracting states’. The CISG is deemed to be incorporated into the domestic law of any trade between these contracting states, unless excluded by the express terms of the individual contract. The major absentees from this list include India, South Africa and the UK, which for domestic legal and governmental reasons have all decided not to ratify the CISG. When dealing with counterparties in countries that have not ratified the treaty, traders need to be aware that local laws and customs will normally apply unless otherwise specified in the contract, and they should not rely on the terms of the treaty to cover their transactions. The CISG is ‘accepted substantive rules on which contracting parties, courts, and arbitrators may rely’ and allows the exporter to avoid choice of law, which is a stage in the litigation of a case involving conflicts of laws. The CISG is written in a style that uses plain language and is translated into six languages. Each text is translated so that it can be easily interpreted by the contracting states and avoids local domestic legal terminologies. Small and medium-sized enterprises and traders located in developing countries can often have a relatively weak bargaining position when dealing with larger counterparties from the developed world. In addition, they generally lack access to legal advice when negotiating a contract. By providing fair and uniform regulations for contracts falling under its scope, the CISG can be particularly beneficial to such businesses.

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3.4.1 Content of the CISG The CISG is divided into four parts. Part I − Sphere of application and general provisions (Articles 1−13) The CISG is applied to sale of goods contracts between contracting states. It applies whether the parties reside in the same country or different countries. A contract between a trader from a contracting state and a trader from a country that has not ratified the CISG, such as India, may contain a clause that, in the event of arbitration, the CISG would apply. The CISG governs contracts for the international sales of goods between private businesses; it does not apply to sales to consumers and sales of services, and sales of certain specified types of goods are also outside its scope. One of the controversial features of the treaty is whether or not a contract needs to be signed to be binding. The CISG allows for a sales contract to be oral or unsigned; however, in some countries, a contract is not valid unless written. Parties to a contract will need to be aware of the rules that apply. Part II − Formation of the contract (Articles 14−24) Any offer to contract must be addressed to a person, must give full details of the goods including price and quantity, and must indicate an intention for the person making the offer to be bound on acceptance. Generally, once the offer has been made, it may only be subsequently revoked if the withdrawal reaches the offeree (ie the party to whom the offer has been made) before or at the same time as the offer has been received or before the offeree has accepted the offer. There are some offers that cannot be revoked, for example when the offeree has reasonably relied upon the offer as being irrevocable. The CISG demands a positive act to indicate acceptance. Inactivity or silence is not recognised as acceptance. Part III − Sale of goods (Articles 25−88) Articles 25−88 outline the sale of goods obligations of the seller and of the buyer, the passing of risk and the obligations common to both buyer and seller. Under the CISG, the duty of the seller is to deliver the goods, hand over any documents relating to them and transfer the property of the goods, as detailed in the contract. The duty of the buyer is to take all steps ‘which could reasonably be expected’ to take delivery of the goods, and to pay 48

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UN Convention on Contracts for the International Sale of Goods (CISG)

for them. In addition, the buyer is to examine the goods and advise the seller within a ‘reasonable time’ of any lack of conformity. Although the CISG outlines when the risk passes from the seller to the buyer, in practice it is the underlying Incoterm (such as FOB, CIF) that will be followed (see Topic 5 for further discussion of Incoterms). Part IV − Final provisions (Articles 89−101) The final provisions outline how and when the CISG comes into force, permitted reservations and declarations, and the application of the CISG to international sales where both trading countries have the same or similar law.

A body of case law has been developed over the years and is available via internet sources, for example: UNCITRAL (2014) Case Law on UNCITRAL texts (CLOUT) [online]. Available at: www.uncitral.org/uncitral/en/case_law.html [Accessed: 10 August 2016]. Visit the above website and examine a small sample of recent case law entries, to familiarise yourself with the types of cases concerned.

3.4.2 Criticisms of the CISG In the event of breaches in contract, decisions made by the courts can be inconsistent between different contracting countries. This is because the CISG is naturally interpreted by judges using the underlying principles and methods that are common in their domestic law. There is also criticism of the multiple-language versions of the treaty in that the versions are not totally consistent with each other − although this could be said about all treaties that are translated into multiple languages. There are also criticisms that the CISG is incomplete. For example, the CISG does not consider electronic contracts, nor the sale of services, and it does not govern the validity of the contract.

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3.5

Dispute handling and arbitration

However carefully contracts are drawn up, it is impossible to foresee every eventuality and, when buyers and sellers are unfamiliar with each other’s commercial practices, laws and customs, misunderstandings will occur. When this happens, there are three basic means of resolving a dispute: 1. The first is for both sides to attempt to reach a mutually satisfactory compromise. This is cheap, with no third-party fees (arbitrators or lawyers) and, if successful, will not get in the way of future opportunities for doing business together. 2. Arbitration (see below) involves both sides agreeing to an independent means of resolving a dispute and deciding what each party should do to resolve matters. There are costs involved. 3. A legal remedy involving lawyers and courts, maybe in unfamiliar jurisdictions. After both sides have taken legal advice, they may agree to compromise or take matters before a court for a decision. An application to a court for a decision to resolve a dispute is usually a last resort, because of the uncertainty of outcome, the cost and the bad feeling that is often engendered between the parties. However, when a general principle of law is at issue, this may be the only option. Overseas agents can prove to be most useful when a dispute arises. In fact, a reputable agent should prevent a dispute from arising in the first place. However, that is not always the case. Agents, frequently of the same nationality and culture as the overseas customer, can stray from full support of their principal’s interests, particularly if regular communication is not maintained. Because there is always a possibility that a dispute may end up in court, it is vital that contracts specify the jurisdiction that will apply and that the jurisdiction specified is one that is respected and whose laws are clear. If arbitration clauses are included in a contract, the jurisdiction specified should be one that is tolerant of arbitration. Arbitration can come about either because the parties to a contract have written an arbitration clause into the contract or because, when a dispute has arisen, they agree to resolve the issues by arbitration. UNCITRAL has a ‘Model Law on International Commercial Arbitration’ (1985) that some countries have adopted. This law defines an arbitration agreement as: an agreement by the parties to submit to arbitration all or certain disputes which have arisen or which may arise between them in respect of a defined legal relationship, whether contractual or not. 50

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Dispute handling and arbitration

An arbitration agreement may be in the form of an arbitration clause in a contract or in the form of a separate agreement. Arbitration therefore can cover all aspects of a commercial contract, not just transport issues. But the use of Incoterms will make it easier to resolve matters within those issues covered by Incoterms. There are a number of organisations that provide arbitration services. The ICC is one. Since its inception in 1923 the ICC International Court of Arbitration (known as ‘the Court’) has handled more than 19,000 cases involving parties and arbitration from 189 countries.

Visit the Court’s website (www.iccwbo.org/about-icc/organization/ dispute-resolution-services/icc-international-court-of-arbitration/ [Accessed: 10 August 2016]) to familiarise yourself with the countries and types of cases it deals with. Other arbitration courts include: u the London Court of International Arbitration; u the American Arbitration Association International Centre for Dispute Resolution; u the Hong Kong International Arbitration Centre. The Court and other institutions have established rules of arbitration and model contract terms. The London Court of International Arbitration (2014) recommends that the following arbitration clause be inserted into contracts: Any dispute arising out of or in connection with this contract, including any question regarding the existence, validity or termination, shall be referred to and finally resolved by arbitration under the LCIA Rules, which Rules are deemed to be incorporated by reference to this clause. The number of arbitrators shall be . . .(1−3) The seat or legal place of arbitration shall be . . .(city) The language used in the arbitration proceedings shall be . . . The governing law of the contract shall be the substantive law of . . . The English courts, in recent decisions, have reinforced the value of arbitration clauses, by deciding that businesses that freely enter into such clauses should expect to resolve disputes accordingly. © The London Institute of Banking & Finance 2016

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Typically, the party raising the dispute will refer the matter, with reasons, to the arbitration court agreed upon and the other party must respond within 30 days for submissions to the Court. The arbitrators will then study these submissions and related documents and hear the arguments put by the parties. The arbitrators will hear witnesses, including experts, called by the parties and may appoint their own experts to examine the issues. The decision made by the arbiters, including deciding who should pay the costs of arbitration, is binding upon the parties. However, there will be an appeal process, for example if one party feels that the arbitrator(s) has been biased.

Chapter summary In this chapter, you have learned about: u the key factors that must be evident in a contract (and that these will differ depending on which legal system is selected); u when contracts are put in place and what they cover; u the order process; u contract management; u the CISG, its content and general criticisms of it; u dispute handling and arbitration.

References The London Court of International Arbitration (2015) Recommended clauses [online]. Available at: www.lcia.org/Dispute_Resolution_Services/LCIA_Mediation_Clauses.aspx [Accessed: 10 August 2016]. UNCITRAL (1985) Model law on international commercial arbitration (2006 rev. edn.) Available at: http://www.uncitral.org/uncitral/en/uncitral_texts/arbitration/1985Model_ arbitration.html [Accessed: 10 August 2016].

Review questions The following review questions are designed so that you can check your understanding of this chapter. The answers to the questions are provided at the end of these learning materials. 52

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Review questions

1.

Which one international organisation provides model contracts and guides to international contracting? a. The International Chamber of Commerce.

b. The CISG.

c. The ICCCA.

d. The United Nations.

2.

Once a seller has produced a contract constituting an offer, in which of three ways may a buyer respond?

3.

France and Germany are two major countries that have not yet ratified the United Nations CISG. True or false?

4.

The CISG is divided into three parts. True or false?

5.

Name three main criticisms of the CISG.

6.

Name three arbitration courts other than that administered by the ICC.

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Chapter 4

Intermediaries and how they operate

Learning objectives By the end of this chapter, you should have an understanding of: u the basic considerations that sellers and buyers need to bear in mind before entering into a binding export / import transaction; u the role of various intermediaries who may be involved in an export / import transaction; u the principles that apply to the relationship between a bank and its customers; u the range of payment and documentary services offered by banks to buyers and sellers (covered in detail in later chapters), with a summary of the balance of risk associated with each payment method; u how banks work with banks in other countries to effect payment.

4.1

Before entering into a transaction with a new counterparty

In purely domestic transactions it is usually possible for a prudent business to obtain information on potential new business partners. It may be possible to visit the other party, obtain a bank reference, or seek formal advice from trade associations or informal advice from others in the same trade. Communication, including face-to-face meetings, is relatively straightforward compared to dealing with businesses located overseas. International business transactions need the same degree of due diligence as domestic transactions, and there are additional potential complications such © The London Institute of Banking & Finance 2016

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as fraud or sanctions that are less likely to be an issue in purely domestic business. Before proceeding in a transaction with a new counterparty located overseas, a business should undertake a preliminary analysis based on the well-known PESTEL system (refer to Chapter 2). This will vary depending on the country concerned, but would usually cover the factors set out in section 2.1. In addition, many banks provide ‘country guides’. The golden rule is to make full use of the services of organisations such as banks, trade bodies and chambers of commerce, and government departments to obtain advice on the local business practices and information about the potential counterparty. As regards the counterparty, the business might proceed as follows: u Check creditworthiness via an international credit reference agency. u Ask for references. u Check reputation with an overseas trade body, if such a body exists for the type of transaction under consideration. u See whether the seller’s own bank can obtain a status report via the banking system. u Examine the published accounts. u Obtain bank account details, including an International Bank Account Number (IBAN) (see section 4.9.3 below) and, after obtaining the information, seek confirmation from a separate source within the counterparty business that the details are correct.

4.2

Potential dangers to avoid

The following examples indicate ‘warning signs’ that should put a business on its guard: u Bribery − if a ‘facilitation fee’ is required, take legal advice to ensure that the incentive is lawful. Most countries in the Organisation for Economic Co-operation and Development have bribery and corruption laws that apply to domestic and international transactions. u Failure of the counterparty to give clear answers to basic questions regarding financial or technical issues. u Lack of a business logo, or an email address from Gmail or Yahoo or similar that suggests a personal email as opposed to a website with

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The balance of risk between the seller and buyer

a registered domain name (although this in itself is no guarantee of business integrity). u An inappropriate address − if the businesses dealing with such transactions are located in a particular district, take care if your potential counterparty’s address is somewhere else. Whenever possible, visit the business in person, although cost has to be considered. While conversations over media such as Skype can take place, it is easy for a fraudster to rent a palatial office for the day and conduct the conversation from these apparently impressive surroundings.

Visit the website of Transparency International, the global coalition against corruption: http://www.transparency.org/cpi2014/ [Accessed: 10 August 2016]. Study its latest survey, which considers transparency on a country-wide basis.

4.3

Sanctions

Any breach of sanctions, even if inadvertent, could result in a prison sentence, a heavy fine and major damage to reputation. Check the route of the carrying vessel, as shipping via countries that are subject to sanctions will invariably result in a breach of those sanctions, even if the goods concerned never leave the ship until they reach the ultimate destination. Sanctions are covered in more detail in Topic 14.

4.4

The balance of risk between the seller and buyer

Once each party has carried out appropriate checks to ensure that the other party is a suitable counterparty and that the transaction is lawful, they can discuss the details of the commercial contract. The buyer and seller should have reached an agreement about where the balance of risk will lie between them, and the service that will be required of one or more banks. When a bank is asked to provide a service appropriate to the contractual agreement between the buyer and seller, such bank must © The London Institute of Banking & Finance 2016

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also decide whether or not that service poses a risk to it and whether or not it wishes to accept that risk. Table 4.1 provides a summary of the payment options that the buyer and seller have and the relative risk to each party of the options listed. Table 4.1. The balance of risk between the seller and buyer Payment method contracted

Goods in

When paid

Seller’s

Buyer’s

hands of

for

risk

risk

As per

Highest

Lowest

High

Low but

buyer before (B) or after (A) payment Open account: Goods shipped and

B

documents forwarded direct to the

contract

buyer on the expectation that it will pay against the invoice and other documents Consignment: similar to open

B

When the

account. The seller sends goods

distributor

will have

to an overseas distributor who

has sold the

storage

is responsible for managing and

goods to the

costs

selling the goods for the seller.

end customer

The seller retains title to the goods until they are sold. Payment to the seller is required only for those items sold. This enhances export competitiveness, as goods are with the distributor and thus readily available for delivery to the end user Collection through a bank with payment on D/A terms

B



As per

Medium to

contract. The

high

documents to be released against

buyer will

acceptance

accept a bill

Low*

of exchange payable after a fixed number of days

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Intermediaries involved in the export transaction Table 4.1. (cont.)

The balance of risk between the seller and buyer

Payment method contracted

Goods in

When paid

Seller’s

Buyer’s

hands of

for

risk

risk

Low*

buyer before (B) or after (A) payment Collection through a bank with

On

Low but

documents released against

A

presentation

if buyer

payment

of documents

refuses payment, goods will need to be stored, resold or returned

Documentary credit

Depends

After

Low

on whether

complying,

(provided

documentary

presentation

documents

credit is

made to

are

available by

the bank or

compliant)

payment or

bank accepts

usance terms

waiver of the

Low*

applicant if discrepancies found Payment in advance

A

Before

None

High

shipment

* Only if the quality of goods shipped has been independently verified.

All of these services will be covered in detail in subsequent chapters.

4.5

Intermediaries involved in the export transaction

Once the seller and buyer are satisfied as to each other’s integrity and the legality of the transaction, negotiations can begin. In the negotiation stages of a contract, a purchase order or a pro forma invoice may be issued. The two

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parties will need to enter into a binding contract, which will cover, among other things: u the terms of payment (open account / documentary collection, documentary credit or payment in advance); u the denomination of the currency in which payment is to be made (see Topic 13 for consideration of foreign exchange risks); u details of how the goods are to be despatched and who is responsible for the various stages of the journey. It is vital that the commercial contract stipulates which Incoterm will apply. Full details of Incoterms® 2010, which are produced by the International Chamber of Commerce (ICC) and are applicable worldwide, are provided in Topic 5, together with details of the various documents required. Sellers must take care to ensure that the goods shipped and any relevant documents are in accordance with the pro forma invoice, or the buyer may be able to refuse to accept / pay for the goods or may try to negotiate a lower price. Once the commercial contract and Incoterm have been agreed, each party can make appropriate arrangements for transportation (as described in section 4.5.1). In practice, trade bodies or chambers of commerce will be able to advise on documentation. These bodies or a freight forwarder will normally be able to help with documentation for duty (for example, value added tax or VAT), customs declarations, import licences and any other export formalities that may apply to the specific country or transaction.

4.5.1 Freight forwarders The term ‘freight forwarders’ is used in this chapter to describe the organisations that manage the movement of goods internationally using the appropriate mode of transport. Freight forwarders are typically appointed by either the buyer or seller to organise the transport of goods. Many countries have freight forwarder trade bodies, which insist that their members adopt good practice and hold appropriate freight forwarder liability insurance. New sellers or new buyers should consult their appropriate trade body, a local chamber of commerce or their bank, depending on the services that the bank offers, when selecting a freight forwarder. A freight forwarder will book space on the appropriate transport mode which could be, for example, by aircraft, ship, rail or road. The freight forwarder will arrange for the goods to be collected from the seller’s premises and 60

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delivered to the carrier at the appropriate time and can liaise with its overseas offices to co-ordinate delivery to the buyer. Freight forwarders may also offer additional services such as: u warehousing; u final assembly and packaging of goods (particularly useful if the importing country has its own specific regulations); u managing customs requirements, including customs clearance of import freight and delivery to final destination.

4.5.1.1

Instructions to freight forwarders

Because transport is so complex, instructions should always be given to a freight forwarder in writing. The details to be communicated will vary, depending on the individual transaction. However, the following should normally be covered: u name and address and other contact details of the seller and buyer; u details of the collection and delivery address if they are different from that of the seller and buyer; u whether the goods are classed as ‘hazardous’ or ‘not hazardous’; u details of the Incoterm that applies; u whether the freight forwarder is asked to arrange insurance; u special instructions, for example whether the terms of payment are by documentary credit or documentary collection.

4.5.1.2

Customs formalities

Governments or governing bodies of the individual countries concerned usually pass laws with which sellers and buyers must comply when they import goods into − or export goods out of − the country. Non-compliance can result in penalties, which may involve fines or even imprisonment. These rules can be complex and inexperienced sellers and buyers should leave the formalities to a suitably qualified freight forwarder or take advice from a chamber of commerce. Typical issues covered by the regulations are: u details of goods which cannot be imported or are subject to licensing; u responsibility of buyers and sellers to submit documentation and pay any duties; u the powers of customs officers to conduct physical inspections of the goods. © The London Institute of Banking & Finance 2016

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4.6

Marine cargo insurance

Whenever goods are in transit, there is an obvious risk of loss or damage, which could have serious consequences for either the buyer or the seller, or both. The term ‘marine cargo insurance’ covers transport of goods in any mode, including road, rail and air as well as by sea. The Incoterm, which should be specified in the commercial contract of sale, will clarify the point or place of ‘delivery’: the point when risk and liability pass from seller to buyer. However, there are only two out of the 11 Incoterms® 2010 (CIF and CIP) that actually state who is specifically liable for providing insurance and which effectively require documentary evidence that insurance has been effected. If one of the other Incoterms is used, the contract of sale should specify who is responsible for effecting insurance for each part of the journey. For example, if the Incoterm® 2010 EXW applies, the seller’s responsibility ends once the buyer has collected the goods from the designated place. By implication, the buyer should insure the goods and cover should take effect immediately the goods have been collected. However, the Incoterm® 2010 EXW does not stipulate that the buyer must insure, it merely states that all responsibility rests with the buyer once the goods have been collected. In such cases, the contract of sale should stipulate that the buyer must insure. If the seller fears that the buyer may not insure the goods for the part of the journey that is his responsibility, then the seller could arrange, and pay for, sellers’ interest insurance. Sellers’ interest insurance would compensate the seller if the goods were damaged in transit and as a result the buyer could not pay for them. Naturally, the existence of any sellers’ interest insurance should not be advised to the buyer. Marine freight insurance is a specialist area, so it may be wise to consult an expert marine broker registered with Lloyds. Alternatively, the freight forwarder could be instructed to arrange the insurance. In such cases, the seller or buyer may benefit from the ‘bulk buying power’ of the freight forwarder, who will be handling insurance for many clients.

4.7

The banker / customer relationship

The general principles that govern any bank / customer relationship apply as much in trade finance as in any other service provided by a bank to its customer.

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The range of services provided by banks

The bank, among other duties, has a duty to: u make payment through a secure and reliable system; u collect amounts payable to its customer in respect of cheques and other instruments, such as bills of exchange; u provide regular statements; u keep its customer’s affairs confidential, subject only to certain laws that require information to be disclosed; u have a clear complaints procedure; u co-operate with the customer to protect against fraud and to prevent criminal activity in accordance with money-laundering regulations. The customer has a duty to: u provide its bank with any reasonable information that it may seek into its activities and those of its customers; u repay advances as agreed; u pay reasonable charges; u co-operate with the bank to protect against fraud and prevent criminal activity in accordance with money-laundering regulations.

4.8

The range of services provided by banks

Section 2.3.4 covered those services that banks may provide for customers planning to become involved in international trade. The remaining chapters cover the services that make it possible for buyers and sellers to reach the right balance of risks between transfers of ownership of the goods shipped against being paid. The services provided by banks can be categorised under the following broad general headings: u providing advice and contact details for other supporting organisations, such as ICC offices; u collecting and making payments; u handling documents;

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u providing guarantees that customers will fulfil obligations to trading partners; u exchanging currencies and protecting customers against currency fluctuations; u providing finance.

4.9

Correspondent banking

To provide many of these services, banks are often required to work with banks in other countries, collectively referred to as ‘correspondent banks’. They may be separate banks or members of the same group. For any domestic bank, their correspondents will include: u wholly independent banks with which formal correspondent banking agreements have been reached; u subsidiary or associate companies operating in another country also subject to a correspondent banking agreement; u state-owned / government-owned banks; u overseas branches of the domestic bank. Alternatively, a company may use the services of a foreign bank’s branch in the same country for a transaction. Representative offices without a banking licence in the country in which it is based will not be able to enter into correspondent banking agreements or conduct any transactions. The mechanisms used in correspondent banking will generally be the same whatever the ownership relationship between the domestic bank and the overseas correspondent. Correspondent banking services include: u ‘nostro’ and ‘vostro’ accounts; u SWIFT payments (requiring IBAN and BIC numbers); u real-time gross settlement (RTGS); u overseas bank accounts; u bank drafts and customer cheques; u continuous linked settlement (CLS).

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4.9.1 Payments There is strong pressure on financial organisations to deliver ever speedier and more efficient means of payment for international trade between countries. The disappearance of exchange control regulations restricting transfers of funds in and out of countries has removed official barriers and delays to international money transmission in most countries, although it is important that full and accurate records of all transactions are maintained for statistical purposes, and also to aid detection of money laundering and other economic crimes. Most banks now offer a full range of choices for international financial transactions, with prices reflecting the speed with which the transaction is completed. The rule is generally that the quicker the beneficiary (seller) receives cleared funds in its account, the higher the charge for the transaction. In today’s IT-enabled environment, funds can be transferred instantaneously around the world by interlinked computers at very little cost to banks. The main requirement to enable banks to make transfers between themselves is the transmission and receipt of an authenticated instruction from one bank to another, authorising the recipient bank to credit the account of the beneficiary (seller). A number of years ago, such instructions were transmitted by sea or air mail in signed documents to correspondent banks overseas and took an inordinate time to be acted upon. Each correspondent bank was sent books containing specimen signatures of those authorised to sign such instructions, so that messages could be confirmed as authentic by the recipient, and such signature books were regularly updated when staff changed. Later, instructions were sent between banks by telex or cable and, lacking signatures that could be authenticated, the messages were encoded and carried test keys, for which banks at either end held books of code tables, enabling authentication to be achieved. Transfers made under such systems were once called ‘mail transfers’ (MTs) or ‘cable / telegraphic transfers’ (TTs) and, for a long time, both systems ran side by side, with both being used depending on the urgency of the transfers in question. Nowadays, funds transfer instructions are sent between banks almost instantaneously through the interlinking of computers, using systems such as ‘SWIFT’, and such transfers tend to be called ‘international payments’, ‘priority payments’, ‘express payments’, or ‘ordinary’ or ‘urgent’ payments, depending on the bank and type of payment required. Authentication is by encryption built into the system.

4.9.2 ‘Nostro’ and ‘vostro’ accounts As well as transmitting instructions to one another authorising transfers, banks need to have systems for settling up with each other financially in © The London Institute of Banking & Finance 2016

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respect of such payments and, when different currencies are involved, nostro and vostro accounts are used. The word ‘nostro’ means ‘our’ and ‘vostro’ means ‘your’.

Example From the point of view of a German bank, a nostro account is its account in the books of an overseas correspondent bank, denominated in foreign currency. An example would be an account in the name of Deutsche Bank, Frankfurt, in the books of Citibank, New York, denominated in US dollars. Deutsche Bank is a customer of Citibank. From the point of view of a German bank, a vostro account is an overseas bank’s account with that bank, denominated in euro. An example of a vostro account would be an account in the name of Citibank, New York, maintained in the books of Deutsche Bank, Frankfurt. The account would be denominated in euro and Citibank would be a customer of Deutsche Bank. When funds are remitted from Germany, nostro accounts are used if the payment is denominated in foreign currency and vostro accounts are used if payment is denominated in euro. Banks treat their nostro accounts in the same way as any other customer would treat their bank account. The bank will maintain its own record of the nostro account, known as a ‘mirror account’, and will reconcile the bank statements against these mirror accounts. In order to maintain accurate records, the bank tries to value-date all transactions: the bank estimates the date on which authorised transactions will actually be debited or credited to the nostro account and it uses these dates in its mirror account.

4.9.2.1

Bookkeeping for transfers of funds

The following examples outline the bookkeeping for a French bank customer transferring funds to the bank account of a beneficiary abroad. It assumes that an account relationship exists between the respective banks.

Example 1 In this example the funds being transferred are denominated in euros. u The French customer is debited with the euro amount, plus charges, and this amount is credited to the euro account of the overseas bank (this is a vostro account from the French bank’s point of view); u On receipt of the advice, the overseas bank withdraws the euro from the vostro account, converts it to local currency, and then credits the beneficiary with the currency equivalent, less its charges. 66

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Example 2 In this example the transfer is denominated in foreign currency. u The customer is debited with the euro equivalent, plus charges, of the required currency amount and the nostro account is credited with the currency (if the French customer maintains a foreign currency account, then the appropriate currency amount can be debited to that account, and there will be no need to arrange for conversion into euro); u The overseas bank is advised that it can debit the nostro account with the requisite amount of currency and credit the funds to the account of the beneficiary. The various methods of settlement all involve the same bookkeeping. The only difference is the method by which the overseas bank is advised about the transfer.

For an alternative explanation of the difference between nostro and vostro accounts, visit: Assignment Point (2013) Assignment on nostro and vostro accounts [online]. Available at: http://www.assignmentpoint.com/business/ finance/assignment-on-nostro-and-vostro-accounts.html [Accessed: 10 August 2016].

4.9.3 Use of BIC and IBAN Banks require all transfers within the EU to include full and clear beneficiary bank and account details. These are known as Bank Identifier Code (BIC) and International Bank Account Number (IBAN) details, and are usually quoted at the top of bank statements of current account holders in the EU.

Example of a BIC A typical BIC identifies the bank and branch. It would appear as follows: MIDLGB22123. The BIC consists of a bank code (MIDL), a country code (GB), followed by a branch identifier number (22123). © The London Institute of Banking & Finance 2016

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Example of an IBAN A typical IBAN can be up to 34 characters long and would appear as follows: GB15MIDL40051512345678. The IBAN consists of the country code (GB), a check number (15), the bank code (MIDL), followed by a sort code (400515) and an account number (12345678). Inclusion of both of these codes in funds transfer instructions enables banks using SWIFT to send messages to each other using Straight Through Processing (STP), eliminating delays and queries. An IBAN-checking tool and more information on some of the above systems is available online at the European Committee for Banking Standards website (www.ecbs.org/iban.htm[Accessed: 10 August 2016]). BICs are being phased out and will no longer be necessary after 1 February 2016; all of the information required to complete a payment will be incorporated in the IBAN.

4.9.4 Real-time gross settlement (RTGS) Banks, on their own behalf and on behalf of their customers and other large institutions, can also access electronic clearing and settlement systems. An example is the UK-based CHAPS payment system used by, among others, solicitors to make payments when a property purchase is completed. CHAPS provides a same-day, secure electronic transfer of funds in either pounds sterling or euro between member banks. This type of arrangement is known as real-time gross settlement (RTGS): a term that describes payment systems that transfer and settle payments electronically in real time (instantaneously) on a one-to-one basis between banks. Payments made either via SWIFT messages or by RTGS systems are irrecoverable. They cannot be withdrawn or cancelled once sent, even if they have been sent in error, unless the recipient agrees to return the money. CHAPS payments in euro involve a linkage between the RTGS systems of each European country, a system called TARGET 2. TARGET 2 provides a direct payment platform in Europe without the involvement of the member country’s own RTGS systems.

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4.9.5 Overseas bank accounts A company that expects to make or receive regular payments in another country may be able to open its own overseas account(s). Such companies open an account with their domestic bank’s correspondent bank or, if their bank is represented in the overseas country by another member of the same banking group or by a branch, then an account can be opened with that group member or branch. Opening an account overseas will be subject to any local rules governing bank accounts and to any exchange controls applicable to accounts belonging to foreign nationals. If the domestic bank of the company is a member of a group of banks with representation in the country with which it is trading, opening an overseas bank account can be a most efficient means of managing and transferring money. For example, a bank with an overseas subsidiary may offer a service that gives its customers with overseas accounts held with that subsidiary the ability to transfer money instantly between the two countries, giving payment instructions online.

4.9.6 Bank drafts and customer cheques Payments can also be made with bank drafts, a form of cheque drawn by a buyer’s bank, payable to the seller and drawn on the buyer’s bank’s correspondent in the seller’s country. If the draft is in the seller’s own currency, the funds can be credited directly to the seller’s account. If the draft is not in the seller’s currency, their bank may negotiate the draft and credit the local currency equivalent at the prevailing exchange rate, subject to any charges. Otherwise, the bank will send the draft to the drawee bank for collection of the proceeds. Settlement between the banks will be via the nostro and vostro accounts. A buyer can pay by issuing their own cheque, subject to local exchange control regulations. The seller’s bank may either agree to negotiate the cheque − credit the seller’s account immediately − or send the cheque to its correspondent to obtain payment, ie via a documentary collection. Negotiation will involve a charge to the seller to cover the interest cost to the bank for the period between paying it and receiving payment. This charge can be built into the exchange rate if the cheque is in a foreign currency. Negotiation will be ‘with recourse’, ie if the cheque is unpaid, the bank will debit the seller’s account to recover the amount originally negotiated. Negotiation facilities are therefore at the bank’s discretion. A collection means that the seller will only get funds when its bank receives payment from the buyer’s bank.

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4.9.6.1

Disadvantages of the buyer using their own cheques

In some countries, sending a cheque abroad may contravene the exchange control regulations of the buyer’s government. The buyer’s bank and the beneficiary’s bank usually impose heavy charges for handling such cheques. There is an inevitable delay between the time when the cheque is collected and the time when funds are actually remitted by the buyer’s bank. One method of speeding up the process of clearing cheques is to use a ‘lockbox’ facility, which is particularly useful for sellers who sell to the USA and who are paid by the buyer’s cheque. The buyer is instructed to post the cheque to a post office (PO) box address in the USA. A local bank opens the ‘lockbox’ at least once a day and initiates the clearing of the cheques. This process dramatically reduces the clearing time, because the cheque itself does not have to go from the USA to the originating country and back again. Banks may be able to organise ‘lockbox’ facilities by making arrangements with correspondent banks abroad. Lockbox facilities are also widely available within the EU. Arrangements can be made for the proceeds of the cheques collected via the ‘lockbox’ system to be held in a collection account with the overseas bank. The funds can then be drawn down as and when required to meet the local currency needs of the seller. From the seller’s point of view, there is no guarantee that the cheque will be paid.

To see how a lockbox system can work in practice, visit: HSBC (2016) Easy Lockbox [online]. Available at: https://www.us.hsbc.com/1/2/home/business/business-banking/ cash-management/collections/ez-lockbox [Accessed: 10 August 2016].

4.9.7 Continuous linked settlement (CLS) CLS is the name of an institution owned by and operated by banks engaged in large multi-currency inter-bank settlements of money owed to other CLS participants, particularly for intra-day (same-day) foreign exchange transactions.

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Chapter summary

The benefits to bank participants are: u elimination of settlement risk − the risk that one bank owing money to another does not pay; u cost-efficiency; u ease of management for the department of the bank that reconciles payments made and due. At the height of the global financial crisis, some financial markets (for example, the short-term inter-bank deposit and borrowing markets) ‘froze’. However, the foreign exchange markets continued to function. Many commentators believe that it was the guarantee afforded by the CLS process that ensured confidence, and hence liquidity continued to be available. The use of CLS has reduced the number of bank nostro / vostro account relationships.

Example For example, UK Bank plc may regularly send customer-initiated transfers of funds to several beneficiaries who bank at several different US banks. Prior to CLS, the UK Bank plc would have needed nostro / vostro relationships with each US bank, the alternative being to face delays in the internal transfer of the funds within the USA. Now, UK Bank plc needs only one nostro account. UK Bank plc will use this nostro account to meet its obligations to CLS as regards the transfers of funds to US beneficiaries. It is CLS that will transfer the funds to the US banks, provided that UK Bank plc has sufficient balances in US dollars with CLS to meet these obligations.

Chapter summary In this chapter, you have learned that: u there are basic checks and precautions that must be taken to ensure that a potential overseas business partner is reputable and creditworthy and that the underlying transaction is legal; u advice may be available from the ICC, trade bodies, banks and government departments; u freight forwarders have a key role in the movement of goods; u customs formalities must be complied with and all duties paid;

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u there is a balance between the risk to the seller and the buyer, with that risk shifting from one to the other according to the payment method agreed; u correspondent banks operate accounts for each other − nostro and vostro accounts − and make payments from these accounts in accordance with secure messages sent on the SWIFT system; u there are international conventions where banks and accounts are identified by IBAN and BIC numbers; u RTGS technology is used to effect electronic payment exchanges; u international electronic payments are irrecoverable once sent; u CLS simplifies the process of international funds transfer and eliminates counterparty risk.

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Review questions

Review questions The following review questions are designed so that you can check your understanding of this chapter. The answers to the questions are provided at the end of these learning materials.

1.

All Incoterms set out the point of delivery: the point when risk and liability pass from seller to buyer. True or false?

2.

Which is most risky from the point of view of a seller?

3.

a. Open account.

b. Documentary collection.

c. Documentary credit.

d. Payment in advance.

Which is more risky from the point of view of a buyer? a. Open account.

b. Documentary collection.

c. Documentary credit.

d. Payment in advance.

4.

A French bank holds a USD-denominated bank account in the books of a US bank. For the US bank this is a nostro account and for the French bank it is a vostro account. True or false?

5.

Insert the missing four words: describes payment systems ‘The system known as that transfer and settle payments electronically in real time (instantaneously) on a one-to-one basis between banks’.

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:

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Chapter 5

Documents used in international trade and the Incoterms® 2010 rules

Learning objectives By the end of this chapter, you should have an understanding of: u the sale and purchase of goods within the EU customs union; u financial documents, including bills of exchange and promissory notes; u other documents used in international trade, including transport, commercial and insurance documents; u the ICC Incoterms® 2010 rules.

5.1

Introduction to documents used in international trade

Following the overview of international contracts given in Topic 3, it is appropriate to learn in more detail about the various documents used by buyers and sellers and about the significance of common shipping terms. The number of documents required and the content of the documentation will vary greatly according to the underlying contract, the nature of the goods, the complexity of the export sale, the type of shipment / transport required, and the rules, restrictions and trade agreements applicable to the transaction and the countries concerned.

5.1.1 Sale and purchase of goods within the EU customs union In the European Union (EU), most goods circulate freely once inside EU borders, whether they are made within the EU or imported from outside. © The London Institute of Banking & Finance 2016

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All customs posts at frontiers between EU countries have been abolished, but they remain at the external borders of the EU. Therefore, and as an example, there are no entry or exit customs requirements for documentation for a sale of computer games from the UK to France. Furthermore, if the games have been imported into the UK and duty paid at the UK border, they may be sold on to France without formality, except for reporting for statistical purposes. Value added tax (VAT), a tax on goods and services levied on sales in the UK, or its equivalent in other countries, is paid by buyers on trade within the EU. Some goods do remain controlled and may not be exchanged, even between EU members, without formality: u excise goods − alcoholic drinks, tobacco and hydrocarbons; u animals and food products controlled under the EU Common Agricultural Policy; u military equipment; u explosives (including fireworks) and firearms; u prohibited (banned) and controlled (permission required) drugs. Three of the four European Free Trade Area (EFTA) countries (Norway, Iceland and Liechtenstein) have joined with the EU to form the European Economic Area (EEA), whereby they have free trade agreements but customs formalities remain in force. The other EFTA country, Switzerland, has a separate agreement with the EU. In the UK, HM Revenue & Customs, in compliance with EU rules, requires buyers and sellers to complete a single administrative document (SAD) for all goods moving in or out of the EU, including EFTA countries and some overseas territories of EU countries. These formalities may be undertaken by agents, such as freight forwarders, but the legal liability for correct reporting remains with the seller or buyer. Almost 200 countries and territories have some preferential tariff agreements with the EU. Importing from those countries involves the buyer demonstrating that the imports come within the rules.

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impose very strict regimes as part of an economic policy to restrict imports; others are more liberal. A few countries are on a list where trade is restricted by the USA: for details, see the US Department of the Treasury Resource Center website (www.treasury.gov/resource-center/sanctions/Programs/Pages/ Programs.aspx [Accessed: 10 August 2016]). The US authorities will seek to impose their laws even on other countries exporting to these restricted countries, if those exports contain any US components. New trading blocs are appearing regularly, with the Comprehensive Economic and Trade Agreement (CETA) between Canada and the EU, and (at the time of writing in 2015) a Transatlantic Trade and Investment Partnership (TTIP) being negotiated between the United States and the EU. There are also potential trade treaties between the USA and several Pacific Rim countries. You should watch carefully for developments in your own area. The World Trade Organization (WTO) continues its attempts to secure a worldwide trading agreement, with success in the ‘Doha Round’ being achieved at a meeting in Bali, Indonesia in December 2013, with subsequent related decisions adopted on 27 November 2014. In the meantime, local trading treaties seem to be yielding results earlier than the long-running WTO negotiations.

Find out which trade agreements, if any, your own country is a member of, and which other countries are also members. Note that your country may be a member of more than one group.

5.2

Financial documents

Although it is perfectly possible to make payment for goods purchased overseas with a cheque or bank draft, this chapter will examine two other financial documents with a long history of use in international trade as a means of minimising risk to all parties: the bill of exchange; and the promissory note. They are widely used today and their specific use will be discussed in later chapters.

5.2.1 The bill of exchange The bill of exchange − or ‘draft’ as it is more commonly referred to − is a convenient method of collecting debts internationally, with a special status recognised in many jurisdictions. © The London Institute of Banking & Finance 2016

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The UK Bills of Exchange Act 1882, applicable to the whole of the UK and widely referred to by many legal jurisdictions, defines a bill as follows: A bill of exchange is an unconditional 1 order in writing, 2 addressed by one person 3 to another, 4 signed by the person giving it, requiring the person to whom it is addressed to pay on demand or at a fixed or determinable future time 5 a sum certain in money 6 to or to the order of a specified person or to bearer. 7 (UK Bills of Exchange Act 1882) Each of these elements needs explanation: 1. ‘Unconditional’ means that no conditions are allowed. A clause such as ‘If you ship this machine by 1 February, I will pay you’ is not a valid draft. 2. ‘In writing’ includes print. 3. ‘Addressed by one person’ refers to the drawer, ie the originator of the draft. The relationship of the drawer to the draft is not always the same. A cheque is a form of draft where the drawer has a debt to pay to the payee and the drawee is the drawer’s bank. In trade finance, the drawer is the seller seeking to collect money and the drawee is the buyer (or sometimes a bank). If the drawer makes the draft payable to it, the drawer / seller is also the payee, as in the example in Figure 5.1. 4. ‘To another’ refers to the person or business that is to make the payment to the drawer, ie the drawee; this might be the buyer’s bank. The drawee will pay the amount of the draft, or if the drawee ‘accepts’ an obligation to pay on a future date by signing the draft on its face and adding the word ‘accepted’, they become the ‘acceptor’ and they are legally committed to pay on the due date. 5. ‘On demand or at a fixed or determinable future time’ means either for payment on immediate presentation to the drawee or for payment at a determinable due date. For example, 90 days after the date of the draft is a determinable date but 90 days after the arrival of a ship is not, as the exact date of arrival can never be certain. 6. ‘A sum certain in money’ effectively means that the draft is to be issued for a sum of legal tender including foreign currencies. 7. ‘A specified person or to bearer’ is either the named payee or the person holding it if payable to bearer. Figure 5.1 provides an example of a term draft (see below for an explanation of ‘term draft’). The numbers in the figure refer to the explanations above.

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Figure 5.1

Example of a term draft

Drafts have a special legal status. They are ‘negotiable instruments’ unless specifically stated not to be. Negotiable means much more than merely transferable from one person to another. A draft stands alone from any contract that might have caused it to be written. Therefore, a holder of a draft who takes it in good faith and for value takes it free from any defect in the title to it of the previous holder. The commercial effect of this is, for example, that a bank that holds a draft and expects to collect money from the acceptor when due, can sue the acceptor, or anyone else whose signature is on the bill of exchange, for non-payment irrespective of any contractual disputes there may be relating to the underlying goods or services. The status of negotiable instruments is recognised by most international jurisdictions. Below is a quotation from the US Uniform Commercial Code (Legal Information Institute, 2012): . . .negotiable instrument means an unconditional promise or order to pay a fixed amount of money, with or without interest or other charges described in the promise or order, if it: 1. is payable to bearer or to order at the time it is issued or first comes into possession of a holder; 2. is payable on demand or at a definite time; and 3. does not state any other undertaking or instruction by the person promising or ordering payment to do any act in addition to the payment of money. . . Drafts may be payable on demand (known in a trade transaction as ‘at sight’), or at some future date (known as a ‘term draft’ or a ‘usance draft’). A sight

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draft is payable on presentation to the drawee and therefore the issue of acceptance does not arise. A term draft or usance draft gives the drawee time for payment. A bank handling a draft on behalf of the seller will first obtain the drawee’s acceptance and may then: u hold it until maturity, present it for payment and then remit the funds to the seller; u ‘discount’ it, by paying the seller immediately the face value less a discount to represent interest for the period between the date of payment and the maturity date − see section 9.6.2. At maturity, the draft will be presented for payment to the drawee or acceptor, or the bank nominated to pay on the acceptor’s behalf. A draft accepted by a bank, and returned to a presenter, will normally be presented to them direct or via a correspondent bank. In documentary credits it is common for a draft to be held by the bank (drawee) on whom it is drawn.

5.2.2 Promissory notes A promissory note is also a negotiable instrument, similar to a bill of exchange, except that there are only two parties. The UK Bills of Exchange Act 1882 defines a promissory note as: . . .an unconditional promise in writing made by one person to another signed by the maker, engaging to pay, on demand at a fixed or determinable future date a sum certain in money to, or to the order of, a specified person or bearer. (UK Bills of Exchange Act 1882) Promissory notes are widely used as debt instruments, for example in long-term projects containing numerous stage payments, where a buyer or borrower issues one or more promissory notes promising to pay a specified amount on a stated due date. Bills of exchange and promissory notes payable at sight must be presented promptly for payment. Term or usance bills of exchange must be presented promptly for acceptance and, when returned to the drawer or the presenter, presented on or just prior to the due date for payment. If a bill of exchange is not accepted or paid when due, or a promissory note is not paid when due, then special procedures in some countries require that the bill of exchange or promissory note be ‘noted’ or ‘protested’ for non-payment, to preserve the holder’s legal rights. It is common that within 80

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Financial documents

24 hours of an indication of non-payment or non-acceptance, a notary public or similar person must be asked to demand acceptance or payment and then write the reason for non-payment or non-acceptance on the bill of exchange or promissory note. Protest for foreign bills may be done later and is a more formal record of non-payment or non-acceptance. Failure to comply with local requirements can result in the drawer (and any endorsers) being absolved from liability to pay. Protesting a bill of exchange or promissory note may indicate an act of bankruptcy in some countries, and the implications of this should be considered before such instructions are given. Rules for noting and protesting dishonoured bills of exchange vary in different jurisdictions, depending upon their sources of law.

Research the legal requirements for dealing with unpaid bills of exchange or promissory notes in your own country. Note that in some countries, the rules may differ from area to area within a country, sometimes depending on local practice or different laws in different states. Bank staff must understand what is expected of each party to a bill of exchange. Banks may be the drawee and / or acceptor on behalf of a customer; or the bank may be acting as the agent of a customer who expects payment on a bill of exchange drawn on, and accepted by, another party. In considering its duties as agent, a bank should act as though it were a party to the bill of exchange. The UK Bills of Exchange Act 1882 has many sections dealing with the responsibilities of each party to negotiable instruments. The general rule is that anyone who signs as drawer, acceptor or endorser is legally liable to pay on it. But the drawer or endorser may refuse liability (except for the validity of the document), if they add the words ‘without recourse’ or ‘sans recours’ next to their signature.

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5.3

Other documents used in international trade

In addition to finance documents, other documents that are used in international trade include: u transport documents; u commercial and other documents; u insurance documents.

5.3.1 Transport documents These are the documents issued by carriers, owners, masters, charterers, or their respective agents that evidence a contract of carriage, the receipt of goods and the details of the transport, ie what was carried, and from where to where. They fall into two main groups: those that give title to the goods (quasi-negotiable); and those that do not (non-negotiable). Quasi-negotiable documents confer upon the holder of an original transport document a right to possession of the goods. The negotiable quality of a bill of lading (see section 5.3.1.1 below) is similar to a bill of exchange, in that a transfer of the document represents a transfer of title to the goods. But a transfer of a bill of lading is subject to any defect of title, which is not the case for a holder of a bill of exchange. Defect of title in this case means that the title to a bill of lading to which the current holder does not have a full legal title (for example, because of theft or fraud) cannot be legally transferred to any other party, so the recipient (transferee, often a bank financing the shipment) can therefore not exercise full legal rights over the bill of lading or the goods covered by that bill. This is because the bill of lading (unlike a bill of exchange) is not a fully negotiable document, but only ‘quasi-negotiable’ (Bills of Lading Act 1855).

5.3.1.1

Bills of lading

Bills of lading are documents issued by a carrier, a master or their respective agent and usually have quasi-negotiable status. As well as evidencing the terms of the contract of carriage and acting as a receipt for the goods, a bill of lading can also provide entitlement to receive the goods. The consignee (ie the entity to whom the goods are being sent or consigned) whose name is preceded by the words ‘to order of’, or an entity to which the bill of lading has been endorsed, can take possession of the goods upon the surrender of an original negotiable bill of lading to the carrier or its agent at the port of 82

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discharge. Banks usually require a bill of lading to be made out to the bank’s order, ie ‘To order of [name of bank]’ or to the shipper’s order, ie ‘To order’ or ‘To order of shipper’ and endorsed by the shipper to order of the bank or in blank, thus enabling the bank, the buyer or any other named entity to take possession of the goods. Bills of lading are issued and released to the seller once the goods are loaded on board the vessel and are marked as ‘shipped on board’, with an indication of the date the goods were shipped on board. Bills of lading are usually issued in a set of three originals, with the number issued being specified on the bill of lading. Once the goods are released to the bank, to the buyer or to another entity against surrender of one original, then the others in the set become void. Sellers will either courier the bills of lading to the buyer or their agent (for an open account transaction) or present them through the banking system for collection (see Topic 7) or for payment by documentary credit (see Topic 8). In the event that a buyer does not receive the bills of lading before the ship arrives, it may face storage costs, known as ‘demurrage charges’, which the buyer may seek to recover from whoever caused the delay. See ‘Missing bills of lading’ (section 5.3.1.2). Bills of lading with this quasi-negotiable status are also issued in the following forms: u Combined transport or multimodal transport documents − These are used when goods are transported by container from an inland terminal to a port, on to a destination port and finally to another inland terminal. The entity that issues a combined transport or multimodal transport document must either sign as carrier or, more often, as the agent for a named carrier. u Liner bills of lading − These are used for regular shipping services between two ports where the carrying vessel has a designated berth. u Charter party bills of lading − These are issued to the exporter by the owner of a ship, the master, the charterer or their respective agent. The terms of a charter party bill of lading are subject to the contract of hire between the ship’s owner and the charterer. Such bills are usually marked ‘subject to charter party’, and are usually issued for bulk cargoes such as oil, wheat and sugar. Because of the legal complexity involved, while charter party bills of lading are often to the order of a named party, they are not always considered to be documents of title, so care needs to be exercised. The bill of lading will give a general description of the cargo with the statement ‘xx boxes / crates etc shipped on board in apparently good condition’. Importers and their banks will expect to receive a ‘clean’ bill of lading with this or a very similar clause. © The London Institute of Banking & Finance 2016

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However, the shipping company may add adverse comments, such as ‘Case number 40 split and broken’, which will have consequences when the exporter seeks payment. Such a bill of lading is not a ‘clean’ bill of lading. As will be seen in Topic 8 on documentary credits, bills of lading so ‘claused’ will not be acceptable, and banks may be called upon to issue an indemnity against any potential loss to the importer or the importer’s bank. There is an ongoing move in industry towards ‘paperless trading’, using electronic versions of various trade documents to remove paper from the system. Among other versions of electronic documentation in use are electronic bills of lading.

For more information on paperless trading generally, visit relevant websites to ascertain what is currently available. In particular, read: UK P&I Club (2014) Paperless trading (electronic bills of lading) − frequently asked questions (FAQs) [online]. Available at: www.ukpandi.com/knowledge/article/paperless-trading-electronicbills-of-lading-frequently-asked-questions-faqs-6167/ [Accessed: 10 August 2016]. This website explains the problems with electronic bills of lading.

5.3.1.2

Missing bills of lading

It regularly happens that a cargo arrives before the bills of lading are in the buyer’s hands. The buyer will have received notification that the goods are ready for collection and that failure to collect will incur demurrage charges. The buyer may ask its bank to issue a guarantee to the carrier, requesting the release of the goods and undertaking to reimburse the carrier, if the carrier faces a loss as a result of releasing such cargo. If the bank accepts the risk of doing so, the bank’s customer / buyer will naturally have to sign a counter-indemnity agreeing to reimburse the bank if any claim is made against the bank. As security for issuing the guarantee, the buyer may be required to deposit cash collateral with the bank for the full period the indemnity is outstanding. The buyer will also undertake to deliver the bills of lading to the bank as and when they come to hand.

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If the bills of lading have been issued in respect of a collection or documentary credit transaction, and in exchange for the issuance of the guarantee, then the buyer will usually be required to additionally undertake: u to pay the collection on receipt or accept any bill drawn on them; or u to accept any discrepancies that may be found in a presentation under the documentary credit and for the bank to pay or agree to pay on a due date.

5.3.1.3

Air waybills and non-negotiable sea waybills

Air waybills are frequently used today. Non-negotiable sea waybills are used less frequently than air waybills, and only on specific routes where the sailing time is quite short. An air transport document is one of the ten transport documents that are recognised by the UCP in articles 19−25. Together with the bill of lading, an air transport document represents one of the most widely used transport documents. It is a non-negotiable document and, as such, should not be issued ‘to order’ or ‘to order of’ a named entity. An air transport document should evidence that the goods are consigned to a named entity. Rules governing the examination of a non-negotiable sea waybill first appeared in UCP 500. At the time, a non-negotiable sea waybill was seen as a potential bridge between paper documents (with the inherent delays in delivery that can occur in the delivery of an original bill of lading) and electronic initiatives of the time. Today, a non-negotiable sea waybill serves primarily as a transport document for use when there is a short sea journey and the delivery of the goods is not conditional upon the surrender of an original negotiable transport document, such as a bill of lading. Use of a non-negotiable sea waybill is not widespread as some banks still express concern over the ability of a consignor to divert the cargo despite the creation of a ‘lien clause’ by some carriers that is intended to ‘fix’ the name of the consignee.

5.3.1.4

Other transport documents

Other transport documents are as follows: u Road transport documents can be a simple document issued on the letterhead of the carrier, or, as is the case for movements within Europe, a more formal document known as a CMR (Convention Relative au Contrat © The London Institute of Banking & Finance 2016

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de Transport International de Marchandises par Route). These are not negotiable documents. u Rail consignment notes are non-negotiable evidence of carriage and are usually issued by the railway company or the railway station of departure. u Parcel or courier receipts are issued by post offices or courier companies.

5.3.1.5

Other issues relating to transport documents

Sellers also need to be aware that each mode of transport: u will have its own set of internationally agreed rules on the transport of hazardous cargoes; u has internationally agreed limitations to the liability of carriers, and these limitations mean that compensation levels may be low. In today’s faster transport systems, goods can arrive before the transport documents. When carriage is by air, for example, evidenced by the presentation of an air waybill, the goods will be released to the named consignee upon proof of identification. If the goods are consigned to a bank, the bank may issue a delivery order (or similar) that will authorise the carrier or its agent to release the cargo to the buyer or its designate. A seller needs to consider the risks involved in despatching goods directly to a buyer, and possibly needs to arrange that the consignee be a bank. Failure to make proper arrangements for prompt clearance of goods on arrival can incur ‘demurrage’ or other such charges.

5.3.2 Commercial and other documents In the negotiation stages, a contract, purchase order or pro forma invoice (see Topic 3) may be issued. Once such documents have been agreed and shipment of the goods is being organised, some of the following documents will be required, depending upon the terms agreed between the buyer and seller and the rules and regulations of the countries concerned.

5.3.2.1

The commercial invoice

A commercial invoice must be produced in accordance with the contract, purchase order or pro forma invoice, incorporating any agreed changes. The invoice will, for example: u include a unique number and quote the contract, purchase order or pro forma invoice number; u mention the seller, buyer and consignee (if different to the buyer); 86

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u describe the merchandise, often itemised by price and quantity; u include all charges and costs for the buyer’s account and specify the Incoterm (see section 5.4) that was agreed for shipment; u mention the terms of payment; u include buyer and seller VAT numbers or similar (if applicable). Where the seller is to be paid under a documentary credit (see Topic 8), the invoice is to be issued by the beneficiary of the credit, to be denominated in the same currency as specified by the documentary credit and to contain a description of the goods that corresponds to that in the letter of credit. Where trade between countries attracts taxes or tariffs, then customs and tax authorities in countries concerned often insist on the provision of special invoices, known as ‘customs invoices’ or ‘tax invoices’, containing sufficient information for the authorities to calculate the tariffs or taxes applicable to each transaction. For exports to some countries, a seller may be required to issue a ‘consular invoice’. A consular invoice is required by some importing countries for customs purposes. The forms can be obtained from the embassy, the consulate or the high commission (for British Commonwealth countries) of the importer’s country. The exporter completes the details on the form and the document is then authenticated by the consulate of the country of the importer. This consulate is usually located in the exporter’s country. The purpose of consular invoices is to certify that the exporter is not dumping goods at artificially low prices. Their other function is to provide information that forms the basis of the import duty to be paid on the goods. Importing countries that require production of consular invoices almost always charge a fee for certification. When a consular invoice is not available, the consulate will authenticate the exporter’s own invoice. This is known as a ‘legalised invoice’.

5.3.2.2

The packing / weight list

A packing list will usually accompany the cargo, but a copy may be required to be attached to the other documents. It will give information relating to the packing of the goods in brief or detailed terms. If requested, it will also list the weights of individual items, together with a total weight (in some cases separate weight lists are required, rather than the weights being included on the packing list). For some countries or types of goods there will be specific requirements for the packaging.

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5.3.2.3

The certificate of origin

The certificate of origin certifies that the goods were produced in the country or countries named therein. Frequently, these are issued by a chamber of commerce in the exporter’s country but some countries, typically those located in the Middle East, will often require an embassy of the importing country to countersign it. EU imports from countries with preferential access (developing countries selling into developed countries) must be supported by the EU ‘generalised system of preferences’ form GSP form A. EU sellers to countries offering preferences will need to complete an EUR1 movement certificate or an invoice with a customs declaration.

5.3.2.4

Pre-shipment inspection certificates

Pre-shipment inspection certificates may be required by the rules of the importing country to ensure that goods conform to local regulations and / or to minimise fraud. Buyers may also require such certificates to ensure that the quality of what is being shipped is in accordance with contractual agreements. For example, an importer of coal might specify a calorific value and a maximum level of moisture. These certificates can be issued by specialist inspection organisations, such as SGS, Intertek International, Cotecna and Bureau Veritas, with staff able to assess goods against chemical, electrical or similar specifications. These certificates can also be described as weight, health, quantity, or quality analysis certificates, depending on what is required by the contract agreed between the buyer and the seller.

5.3.2.5

Phytosanitary inspection certificates

Phytosanitary inspection certificates are issued to satisfy the import or export regulations of some countries. They indicate that a shipment has been inspected and is free from harmful pests and plant diseases.

5.3.2.6

Export licences

Export licences may be required because a country wishes to impose a general control over exports, or to control export of certain goods (firearms, explosives, military equipment, commercial goods with a possible military use, drugs and goods deemed to be of strategic importance) or to control all exports to some countries. Quite often the buyer has to give an undertaking (sometimes called a ‘beneficiary certificate’) covering its use and further onward sale of sensitive 88

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goods or technology. This is very common with sales by US or US-controlled businesses.

5.3.2.7

Import licences

Countries also wish to control what comes in. In most cases, the buyer will be responsible for complying with local regulations regarding import licences and payment of tariffs. When applying for export or import licences, it is often necessary to provide a provisional invoice describing in detail what goods are involved in the proposed transaction.

5.3.3 Insurance documents Cargo insurance is vital to protect buyers, sellers and banks who finance trade transactions against risk of loss, eg due to weather, theft, strikes, civil commotion, war and piracy − this last aspect being particularly worthy of attention as, at the time of writing, a number of ships have recently been hijacked by pirates in various parts of the world. The decision as to who pays for insurance cover for all of (or each stage of) a journey is a commercial decision, is subject to negotiation between the parties and will form an important part of the contract. As outlined later in this chapter, the Incoterm® 2010 selected clarifies which party or parties are responsible for arranging and paying for insurance. Banks that advance money against shipments will, however, wish to be aware that an appropriate insurance policy is in place. The level and nature of insurance cover provided has been codified and will be applicable to most cargoes. The two main codes are contained in the clauses of the Institute of London Underwriters and the American Institute Clauses. Based on the London code, the General Cargo Clauses of the Institute of London Underwriters are available at three levels of cover: A. This level covers loss due to: 1. Problems with the carrying vessel or train, such as collision, explosion, fire, sinking, capsizing, running aground, washed overboard, lost on loading or unloading and derailment. 2. It also covers events such as lightning, volcanic activity and earthquakes. 3. It also covers costs incurred due to theft and non-delivery. B. This level includes all of the risks in (1) and (2) above. C. This level includes risks listed under (1) above only. © The London Institute of Banking & Finance 2016

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Level A insurance also protects against ‘general average’. For example, if it were necessary to jettison some cargo to save a ship, the normal rule is that all those with goods on board share the loss, even if their own cargo is not thrown overboard. But the general average clause protects the insured against this loss. The insured would also be covered in the event of a dispute as to which ship was to blame for a collision. ’Particular average’ may not be covered, ie the failure of the insured to insure the goods for their proper value. Where the goods are underinsured, the insured will have to bear a partial loss in proportion to the underinsurance. Additional cover can be obtained by purchasing insurance with one of the standard Institute cargo clauses for war or strikes. Piracy is no longer covered by ordinary marine risk insurance, but cover is available under war risk policies where premiums are set according to the regions into which a ship is due to sail. The insured is not covered for: u misconduct of the insured; u poor packing; u any inherent vice of the cargo, such as a tendency to deteriorate over time; u insolvency of the carrier; u an unseaworthy vessel. A significant volume of insurance is arranged by freight forwarders on behalf of their customers and on a ‘warehouse to warehouse’ basis, ie covering multimodal shipments. When presenting documents of insurance under a documentary credit, sellers must be careful to produce an insurance document that evidences coverage of all the cargo clauses specified in the credit. Banks may receive insurance documents as a policy or, more frequently, an insurance certificate. Policies of insurance set out the full terms of the insurance contract between the insurance company and the insured. They are usually only seen when a seller is handling a one-off shipment or when a specific policy to cover unusual risks is involved. Insurance certificates are used when there is an ‘open policy’ of insurance in place for a regular seller or buyer. The policy will be renewed annually and each shipment will be declared to the insurer, with details, against which an insurance certificate is issued. The insurance certificate will state: u the details of the goods; u the amount of insurance (frequently for at least 110 per cent of the value of the goods); 90

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u the routing of the goods and possibly the mode of transport; u the date when cover commences; u the cargo clauses covered; u the name of the assured or insured. If the certificate is issued under a seller’s policy, where the seller is shown as the assured or insured, the seller will endorse the certificate in blank, so that it may be passed on to any holder, or to the buyer’s order. Under a documentary credit, such endorsement will be completed according to the terms of that credit.

5.4

The purpose of shipping terms (Incoterms)

In international trade there may be one contract covering the entire journey, or there can be up to three separate contracts of transport for the goods: u from the seller’s premises to a carrier or its agent within the seller’s country; u from the carrier or its agent’s premises in the seller’s country to a named point in the buyer’s country (eg a port, airport or container depot); u from the port, etc, in the buyer’s country to the buyer’s own premises. It is vital to establish a clearly defined point of delivery of the goods, to indicate where the seller’s responsibility ends and where the buyer’s responsibility begins. This delivery point refers, in the main, to the scope of the payment of freight and insurance of the goods while in transit. Unless the demarcation of responsibility is clearly understood, it will be difficult for a seller to price its goods accurately and for a buyer to calculate accurately the full cost of the import. The problem in international trade is that different countries have different interpretations of the same contractual terms, and this problem can only be solved by creating a set of internationally agreed terms. The purpose of the International Commercial Terms (Incoterms®) is to provide such a set of standardised terms that mean exactly the same to both parties and which will be interpreted in exactly the same way by courts in every country. They were drafted by the International Chamber of Commerce (ICC) and full details can be found in its publication no. 715, Incoterms ® 2010.

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Incoterms rules are not incorporated into national or international law, but they can be made binding on both buyer and seller, provided that the sales contract, purchase order or pro forma invoice specifies that a particular Incoterm rule will apply. Note that the Incoterms rules apply to domestic as well as international trade. Please note: In the context of the examination, the words ‘shipment terms’ or ‘terms of delivery’ might be substituted for the word ‘Incoterms’. All of these words and phrases are synonymous.

5.4.1 The 11 Incoterms There are 11 different Incoterms and each term sets out the obligations of the seller and buyer. It is not necessary to memorise the 11 terms, but it is necessary to be able to work out their implications, should such a term appear in an examination question. An easy way of recalling the various Incoterms is that they are grouped according to the first letter of the term, ie ‘E’ terms (Ex works), ‘F’ terms (FCA, FAS or FOB), ‘C’ terms (CPT, CIP, CFR, or CIF) and ‘D’ terms (DAT, DAP or DDP). Generally speaking, where an Incoterm sets out the obligations of the seller, by a process of elimination, any obligation that does not appear must be the responsibility of the buyer. Incoterms EXW, FCA, CPT, CIP, DAT, DAP and DDP are applicable to all modes of transport, including more than one means of transport used in the journey. Incoterms FAS, FOB, CFR and CIF cover transport by sea or inland waterway. If responsibility for insuring the goods is not clearly specified in the Incoterm used (such as CIF and CIP), then it should be made clear in the contract of sale exactly who is responsible for insuring all parts of the journey. It should be noted that contracts commencing before 1 January 2011, when Incoterms ® 2010 rules took effect, may still refer to Incoterms set out in the previous version of the rules, Incoterms ® 2000. Terms such as DAF (Delivered at Frontier), DES (Delivered ex Ship), DEQ (Delivered ex Quay) and DDU (Delivered Duty Unpaid) may have been applied to such contracts, but no longer appear in the latest rules. To illustrate how the rules work, we will examine various documents relating to a sale by Speirs and Wadley Ltd of Adderley Road, Hackney, London, to Woldal Ltd of New Road, Kowloon, Hong Kong. Tables 5.1 to 5.11 explain the implications, where appropriate, to both parties for the different Incoterms that could be applied to such a sale. The various Incoterms are set out in a logical order, starting with that which imposes least obligation on Speirs and Wadley and ending with that which imposes the most. 92

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Table 5.1

EXW

Incoterm

Standard ICC abbreviations

Ex works [named place of delivery, eg Adderley Road, Hackney]

EXW

Obligations of Speirs and Wadley Ltd (exporter)

Responsibilities of Woldal Ltd (importer)

Make the goods available for collection from Adderley Road, Hackney, by Woldal Ltd. Once collected by Woldal, all responsibility of Speirs and Wadley is ended. A commercial invoice or equivalent electronic message will be provided for Woldal. Goods will be suitably packed, unless it is the norm for the goods involved to be delivered unpacked.

Take delivery from Adderley Road. Make all arrangements at own cost to take goods to own premises. It is in Woldal’s interests to arrange appropriate insurance to cover this journey. The obtaining of relevant export and / or import licences and also the completion of any customs formalities and payments for the export of the goods is the responsibility of Woldal.

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Table 5.2

FCA

Incoterm

Standard ICC abbreviations

Free carrier [named place of delivery, eg Hackney container depot]

FCA

Obligations of Speirs and Wadley Ltd (exporter)

Responsibilities of Woldal Ltd (importer)

Make the goods available to Hackney Containers at the inland container depot on the exporter’s means of transport, not unloaded. (Note: If the goods were to have been made available at the premises of Speirs and Wadley, delivery would be incomplete until the goods had been loaded onto the carrier’s own transport.) Advise delivery of the goods at Hackney container depot to Woldal. Complete export and customs requirements, including obtaining any export licence and paying any costs, duties and taxes. Supply Woldal with commercial invoice or its equivalent electronic message, together with proof of delivery to Hackney container depot, eg a multimodal transport document. Goods will be suitably packed unless it is the norm for the goods involved to be delivered unpacked.

Make all arrangements at own cost and risk to cover transport of goods to own premises from Hackney container depot. It is in Woldal’s interests to arrange appropriate insurance to cover this journey. Woldal should obtain any import licence and perform any customs requirements necessary for the import of the goods, including paying all costs, duties and taxes.

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Table 5.3

FAS

Incoterm

Standard ICC abbreviations

Free alongside ship [named port of shipment, eg Tilbury]

FAS

Obligations of Speirs and Wadley Ltd (exporter)

Responsibilities of Woldal Ltd (importer)

Complete export and customs requirements, including obtaining any export licence and paying any costs, duties and taxes. Supply Woldal with commercial invoice or its equivalent electronic message, together with proof of delivery, eg a transport document. Deliver goods to the quayside alongside the nominated vessel at the port of Tilbury, after which the liability of Speirs and Wadley basically ends. Goods will be suitably packed, unless it is the norm for the goods involved to be delivered unpacked. FAS terms are mainly used in the bulk and break-bulk trade (ie where goods such as coal are shipped loose in bulk).

Make arrangements with a shipping company for transport of goods by sea to Hong Kong. Notify Speirs and Wadley of the day and time that delivery is required at the port of Tilbury and the name of the nominated vessel. Woldal is responsible for all risks from the quayside in Tilbury to the delivery of the goods to their final destination. It is in Woldal’s interests to arrange appropriate insurance to cover this journey. Woldal should obtain any import licence and perform any customs requirements necessary for the import of the goods, including meeting all costs involved, duties and taxes.

Table 5.4

FOB

Incoterm

Standard ICC abbreviations

Free on board [named port of shipment, eg Tilbury]

FOB

Obligations of Speirs and Wadley Ltd (exporter)

Responsibilities of Woldal Ltd (importer)

As for FAS, but Speirs and Wadley’s delivery liability does not end until the goods have been loaded on board a named vessel at Tilbury.

As for FAS, but with the exception that Woldal does not assume responsibility for the goods until they are on board the vessel in the port of Tilbury.

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Table 5.5

CFR

Incoterm

Standard ICC abbreviations

Cost and freight [named port of destination, eg Hong Kong]

CFR

Obligations of Speirs and Wadley Ltd (exporter)

Responsibilities of Woldal Ltd (importer)

Arrange and pay for transport of goods to Hong Kong port. Loading and unloading costs should be met, if they form part of the charge for carriage. Complete export and customs requirements, including obtaining any export licence and paying any costs, duties and taxes. Advise Woldal of delivery of the goods on board the carrying vessel and also details of the voyage. Supply Woldal with a commercial invoice or its electronic equivalent, together with the relevant transport document, eg a bill of lading. Goods will be suitably packed unless it is the norm for the goods involved to be delivered unpacked. Speirs and Wadley are free of liability (for insurance purposes) once the goods are on board the vessel in Tilbury port.

Woldal should obtain any import licence and perform any customs requirements necessary for the import of the goods, including meeting all costs involved, duties and taxes. It is in Woldal’s interests to arrange and pay for insurance of the goods from when they are on board the vessel in Tilbury. If unloading costs are not covered by the charge for carriage, Woldal must also pay these.

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The purpose of shipping terms (Incoterms)

Table 5.6

CIF

Incoterm

Standard ICC abbreviations

Cost, insurance and freight [named port of destination, eg Hong Kong]

CIF

Obligations of Speirs and Wadley Ltd (exporter)

Responsibilities of Woldal Ltd (importer)

As for CFR but, in addition, Speirs and Wadley must insure the goods as far as the port of Hong Kong and supply Woldal with evidence of this, eg an insurance policy or certificate.

As for CFR, but insurance risk falls on Woldal only when the goods have been offloaded from the vessel at Hong Kong.

Table 5.7

CPT

Incoterm

Standard ICC abbreviations

Carriage paid to [named place of destination, eg Kowloon]

CPT

Obligations of Speirs and Wadley Ltd (exporter)

Responsibilities of Woldal Ltd (importer)

Similar to CFR, except that Speirs and Wadley must arrange and pay for transport to the named place of destination, which could be an inland container depot in Hong Kong, as opposed to Hong Kong port. Speirs and Wadley must advise Woldal of details of the shipment and the name and address of the shipping company into whose custody the goods have been given, so that Woldal can arrange insurance. Complete export and customs requirements, including obtaining any export licence and paying any costs, duties and taxes. Supply Woldal with commercial invoice or its equivalent electronic message, together with the relevant transport document. Goods will be suitably packed unless it is the norm for the goods involved to be delivered unpacked.

Woldal should obtain any import licence and perform any customs requirements necessary for the import of the goods, including meeting all costs involved, duties and taxes. It is in Woldal’s interests to arrange and pay insurance for the goods from when they are delivered into the custody of the carrier at Tilbury. If unloading costs at place of destination are not covered by the charge for carriage, Woldal must pay them. Also it must pay all costs of transport from Kowloon freight yard to its own premises.

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Table 5.8

CIP

Incoterm

Standard ICC abbreviations

Carriage and insurance paid [to named place of destination, eg Kowloon]

CIP

Obligations of Speirs and Wadley Ltd (exporter)

Responsibilities of Woldal Ltd (importer)

Similar to CPT, except that Speirs and Wadley must pay insurance charges during the carriage. The relevant insurance policy or certificate must be supplied to Woldal.

Similar to CPT, except that Woldal does not have to arrange and pay insurance charges, which are met by Speirs and Wadley.

Table 5.9

DAT

Incoterm

Standard ICC abbreviations

Delivered at terminal [named terminal at port or place of destination, eg Terminal 2A Hong Kong Port]

DAT

Obligations of Speirs and Wadley Ltd (exporter)

Responsibilities of Woldal Ltd (importer)

Similar to CIF, except that the liability of Speirs and Wadley does not cease until the goods have been placed at the disposal of Woldal by unloading the goods from the arriving means of transport and placing them at the disposal of the buyer at a specific terminal at the named port or place of destination (if one is not specified, the seller may select the terminal that best suits its purpose). Theoretically, Speirs and Wadley need not insure the goods, but in practice it would be wise to do so.

Similar to CIF. The liability of Woldal exists from the time when goods are placed at its disposal in the destination terminal, and they must take delivery of the goods from that time. The insurance risk falls on Woldal once the goods are unloaded at the terminal.

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Table 5.10

DAP

Incoterm

Standard ICC abbreviations

Delivered at place [named place of destination, eg Kowloon]

DAP

Obligations of Speirs and Wadley Ltd (exporter)

Responsibilities of Woldal Ltd (importer)

Deliver the goods to the agreed place of destination ready for unloading. Supply Woldal with a commercial invoice or its electronic equivalent together with the relevant transport document or delivery order. Arrange any export licence and complete export customs requirements, including payment of costs, duties and taxes. Arrange and pay for contract of carriage to the named point of destination. Advise Woldal of the expected time of arrival of the goods, so that arrangements can be made to take delivery. Theoretically, Speirs and Wadley need not insure the goods on their voyage. However, in view of their liability for the goods, such action would be unwise. Goods will be suitably packed unless it is the norm for the goods involved to be delivered unpacked.

Woldal should obtain any import licence and perform any customs requirements necessary for the import of the goods, including meeting all costs involved, duties and taxes. Accept delivery of goods at the named place of destination. Woldal is liable for goods and costs from the time the goods are placed at its disposal at the place of delivery. The insurance risk is Woldal’s once the goods have been delivered to the agreed place.

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Table 5.11

DDP

Incoterm

Standard ICC abbreviations

Delivered duty paid [named place of DDP destination, eg Kowloon] Obligations of Speirs and Wadley Ltd (exporter)

Responsibilities of Woldal Ltd (importer)

Deliver the goods not unloaded to the named place of destination, and bear costs and risks involved in carrying the goods to that place. Advise Woldal of despatch in sufficient time for the company to make arrangements to take delivery of the goods. Arrange any export licences and complete export customs requirements, including payment of costs, duties and taxes. Supply a commercial invoice or its electronic equivalent, together with the relevant transport document or delivery order to Woldal. Speirs and Wadley theoretically need not insure the goods, but in view of its liability for them, such action would be unwise. Goods will be suitably packed unless it is the norm for them to be delivered unpacked. Speirs and Wadley are responsible for all import requirements and payments in addition.

Woldal must take delivery of the goods at the named place of destination and is liable for all risks from then on. Woldal is not responsible for all import requirements and payments.

Explore what materials are available to assist traders in the use of Incoterms rules, by visiting: ICC (no date) The new Incoterms ® 2010 rules [online]. Available at: www.iccwbo.org/products-and-services/tradefacilitation/incoterms-2010 [Accessed: 10 August 2016].

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Trust receipts

5.5

Risks on transport documents for banks

From the descriptions given above, it can be seen that the main risk is that documents fall into the wrong hands. A quasi-negotiable bill of lading may, if endorsed in blank by the shipper, get into the wrong hands and the goods could be collected and lost to their rightful owner. As bills of lading are usually issued in sets with more than one original, it is particularly important to keep track of the whereabouts of the full set. With a non-negotiable bill of lading, the goods will be released to the named consignee and the bank will have no security over the goods unless the bank or its agent is named as consignee. The risk of fraud is covered in Topic 14.

5.6

Storage

Where a bank is requested or required to store goods, either as security or as agents for a correspondent, the bank will wish to ensure that the storage is with a reputable warehouse or yard, and that the goods are appropriately insured and protected against the weather, insect attack or other risk relevant to the cargo. The bank will either obtain a warehouse receipt (a non-negotiable document confirming receipt and the conditions of storage) or a warehouse warrant. The latter can be a document of title, similar to a quasi-negotiable bill of lading. Where a bank holds such a warrant, it should be in the bank’s name or deliverable to the bank’s agent.

5.7

Trust receipts

Trust receipts are written agreements between a bank holding specific goods pledged to the bank as security, and a borrower or buyer. It allows the buyer to handle the goods before payment. The agreement permits the borrower / importer to take physical possession, while the bank retains title. The issuer of the trust receipt agrees to hold the merchandise in trust for the bank and to keep the merchandise, as well as any proceeds of sale, separate and distinct from their own property.

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Chapter summary In this chapter, you have learned about: u the rules for trade within the EU; u bills of exchange and promissory notes and their special negotiable status that means that a holder for value and in good faith can obtain a better title to the instrument than the person giving it; u the right to take legal action on a negotiable instrument, irrespective of any underlying commercial dispute; u the rights and duties of drawers, acceptors and holders of negotiable instruments; u bills of lading and how some versions carry a quasi-negotiable status in addition to evidencing receipt of a cargo and the terms of carriage; u the assistance that banks can provide when bills of lading go missing, and how banks protect themselves against the risk of doing so; u the other documents regularly called for in a trade transaction, such as invoices, certificates of origin, inspection certificates and licences; u the insurance of transport risks and the standard risk levels provided by insurers; u the protection against ‘general average’ risks; u what is not covered by marine insurance, such as poor packing or financial failure of the carrier, and how special risks such as war and piracy are covered; u the use of the International Chamber of Commerce Incoterms® 2010 rules; u the relationship between Incoterms and documents; u the risk to banks of goods being misappropriated due to missing bills of lading; u the role of banks in storing goods.

References Bills of Exchange Act 1882, London: HMSO [online]. Available at: www.legislation.gov.uk/ukpga/Vict/45-46/61 [Accessed: 10 August 2016]. ICC (2000) Incoterms® 2000. ICC Publication No. 560E.

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Review questions ICC (2010) Incoterms® 2010. ICC Publication No. 715E. Legal Information Institute (2012) Uniform Commercial Code [online]. Available at: www.law.cornell.edu/ucc [Accessed: 10 August 2016].

Review questions The following review questions are designed so that you can check your understanding of this chapter. The answers to the questions are provided at the end of these learning materials.

1.

What legal statute covers the use of bills of exchange in the UK and is recognised on a global basis?

2.

The following countries are members of EFTA − Belarus, Estonia, Latvia and Lithuania. True or false?

3.

What is a promissory note?

4.

There are two levels of cover available in General Cargo Clauses. True or false?

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5.

What is a trust receipt?

6.

On what date did the last revision of Incoterms come into effect?

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Chapter 6

Methods of settlement

Learning objectives By the end of this chapter, you should be able to: u understand the concept of the risk ladder; u distinguish between the five types of payment methods used in international trade; u assess the risks and appreciate which methods of payment are suitable for the seller and which are suitable for the buyer.

6.1

Definitions of payment terms

This chapter introduces the main payment methods available to buyers and sellers in international trade finance. Once the negotiation process is completed between the parties, the next stage is to draw up a contract. The first and most important question that arises in any international trade transaction is what law will govern the contract. The contract should always specify the applicable law, as each legal jurisdiction from around the world will have different laws and interpretations, each of which will have their own advantages and disadvantages. For example, under English law, for a valid contract to exist there must be ‘consideration’, whereas French law recognises as a contract any agreement between parties who have negotiated in good faith. The five basic terms of payment are: 1. open account; 2. documentary collection; © The London Institute of Banking & Finance 2016

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3. bank payment obligation; 4. documentary credit; 5. payment in advance. The selection of which payment term is used will largely depend on a number of issues, including: u the relationship between the buyer and seller; u the availability of facilities and working capital to the buyers and sellers; u the countries involved in the transactions. These methods of payment will be explained in detail in later chapters. The purpose of this chapter is to provide you with a brief overview of the terms.

6.2

Basic principles of the risk ladder

At the outset of negotiations, the buyer and seller must agree on the terms of how they are to trade. The risk ladder (Figure 6.1) is a popular concept that outlines the fact that the most secure method of payment for a seller is the least secure for a buyer. Figure 6.1

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The risk ladder

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Documentary collection

As a buyer−seller relationship develops, more relaxed terms of payment may be agreed. Later in this study text, the various payment methods will be explored − from the most defensive from the seller’s point of view (payment in advance) to the most risky from the seller’s point of view (open account payment, ie some days after goods are shipped and without any form of guarantee of payment). There are a variety of guaranteed − or partially guaranteed − mechanisms that lie somewhere between these extremes.

6.3

Open account

In an open account transaction, a seller will despatch its goods to a buyer and send an invoice (and any other customary or required documents) asking for payment or agreement to pay on a specified date. If goods are shipped by sea, the goods are consigned to the buyer and the documents of title will be sent direct to the buyer; if goods are despatched by air, then the goods are consigned direct to the buyer. A set date for payment is given and the buyer remits the necessary funds to the seller as agreed. Open account arrangements therefore imply a considerable amount of trust being placed on the buyer by the seller. Once goods have been despatched or services delivered, a seller will lose all control over payment, and is reliant on the trustworthiness and creditworthiness of the buyer to pay. Open account trade is common in international trade, with an estimation of over 80 per cent of world trade being concluded on open account terms. It is particularly useful in transactions involving regular shipments, where the importer often makes payments at set intervals for goods received during a preceding period. Where necessary, sellers can seek to obtain credit insurance on their overseas debtors and can use an export invoice discounting or factoring facility to accelerate cash flow. Please see section 6.5 below, and Topic 15 later, to learn how payments under open account trade can be improved by use of bank payment obligations (BPOs).

6.4

Documentary collection

In a documentary collection, a seller will ship or despatch its goods. However, instead of sending the documents direct to the buyer, it will send them via the banking system, for holding pending payment or acceptance by the buyer. This is covered in more detail in Topic 7. Documentary collections are governed by the International Chamber of Commerce’s (ICC’s) publication Uniform Rules for Collections 522 (1995) © The London Institute of Banking & Finance 2016

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(known as ‘URC 522’) when reference is made to their application in the collection instruction.

6.5

Bank payment obligations (BPOs)

In conjunction with the Society for Worldwide Interbank Financial Telecommunications (SWIFT), the ICC and several banks have developed a new instrument, the bank payment obligation (BPO), intended to support open account trade (ICC, 2013). The BPO enables data to be sent by a Trade Services Management (tsmt) message and matched electronically in ISO 20022 XML format using a transaction matching application (TMA), such as SWIFT’s Trade Services Utility (TSU). ISO 20022 is the International Organization for Standardization standard covering financial messaging definitions. As of June 2014, 58 banks had already signed up to support BPOs and many large corporate businesses had become early adopters. With the agreement of the seller, the buyer asks its bank to set up an open account payment instrument covering the proposed purchase, incorporating a BPO. In simple terms, the buyer’s bank uploads data provided by the buyer to the SWIFT TSU (TMA platforms are expected to be available from other suppliers too), which passes that information to the seller’s bank for relaying to the seller for checking and agreement. Agreement will create an ‘established baseline’ that incorporates a BPO, and the buyer’s bank (as ‘obligor bank’) or another named obligor bank will undertake to pay the seller’s bank, as long as the seller ships the merchandise in accordance with the commercial terms agreed between the buyer and seller. In the light of this undertaking, the seller’s bank may be more inclined to offer its client pre-shipment finance, if required. Once the goods have been shipped, the seller’s bank uploads the shipping and logistics data, provided by the seller, to the TSU to be matched against the established baseline. If the data match, the obligor bank is required to settle the invoice according to the terms stated in the BPO segment of the established baseline. BPOs are covered by the ICC’s Uniform Rules for Bank Payment Obligations (Publication No. 750E) (ICC, 2013) and are discussed in more detail in Topic 15.

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Payment in advance

6.6

Documentary credit

A documentary credit (also known as a ‘letter of credit’) is basically an undertaking provided by the buyer’s bank, stating that if the seller complies with its various terms and conditions, the bank will guarantee payment in the manner described therein. If the seller is in a strong bargaining position, but not strong enough to obtain payment in advance, then the next-best payment method is a documentary credit (letter of credit). If the buyer agrees to settlement by documentary credit, it will request the issuance of the credit by its bank. Details of the credit are then advised through the banking system to the seller. Once the seller receives the documentary credit, it can ship the goods, collate all of the documents required by the credit and present them through the banking system. Once an issuing bank has fully compliant documentation in its possession, then it must make payment or, if it was agreed for payment to be made at a future date, undertake to make payment when it falls due. As it is the buyer that requests its bank to issue a credit, the amount of the credit will be treated by its bank as a contingent liability in its credit facility. The buyer’s bank must be satisfied that the buyer can reimburse it, if the bank is required to pay out under the undertaking. Finance can be provided against the credit for both the buyer and seller, and the credit can be available in other forms − for example to allow for an advance payment, or to be transferable. When reference is made to a documentary credit being subject to UCP 600, this refers to the rules set out in the ICC’s publication Uniform Customs and Practice for Documentary Credits 600 (ICC, 2007) (known as UCP 600). Documentary credits are covered in more detail in Topic 8.

6.7

Payment in advance

With this method of payment, the buyer pays the money in advance. Once the seller is in receipt of the funds, it arranges for the goods to be shipped or despatched. From the seller’s point of view, receiving payment in advance of the shipment is an ideal situation, as it appears to eliminate all risks associated with non-payment. However, to be certain of payment, attention must be given to how the money is paid to the seller. For example, if payment is made by a cheque issued by an overseas institution, then time must be taken for the © The London Institute of Banking & Finance 2016

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cheque to clear and to be honoured. Some sellers may accept payment by credit card. In the event that a fraudulent credit card is used, then the seller’s merchant processor may reclaim the money from the seller’s account. From the buyer’s point of view, payment in advance carries the greatest risk, as it is wholly dependent on the seller shipping the correct goods in accordance with the contract. In addition, payment in advance can create cash-flow problems for the buyer, as it has to wait to receive the goods. Occasionally, a transaction can be arranged where part payment is made in advance, a deposit of 30 per cent for example, and the balance is paid at a later date using one of the other three methods of payment. Since the tightening up of money-laundering regulations in most countries, most transactions higher than a certain amount (varying from country to country, but typically GBP10,000 or USD10,000 or the equivalent in local currencies) will almost certainly be queried by the remitting bank and may well attract the attention of the local money-laundering prevention authorities, resulting in possible investigations. If cash is used for the advance payment, it will at some stage need to be paid into a bank account, and the receiving bank will be obliged to report the transaction through its money-laundering compliance officer. If a bank transfer is made, similar attention may be attracted at the remitting and receiving banks. Clients with bona fide transactions will no doubt be able to satisfy any queries by producing appropriate documentation, but busy traders may not wish to attract unwelcome attention to their businesses in this way.

Check your local bank transfer rules, so that you are aware of the requirements for making or receiving advance payments, and the transaction amounts that banks in your country are obliged to report under local anti-money-laundering regulations.

Chapter summary This chapter has given a brief overview of: u the various methods of payment − open account; − documentary collection; 110

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− bank payment obligations; − documentary credits; − payment in advance; u the risks that each method presents for the buyer and for the seller.

References ICC (1995) Uniform rules for collections. ICC Publication No. 522. ICC (2007)Uniform customs and practice for documentary credits. ICC Publication No. 600LE. ICC (2013)Uniform rules for bank payment obligations. ICC Publication No. 750E.

Review questions The following review questions are designed so that you can check your understanding of this chapter. The answers to the questions are provided at the end of these learning materials.

1.

Documentary collection poses the highest risk for the buyer. True or false?

2.

Which method of payment is covered by URC 522?

3.

Which method of payment is covered by UCP 600?

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4.

What is the most common term of payment used in trade transactions?

5.

Large cash payments are inadvisable in international trade. True or false?

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Chapter 7

Documentary collections

Learning objectives By the end of this chapter, you should have an understanding of: u what is meant by a ‘documentary collection’; u the nature of the instructions given by one bank to another; u the responsibilities of the parties to a collection; u the processing and monitoring of collections; u how documents are delivered to a buyer and how payment or acceptance is obtained from them; u what happens when payment is not forthcoming. This chapter will also introduce the issue of finance, which is covered in more detail in Topic 9.

In Topic 5 we looked at some of the documents that are used in international trade finance. This chapter will look at how these documents are used to facilitate payment for an underlying transaction, with the seller presenting them to the buyer through their respective banks in exchange for payment, or an acceptance that the buyer will pay at a future date. The seller agrees with the buyer to obtain reimbursement by asking its bank to send the documents, often accompanied by a bill of exchange (‘draft’), to the buyer’s bank for payment or acceptance against release of the documents.

7.1

Basic principles of documentary collections

A documentary collection transaction is initiated by the seller, who despatches goods to the buyer. At the same time, the seller entrusts the © The London Institute of Banking & Finance 2016

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related documents (which may include negotiable bills of lading) to its bank for collection of the sale proceeds, and the delivery of the documents to the buyer, according to the terms of the sales contract. The seller’s bank will ask a correspondent bank in the buyer’s country to deliver to the buyer the documents of title to the goods against payment of the amount due (documents released against payment − ‘D/P’) or against acceptance of a term bill of exchange (documents released against acceptance − ‘D/A’). The International Chamber of Commerce (ICC) publication that governs documentary collections is the Uniform Rules for Collections (URC) − publication no. 522 − referred to as ‘URC 522’. All instructions relating to the handling of a documentary collection should indicate that it is subject to URC 522 in order for the rules to be applicable to that transaction. If a collection instruction does not make reference to URC 522, caution is advised and the sender of those instructions should be contacted to ascertain the applicable rules or framework under which the collection is to be processed.

7.1.1 Definitions URC 522 (ICC, 1995) sub-article 2 (a) defines a collection as being: the handling by banks of documents instructions received, in order to:

. . .in accordance with

I. obtain payment and / or acceptance, or II. deliver documents against payment and / or against acceptance, or III. deliver documents on other terms and conditions. More commonly, collections are described as being ‘D/P’, documents release against payment or ‘D/A’, documents release against acceptance, with payment due at a future date. The following are the main parties to a collection: u The principal, who is normally the seller − the principal entrusts the handling of a collection to a remitting bank. u The remitting bank, ie the bank that acts for the seller − it is usually based in the seller’s own country and is invariably the seller’s own bank. u The collecting bank, normally a correspondent of the remitting bank based in the buyer’s country − the collecting bank, as agent of the remitting bank, will present the documents to the drawee (usually the buyer of the goods) for payment or acceptance. 114

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u The presenting bank − this is a bank used by the collecting bank where it has been identified by the collecting bank that the presenting bank is the banker of the drawee and is better placed to approach the drawee with a request for payment or acceptance. It is not common to have a collecting bank and a presenting bank. u The drawee − the party requested to pay or accept in accordance with the collection instructions. The drawee is usually the buyer.

7.1.2 Summary of URC 522 articles Article 1 Article 1 defines the application of URC 522. It states that banks are not obliged to handle any collection. Should a bank decide not to handle a collection, it must advise the party from which it received the collection or instruction without delay.

Article 2 Article 2 defines the different types of collection instructions, and differentiates between the various terms. Sub-article 2 (b) gives a definition of documents as being financial documents and / or commercial documents: u Financial documents are those that are used to obtain payment of money, such as a bill of exchange or promissory note. u Commercial documents are those that relate to the goods themselves, such as an invoice or transport documents, or any documents that are not financial documents. Sub-articles 2 (c) and 2 (d) define, respectively: u clean collection as ‘a collection of financial documents, such as a bill of exchange, promissory note or cheque without any other commercial and transport documents being part of the presentation’; u documentary collection as ‘either the collection of financial documents accompanied by commercial documents, or commercial documents not accompanied by financial documents’.

Article 3 Article 3 identifies the main parties to a collection as the principal, the remitting bank, the collecting bank, the presenting bank and the drawee. Definitions of these are given above. © The London Institute of Banking & Finance 2016

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Article 4 Article 4 covers the form and structure of a collection. It also states that banks will not examine documents in order to ascertain instructions and are only obliged to act on the instructions received from the party that presented the collection to them unless the collection instruction states otherwise. Sub-article 4 (b) gives a detailed explanation as to what information, as appropriate, should be included in a collection instruction: u details of the bank from which the collection was received; u details of the principal, eg name, address and contact details; u details of the drawee, eg name, address and contact details; u details of the presenting bank; u the amount and currency that is to be collected; u a list of the documents enclosed and a numerical count; u terms and conditions on how payment or acceptance is to be obtained; u terms of delivery of the documents, eg against payment, acceptance or other terms and conditions; u details of charges and interest to be collected and whether or not they may be waived; u the method by which payment is to be remitted and form of payment advice that is required; u instructions in the event of non-payment / non-acceptance or non-compliance with other instructions.

Articles 5−8 Articles 5, 6, 7 and 8 give details on the procedures relating to the form of presentation, making presentation for payment or acceptance, release of commercial documents and creation of documents.

Article 9 Article 9 states that banks will act in good faith and will exercise reasonable care when handling a collection instruction.

Article 10 Article 10 states that goods should not be despatched directly to a bank − nor a transport document evidence that goods are consigned to or consigned to order of a bank − without the bank’s prior agreement. Where no prior 116

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agreement has been given, there is no obligation on the part of the bank to take delivery of the goods. A collecting or presenting bank is under no obligation to take action to store and insure goods, even if there are instructions to that effect in the collection instruction.

Article 11 Article 11 provides a disclaimer for a remitting or collecting bank when it utilises another bank to fulfil the instructions of a principal, and such acts are not carried out by that other bank.

Article 12 Article 12 states that although the banks are not obliged to examine the documents presented in detail, a bank must check that it has received all of the documents listed on the collection instruction and in the number stated. In the event that some documents are missing or additional documents are received that are not listed, the bank must advise the party who sent the collection by telecommunication or other expeditious means, without delay.

Articles 13 and 14 Articles 13 and 14 provide a disclaimer on the effectiveness of data appearing within the presented documents, eg sufficiency, accuracy, genuineness, falsification etc, and against any delays or loss of documentation in transit.

Article 15 Article 15 covers ‘force majeure’, which comes from the French term meaning ‘superior force’. It indemnifies banks against any responsibility or consequences arising from interruption of their day-to-day business due to an act of God, riots, civil commotions, insurrections, war or any event that is beyond their control.

Articles 16−19 Articles 16−19 give definitions and explanations concerning payments procedures. Article 19, in particular, covers partial payment and differentiates between clean collections (where such payments may be accepted, provided that such an action is authorised by the law in force in the place where the payment is made) and documentary collections (where partial payments are only permissible when the collection instruction expressly permits them).

Articles 20 and 21 Articles 20 and 21 relate to interest, charges and expenses and, in particular, the action that should be taken by a bank where these have been refused by the drawee. © The London Institute of Banking & Finance 2016

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Article 22 Article 22 states that the bank that releases documents against acceptance is responsible for seeing that the form of acceptance appears to be complete and correct, but there is no responsibility to ascertain the genuineness or authority of any signatory to the acceptance.

Article 23 Article 23 states that a presenting bank is not responsible for the genuineness or authority of any signatory appearing on a promissory note, receipt or other instrument.

Article 24 Article 24 states that a bank is not obliged to protest in the event of non-payment or non-acceptance unless it is expressly required in the collection instruction.

Article 25 Article 25 relates to the use of a case of need. A case of need will usually be an agent of the exporter resident in the country where the goods have been shipped. Where indicated, the collection instruction should specify the scope of the powers that have been granted.

Article 26 Article 26 states that it is the collecting bank or presenting bank’s responsibility and duty to advise the fate of the collection to the bank from whom the collection was received − whether paid, accepted or any advice of non-payment or non-acceptance.

7.2

Example of the operation of a documentary collection

The example given below typically occurs in the documentary collection process and shows the application of URC 522, where applicable. A seller would first agree with a buyer to utilise the banking system to arrange the transfer of documents and payment or acceptance. The seller then ships the goods and obtains the documents relating to the shipment, such as the commercial invoice, transport document, certificate of origin, etc. The seller will complete and sign a collection instruction form provided by its bank and present the documents together with the collection instruction to the bank.

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Example of the operation of a documentary collection

Although every bank’s documentary collection instruction form will differ slightly, you would expect to see the following information included on the form: u the seller’s name, address and contact details; u the buyer’s name, address and contact details; u the name of the consignee if different to that of the buyer; u the amount to be collected and details of the draft drawn on the buyer; u a description of the goods and their shipment; u a list and number of the documents that accompany the collection instruction; u detailed instructions concerning settlement: − payment against release of documents (D/P terms); − acceptance against release of documents (D/A terms); − how any interest charges are to be calculated and collected; − whether payment / acceptance may be deferred until arrival of the cargo; u what the collecting or presenting bank must do if payment or acceptance is refused: whether goods are to be warehoused and insured; whether there is a need for ‘protest’ for non-payment / non-acceptance, if that procedure is available in the local jurisdiction; u whether the seller has an agent from whom assistance can be sought ‘in case of need’; u whether charges are for the buyer’s account and whether or not they may be waived if refused, or whether they would be paid by the seller. The seller will sign the collection form, which would usually contain a declaration to the effect that the bank is not liable for loss or delay due to factors beyond its control, eg postal delays, or loss of documents in transit to the collecting or presenting bank. The following points should be noted: 1. The consignee on a transport document should not be the buyer’s bank or any other bank unless prior arrangements have been agreed. 2. Drafts drawn to the seller’s order should be blank endorsed. 3. Bills of lading made out ‘to order’ or ‘to order of the shipper’ should be endorsed in blank by or on behalf of the named shipper. © The London Institute of Banking & Finance 2016

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4. Instructions to release goods against payment of a term draft, where it is accepted by the buyer but documents are not to be released until the draft is paid (D/P terms), are technically possible but are discouraged by the ICC. 5. The collecting or presenting bank will require a title document such as a negotiable bill of lading to arrange clearance of the goods and storage unless the collecting or presenting bank is the named consignee (provided of course the bank is willing to take such action). Any local regulations will have to be complied with, such as those covering import licences and rules regarding the storage of certain types of cargo. 6. Where D/A terms have been agreed, a draft drawn on the buyer will usually be enclosed with the documents, with details of acceptance terms given on the collection instruction. Where D/P terms are agreed, technically a draft is not required, as the documents will be released upon payment by the buyer. Indeed, in some countries where drafts still attract stamp duty, it is best not to enclose them with a collection instruction, thus avoiding payment of expensive pro-rata stamp duty. If in agreement with the seller’s instructions, the remitting bank will then send its own collection instruction (based on the instructions received from the seller) to the collecting bank, with confirmation that the collection is subject to the URC 522 rules and accompanied by the documents provided by the principal. They will normally be sent by courier service. As an alternative to a paper-based system, such as that outlined above, a number of sellers will have access to its bank’s e-banking systems, whereby the seller prepares a collection instruction online in the name of the remitting bank, prints the collection instruction and attaches the documents, and sends them to the buyer’s bank. The remitting bank will then perform the follow-up messaging with the collecting or presenting bank until the documents are paid or accepted. This procedure is commonly known as an ‘accelerated bill for collection service’ or a ‘direct collection’.

Obtain and study a copy of your own bank’s (or any local bank’s) documentary collection instruction, to see exactly what is included.

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Check whether bills of exchange in your country require payment of stamp duty upon payment or acceptance, and find out the rate applicable.

7.2.1 Obligations of the collecting / presenting bank For the collecting bank, the collection will often be referred to as an ‘inward bill for collection’. When we looked at URC 522 above, we identified that no bank is obliged to handle a collection they receive. If they decide not to handle a collection, the bank must inform the sender, by telecommunication or other expeditious means, of their decision without any delay. URC sub-articles 1 (b) and 1 (c) apply in this respect. On receipt of the remitting bank’s collection instruction and the documents, the collecting bank will examine what has been received, check the schedule of instructions it has been given, and make sure that the documents attached are as described and in the correct number of originals and copies. Collecting banks are not required to look to the documents for any instructions (URC 522 sub-article 4 (a) (ii)). The collecting bank should then contact the buyer and inform them of the instructions they have received. The collecting bank may well have a banking relationship with the buyer but, when handling a collection, they are acting as agents for the remitting bank and therefore owe the remitting bank the normal duty of care of an agent to its principal. Therefore, the collecting bank’s duty and responsibility to the remitting bank overrides any duty to its customer. What happens next depends upon the type of collection.

7.2.1.1

Clean collection

A clean collection will involve the collecting bank presenting a draft for payment or acceptance or presenting a cheque for payment. u If paid, the collecting bank will transfer the funds to the remitting bank, normally via SWIFT. u If accepted, the collecting bank will advise the remitting bank, and the accepted draft will be handled according to the collection instruction, ie © The London Institute of Banking & Finance 2016

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hold it until maturity and present it to the buyer for payment, or return it to the remitting bank for re-presentation shortly prior to the maturity date. u If unpaid or unaccepted, the instructions to protest, if applicable, should be carried out pending further instructions.

7.2.1.2

Documentary collection

A documentary collection will involve the collecting bank as follows: u If accompanied by a draft payable at sight, the documents will be released against payment. Where no draft is attached, the covering schedule will merely call for payment in exchange for release of the documents. u If accompanied by a term draft, then the collecting bank must obtain the buyer’s acceptance prior to release of the documents. In either case, the buyer may be allowed to examine the documents at the bank. Or the buyer may have received copy documents, by separate post, direct from the seller. The collecting or presenting bank may also make copies available to the buyer to aid their decision process. Some buyers and sellers have established electronic means of exchanging PDF format documents for review prior to the arrival of a collection. As explained in URC 522 article 13, banks are not responsible for the genuineness or validity of any documents. Once a bill is accepted, the collecting bank must inform the remitting bank and, once payment thereof is received on the due date, funds, less any charges, will be sent via SWIFT.

7.2.2 Payment, partial payment, currency, interest and charges There are a number of issues that arise when it is time to make payment: u URC 522 article 16 states that collecting banks will make payment only to the remitting bank, unless there is some agreement to the contrary. u When the sum payable and collected is denominated in the local currency of the buyer, and this is the currency that will be paid to the remitting bank, the collecting bank should not release the documents without seeking further instructions if payment of such local currency is subject to completion of any exchange control regulations.

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u When a collection is denominated in a foreign currency, the same applies. The SWIFT remittance / payment will be made in that currency unless there is a regulatory reason not to do so. In such an event, the collecting bank must retain the documents. The non-availability of foreign currency can occur in countries where buyers must, in addition to an import licence (from one department of government), obtain an approval to purchase foreign currency from the central bank (another department). If they have failed to obtain the necessary approval, the collecting or presenting bank will be unable to make a payment. u Buyers may offer to make a partial payment. On a clean collection, partial payments can be made, but the financial document will only be released when payment is made in full. u For documentary collections, it may be that partial or instalment payments have been provided for in the instructions given to the collecting bank, in which case the collecting or presenting bank must follow those instructions. However, an offer to make partial payment without prior arrangement must be referred to the remitting bank for instructions, with the documents being retained by the collecting or presenting bank. u When interest is due to the seller, the collecting or presenting bank should collect the interest due at the rate stated and for the period involved. Unless it is specifically stated that interest may not be waived, the collecting or presenting bank may release documents against payment of the principal sum only (URC 522 article 20). u The same rule applies to bank charges. Documents may be released without charges having been collected unless waiver of charges is specifically not permitted. Collecting or presenting banks are entitled to be reimbursed for their costs and charges and, if not paid by the buyer, these will be collected from the remitting bank (usually by a deduction from the amount due) and the remitting bank will, in turn, collect the costs from the seller (URC 522 article 21).

7.2.3 Receipt of documents after arrival of goods Where goods arrive before the relevant documents, the collecting bank may be willing to assist a creditworthy buyer to take delivery of the goods without delay. In doing so, it is no longer acting as agent for the remitting bank but on its own account and at its own risk. The buyer will be asked to provide a ‘trust receipt’ (see Topic 5) undertaking to pay or accept, as the case may be, the draft on presentation, so that the collecting or presenting bank can then honour the collection instruction. © The London Institute of Banking & Finance 2016

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Topic 5 also gives explanations of the various types of negotiable and non-negotiable transport documents. Where a negotiable bill of lading is involved, clearing the goods before the arrival of the bill of lading will require the buyer’s bank to provide a guarantee to the carrier on the buyer’s behalf and against the buyer’s counter-indemnity. In this case, a guarantee from the bank undertakes that the recipient will not suffer loss as a result of their actions, ie releasing the cargo. For non-negotiable documents, goods are released to the named consignee without the need for the surrender of a transport document. When the collecting bank is the consignee and releases goods to the buyer against payment, acceptance or other terms and conditions, the remitting bank is deemed to have authorised such action. In practice, the collecting bank will then issue its own delivery order to the carrier, authorising release of the goods to a specific party, usually the buyer.

7.2.4 Non-payment/non-acceptance by the drawee Despite the above, in a normal correspondent relationship, a collecting or presenting bank may seek to protect the remitting bank’s interests and hence that of the seller, when payment or acceptance is not forthcoming, by arranging for storage and insurance at the remitting bank’s expense. This is where a ‘case of need’, who may be the seller’s local agent, can help, particularly if a new buyer must be found. If the buyer fails to pay, even at a renegotiated price, and no other buyer can be found, the goods will either have to be shipped back to the seller, sold by auction (almost certainly at a huge loss to the seller) or destroyed. If a previously accepted bill of exchange is subsequently dishonoured, then there is little to be done as far as the goods are concerned − they will already have been released to the buyer at the time the bill was accepted.

7.3

Finance against documentary collections

A seller may seek an advance from its bank, in anticipation of the proceeds of a collection. Alternatively, a collection may be handled as a ‘negotiation’, when the seller will sign an undertaking in addition to the collection instruction. In a negotiation, the seller’s bank will agree to pay the seller immediately the value of the draft. This type of arrangement would be with recourse to 124

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the seller, meaning that if the bank were unable to obtain payment from the importer, it would come back to the seller to retrieve its payment. The seller would also agree to pay interest for the period between the negotiation date and the date when the remitting bank receives payment. Finance can also be provided to the buyer, by the buyer’s bank, by way of an advance to the buyer, to help pay the sight or term draft. The buyer’s bank may also provide a form of additional acceptance to the draft accepted by the buyer. This is common in a number of European countries and is known as ‘avalisation’, because the bank signs the draft with the words ‘Bon pour aval’. Clearly, with the collecting bank’s name on the draft, the collecting bank effectively guarantees payment. Thus, it is possible for financing to be raised on the draft prior to the due date on the strength of the bank avalisation. The prior permission of the buyer and its bank should be obtained before submitting a collection instruction with a request for avalisation. The bank’s acceptance ‘pour aval’ will incur further bank charges, and, prior to the collection being despatched, the buyer and seller must agree who will be responsible for these charges. Collecting banks must not release the documents unless they are prepared to avalise the draft, and to do so, they should ensure that the buyer is financially capable of paying the draft on the due date.

7.4

Advantages and disadvantages of using documentary collections

The safest method of payment for a seller would be to receive payment in full and in advance, before the goods are shipped. However, this is the highest risk to a buyer. From a buyer’s point of view, its first choice of settlement method would be to have the goods sent on an ‘open account’ basis, where payment would often be made after the goods arrive. Commercial reality, however, will frequently mean that a compromise position must be reached, which will provide some built-in protection for both sides. Of the two main banking arrangements that enable buyers and sellers to protect their interests, the ‘collection’ is the simplest and cheapest. The other, the ‘documentary credit’, is the subject of Topic 8.

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A documentary collection can: u increase the likelihood of payment for the seller, as the buyer may not be able to obtain the goods without payment or acceptance of the collection; u provide some assurance to the buyer that the shipment will arrive, although the buyer will often not be able to examine the goods before payment or acceptance of the collection; u provide an opportunity to sell goods on, before payment has to be made (under a D/A transaction). But there are also disadvantages: u The security of payment for the seller is less than payment in advance, a bank payment obligation or a documentary credit. u The seller does not have the benefit of a bank guarantee of payment provided by a documentary credit, and relies only upon the credit standing of the drawee / buyer. u Should the collection be unpaid, the costs of protecting the goods can be high. Finding an alternative buyer, willing to pay a fair price, in a far country, may be difficult, particularly for perishable goods.

Chapter summary This chapter has looked at collections governed by the rules laid down in URC 522. Collections come in three categories: 1. Clean collections: for the payment of a bill of exchange by the buyer on a sight basis or acceptance of a draft and payment on the due date. This type of collection is also used for cheques. 2. Documentary collections for payment on D/P terms: the payment at sight by the buyer against release of documents. 3. Documentary collections for acceptance on D/A terms: the acceptance of a term draft by the buyer against release of documents. Collections are handled for a seller by its bank, which becomes the remitting bank, from where documents are sent to the buyer’s bank − the collecting bank. The collecting bank’s duty is to the remitting bank in an agency role.

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The risks to sellers and buyers are as follows: u The seller is at less risk than ‘open account’ − sending the goods and awaiting payment − but remains reliant on the credit standing of the buyer to a considerable extent. u If the buyer does not pay or accept, the seller and the remitting bank are dependent upon the collecting bank acting efficiently, if so instructed, to store and insure the goods and, in the worst case, arrange for a sale. u Sellers have a risk, more in some countries than others, that foreign exchange will not be available to the buyer. u Buyers will have had no chance to examine goods before accepting or paying a draft. Many of these risks can be covered by the following means: u issuance of inspection certificates (see Topic 5); u insurance against non-payment or country risk such as non-availability of foreign exchange (see Topic 12); u currency fluctuation risks (see Topic 13). Both sellers and buyers can obtain finance to overcome a cash-flow deficiency. Sellers can, subject to their credit standing, obtain loans against collections or they may negotiate a draft sent for collection to obtain early payment. A buyer’s bank may also make funds available to its customer, so that it can meet its payment obligations before the imported goods have been processed and / or sold.

References ICC (1995) Uniform rules for collections. ICC Publication No. 522.

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Review questions The following review questions are designed so that you can check your understanding of this chapter. The answers to the questions are provided at the end of these learning materials.

1.

What is the number of the ICC publication that covers documentary collections? a. 645

b. 522

c. 600

d. 458

2.

The ‘principal’ in an outward documentary collection transaction will normally be the buyer. True or false?

3.

What is a documentary collection presenting only financial documents, without any commercial documents attached, normally called?

4.

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a. A documentary collection.

b. A commercial collection.

c. A clean collection.

d. A financial collection.

Is a collecting bank responsible for the genuineness of documents included in a collection instruction?

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5.

A previously accepted draft used for a documentary collection is dishonoured when presented for payment to the drawee. What can the collecting bank do about the underlying goods in the transaction?

6.

If goods arrive before documents, what can the presenting or collecting bank do to assist its buyer client to obtain the goods?

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:

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Chapter 8

Documentary credits

Learning objectives By the end of this chapter, you should have an understanding of: u what a documentary credit is and its main features; u the principles that determine the processing and interpretation of documentary credits; u the responsibilities and risks of the parties involved; u the various types of documentary credit; u the ICC rules for Documentary Instrument Dispute Resolution Expertise (DOCDEX).

In Topic 6 we looked very briefly at documentary credits. This chapter will now look at how the documents described in Topic 5 can be presented through the banking system against a documentary credit, which is a form of bank undertaking.

8.1

Basic principles of documentary credits

As with documentary collections (described in Topic 7), the International Chamber of Commerce (ICC) has produced a set of rules for documentary credits, which are almost universally accepted. These are known as the Uniform Customs and Practice for Documentary Credits − or ‘UCP’ for short. The latest version of these rules came into force on 1 July 2007 and was published under ICC publication no. 600 (referred to as ‘UCP 600’). © The London Institute of Banking & Finance 2016

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In addition, the ICC has produced a publication giving guidance on how the articles of UCP 600 should be interpreted and applied in the examination of documents, called International Standard Banking Practice for the Examination of Documents under Documentary Credits subject to UCP 600 − or ‘ISBP’ for short (ICC, 2013). The ISBP is a necessary companion for UCP 600, whether the reader has a banking, logistics, legal or corporate background; the latest version is ISBP 745. Other ICC publications that may be relevant to a documentary credit transaction are: u Uniform Rules for Bank-to-Bank Reimbursements Under Documentary Credits − URR 725 (ICC, 2008); u ICC Supplement to the Uniform Customs and Practice for Documentary Credits for Electronic Presentation − eUCP version 1.1.

8.1.1 Definitions Documentary credits are very often used to settle the payment obligation of a buyer and, in the context of an issuing bank, may be defined as: an irrevocable undertaking given by a bank 1 whereby it undertakes to honour 2 a presentation of documents 3 submitted in accordance with the terms and conditions of the documentary credit 4 and in compliance with UCP 600. (ICC, 2013) The main features, numbered in the definition above, require explanation. 1. With an ‘irrevocable undertaking given by a bank’, an issuing bank, on behalf of a buyer of goods, services or performance, issues an undertaking that it agrees not to amend or cancel without the consent of the beneficiary or a confirming bank, if any. Once a documentary credit is issued, the buyer will become known as the ‘applicant’. A seller requiring payment by documentary credit should always insist that it be an irrevocable credit. Revocable credits do exist but they are seldom used, and UCP 600 no longer makes reference to them. A revocable credit can be cancelled at any time and without the consent of a beneficiary. A bank should never confirm a revocable credit. A seller will prefer a guaranteed method of payment that can be achieved through the issuance of an irrevocable credit. 2. The issuing bank of a documentary credit can ‘honour a presentation’ by:

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u payment at sight; u incurring a deferred payment undertaking, ie issuing an undertaking to pay on a determinable due date, when the credit is available by deferred payment (under a deferred payment credit, there is no requirement for a bill of exchange or ‘draft’− the word ‘draft’ is frequently used in place of ‘bill of exchange’, and will be used as such throughout the rest of this chapter); u accepting a draft for payment on a determinable due date (maturity date) and paying it on that date. 3. Banks only deal with documents and not the goods, services or performance to which the documents may relate. UCP 600 sub-article 14 (a) states that banks examine a presentation to determine, on the basis of the documents alone, whether or not the documents appear on their face to constitute a complying presentation. Documents presented by the beneficiary must be as specified in the credit, and for most transactions will consist of the kind of documents described in Topic 5, eg invoices, transport documents, insurance documents. 4. The phrase ‘in accordance with the terms and conditions of the documentary credit’ refers to the fact that the undertaking to pay is conditional upon the terms of the credit being met. Banks are only required to examine documents according to the terms and conditions of the credit and not terms that may appear in an underlying contract, pro forma invoice or purchase order. The applicant for a documentary credit is the buyer that asks its bank to issue the credit. An applicant is not a party to a documentary credit. The main entities in a documentary credit transaction are as follows: u Advising bank − the bank through which the credit is transmitted by the issuing bank for advising to the beneficiary. u Beneficiary − a company or individual to whom the credit is issued, in most cases the provider of the goods, services or performance. u Issuing bank − the bank acting for the applicant by issuing or opening the credit on the applicant’s behalf. The issuing bank gives an undertaking to reimburse a nominated bank that has honoured or negotiated compliant documents under the terms of the credit, even if the applicant is unwilling or unable to pay. It also gives an undertaking to honour a complying presentation that is made to it directly by the beneficiary. u Confirming bank − a bank that adds its additional undertaking to that of the issuing bank and thereby undertakes to honour or negotiate a complying presentation made to it by the beneficiary. If a bank confirms © The London Institute of Banking & Finance 2016

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a credit, the documentary credit is commonly known as a ‘confirmed letter of credit’. u Nominated bank − a bank at whose ‘counters’ a beneficiary may make a presentation of documents for honour or negotiation. Each credit must indicate whether it is available with the issuing bank or with a nominated bank or with any bank (in which case, any bank is a nominated bank). The advising, confirming and nominated bank may be the same institution.

8.1.2 Summary of UCP 600 Article 1 Article 1 outlines the application of UCP, stating that the rules are binding on all parties unless expressly modified or excluded by the credit.

Article 2 Article 2 gives the definitions of terminology used throughout the rules. In addition to the definitions of the parties involved, which are outlined above, the following terms are defined: u ‘Banking day’ is the day on which a bank is regularly open at the place at which an act subject to UCP 600 is to be performed. u ‘Complying presentation’ is a presentation of documents that is in accordance with the terms and conditions of the credit, the applicable provisions of UCP 600 and international standard banking practice. u ‘Confirmation’ is a definite undertaking of the confirming bank to honour or negotiate a complying presentation. Note that this undertaking is in addition to the undertaking given by the issuing bank. u ‘Credit’ is any irrevocable arrangement, however named or described, that is irrevocable and thereby constitutes a definite undertaking of the issuing bank to honour a complying presentation. u ‘Honour’ can mean: − to pay at sight − where the credit is available by sight payment; − to incur a deferred payment undertaking and pay at maturity, if the credit is available by deferred payment; − to accept a bill of exchange (‘draft’) drawn by the beneficiary and to pay at maturity if the credit is available by acceptance.

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u ‘Negotiation’ means the purchase by the nominated bank of drafts (drawn on a bank other than the nominated bank) and / or documents under a complying presentation, by advancing or agreeing to advance funds to the beneficiary on or before the banking day on which reimbursement is due to the nominated bank. u ‘Presentation’ means either the delivery of documents under a credit to the issuing bank or nominated bank or the documents so delivered. u ‘Presenter’ means a beneficiary, bank or other party that makes a presentation.

Article 3 Article 3 gives a list of interpretations, including that all documentary credits are irrevocable, the manner in which documents may be signed, how the act of legalisation or certification may be evidenced on documents, the use of terms in a credit to describe the issuers of documents, what is understood by terms such as ‘promptly’, ‘immediately’, etc, the meaning of terms such as ‘from’, ‘to’, ‘until’, ‘after’, etc, and terminology used to describe certain parts of a month.

Article 4 Article 4 makes the distinction between a credit and the contract. Sub-article 4 (a) states: A credit by its nature is a separate transaction from the sale or other contract on which it may be based. Banks are in no way concerned with or bound by such contract, even if any reference whatsoever to it is included in the credit. Consequently, the undertaking of a bank to honour, to negotiate, or to fulfil any other obligation under the credit is not subject to claims or defences by the applicant resulting from its relationship with the issuing bank or the beneficiary. In addition, this article gives a recommendation discouraging issuing banks from including the underlying contract as an integral part of the documentary credit.

Article 5 Article 5 makes the distinction between documents versus goods, services or performance. This is an extremely important feature of a documentary credit, and an applicant must be aware that the banks only deal in documents and not the underlying goods, service or performance. In the event that a beneficiary ships the wrong or substandard goods, the applicant must still reimburse the issuing bank if a complying presentation has been made.

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Article 6 Article 6 details the requirements concerning availability, the need for an expiry date and the place for presentation.

Article 7 Article 7 covers the issuing bank’s undertaking, which can be summarised as follows: the issuing bank undertakes to honour a presentation made to it by the beneficiary, provided the documents comply with the credit. A credit may allow a beneficiary to submit a presentation to a named nominated bank or any bank, as specified in the credit. If a complying presentation is received from a nominated bank, the issuing bank must reimburse that bank, provided that the issuing bank is itself satisfied that the terms of its credit have been met.

Article 8 Article 8 looks at the undertaking of the confirming bank. The confirming bank gives a similar undertaking to the beneficiary as that of the issuing bank. It will undertake to honour or negotiate a complying presentation that is made to it or to another nominated bank. The issuing bank is obligated to reimburse the confirming bank for any honour or negotiation that it effects, provided that the documents conform to the terms of the credit.

Article 9 Article 9 gives details on the advising of credits and any subsequent amendments. An advising bank is under no obligation to advise a credit or amendment to the beneficiary. If it agrees to do so, it is required to satisfy itself with the apparent authenticity of the credit or an amendment, or to advise the beneficiary that it has been unable to complete this task.

Article 10 Article 10 covers amendment in more detail. As a documentary credit is irrevocable, any amendment is subject to the consent of the issuing bank, the beneficiary and a confirming bank (if a confirming bank is involved in the transaction). However, once the parties to the credit have agreed to an amendment, the amendment will become an integral part of the credit and the beneficiary must comply with the original credit and the accepted amendment.

Article 11 Article 11 states that an authenticated teletransmission of a documentary credit or amendment will be deemed to be the operative credit or amendment. A pre-advice will only be sent if the issuing bank is fully prepared to issue the operative credit or amendment. 136

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Article 12 Article 12 declares that a nominated bank is not obliged to honour or negotiate, unless it is also the confirming bank or it has expressly communicated to the beneficiary its agreement to honour or negotiate. When an issuing bank issues a credit that is available by acceptance or deferred payment, it is an implied authorisation for the nominated bank to prepay or purchase the draft accepted by it or the deferred payment undertaking incurred by it.

Article 13 Article 13 examines fairly basic bank-to-bank reimbursements arrangements. Banks should utilise the more extensive rules that exist in the ICC’s Uniform Rules for Bank-to-Bank Reimbursements Under Documentary Credits (publication no. 725) (ICC, 2008).

Article 14 Article 14 gives a number of standards relating to the examination of documents (see also section 8.1.3). Banks have a duty to examine documents, on the basis of the documents alone, to determine whether they appear on their face to constitute a complying presentation. This article gives banks a maximum of five banking days following the day of presentation to determine whether the presentation does comply.

Article 15 Article 15 reminds banks that once a presentation is determined to be complying, they must honour or negotiate. In the case of the confirming bank or nominated bank, they must also forward the documents as required by the documentary credit.

Article 16 Article 16 looks at the scenario when discrepant documents are presented. In this instance, the nominated, confirming or issuing bank may refuse to honour or negotiate; however, it must notify the presenter by the close of the fifth banking day following the day of presentation, giving details of the discrepancies and indicating one of four statuses for the documents: a. that the bank is holding the documents pending further instructions from the presenter; or b. that the issuing bank is holding the documents until it receives a waiver from the applicant and agrees to accept it, or receives further instructions from the presenter prior to agreeing to accept a waiver; or

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c. that the bank is returning the documents; or d. that the bank is acting in accordance with instructions previously received from the presenter.

Article 17 Article 17 states that at least one original of each stipulated document must be presented. A bank may treat a document as an original if it bears an apparently original signature, mark, stamp or label of the issuer unless the document states that it is not an original.

Article 18 Article 18 requires that the commercial invoice must appear to have been issued by the beneficiary (except as required in Article 38 − see below), must be made out to the applicant and must be in the same currency as the credit. It need not be signed. The invoice must contain a description of the goods, services or performance that corresponds with that in the credit.

Article 19 Article 19 establishes that when a transport document covers at least two different modes of transport, the document must, among other conditions: u appear to indicate the name of the carrier and be signed by the carrier or its named agent, or the master or its named agent; u indicate that goods have been despatched, taken in charge or shipped on board at the place stated in the credit; u indicate the place of despatch, taking in charge or shipment and the place of final destination stated in the credit; u be the sole original or, if issued in more than one original, be the full set of originals as indicated on the transport document; u contain all conditions of carriage or make reference to another source containing the full terms and conditions of carriage; u contain no indication that it is subject to a charter party.

Article 20 Article 20 states that a bill of lading must, among other conditions: u appear to indicate the name of the carrier and be signed by the carrier or its named agent, or the master or its named agent; u indicate that goods have been shipped on board a named vessel at the port of loading; 138

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u indicate the port of loading and discharge as stated in the credit; u be the sole original or, if issued in more than one original, be the full set of originals as indicated on the bill of lading; u contain all conditions of carriage or make reference to another source containing the full terms and conditions of carriage; u contain no indication that it is subject to a charter party.

Article 21 Article 21 covers non-negotiable sea waybills, the requirements of which are similar to those detailed for bills of lading.

Article 22 Article 22 states that a charter party bill of lading must, among other conditions: u contain an indication that it is subject to a charter party; u appear to be signed by the master or its named agent, the owner or its named agent, or the charterer or its named agent; u indicate that goods have been shipped on board a named vessel at the port of loading; u indicate the port of loading and discharge as stated in the credit; u be the sole original or, if issued in more than one original, be the full set of originals as indicated on the charter party bill of lading; Banks will not examine charter party contracts.

Article 23 Article 23 states, among other conditions, that air transport documents must appear to indicate the name of the carrier and be signed by the carrier or its named agent. In addition, they must state a date of issuance and indicate the airport of departure and destination as stated in the credit.

Article 24 Article 24 states, among other conditions, that road, rail or inland waterway transport documents must appear to indicate the name of the carrier and be signed by the carrier or its named agent, or indicate receipt of the goods by either a signature, stamp or notation. In addition, they must indicate the place of shipment and place of destination as stated in the credit.

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Article 25 Article 25 establishes, among other conditions, that courier and postal receipts must both be stamped or signed at the place from which the credit states the goods are to be shipped.

Article 26 Article 26 requires that transport documents must not indicate that the goods are or will be loaded on deck. However, a clause on a transport document stating that the goods may be loaded on deck is acceptable.

Article 27 Article 27 states that a bank will only accept a clean transport document, ie one that bears no clause or notation that expressly declares a defective condition of the goods or their packaging.

Article 28 Article 28 examines insurance documents and coverage. Important features include that the date of the insurance document must be no later than the date of shipment or the document must indicate that cover was effective no later than the date of shipment. It must indicate the amount of insurance coverage in the same currency as the credit. Cover notes will not be acceptable unless required by the credit. The minimum insurance coverage is 110 per cent of the CIF or CIP value of the goods (see Topic 5 for explanation of these Incoterms).

Article 29 Article 29 permits the expiry date or last date for presentation to be extended when that date falls on a non-banking day, except due to a ‘force majeure’ event. If the latest shipment date falls on a non-banking day, it is not extended.

Article 30 Article 30 states that the words ‘about’ or ‘approximately’ when used in the credit in connection with the amount, quantity of goods or unit price can be construed as allowing a tolerance of not more than 10 per cent more or less. In the event that the goods are described by weight or volume, then a plus or minus 5 per cent tolerance in the quantity shipped is permissible, providing the amount of the credit is not exceeded.

Article 31 Article 31 covers partial drawings and shipments, which are allowed unless the credit states otherwise.

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Article 32 Article 32 states that when a credit includes a schedule for instalment drawings or shipments within given periods (ie a start date and an end date), a failure to ship or present under one of the dates or instalments will render the credit unavailable for that and any subsequent instalment.

Article 33 Article 33 states that a bank has no obligation to accept a presentation outside its banking hours.

Articles 34 and 35 Articles 34 and 35 cover disclaimers on effectiveness of documents and on transmission and translation, limiting the bank’s liability or responsibility. Loss of documents in transit is also covered and offers some protection to a beneficiary where a nominated bank has previously examined the documents and determined that they comply, whether or not the nominated bank has honoured or negotiated.

Article 36 Article 36 covers the event of ‘force majeure’, which comes from the French term meaning ‘superior force’. It simply means that the banks involved with the credit assume no liability or responsibility for any consequences arising out of any interruption in business caused by acts of God, riots, civil commotions, insurrections, wars and acts of terrorism, or by any labour strikes.

Article 37 Article 37 makes it clear that the issuing bank is not liable should the advising bank not carry out its instructions, even if the issuing bank selected the bank. The applicant remains ultimately liable for any charges that cannot be collected from a beneficiary.

Article 38 Article 38 outlines the rules relating to a transferable credit (which are detailed fully in section 8.4.1). Important features of this article are that only certain parts of the transferable credit can be amended by the first beneficiary, namely: u amount of the credit; u unit price; u expiry date;

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u period for presentation; u latest date for shipment; u percentage of insurance cover; u the name of the first beneficiary, which may be substituted for that of the applicant in the transferred credit. Note that, of these, the first five listed above may be reduced or curtailed. A bank that is nominated to transfer a credit is under no obligation to do so.

Article 39 Article 39 looks at assignment of proceeds of a documentary credit. Even if a credit is not designated as transferable, it does not affect the right of a beneficiary to assign the proceeds under the credit. This article relates only to the assignment of the proceeds under the credit and not the assignment of the right to perform under the credit.

Visit the ICC website (www.iccwbo.org [Accessed: 10 August 2016]) to read more about UCP 600.

8.1.3 Standards for the examination of documents The standards for the examination of documents are detailed in UCP 600 article 14. They are also given in more detail in the ICC’s International Standard Banking Practice for the Examination of Documents under UCP 600 (publication no. 745) (ICC, 2013). In UCP 600 article 14, it includes the default rule for the presentation of documents after the date of shipment, ie within 21 calendar days. Ideally, each credit will indicate the presentation period that will be applicable. Other standards in article 14 include the following: u As stated earlier, an issuing bank, a confirming bank or a nominated bank acting on its nomination has a maximum of five banking days following the day of presentation to determine whether the presentation complies. u A document must not be dated later than the date of its presentation. 142

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u In documents other than the invoice, the description of the goods, services or performance, if stated, may be given in general terms not conflicting with their description in the credit. u If the credit does not indicate a specific issuer for a document, such as for an inspection certificate, then the issuer named on the document will be accepted as submitted. Where the data content for a document is not given in a credit, banks will accept the document as presented, provided it fulfils the function of that document. u Data in a document − when read in context with the credit, the document itself and international standard banking practice − need not be identical to, but must not conflict with, data in that document, any other stipulated document or the credit.

8.1.4 Discrepant documents A high percentage of documents are found to be discrepant on first presentation, ie they do not comply with the terms and conditions of the credit. This is why the theoretical benefit to a beneficiary of a bank undertaking can be less than perfect in practice. Some estimates have put the percentage of discrepant presentations at 50−60 per cent. When the officer of the bank examining documents notices discrepancies, they will, in the first place, advise the presenter of the discrepancies in the form of a refusal notice. The bank will give the beneficiary an opportunity to correct the documents or, where that is not possible, to contact the applicant to arrange for an amendment or to seek the applicant’s agreement to accept documents as presented. The issuing bank should not be contacted about the discrepancies until the beneficiary has had a chance to correct any discrepancies or it gives permission to do so. Once the beneficiary has been given the opportunity to correct any discrepancies, the nominated bank has several courses of action open to it: u It may honour or negotiate against the corrected documents. u It may send a message to the issuing bank, asking for permission to honour or negotiate despite identified discrepancies. The nominated bank will approach the issuing bank and the issuing bank, if it is in agreement, will in turn approach the applicant for a decision (known as a ‘waiver’) as to whether the presentation may or may not be accepted as presented. u It may agree to make settlement to the beneficiary despite the noted discrepancies against a specific indemnity from the beneficiary, subject © The London Institute of Banking & Finance 2016

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to the credit standing of the beneficiary, or it may accept an indemnity from the beneficiary’s own bank. This will indemnify the nominated bank against any claims from the issuing bank, and will incorporate an authority to debit the beneficiary’s account with any amount claimed or to claim from the beneficiary’s bank. (This course of action may be prohibited by the terms of some documentary credits and is not a common feature today, due to the amount being reflected against a credit facility). u It may forward the documents to the issuing bank for settlement, if requested to do so by the beneficiary. u It may return the documents to the beneficiary.

8.2

Example of the operation of a documentary credit

The following example outlines a typical transaction utilising a documentary credit as a mechanism for settlement. A seller would first agree with a buyer to utilise the banking system to arrange the transfer of documents and payment or acceptance. The seller then ships the goods and obtains the documents relating to the shipment, such as the commercial invoice, transport document, certificate of origin, etc. The seller will complete and sign a collection instruction form provided by its bank and present the documents together with the collection instruction to the bank. Once a seller and buyer have agreed on the principles of the underlying sale, they agree to settlement utilising a documentary credit. There is then a series of details that must be considered by both parties, before the buyer asks its bank to issue the credit. These considerations include: u the nature of the credit required: irrevocable, confirmed, transferable (see section 8.4.1 for a description of a transferable credit); u the payment terms: at sight, acceptance, deferred payment, or negotiation; u the currency and amount; u the Incoterm that will apply and the associated responsibilities for each party; u the validity of the credit, ie the expiry date for presentation of documents and the period for presentation; 144

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u the latest shipment date and routing of the goods; u other shipment issues: whether part shipments and transhipment (a change of vessel during the shipment) is allowed or not, the type of transport document to be presented and any other documentary requirements; u the description of the goods; u the insurance requirements; u whether the credit is to be confirmed by a bank in the exporter’s country; u who is responsible for bank charges; u whether goods are to be inspected prior to shipment. These points must be agreeable to all sides. After all, the documentary credit only gives certainty of payment to the seller / beneficiary if it can comply with the terms and conditions. Once agreement is reached on these issues, the buyer can approach its bank for the issuance of the credit on its behalf. The issuing bank will already have in place − or will need to establish − a documentary credit facility for the buyer. As the credit is a binding undertaking to guarantee payment either at sight or at a future date, if all terms and conditions of the credit are met, the bank marks the credit as a contingent liability. This syllabus does not cover the lending process and decisions made by the bank. However, in essence, the bank should be comfortable with the financial standing of the buyer and its ability to undertake import business and honour its obligations. The bank may also wish to take security to further protect it against possible loss. This may take the form of: u security independent of the transaction, such as a charge over the buyer’s assets and guarantees of the directors; u security provided through the documents (see Topic 5), such as: − original bills of lading issued to order of the bank or endorsed by the shipper to their order or in blank, giving the bank the ability to take possession of the goods and, if necessary, the sale of them; − the bank may be satisfied with non-negotiable transport documents that consign the goods to the bank, giving the bank control over them.

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Charges over a company’s assets come in two forms: a fixed charge over a specific asset such as property; or a floating charge over current assets such as stocks of raw materials and finished goods, debtors (money owed to the company) and work in progress. The value of a floating charge goes up and down as the company trades. Should the business be unable to meet its financial obligations to the bank, the property covered by a fixed charge can be sold to repay debts and, if the company goes into liquidation, the floating charge assets can be sold for the bank’s benefit. Assuming that the issuing bank agrees to issue the documentary credit, the buyer will need to complete the bank’s application form, giving exact details of what is required. The application form will require the buyer to detail all the conditions that have been agreed with the seller (as noted above) and: u full details of the buyer as applicant; u full details of the seller as beneficiary; u details of the seller’s bank through which the credit will be advised and add confirmation, if required; if this is not known to the buyer, then the issuing bank would advise the credit through one of its group offices or correspondent banks. When the issuing bank opens the documentary credit, it will usually use the SWIFT MT700 message type, which is used by most banks today. The issued documentary credit will include the details on the documentary credit application form and the following: u issuing bank details; u the documentary credit reference number; u date of issue; u reimbursement instructions that conform to the type of availability of the documentary credit.

8.2.1 Responsibilities of the advising bank The advising bank must first satisfy itself as to the apparent authenticity of the credit or amendment. With a SWIFT MT700 message, no further checks are necessary, as it is an authenticated message. If the documentary credit is sent in paper form, the advising bank will need to check the signatures against specimens that will be held for the issuing bank. Documentary credits advised by telex will have the messages authenticated by the use of test keys or codes exchanged between correspondent banks to authenticate transactions between them. 146

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There is no obligation for an advising bank to examine any credit for workability. If it has been asked to add its confirmation and it is not willing to do so, or if it is not willing to merely advise the credit, it must inform the issuing bank without delay. There is no requirement to give any reason to the issuing bank. Reasons for refusal would include a lack of available credit limit or country appetite. If it is willing to confirm the credit, it will advise the beneficiary of the details of the credit and add its confirmation. Once the seller is in receipt of the credit, it should check that the credit conforms to the agreed sales contract and that it is able to meet its requirements. If the seller is not satisfied, it should immediately contact the applicant for them to arrange a suitable amendment.

8.2.2 Presentation of documents against payment If the documentary credit is available by sight payment, as soon as shipment has taken place, the beneficiary will assemble the required documents and present them to the nominated bank or issuing bank, along with a draft (if required), for examination and payment. Where there is a nominated bank, it will have been given a reimbursement instruction that will allow it to pay the beneficiary immediately and to be reimbursed. If the nominated bank has confirmed the credit, it has no option but to pay, if the documents comply. If it has not confirmed the credit, it is under no obligation to pay. If it chooses not to pay, even if the documents comply, the bank will forward thef documents to the issuing bank for their examination and payment, payment being made to the beneficiary once authorised by the issuing bank. When the issuing bank is satisfied that the documents are compliant, it will inform the applicant and debit its account. The documents will then be released to the applicant. The limit on the import facility will be reduced by the amount of the presentation.

8.2.3 Presentation of documents for acceptance If the documentary credit is available by acceptance, as soon as shipment has taken place, the beneficiary will assemble the required documents and present them to the nominated bank or issuing bank, along with the usance draft, for examination and acceptance. If the documents are compliant and the draft is drawn on the nominated bank, and the credit has been confirmed by the nominated bank, the draft © The London Institute of Banking & Finance 2016

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will be accepted to mature on the determinable due date. At the request of the beneficiary, the nominated bank can purchase the draft and advance funds without recourse to the beneficiary. Otherwise, the accepted draft may be returned to the beneficiary or may be held by them until the due date and paid on that date. If the nominated bank has not added its confirmation, and the draft is drawn on it, it is under no obligation to accept the draft. If it chooses not to accept the draft, the nominated bank will forward the documents to the issuing bank for their examination and acceptance. When the issuing bank is satisfied that the documents are compliant, it will be required to accept a draft payable on the determinable due date. The documents will then be released to the applicant and they will be informed of the due date. On the due date, the applicant’s account will be debited and reimbursement made available to the nominated bank. The import facility will be reduced by the amount of the presentation. The beneficiary will be paid on the due date.

8.2.4 Presentation of documents payable by deferred payment This is similar to the procedure used for a credit available by acceptance, except that no draft is required. Payment is made at a future date, or the nominated bank can agree to prepay its deferred payment undertaking and advance funds to the beneficiary. Should there be discrepancies upon presentation of documents against payment, for acceptance or payable by deferred payment, then the presentation would be dealt with as detailed in section 8.1.4. Finance can be provided against a documentary credit that is available by acceptance or deferred payment. This will be detailed further in Topic 9.

8.2.5 Presentation of documents where the documentary credit authorises payment by negotiation If a credit is available with a nominated bank by negotiation, and it agrees to act on that nomination, it will either advance funds, or agree to advance funds, to the beneficiary on the basis of a complying presentation being 148

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made. Any negotiation made by the nominated bank will incur a charge to the beneficiary for interest for the period between the date of the advance and when it receives reimbursement from the issuing bank. Such advances are made ‘with recourse’, so that if reimbursement is not received when due from the issuing bank, repayment of the advance can be demanded from the beneficiary. If the credit was confirmed and the terms and conditions are fully complied with, the advance or agreement to advance is made on a ‘non-recourse’ basis.

8.3

Advantages and disadvantages of using documentary credits

8.3.1 Advantages to the applicant u The applicant will be able to specify documentation that meets the company’s requirements. u They may be able to obtain a better price or more favourable credit terms. u Timing of shipments and presentation of documents may be more tightly controlled by the wording of the documentary credit.

8.3.2 Disadvantages to the applicant u The credit creates a contingent liability with its bankers and, therefore, utilises part of a credit facility. u If irrevocable, the credit cannot be cancelled or amended without the beneficiary’s consent. u Costs in issuing the documentary credit and handling documentation in the issuing country are likely to be for the account of the applicant and will be significantly higher than other terms of payment, such as open account or documentary collection. u The applicant will have no opportunity to delay the payment to the beneficiary if the documents are presented in conformity with the documentary credit terms and conditions, and must provide reimbursement to the issuing bank according to the terms of settlement. u As banks deal with documents (not in goods), a presentation of complying documents will result in payment regardless of whether the goods are of © The London Institute of Banking & Finance 2016

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the required quality. It is important, therefore, that the applicant is fully satisfied about the reliability of the beneficiary or addresses any concerns in the terms and conditions of the credit.

8.3.3 Advantages to the beneficiary u Payment is guaranteed by the issuing bank (or a confirming bank) provided the terms and conditions of the documentary credit are fully met, and cash flow is hence more certain. u Applicant risk is transferred to the issuing bank (and the risk of the issuing bank is transferred to the confirming bank, if the credit is confirmed). u Pre-shipment finance may be available from its bankers on the strength of the documentary credit from the issuing bank. u There is an opportunity to have accepted drafts or deferred payment undertakings discounted.

8.3.4 Disadvantages to the beneficiary u To be certain of settlement, the beneficiary must produce compliant documents within the validity of the documentary credit. Presentation of non-compliant documents will almost certainly delay payment, may result in the beneficiary being forced to accept a lower price for the goods, service or performance, or may ultimately result in non-payment if the issuing bank or applicant refuses to accept discrepant documents. u The beneficiary documentation.

may

need

to

train

specialist

staff

to

prepare

u Any costs of advising / confirming the documentary credit are usually borne by the beneficiary.

8.4

Forms of documentary credit

We will now examine various types of documentary credit.

8.4.1 Transferable credits The example given in section 8.2 of this chapter involved the seller selling directly to a buyer. 150

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It is a common arrangement that buyers or sellers make use of intermediaries to purchase and sell goods on their behalf. Intermediaries may be operating on narrow margins and do not carry stocks of goods themselves. Such intermediaries therefore look for an arrangement that does not place a financial burden upon their own working capital and does not draw upon their own banking facilities. The transferable credit fulfils this need. The buyer can instruct its bank to issue a credit stating that it is transferable. UCP 600 (ICC, 2007) article 38 defines a transferable credit as: a credit that specifically states it is ‘transferable’. A transferable credit may be made available in whole or in part to another beneficiary (known as a ‘second beneficiary’) at the request of the beneficiary (known as a ‘first beneficiary’). The following points are important in this context: u Transfers can be − and usually are − for less than the full value of the transferable credit. u There can be more than one second beneficiary, provided the documentary credit allows for partial shipments. u Onward transfers from second to third beneficiaries are not permitted by UCP 600, but may be accomplished if the terms and conditions of the transferable credit allow it to occur. u The final supplier(s) benefit(s) from the security of a documentary credit and can present compliant documents direct to the transferring bank or a local nominated bank for settlement. u There is, however, an additional risk for the applicant: the applicant may not know the credit standing or reliability of the supplier, or even their name.

8.4.1.1

The procedure for handling a transferable credit

The procedure is as follows: u The contract between the buyer and the intermediary is completed in the usual way but must allow for a transferable credit (the intermediary need not be in the seller’s country). u The issuing bank issues the documentary credit as usual, but indicates that it is transferable. u When advising the credit, the advising bank will attach its form of request for transfer for completion by the intermediary (who will become known as the ‘first beneficiary’ when the credit is transferred). © The London Institute of Banking & Finance 2016

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u The first beneficiary will request the transferring bank to transfer part of the credit to the ultimate supplier(s). The transferring bank has discretion over this − see UCP 600 sub-article 38 (a). The supplier(s) will be known as the ‘second beneficiary’. u The credit, as transferred, must carry the same terms and conditions as the transferable credit, except that: the amount of the credit, the unit prices, the expiry date, the latest shipment date and the last date for presentation may be reduced or curtailed; the required insurance cover may be increased; and the applicant’s name may be substituted by the name of the first beneficiary. u The instructions from the first beneficiary to transfer must make clear the basis upon which amendments to the transferable credit are to be advised to the second beneficiary / beneficiaries, ie immediately or only after instructions are provided. u Provided the second beneficiary is in agreement with the transferred credit, it ships the goods and presents documents for settlement to a nominated bank or the transferring bank. u On receipt of these documents, the documents are examined in the usual way. In the case of the transferring bank, it will then invite the first beneficiary to substitute its invoice and draft (if any) for those of the second beneficiary. The first beneficiary’s invoice will usually be for a larger sum, the difference in values representing their profit margin. When dealing with transferable credits, it is particularly important to respect the last point. The first beneficiary’s business is likely to depend upon contacts and expertise. In some cases, therefore, they may not wish the applicant to become aware of the actual supplier’s identity, because they risk being cut out of future transactions. This point is also pertinent at the time of issuance of the transferred credit, ie by not divulging the name of the actual buyer in the transferred credit. However, should the first beneficiary fail to present its substitute invoice and draft (if any), the transferring bank may present the documents as received from the second beneficiary to the issuing bank. Note: The fact that a credit is not transferable does not mean that the beneficiary cannot assign to a third party part or all of the proceeds due to it, in accordance with the assignment laws of the beneficiary’s country. See UCP 600 article 39.

8.4.2 Back-to-back credits Back-to-back credits are used by intermediaries in similar circumstances to transferable credits above, but consist of two entirely separate credits, 152

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with one credit acting as part or full security for the issuance of the other. If an intermediary’s supplier insists upon a documentary credit, the intermediary’s bankers may insist that it obtains a documentary credit in its favour from the ultimate buyer as security for the documentary credit in favour of its supplier. The two credits operate entirely separately, but the beneficiary (who will be the applicant of the second credit) will have to structure its credit in such a way that, when compliant documents are presented by the beneficiary of their documentary credit, it can use those documents (such as bills of lading), together with any documents added or substituted by it, such as invoices, in time to make a compliant presentation under the original credit in its favour. Any amendments to the original credit may have to be reflected in the back-to-back credit, and the beneficiary will not wish to agree to any amendment until it has obtained the agreement of the ultimate supplier to a like amendment to the back-to-back credit. There is considerable scope for difficulties with back-to-back credits, and banks will normally only allow experienced and creditworthy traders to have facilities for back-to-back credits.

8.4.3 ‘Red clause’ and ‘green clause’ credits ‘Red clause’ credits (sometimes known as ‘packing’ credits) are credits that include a clause that permits the advising bank to make an advance payment to the beneficiary. This is an old term used when documentary credits were sent in paper form and quoted the advance payment condition in red ink. With the almost exclusive use of the SWIFT MT700 message, such indications cannot be made today, but the term is still widely used. Such credits originated in trades such as the Australian wool trade, where European buyers agreed to finance their suppliers who, in turn, used the funds advanced to collect and purchase wool from farmers over a wide area. Once a sufficient quantity had been gathered, the wool would be shipped, documents would be presented in the normal way and the advance would be repaid out of the proceeds. Red clause type credits are not, however, restricted to the wool trade. The issuing bank and the applicant are liable to reimburse a nominated bank for any advance made and not repaid through the presentation of compliant documents. Therefore, such arrangements are only made available to applicants who have the appropriate financial standing, expertise and knowledge of the trade to select reliable beneficiaries. Today, most advances are covered by an advance payment guarantee issued by the bank of the © The London Institute of Banking & Finance 2016

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beneficiary, agreeing to repay the advance or any part thereof in the event that the beneficiary does not ship the required goods or any part thereof. Normally such credits are issued without any instructions to the advising bank to take security or control of the goods. However, a ‘green clause’ documentary credit allows pre-shipment advances to be made as with a red clause credit, but stipulates that advances may only be made against goods stored to the advising bank’s order pending shipment. The funds are advanced against warehouse receipts in the lending bank’s name. Such ‘green clause’ credits are rare nowadays.

8.4.4 Revolving documentary credits Revolving documentary credits can be used where regular shipments are involved. They avoid the need for repetitive opening formalities and documentary credits for repeat shipments over a period of time. The credit will state: u that it is revolving and how many times; u whether it will revolve automatically or not; u whether the revolving will occur on a cumulative or non-cumulative basis. These credits usually revolve around time or payment of money. A credit revolving in time, for example monthly, means that the credit is available every month until the expiry date, subject to the number of times that it is stated to revolve. With an automatically revolving credit, the main disadvantage to the applicant and their bank is that it creates a liability equal to the face value multiplied by the maximum number of drawings.

8.4.5 Standby letters of credit Standby letters of credit are similar to guarantees, in that they are used as a security to ensure that contractual undertakings of the applicant are fulfilled. They are discussed further in Topic 11.

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8.5

The ICC rules for Documentary Instrument Dispute Resolution Expertise (DOCDEX)

Most presentations under documentary credits are found to have discrepancies on their first presentation, many of which are admitted and can be easily corrected. There have, however, been a growing number of disputes between parties to documentary credits that have been difficult to resolve. For example, an issuing bank determines that the documents are discrepant and the confirming bank disagrees. Similar disputes may arise between the applicant and issuing bank, between the confirming bank or nominated bank and the beneficiary, or between the issuing bank and the beneficiary. If these disputes cannot be resolved amicably, the only course of action available is to take it to the applicable court of law. This can be costly and may take some time to be heard and resolved. Consequently, the ICC established the Rules for Documentary Instrument Dispute Resolution Expertise (DOCDEX), effective from 15 March 2002, which is designed to expedite the resolution of disputes by providing impartial and expert-recommended solutions. The ICC’s International Centre for Expertise oversees the operation of DOCDEX. Use of the DOCDEX process is normally considered only when both parties have exhausted all other avenues of communication in an attempt to resolve differing viewpoints on the status of the documents. For use of the DOCDEX process, one or both parties must agree to bear the costs involved. Full details and the rules themselves (available in several languages) can be found online at www.iccwbo.org/Products-and-Services/Arbitration-andADR/DOCDEX/Rules/DOCDEX-Rules-in-several-languages/ [Accessed: 10 August 2016]. A new version of the rules was implemented from 1 May 2015 covering a wider range of trade finance instruments. It should be noted that this is not an immediate service and that, generally, decisions are given within 30 days after submission of all the paperwork for review by the nominated experts.

8.6

Risk review

The undertakings of − and risks to − those involved in documentary credits are summarised in Table 8.1.

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8: Documentary credits Table 8.1. Documentary credits: undertakings of participants and the risks involved Participants

The participant undertakes . . .

Risks to the participant

That the transaction is genuine and

Banks are not responsible for

import formalities will be completed

the genuineness or validity of

and insurance cover arranged by

documents.

the applicant, if required by the

Even genuine documents do not

Incoterm used, and that insurance

necessarily guarantee that the

will be arranged.

contractual obligations of the

To reimburse the issuing bank,

beneficiary have been fully met.

in a documentary credit Applicant

when demanded or on the due date, when compliant documents are submitted. Issuing bank

That on presentation of compliant

The applicant will be either unable

documents it will honour as

to reimburse the bank when called

stipulated in the credit.

upon or may refuse to do so.

To reimburse a nominated bank

That it provides a credit, the terms

that has honoured or negotiated a

of which do not give the bank

complying presentation.

control over the goods that it may require. The applicant has failed to obtain the necessary import licences and / or provide for insurance cover (when for its account).

Advising bank

To satisfy itself as to the apparent

It advises a credit that was

authenticity of the credit or any

subsequently found not to be

amendment.

authentic.

To forward to the beneficiary the credit or amendment as received from the issuing bank. Confirming

To satisfy itself as to the apparent

The issuing bank fails to honour its

bank

authenticity of the credit (if it is not

obligations to reimburse.

the advising bank and has already undertaken this role). To provide an undertaking to the beneficiary that conforms to the form of availability stated in the credit. To honour or negotiate a complying presentation.

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Chapter summary Table 8.1. (cont.)

Documentary credits: undertakings of participants and the risks involved

Nominated

That, if the bank accepts its

It fails to correctly examine

bank

nomination, it undertakes to honour

documents presented.

or negotiate according to the terms

The issuing bank or confirming

and conditions of the credit.

bank fail to reimburse for payments, negotiations or acceptances. Negotiation is effected with recourse to the beneficiary, but the beneficiary fails to reimburse the bank when recourse is exercised.

Beneficiary

To present compliant documents.

It is unable to provide compliant

/ first

documents.

beneficiary

A request for a necessary amendment is refused. The nominated bank refuses to honour or negotiate. A confirming bank refuses to reinstate its confirmation, once discrepant documents have been accepted by the issuing bank. The issuing bank will not (or cannot) pay, if credit is not confirmed.

Second

To present compliant documents.

beneficiary of

The first beneficiary does not arrange for transfer or any required

a transferable

amendment

credit

are as for the first beneficiary.

− and then the risks

Chapter summary In this chapter, you have learned the following: u A documentary credit is an irrevocable undertaking given by a bank and is entirely separate from any underlying contract of sale agreed between the applicant / buyer and the beneficiary / seller. u By issuing a documentary credit, a bank adds its own name and risk to the transaction on behalf of its applicant customer. u Banks deal with documents only and are not concerned, when deciding whether or not to honour or negotiate a presentation, with disputes concerning the underlying goods, transactions or contracts.

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u While in principle a bank’s undertaking to pay against complying documents is a protection to the beneficiary, in practice discrepancies are very frequent and potentially numerous. u A bank’s concerns with the type of goods being imported may be relevant to its security and reimbursement arrangements with the applicant and may be a factor in the bank agreeing to issue the credit or not. u Once the credit has been issued, decisions regarding settlement will be based on compliance with the documentary requirements alone.

References ICC (2007) Uniform customs and practice for documentary credits. ICC Publication No. 600LE. ICC (2008) ICC Uniform rules for bank-to-bank reimbursements under documentary credits. ICC Publication No. 725E. ICC (2013) International standard banking practice. ICC Publication No. 745E.

Review questions The following review questions are designed so that you can check your understanding of this chapter. The answers to the questions are provided at the end of these learning materials.

1.

2.

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When dealing with documentary credits, which trading party would be known as ‘the applicant’? a. The seller.

b. The bank issuing the documentary credit.

c. The bank advising the documentary credit.

d. The buyer.

The ICC publication governing documentary credits is called what, and when was it last revised? a. UCP 600 (2007).

b. URDG 758 (2010).

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c. URC 522 (1995).

d. ISP98 (1998).

3.

A bank dealing with a documentary credit deals only in the goods involved. True or false?

4.

Unless specified in a documentary credit, within how many calendar days after the date of shipment should documents be presented for honour or negotiation?

5.

When an intermediary trader buys goods to be shipped direct to a third party, what type of documentary credit might be useful to them?

6.

What is the significance of a documentary credit being confirmed by a bank in the seller’s own country?

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:

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Chapter 9

Short-, medium- and long-term trade finance

Learning objectives By the end of this chapter, you should have an understanding of: u short-, medium- and long-term trade finance; u the concept of ‘the trade cycle’; u when short-term finance is required; u the various forms of short-term finance that are available for a business; u the differences between pre-shipment and post-shipment finance; u the significance of the difference between ‘with recourse’ and ‘without recourse’ finance; u the various forms of longer-term finance available; u the differences between supplier credit, buyer credit and forfaiting; u produce loans for importers; u the various forms of counter-trade.

In previous chapters, reference has been made to the financial requirements of buyers and sellers and to the security available to banks through the control of goods. We have looked at how bills of exchange (drafts), documentary collections and documentary credits work. We have also briefly considered finance options open to the buyer and seller. This chapter will examine in greater detail those options in relation to short-, medium- and long-term finance.

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9.1

Definition of short-term trade finance

Although there is no set definition of short-term trade finance, it is generally accepted that it is finance that is provided and repaid within one year. This type of finance generally covers the purchase and sale of consumer goods.

9.2

The concept of the ‘trade cycle’

All businesses require some working capital: the immediately available cash needed to finance the everyday running of a business, such as the payment of wages and the purchase of materials. This comes from either the capital provided by the owners / shareholders of the business or from bank facilities such as overdrafts. The working capital finances the trade cycle, which can be defined as: the time period between the start of the supply chain − the ordering of goods and raw materials − and the receipt of payment for the corresponding sales of finished products. International trade can impose extra strains on the working capital needs of a business, because the period between making payment for materials and wages and the time of receipt of payment for goods supplied will often be longer than on domestic business. Thus for sellers the trade cycle is usually extended. Most international trade is conducted on payment terms agreed between seller and buyer of 180 days or less. In practice, a bank will examine an individual company’s trade cycle and tailor the length of finance it provides accordingly.

9.3

When short-term trade finance is required

The points at which finance may be required by a seller or buyer will be determined by their commercial contract. If a seller has agreed to ‘open account’ terms or payment, say 90 days after sight, it may require finance for the period of credit extended to the buyer. In an open account transaction, a seller will despatch its goods to a buyer and send an invoice (and any other customary or required documents) asking for payment or agreement to pay on a specified date. If goods are shipped by sea, the goods are consigned to the buyer and the documents of title will be sent direct to the buyer; if goods are despatched by air, then the goods are consigned direct to the buyer. A set date for payment is given, and 162

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the buyer remits the necessary funds to the seller as agreed. Open account arrangements therefore imply a considerable amount of trust being placed on the buyer by the seller. Once goods have been despatched or services delivered, a seller will lose all control over payment, and is reliant on the trustworthiness and creditworthiness of the buyer to pay. Open account trade is common in international trade, with an estimation of over 80 per cent of world trade being concluded on open account terms. It is particularly useful in transactions involving regular shipments, where the buyer often makes payments at set intervals for goods received during a preceding period. Where necessary, sellers can seek to obtain credit insurance on their overseas debtors and can use an export invoice discounting or factoring facility (see section 9.4.2 below) to accelerate cash flow. Alternatively, if a buyer is paying for the goods in advance or on an ‘at sight’ basis, it may require finance for the period between making payment and when the imported goods can be turned into cash from onward sales. A distinction should also be made between pre- and post-shipment finance: u Pre-shipment finance is more often provided to a seller to commence manufacture of the goods, although a buyer may be given pre-shipment finance to pay a deposit to a seller. u Post-shipment finance can either be provided to a seller if it has agreed credit terms with a buyer, or to a buyer if it has granted credit terms to its customers or if it is required to hold the stock for a period of time.

9.4

Examples of short-term trade finance

Many businesses will finance their trade cycle through conventional methods, such as an overdraft. However, many banks may be willing to provide additional finance against more specific products that are more suited to international trade.

9.4.1 Overdrafts and revolving credit facilities Although the overdraft is not specifically a ‘trade finance’ product, it is one of the most important and most flexible sources of business finance. Facilities can be provided both in the company’s domestic currency as well as in foreign currencies. Foreign currency overdrafts would normally be © The London Institute of Banking & Finance 2016

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provided when a company has both payments and receipts denominated in that currency. Some banks have the ability to provide a facility that will ‘net off’ the debit and credit balances of multi-currency accounts. Foreign currency accounts are described in further detail in Topic 13. Some private sector insurers and some government bodies (for example UK Export Finance in the UK or Coface in France) may provide insurance against buyer and country risk. It is often possible for the seller’s bank to obtain an assignment of any proceeds of such policies. This means that the advance is less risky and hence a lower rate of interest will apply. The security is not ‘100 per cent guaranteed’, since the lending bank’s rights will be no better than those of its customer. In other words, the lending bank could only claim to the extent that the customer has a valid claim on the policy. In addition, most policies only cover up to 85−95 per cent of the loss, so that the customer will not recklessly grant credit, while relying on the insurer to compensate all losses. Business lending decisions are not covered in the scope of this syllabus; however, it is worth noting that a bank would usually look to secure the overdraft facility. It is necessary to distinguish between committed overdraft facilities and uncommitted overdraft facilities. With a committed overdraft facility, the bank formally agrees that: u for a specified period of time it will allow the bank account to go overdrawn up to a stated amount; u the facility will remain in place for the whole of the stated period, provided the customer is not in breach of any of the conditions of the facility. Banks charge a commitment fee for such facilities and they are sometimes known as ‘revolving credit facilities’. For an uncommitted overdraft, the bank does not charge any commitment fee, but technically at least the bank could withdraw the facility at any time, usually with a seven-day notice period.

9.4.2 Invoice discounting and factoring Invoice discounting and factoring are applicable to fast-growing companies with good-quality debtors. The minimum annual turnover varies between factoring companies. The terms of trade must be simple, with no complex documentary requirements. With factoring (see section 9.4.2.2 below), normally only open account terms will apply, although documentary collection could be appropriate for invoice discounting. The factor must approve the debtors. Debtors should be well

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spread, and a factor may be keener to cover the export business if the seller has a good spread of domestic business that is offered as well.

9.4.2.1

Invoice discounting

Under an invoice discounting arrangement, the seller presents copies of the invoices to the invoice discounter against which finance is provided, usually for 80−90 per cent of the face value of the invoice. The use of this facility can be withheld from a buyer (ie will not be disclosed to the buyer), in which case it is known as a ‘confidential invoice discounting facility’. The seller remains responsible for managing the sales ledger by: u sending original invoices to the buyer; u monitoring receipt of funds; u chasing late payments. On receipt of payment, the seller pays what is due to the discounter of the invoice, plus charges and interest, and retains the balance. In practice, where there is a constant stream of new invoices to discount and inflows of payments from buyers, the discounter advances, say, 80 per cent of the total acceptable invoices outstanding. Therefore, if the total of unpaid invoices outstanding falls during a monthly period, a repayment will be made to the discounter. But in months when the outstanding invoices increase, as more new invoices are issued than settled, 80 per cent of the increase will be advanced to the seller. Interest is charged on the outstanding balance, and a monthly administration fee is payable by the seller, which is usually a percentage of turnover. One of the advantages of an invoice discounting facility over a factoring facility is that the seller can be selective on the invoices that it sends to the invoice discounting company to discount. The lender providing an invoice discounting service will have to consider whether: u the seller can be relied upon honestly and promptly to account for payments received; u the seller’s credit control and sales ledger departments have the necessary experience and systems in place; u the buyers are known to be bad risks or based in a country from which obtaining payment is difficult.

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Where invoice discounting is offered on a ‘without recourse’ basis, the last point above will be of even higher concern to the discounter. A ‘without recourse’ service is one where the discounter accepts the credit risk: the risk of non-payment of the invoice by the buyer. Sellers have a choice of with or without recourse discounting services, with a fee structure that reflects the difference in risk to the discounter. The discounter will levy an additional credit protection fee for ‘without recourse’ facilities. Most invoice discounting is provided to companies with an annual export turnover of more than GBP500,000 and to companies trading with the EU, the European Free Trade Association (EFTA), North America and Australasia. The facility is not always appropriate for developing countries.

9.4.2.2

Factoring

A factoring service is provided by a specialist factoring company and is similar to invoice discounting, except that the whole of the administration and credit control of the sales ledger is taken over by the factoring company. For this reason, the provision of this facility is known to the buyer. A seller and a factoring company will need to agree precisely what services are required and will be offered by the factor, taking account of the following considerations: u Whether the seller’s international and domestic sales turnover are of a sufficient and appropriate level for a factoring facility to be established. What is considered sufficient may differ between different factoring companies. u Whether the seller is prepared to pass the entire sales ledger to the factoring company, as the factoring company will not want to take only the less creditworthy business. u The spread of the seller’s business; too much concentration on one buyer, eg more than 30 per cent of turnover, will make the seller’s business unsuitable for factoring. u Whether the seller has a good track record as a reliable business and does not have a poor history of bad debts, eg customers who have failed to pay. u Whether the seller requires a ‘with recourse’ or ‘without recourse’ service. For the seller, there are a number of advantages in working with a factoring company: u Factors are expert at collecting and chasing up unpaid invoices, with excellent credit control systems that might be costly for the seller to 166

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provide for itself. Businesses that are not large (or are not part of a large group) may find factoring to be very cost-effective. u Financing the working capital needs of the trade cycle will be straightforward. Cash flow is more predictable, because of the immediate advance against invoices. u ‘Without recourse’ factoring provides a guarantee against bad debts, because: − factors can run credit checks on potential buyers / debtors via their computerised credit reference systems; − factors can provide assistance with the resolution of disputes; − the cash advance against the invoice means that there is a shorter period when the exchange risk can apply − the shorter the period, the lower the risk; − there is a saving on sales ledger administration costs. But factoring does have some disadvantages too: u Book debts in the hands of the factor reduce the net assets of the business, which may make the bank reduce the overdraft facility, especially if the net asset value of the business was a consideration when granting a facility. In other words, you can only lend against the debtors once. u A factor whose service standards are poor, particularly where this impacts on the seller’s customers, can impact adversely on the commercial relationship between seller and buyer. u The factor will not be able to deal with queries about the underlying goods or services supplied without reference back to the seller. Once an agreement is reached to proceed, the process for making use of the service will be as follows: u The seller raises an invoice on the buyer, with a copy to the factoring company. u The buyer is instructed to settle the invoice to the factoring company. u An agreed percentage of the invoice value, eg 85 per cent, is then paid by the factoring company to the seller. u The factoring company then enters the details onto its credit control system, and sends out statements or chases for payment as required. u Once the invoice is paid, the balance due of 15 per cent is paid by the factoring company to the seller, less fees and interest charges. © The London Institute of Banking & Finance 2016

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Visit your local bank or access its website. Make a note of the minimum turnover that must apply before the bank will agree a factoring or invoice discounting facility. If you cannot access your local bank, read: HSBC (no date) Export invoice finance [online]. Available at: http://www. business.hsbc.uk/en-gb/finance-and-borrowing/receivables-finance/ export-invoice-finance [Accessed: 10 August 2016].

9.5

Supply chain finance

Supply chain finance is similar in concept to factoring or invoice discounting. In a typical supply chain finance arrangement, a creditworthy buyer (for example Tesco in the UK or Volvo in Sweden) allows its suppliers to access their invoices on an internet platform and obtain a formal confirmation that the invoice has been approved. Having the formal confirmation will enable the seller’s bank to make an immediate advance to the seller, knowing that the invoice has been agreed and hence payment will be forthcoming. The advance will be charged at a lower rate of interest, based on the creditworthiness of the buyer, which in the case of buyers such as Tesco or Volvo will almost certainly be very beneficial to the seller. In addition, the buyer can also benefit. By providing the confirmation of the invoice acceptance, the buyer enables the supplier to obtain cheap finance early in the transaction. Thus, the buyer may, in exchange, expect to be allowed a longer period of credit. Thus, both buyer and seller improve their working capital and the banks earn interest from low-risk lending. The words ‘win-win’ could be used to describe supply chain finance. Supply chain finance, and in particular the bank payment obligation (BPO), are discussed in Topic 15.

Visit your local bank branch or access its website. List the additional benefits that supply chain finance brings to both buyer and seller over and above those shown in section 9.5 above. 168

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If you cannot access a local bank, visit: Barclays (2016) Supplier finance [online]. Available at: www.barclayscorporate.com/products-and-solutions/financing/ supplier-finance.html [Accessed: 10 August 2016].

9.6

Bills of exchange (drafts)

Drafts can be negotiated or discounted, as described in section 9.6.2 below. However, finance can also be provided against their ‘avalisation’ (see section 7.3). When a seller supplies on a documentary acceptance basis, the documents will be released to the buyer against acceptance of a draft. This will then enable the buyer to collect the goods. An ‘aval’ or ‘pour aval’ is when the buyer’s bank also endorses (accepts) the draft, adding their guarantee. This means that if the buyer fails to pay on the due date, the bank will be liable to honour the draft. The buyer would require a facility for this service, as it creates a contingent liability. The benefit to the seller, in addition to the removal of counterparty buyer risk, is that they could obtain finance against the accepted and avalised draft. Avalisation is not always available. The prior agreement of the buyer’s bank should be obtained and that bank will wish to consider the creditworthiness and importance of its customer. In addition, each bank may have minimum amounts below which they will not avalise. However, where the facility is available, the interest rate or discount rate will be based on the creditworthiness of the buyer’s bank as opposed to the creditworthiness of the seller.

9.6.1 Negotiation of a documentary collection Negotiation is the purchase of drafts and / or documents by the bank from the seller. The bank will then collect the proceeds in its own name. The seller would send its documents and draft to its bank but, instead of signing a collection instruction, it would sign a negotiation request. The decision to negotiate would be made by the bank like any other lending decision. Once agreed, the bank would immediately credit the customer’s account with the full value of the draft and would debit a negotiation account. The seller’s bank would send the collection as usual to the collecting bank. When the collection is paid, the bank will repay its negotiation account with the proceeds and calculate interest, which will be debited to the seller’s account. © The London Institute of Banking & Finance 2016

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If the draft is dishonoured, the seller’s bank has rights against: u the seller, as negotiation is ‘with recourse’; u the drawee, provided they have accepted the draft; u the goods, provided they have not been released to the buyer. Banks may advance less than the face value when the seller does not need to borrow the full amount, or when the seller’s bank does not wish to lend the full face value.

9.6.2 Acceptance credits Acceptance credits are documentary credits where the beneficiary draws a draft on the bank nominated to accept it. The issuing bank will have indicated in the documentary credit that the draft is to be drawn on the nominated bank and that the credit was available with the nominated bank by acceptance. If the presentation of documents is compliant, the draft drawn on the nominated bank may be returned to the beneficiary, bearing that bank’s acceptance. With such an accepted draft in its hands, the beneficiary can easily raise finance by discounting the bill, either with the nominated bank or any other bank that is willing to discount the draft. There may be a separate ‘acceptance credit’ facility arranged with the beneficiary’s bank, and that bank will agree to discount drafts accepted by approved banks. The rate of discount will be based on the creditworthiness of the accepting bank, as opposed to the creditworthiness of the customer. The credit facility will allow discounting of approved drafts up to a stated maximum maturity. This period could be anything from 30 days to 180 days, depending on the creditworthiness of the acceptor and the integrity of the customer.

9.7

Documentary credits

9.7.1 Negotiation of drafts and/or documents drawn under documentary credits We have already defined negotiation as the purchase of drafts and / or documents. In documentary credits, the drafts and / or documents can be negotiated by the nominated bank, when the presentation complies with the 170

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terms and conditions of the documentary credit (see Topic 8). By negotiating, the nominated bank is advancing − or agreeing to advance − funds to the beneficiary in anticipation of being reimbursed by the issuing bank. The issuing bank’s undertaking is to pay drafts and / or documents drawn and / or presented by the beneficiary and to honour against compliant documents. Negotiation by the nominated bank is usually ‘with recourse’ to the beneficiary. If funds are not forthcoming from the issuing bank, the nominated bank will claim the funds back from the beneficiary. However, a confirming bank will negotiate on a ‘without recourse’ basis, since it has given its own undertaking that it will negotiate, if the documents conform to the terms and conditions of the credit. The beneficiary will receive a sum less than the face value of the draft drawn or documents presented, representing interest costs for the period between the date of the nominated bank’s payment and its receipt of funds from the issuing bank.

9.7.2 Assignment of proceeds under a documentary credit Assignment of proceeds under a documentary credit is a form of pre-shipment finance that can be offered to the seller’s local suppliers. The seller’s bank would issue a ‘letter of comfort’ to the supplier, indicating that: u the seller is the beneficiary of a documentary credit; u the bank is authorised to pay to the supplier a specified sum of money from the proceeds of the credit when they are received. The letter of comfort can then be used by the supplier to raise finance from its own bank. Under an assignment, there is no undertaking given by a bank, and any payment will only be made if the documents are presented to the bank to which the assignment notice was given. The supplier carries the risk that its goods will be taken by the seller but not paid for.

9.7.3 ‘Red clause’ and ‘green clause’ credits A ‘red clause’ credit contains a request from the issuing bank to the negotiating bank to advance a portion of the credit value to the seller, to © The London Institute of Banking & Finance 2016

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enable it to purchase goods for shipment, to pay for manufacturing costs, etc. A ‘green clause’ credit is less valuable to the exporter, because it requires evidence that the goods are warehoused. Please see section 8.4.3 for full details of these facilities.

9.7.4 Produce loans for importers Nowadays it is common for banks to provide their importing customers with finance in the form of a short-term loan. The suppliers are paid when the drafts − or letters of credit − are due, and the term will usually be for between at sight and 180 days, which will cover the average stockholding period for the individual customer. Many of these loans are secured against a charge on the assets of the company or guarantees from the directors. However, many trade finance houses and some banks will still offer a stock facility, which provides finance to the importer with the underlying goods being held as security. This is sometimes referred to as a ‘produce loan’, an ‘import loan’ or a ‘warehousing loan’. Produce loans work in various ways, and a typical example is outlined below.

9.7.4.1

Example of a produce loan

Suppose a buyer buys goods on D/P collection terms for resale to a third party in the same country. Let us also assume that the buyer requires finance to bridge the gap between payment of the sight draft and receipt of funds from the ultimate buyer. In such cases, a produce loan (also known as a ‘warehousing loan’) facility can enable the buyer’s bank to advance funds against the security of goods and / or their sale proceeds. The procedure is as follows: 1. The bank must be satisfied that the supplier of the goods is competent and reputable, that the goods are of sound quality, and that the ultimate buyer is creditworthy. Depending on its knowledge of the parties involved, the bank may undertake credit checks and could possibly require a third-party inspection certificate covering the goods. In addition,

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the goods must be readily saleable, should the ultimate buyer not accept them. 2. The bank then pays the draft in accordance with the instructions on the collection order against a signed letter of pledge, which states that the documents and / or goods are pledged as security to the bank. 3. The bank credits the customer’s current account with the agreed amount of the advance and makes a corresponding debit entry on a produce loan account in the customer’s name. 4. In accordance with the authority on the letter of pledge, the bank will arrange with its agents to have the goods warehoused in the bank’s name. 5. The agent will arrange to insure the goods, and the cost will be charged to the customer. 6. The goods remain in the warehouse until due for delivery to the ultimate buyer. When that time comes, the customer must sign a ‘trust receipt’. The bank will then issue a delivery order to enable the customer to obtain the goods and take them to the ultimate buyer. The trust receipt states that the customer holds the goods as trustee for the bank. Under the terms of a trust receipt, a customer will generally be required to agree that: u the bank has released the documents in trust to the customer; u the goods remain pledged to the bank and the customer holds the goods as trustee of the bank; u the goods or their sale proceeds or any insurance proceeds are to be held in trust for the bank; u the goods will not be pledged elsewhere; u the customer will be liable to pay all costs of insurance; u in the event of any default by the customer, the trust becomes invalid and the bank can demand to repossess the goods or any documents of title. 7. The bank has now lost physical control of the goods and relies on the customer to deliver them to the ultimate buyer. 8. The ultimate buyer pays directly to the bank and the proceeds are used to clear the produce loan, including interest and charges. Obviously all parties must be reputable and trustworthy for the procedure to be acceptable to the lending bank. © The London Institute of Banking & Finance 2016

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9.7.5 Commercial paper issues by large companies Some very large companies can raise short-term funds by the issue of commercial paper direct to investors. Commercial paper, issued in the form of a promissory note, is discounted with investors. Such paper is traded and therefore provides a liquid investment for the investors. Commercial paper facilities are available, for creditworthy companies, for all types of business, not just for import / export trade.

9.8

Introduction to medium- to longterm trade finance

Medium- and long-term finance will generally be used to finance capital goods and services. While there is no hard and fast rule, lending over one to five years would normally be considered medium term and more than five years would be considered long term. Many of the supporting financial products have been created by government bodies to enable sellers from that country to offer credit terms to the buyer. Such support allows banks to finance buyers who would otherwise be unable to obtain financing in their domestic country, either due to the size of the transaction or the associated risk of long-term projects. Each country’s medium- to long-term finance products will differ. However, in general terms, the majority of developed countries offer buyer and supplier credit lines from a government-backed body. Examples of such government or quasi-government departments are listed in the further resources at the end of this chapter. There are various international agreements, usually agreed via the Organisation for Economic Co-operation and Development (OECD), to cover government-supported assistance. Government bodies that provide support, for example Austrade or Coface, will need to be satisfied that appropriate standards apply before they become involved in any support for sellers. Thus the government body will need to review a project against appropriate international standards dealing with environmental issues or social and human rights impacts. Essentially, the government body providing the financial support must be satisfied that any lending involved will represent sustainable debt for the country concerned and that the anti-bribery and corruption procedures have been complied with. 174

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There will also be international agreements that must be complied with.

For an illustration of EU regulation, read: Croucher, S. (2013) EU law blocking ‘urgent’ finance help for UK exporters. International Business Times [online], 12 April 2013. Available at: www.ibtimes.co.uk/articles/456385/20130412/uk-exportfinance-eu-state-aid-law.htm [Accessed: 10 August 2016]. Reflect: is there any similar situation regarding your own country’s exports, where externally imposed regulation may prohibit your government from providing the assistance that it wishes to provide?

9.9

Supplier and buyer credit

Supplier credit applies when the exporter’s bank lends the money direct to the seller. It is a form of post-shipment finance. Buyer credit is where the seller’s bank makes money available for the buyer to pay the seller. It can be in the form of a direct loan to the buyer or a loan via an intermediary organisation in the buyer’s country. This type of finance is usually without recourse to the seller, as it is the buyer that borrows the money. The seller also avoids the need to pay interest, as the loan is made to the buyer. Buyer credit facilities benefit both parties to the transaction: the seller receives cash on delivery or acceptance of the goods or service; and the buyer has affordable medium- or long-term finance that may not have been readily available in its own country. Most banks will have specialist departments dealing with medium- to long-term finance. Providing medium- and long-term finance for exports is very risky, because of the buyer, political or country risks. Hence, such finance is usually supported by long-term insurance and / or guarantees that are mainly provided by government agencies such as the ones listed in the further resources at the end of this chapter. In effect, this means that although it is the seller’s bank that lends the money, they have the comfort that a government agency will ‘insure’ or guarantee the debt in the event of default. © The London Institute of Banking & Finance 2016

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9.9.1 General features of a supplier credit finance facility Obviously, each country will have its own individual approach, but the following features of a supplier credit finance facility generally apply: u There would be a minimum contract size for eligibility. u There would be a minimum and maximum time period for the facility. u The seller would liaise with the government agency and their bank to agree the facility in the early stages of the transaction. u The bank providing the finance would be protected by a guarantee in the event that the loan is not paid at maturity. The guarantee may be for the full amount, but could be for less, depending on the country concerned. u Finance, possibly for up to 85 per cent of the contract value, can be provided in several internationally traded currencies and at a favourable fixed interest rate. u Funds will be made available by a bank that has been involved in arranging a facility with the government agency on the seller’s behalf and will be forthcoming when the exporter produces: − bills of exchange or promissory notes with an ‘aval’ or guarantee; − evidence of performance under the contract; − the bank’s facility letter, duly signed.

9.9.2 General features of a buyer credit finance facility Again, each country will have its own individual approach, but the following features of a buyer credit finance facility generally apply: u There would be a minimum contract size for eligibility. u There would be a minimum and maximum time period for the facility. u The seller would liaise with the government agency and their bank to agree the facility in the early stages of the transaction. u The seller is paid as if a 100 per cent cash contract had been agreed: − a percentage from the buyer − typically 15 per cent; − a percentage from the buyer credit facility, typically 85 per cent. 176

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u The buyer has time to pay the 85 per cent by borrowing at fixed or floating rates of interest. u The funds can be made available to a bank in the buyer’s country.

9.9.3 Documents required in supplier and buyer credit finance facilities In both supplier and buyer credit facilities, there are usually a number of documents that need to be completed. In addition to the contract, the following documents are usually required, depending on the facility being offered: u a premium agreement − whereby the exporter agrees to pay a premium to the underpinning government agency; u a support agreement − this is the government agency’s guarantee to the lending bank for principal and interest; guarantees may be for 100 per cent of the loan value or for a lower percentage when a lower premium will be offered; u a loan agreement − between the lending bank and the buyer, setting out the terms of repayment and any preconditions, including the initial 15 per cent payment to the exporter; u a qualifying certificate − as the seller fulfils the contract, usually in stages for large contracts, a qualifying certificate, usually signed by the buyer, is presented to the bank by the exporter. Once these formalities are completed, the seller receives a cash payment for all or part of the goods or work delivered. Large facilities may be arranged by a consortium of banks where one takes the lead − the ‘lead manager’ − and acts as agent for the other lenders, including receiving payments and disbursing funds to the other members of the consortium.

9.9.4 Lines of credit Lines of credit are facilities that enable the seller to finance its overseas buyers. How they operate will vary from country to country, but the following examples are typical. From a seller’s point of view, lines of credit operate in a similar way to buyer credit. The lines of credit cover loans to buyers, to enable them to pay on cash terms for exports of capital goods and associated services © The London Institute of Banking & Finance 2016

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from the seller’s country. The basic difference from the individual seller’s point of view, is that the minimum contract value (although varying with different lines of credit) can be as low as USD40,000 or currency equivalent, as opposed to the usual USD7.5m minimum contract value of a buyer credit. A variation is the project lines of credit. These are useful for major projects, in which a number of suppliers in the same country are nominated by the overseas buyer to provide goods and services. The financing entity will guarantee a loan from the seller’s bank to the overseas buyer or procurement agent. The buyer can split up the loan, using it to pay various suppliers in the seller’s country on individual contracts that may be worth as little as USD40,000 or currency equivalent. The total amount lent to the overseas buyer will normally exceed USD5m, but, as already shown, this sum can be divided to cover individual contracts of USD40,000 or equivalent minimum, with credit periods of one to five years.

Visit the website of the government agency that applies to your own country (see the further resources at the end of this chapter for a list of some of these agencies). List the main criteria that must apply for these agencies to provide buyer or supplier credit facilities.

9.10

Forfaiting (structured trade finance)

The word ‘forfaiting’ derives from a French term ‘à forfait’, meaning ‘fixed price’, and is a method used for financing the trade receivables of sellers. It has been developed to provide medium-term finance (up to ten years) at fixed interest rates for construction projects or the sale of capital goods. Today, its use has been extended to include shorter terms (but more than six months) and for a wider range of sales. The principal element of an ‘à forfait’ facility is that the seller, holding a series of drafts accepted by the buyer or a bank, or promissory notes issued by the buyer, can discount these on a ‘without recourse’ basis with a forfaiter or the forfaiting arm of a bank, ‘without recourse’ being an essential element of ‘à forfait’ arrangements. The forfaiting bank is therefore taking on the seller’s non-payment risk.

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Unless the acceptor of a draft or drawer of the promissory note is of undoubted international credit standing, a guarantee of the buyer’s obligations will be required by the bank or forfaiter providing the facility. This can be in the form of: u a standby letter of credit issued on the buyer’s behalf; u a bank guarantee; u an ‘aval’ placed on the draft or promissory note. An ‘aval’ amounts to a guarantee by the organisation endorsing the draft or promissory note that it will be paid. Where the term ‘aval’ is not recognised or not legal, a separate standby letter of credit or guarantee may be used as security. Forfaiting facilities are arranged in advance between the parties to the contract and the bank or forfaiter, and a commitment letter is drawn up. The structure can be quite flexible: u The term can be anything up to ten years and repayment made by a series of drafts or promissory notes payable at regular intervals − quarterly is typical. u Traditionally this method of finance has been at fixed rates of interest. This suits the mechanism of discounting a draft or promissory note, where the holder receives the face value, less an interest charge. However, it is possible to structure floating-rate arrangements. u The interest charge is normally incorporated into the draft. By issuing a draft or promissory note with a face value that represents the sales price plus an amount of interest at a rate of interest agreed in advance between the buyer and seller, the buyer pays the interest cost. But the drafts or promissory notes could be issued without interest, in which case the seller carries the interest cost when they receive the face value, less the discount costs. Once the drafts or promissory notes have been discounted for the seller and it has been paid, the bank or forfaiter can either hold the drafts or promissory notes until maturity and collect payment from the drawer, or it can sell the drafts or promissory notes on the ‘secondary market’ to refinance itself. The ultimate holder will then present the drafts or promissory notes at maturity to the accepting party and collect payment.

9.10.1 The benefits to the seller of forfaiting u The documentation can be set up in a matter of hours, whereas buyer credit facilities, for example, can take up to three months to arrange. In © The London Institute of Banking & Finance 2016

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suitable cases, the forfait facility can cover the full amount of the contract price. u The rate of discount applied by the bank or forfaiter is usually fixed, and subsequent changes in the general level of interest rates do not affect the discount. u The finance is without recourse, so there is no need for any contingent liability on the seller’s balance sheet. Forfaiting does not affect any other facilities, eg an overdraft. u All exchange risk, buyer risk and country risk are removed. u The seller receives cash in full at the outset. u The finance costs can be passed on to the buyer, if the seller is in a strong bargaining position. u Administration and collection problems are eliminated.

9.10.2 The disadvantages of forfaiting u Costs can be high, and there is no interest rate subsidy. u It may be difficult to find an institution that will be prepared to guarantee the buyer’s liabilities. The guarantor institution might charge a high commitment fee, unless the buyer is considered to be totally creditworthy.

9.10.3 Uniform Rules for Forfaiting (URF 800) The International Chamber of Commerce’s (ICC’s) Uniform Rules for Forfaiting (ICC, 2012a) − known as ‘URF 800’ − came into effect on 1 January 2013, providing a set of rules for the sale of instruments used for financing trade, which include bills of exchange, promissory notes, documentary credits and invoice purchases as well as some newer instruments. To quote the ICC: ‘The newly-adopted forfaiting rules are the latest example of ICC’s leadership in writing rules that govern international trade and investment and highlight the crucial role forfaiting plays in securing financing for exporters and importers.’ (ICC, 2012b)

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URF 800 does not change the nature of the payment claim being originated or on-traded and, as such, can be used alongside the full and ever-expanding range of instruments used to finance trade. Below is a summary of the articles.

Article 1 The Uniform Rules for Forfaiting (URF) are rules that apply to a forfaiting transaction when the parties expressly indicate that their agreement is subject to these rules. They are ‘binding on all parties thereto except so far as modified or excluded by agreement’.

Articles 2 and 3 Articles 2 and 3 define the various terms and interpretations that appear in the URF, for example helpful guidance such as: ‘where applicable, words in the singular include the plural and in the plural include the singular’.

Article 4 This article covers the ‘without recourse’ position. Normally the party purchasing the forfaiting instrument will do so without recourse, except under specific circumstances defined in article 13b − usually where bad faith applies.

Article 5 Article 5 recommends what the forfaiting agreement should contain: u details of the payment claim and any credit support documents, including the amount, currency, due date and obligors; u a list of the required documents known by the parties at the date of the forfaiting agreement; u the availability date; u the purchase price; u the settlement date or an anticipated settlement date; u its governing law and jurisdiction provisions.

Article 6 This article sets out the position if the terms of the forfaiting agreement are not fulfilled on or before the availability date.

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Article 7 Article 7 covers the criteria that can be used to decide whether any documentation that is submitted is satisfactory. In making its determination, the primary forfaiter is entitled to take into account, without limitation, whether: u the required documents are supported by satisfactory evidence as to their authenticity; u each of the payment claims and the obligations in any credit support document is a legal, valid, binding and enforceable obligation of the relevant obligor; u the payment claim and the rights under the credit support documents are freely transferable; u the required documents conform with the terms of the forfaiting agreement.

Articles 8 and 9 Articles 8 and 9 relate to forfaiting confirmations and to conditions in the secondary market.

Article 10 Article 10 ‘relates to the responsibilities of the seller and buyer in determining satisfactory documents in the secondary market’.

Article 11 Article 11 relates to payment: u The buyer must pay the purchase price to the seller on the settlement date. u Payment must be made in the currency specified in the forfaiting agreement or forfaiting confirmation without deduction or counterclaim. u Payment must be made in immediately available funds at the place stated in the forfaiting agreement or forfaiting confirmation, provided the due date for payment is a business day in that place. If the due date for a payment is not a business day, payment must be made on the first business day in that place after its due date.

Article 12

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Leasing and hire purchase

This article covers payment under reserve: u The buyer must pay the purchase price to the seller on the settlement date. u Payment must be made in the currency specified in the forfaiting agreement or forfaiting confirmation without deduction or counterclaim. u Payment must be made in immediately available funds at the place stated in the forfaiting agreement or forfaiting confirmation, provided the due date for payment is a business day in that place. If the due date for a payment is not a business day, payment must be made on the first business day in that place after its due date.

Article 13 Article 13 covers the liabilities of the parties under a forfaiting agreement.

Article 14 Article 14 covers the technicalities that need to be fulfilled in order for any notice to be considered valid and effectively delivered.

9.11

Leasing and hire purchase

Leasing of goods that are exported operates in much the same way as the leasing of goods traded within the domestic market. The leasing company (the ‘lessor’) buys the goods outright from the supplier and then leases them to the ultimate buyer, who has the use of the goods for an agreed period, subject to payment of the agreed rent to the lessor. There are various taxation complexities in connection with leasing, but these are not included in this syllabus. The system can work in one of two ways: 1. by arranging for a lessor in the seller’s country to buy the goods and to lease them to the overseas buyer − known as ‘cross-border leasing’; 2. by arranging for a lessor in the buyer’s country to act. Most banks have subsidiary or associate leasing companies that can provide cross-border leasing facilities. These companies are also able to arrange for overseas lessors to act, where appropriate. The benefit to the seller is that the sale is, in effect, a cash sale and that there is no recourse, unless it has defaulted on its commercial contracts. Most forms of plant and machinery, vehicles or office equipment can be leased. © The London Institute of Banking & Finance 2016

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Hire purchase performs a similar function to leasing, but the buyer may be required to pay a deposit from its own resources. Once again, the legal differences between leasing and hire purchase are outside the scope of this syllabus.

9.12

Counter-trade

‘Counter-trade’ is a term used to describe a variety of trade contracts that, at least to some extent, involve an agreement by the seller to reciprocate by taking in exchange goods or services from the buyer. It is hard to find reliable statistics showing how important this trade may be, but some estimates put the total value of various forms of counter-trade at around 9 per cent of total world trade. Counter-trade is certainly an important element of trade with some developing countries and transition economies. The World Trade Organization includes counter-trade in its list of ‘non-tariff barriers’ to trade. (Non-tariff barriers are measures designed to restrict imports by imposing special rules, regulations and quantitative restrictions.) The various forms of counter-trade are outlined in sections 9.12.1 to 9.12.4 below.

9.12.1 Barter Barter agreements are the simplest and most basic form of counter-trade. One contract is drawn up, setting out what will be exchanged for what and giving the terms of the exchange. Cash is not involved unless there is a balancing sum required. The main difficulty for the seller is the disposal of what they have agreed to take in exchange for what has been sold. For example, a manufacturer of water purification equipment might be expected by a poor agricultural country to sell an agricultural commodity of which the seller has no knowledge or experience. Such a seller may have to involve the services of a third party, who can dispose of the agricultural products at a reasonable price on the seller’s behalf. Pure barter transactions are not common.

9.12.2 Counter-purchase Counter-purchase is a more sophisticated form of barter. Two separate contracts are involved: one for the sale and one for the counter-purchase. 184

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Counter-trade

The seller may agree to counter-purchase anything between 9 per cent and the full value of what has been sold. The original sale goes forward in the normal way, with payment for the goods supplied. The seller’s counter-purchase contract may be binding, or on a ‘best-efforts’ basis. A third party with the expertise to market and sell what the importing country has to offer may be involved. A transaction may involve the parties and stages outlined in Figure 9.1. Figure 9.1

Counter-purchase transactions

9.12.3 Buyback Buyback agreements involve the supplier agreeing to take back a percentage of what has been produced. For example, a supplier of a tyre-making plant might agree to buy a certain percentage of the output. Again, the contractor may have to involve a third party that is able to dispose of the tyres for a good price.

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9.12.4 Off-set This method is often used where a transfer of technology is involved. The seller agrees to incorporate into the end product components or partly manufactured goods made by the buyer to off-set the full cost of the technology transfer to the buyer.

9.12.5 Advantages and disadvantages of counter-trade For most sellers, counter-trade has no real advantages over a straightforward payment for goods or services supplied. However, a seller that can offer a contract based on counter-trade will have a competitive advantage in some countries. For buyers based in some developing countries there are advantages: u Counter-trade is a form of finance where the buyer makes a deferred payment by the supply of counter-trade goods at a local currency cost. u For the buyer’s country, counter-trade enables the central bank to conserve scarce hard currency. u The buyer’s country has an opportunity to market its products in the wider world with the assistance of the seller or an expert acting for the seller. However, these benefits can be more apparent than real: u The seller’s additional costs will have to be recovered from the transaction through higher prices for what is supplied and / or lower prices for the goods taken in counter-trade. u The complexity of these transactions often results in lengthy negotiations and deals that in the end do not proceed. Some banks specialise in providing counter-trade expertise to their customers and become involved in helping to negotiate deals, finding businesses that can take counter-trade goods and providing the normal banking services of documentary credits, foreign exchange, payments and accounts in various currencies. Banks may also be asked to hold ‘escrow’ accounts where funds can be held on behalf of all parties to a transaction. For example, in Figure 9.1 above, a bank may be asked to hold part of the money paid for the machinery by the buyer until the seller carries out the obligation to purchase corn. Finance

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Chapter summary

may also be required: the manufacturer in Figure 9.1 may have to wait to be paid by the trader.

Chapter summary This chapter has been about financing the ‘trade cycle’, the time gap between paying for supplies and labour and receiving payment. Working capital is required to finance this gap. u International trade may have an extended trade cycle. u Banks can provide various types of finances that are in addition to businesses’ regular sources of working capital, by relating finance to trade transactions and the security that can be taken over the goods involved. Debtor finance can be provided in the form of invoice discounting and factoring. u There are special government-backed forms of medium- and long-term finance for capital goods. u Letters of credit and drafts provide finance opportunities to both sellers and buyers. u Counter-trade comes in various forms − from simple barter to counter-purchase agreements where the seller agrees to buy a certain amount of goods from the buyer’s country. u Another version of counter-trade is ‘buyback’, where the seller agrees to take back some of the products of the machinery or equipment that has been supplied. u The advantages to importers in developing countries with limited amounts of hard currency include minimising the use of hard currency, and getting sellers or traders employed by them to market goods on world markets.

Further resources Government and quasi-government departments providing assistance with international trade (all websites accessed 10 August 2016): u Australia − Austrade (www.austrade.gov.au/export-assistance) u France − Coface (www.coface.com/) u Germany − Germany Trade & Invest (www.gtai.de/GTAI/Navigation/EN/Meta/about-us.html) © The London Institute of Banking & Finance 2016

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u Republic of Korea − The Export-Import Bank of Korea (www.koreaexim.go.kr/en/) u South Africa − Department of Trade and Industry (www.southafrica.info/business/trade/export/incentives.htm) u UK − UK Trade & Investment (www.gov.uk/government/organisations/uk-trade-investment) u USA − US Small Business Administration (SBA), Department of Commerce (www.sba.gov/content/us-exports-assistance-centers)

References ICC (2012a) Uniform rules for forfaiting. ICC Publication No. 800E. ICC (2012b) ICC unveils new rules for forfaiting [online]. Available at: www.iccwbo.org/News/Articles/2012/ICC-unveils-new-rules-for-forfaiting/ [Accessed: 10 August 2016].

Review questions The following review questions are designed so that you can check your understanding of this chapter. The answers to the questions are provided at the end of these learning materials.

1.

2.

Which of the following is a simple banking product that is not specifically export related, but which can provide flexible short-term finance to creditworthy small firms that are new to exporting? a. Barter.

b. Acceptance credit.

c. Produce loan.

d. Overdraft.

A bank has granted a produce loan to a buyer and the relevant goods are currently warehoused in the bank’s name. The buyer now wishes to obtain possession of the goods, so they can be delivered to the ultimate buyer. The lending bank is happy to follow the normal procedures at this stage. Name:

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a. the document that the buyer will be required to sign and which the bank will retain; b. the document that the bank will give to the customer in order to allow him to obtain possession of the goods from the warehouse.

3.

Factoring is an appropriate form of post-shipment finance for an exporter who sells on documentary credit terms. True or false?

4.

Name a form of finance for open account transactions that can allow sellers to obtain relatively cheap post-shipment finance and at the same time allow buyers to insist on longer periods of credit.

5.

A seller’s bank is asked to negotiate a documentary collection. From the bank’s point of view, a ‘documents against payment’ collection is less risky than a ‘documents against acceptance’ collection. True or false?

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Chapter 10

Islamic trade finance

Learning objectives By the end of this chapter, you should have an understanding of: u the core principles of Islamic finance; u the structures of Islamic trade finance.

We will begin this chapter by outlining the background to Islamic finance and how it fits in with the Islamic faith. We will also provide an overview of the core principles of Islamic finance and the structures commonly used today, before we move on to discuss Islamic trade finance.

10.1

The growing significance of Islamic finance

Islamic finance is a growing part of the international financial system, with assets worth USD2tr at the end of 2014. While demand comes primarily from the world’s Muslim economies, Islamic finance is not restricted to the Middle East and the Far East alone − its reach is global. In London, Islamic finance has helped to transform the city’s skyline, by financing, in whole or in part, developments such as The Shard, Chelsea Barracks, Harrods and the Olympic Village. On the retail banking side, there is also growing demand from non-Muslim contingents; for example, a quarter of Malaysian Islamic finance customers are not Muslim. Ethical investors too are attracted by the emphasis in Islamic finance on justice and on the promotion of publicly beneficial activity and services. © The London Institute of Banking & Finance 2016

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With an estimated annual growth rate of 10−15 per cent, Islamic finance is likely to become an increasingly important financial market in the future. Industry forecasts estimate that Islamic investments might be worth nearly US$2.5tr by the end of 2015 (Dar, 2014). Such significant growth potential is underpinned by the fact that 10 of the world’s 25 fastest-growing markets are in Muslim-majority countries. An increasingly confident Muslim population and a growing middle class are also contributory factors. In the West, its growth has mainly been driven by institutions seeking to benefit from the immense liquidity and the ‘petrodollars’ of the Middle Eastern individuals and institutions who demand such products.

10.2

How Islamic finance fits within Islam − a brief introduction

The central belief around which all the Islamic concepts revolve is that the whole universe and everything therein is created and controlled by One, the only One God. He has created humans to fulfil certain objectives through obeying His commands. These commands cover a wide range of every aspect of the human life − including finance. However, these commands are not so prescriptive that they leave no role for the human intellect, nor are they so vague that they leave every aspect of the human life to the individual’s desires. Rather, the commands strike a fine balance between these two extremes: on the one hand, Islam has left a very wide area of human activities to the individual’s own rational judgement; on the other, Islam has subjected human activities to a set of principles that have eternal application. The raison d’être for this is simple. Despite the vast capabilities of human reason, it cannot claim to have unlimited power to reach the truth. There are numerous spheres of human life where ‘reason’ is confused with ‘desires’ and where unhealthy instincts can take − and have taken − precedence. For instance, in the area of economics, in conventional finance, the profit motive, by and large, drives economic decisions. In Islam, economic activities are controlled by divine injunctions. An overarching characteristic of Islamic finance is that it is an asset-backed type of financing. Apart from some special cases, Islam does not recognise money as a commodity to be traded. Money has no intrinsic utility; it is merely a medium of exchange − each unit of money is 100 per cent equal to another unit of the same currency, therefore there is no room for making profit through the exchange of these units. Profit is generated when something that has intrinsic utility is sold for money or when different currencies are exchanged.

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Core principles

Consequently, financing in an Islamic system is always matched with corresponding goods and services, and creates real assets. This is in stark contrast with conventional finance, which does not necessarily create real assets − the supply of money through the loans advanced by financial institutions does not normally match with the real goods and services produced in society: loans create artificial money through which the money supply is increased, without creating real assets in the same quantity. This gap between the supply of money and the production of real assets creates − or fuels − inflation.

10.2.1 Divine guidelines in Islamic finance By mentioning that Islam does not allow profit-making through the exchange of money for money in the same currency, we have just touched on one of the main divine restrictions in Islam governing finance: u the prohibition of usury and interest (riba). Other divine guidelines in Islamic finance include: u the prevention of excess uncertainty (gharar) in contracts; u the prohibition of speculative transactions (maysir); u the exclusion of investments that are forbidden in Islam (muharramat). We will now have a brief look at each of these core principles.

10.3

Core principles

10.3.1 The prohibition of usury and interest (riba) Riba, or the prohibition of usury and interest (we will refer to ‘usury and interest’ simply as ‘interest’ hereafter) in the Islamic faith, is well known and well documented. The Qur’an, whose words have not changed since its revelation over 1,400 years ago and which Muslims believe will be preserved for eternity and relevant for all times, is the holy book for Muslims, which Muslims believe to be the divine revelation, ie the word of God. In the Qur’an, the prohibition of interest is evidenced by a number of verses. For example, the English translation of the second chapter, Surah al-Baqarah (there are 114 chapters, or ‘Surahs’, in the Qur’an), verse 275, is: © The London Institute of Banking & Finance 2016

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Those who take riba (usury or interest) will not stand but as stands the one whom the demon has driven crazy by his touch. That is because they have said: ‘Trading is but like riba.’ And Allah has permitted trading, and prohibited riba. So, whoever receives an advice from his Lord and stops, he is allowed what has passed, and his matter is up to Allah. And the ones who revert back, those are the people of Fire. There they remain for ever.

10.3.2 Prevention of excess uncertainty (gharar) in contracts Gharar refers to uncertainty that may lead to dispute between contracting parties. It is often defined as ‘unnecessary uncertainty’. In a commercial transaction, such uncertainty may exist as a result of the omission or lack of clear description in contracts. From a Sharia (Islamic law) point of view, any agreement that has a significant element of uncertainty is invalid, regardless of whether the parties have agreed the contract. Scholars generally distinguish between contracts containing minor gharar and major gharar. Minor gharar tends to be seen as valid, while major gharar is generally prohibited. An example of minor gharar would be in a sale of a sack of potatoes, in which it is impossible to know whether each potato in the sack is of consumable quality. As this is minor gharar, the sale of the sack of potatoes is generally permitted. The justifying principle invoked in this instance is the facilitation of ease, along with the absence of any clear inequality in the values of the exchanged items. An example of uncertainty in a financial transaction would be if a person accepts an unspecified amount of money for a specific asset (ie the price is left undetermined), or offers an amount of money for an unspecified asset (ie the asset is left undetermined).

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Structures in Islamic finance

10.3.3 Prohibition of speculative transactions (maysir) Maysir, or speculative transactions, is defined as: u the act of gambling or playing games of chance with the intention of making an easy profit; u the element of speculation in a contract.

10.3.4 Exclusion of investments forbidden in Islam (muharramat) Transactions in the following industries are prohibited: u alcohol; u tobacco; u armaments; u certain sectors of the entertainment industry, including pornography; u gambling; u pork; u conventional finance. The four core principles discussed in section 10.2.1 to section 10.3.4, combined together, have the cumulative effect of maintaining balance and reducing economic disparity, while spurring on economic development.

10.4

Structures in Islamic finance

The ideal instruments of financing in Islamic finance are those based on profit-and-loss sharing concepts, namely musharaka (see section 10.4.1) and mudaraba (a partnership agreement in which one party invests all the capital while the other manages the business). Financing on the basis of these two instruments creates real assets from which profit can be generated. However, where financing on the basis of profit-and-loss sharing is not feasible, financing on the basis of salam (see section 10.4.3) and istina has been suggested by contemporary scholars. (Istina is used to provide a facility for financing the manufacturing or © The London Institute of Banking & Finance 2016

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construction of projects; the contract allows cash payment in advance and future delivery, or future payment and future delivery.) In instances where musharaka, mudaraba, salam or istisna are not workable, then ijara and murabaha are modes of financing that contemporary scholars have permitted. Murabaha is described in section 10.4.4. Ijara is a leasing arrangement in which the known benefit arising from a specified asset is made available over an agreed period, in exchange for an agreed payment. Neither of these are believed to be ideal modes of Islamic financing, as their net result is often the same as the net result of interest-based transactions; they should be used only in cases of need and where the Sharia conditions prescribed for such modes of financing are fully observed. We will describe the Islamic finance structures of musharaka, salam and murabaha below, as these are the structures that are relevant in Islamic trade financing. Grasping the concepts under these structures will be vital to understanding how they are used in Islamic trade finance (see section 10.5). The aim is to give you a good idea of how musharaka, salam and murabaha work; however, a thorough discourse on the structures is outside the scope of this study text.

10.4.1 Musharaka Musharaka, which literally means ‘sharing’, is the ideal mode of Islamic finance. In the context of commerce, it means a joint venture, in which all the partners share in the profit and loss of the joint venture (see Figure 10.1). Consequently, musharaka does not envisage a fixed rate of return, as the return is based on the profit earned by the joint venture. Figure 10.1

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A basic illustration of musharaka

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Structures in Islamic finance

The elementary rules of musharaka are as follows: 1. Profit is distributed among the partners in pre-agreed ratios. 2. The ratio of profit for each partner must be a function of the profit earned by the business, not a function of the capital invested by the partner. For example, if Partner A and Partner B enter into a partnership in which it is agreed that Partner A will get 20 per cent of his investment, the contract would be invalid in Sharia. Similarly, if they agree that Partner A will be given $5,000 per month as his share in the profit and the remaining amount to Partner B, this would be invalid in Sharia. 3. Loss is borne by each partner strictly in proportion to their respective capital contribution. 4. Each partner has the right to end the contract at any time, as long as notice to this effect is given to the other partners.

10.4.2 Basic rules of sale in Sharia Before moving on to salam and murabaha structures, it is important to assess the basic rules of sale in Sharia. While Islamic jurisprudence includes very detailed and numerous rules governing the contract of sale, the rules below are a summary, to give a flavour of what constitutes a valid sale in Islamic finance. 1. One of the key rules is that the seller must have physical or constructive possession of the subject of sale. This rule has three crucial components: i. The subject of sale must exist at the time of sale. ii. The seller should have acquired ownership of the subject of sale. iii. The subject of sale must be in the physical or constructive possession of the seller when selling to another party. 2. The sale attributed to a future date or contingent on a future event is invalid, ie the sale must be instant and absolute. 3. The subject of sale must be a property of value. 4. The subject of sale must be specifically known and identified to the buyer. 5. Delivery of goods sold to a buyer must be certain and should not depend on a contingency or chance. 6. The certainty of price is necessary; if price is uncertain, the sale is invalid. © The London Institute of Banking & Finance 2016

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7. The sale must be unconditional. The exception is if a condition is recognised according to the usage of trade as part of the transaction. 8. The subject of sale cannot consist of something that is impermissible in Islam, such as alcohol, pork, etc.

10.4.3 Salam Salam is a sale contract, albeit of a special nature, in which payment occurs today for goods to be delivered in the future (see Figure 10.2). Figure 10.2

The salam sale contract

It is of a special nature, because salam is exempt from two of the three crucial components of the key rule of sale stated in the previous section: under salam, the asset does not have to be in existence at the time of sale, and the seller does not need to have ownership. Initially, the purpose of a salam sale was to meet the needs of farmers who needed funds to grow their crops and feed their families up to the time of harvest. As salam is an exception to the general rule that prohibits forward sales, it is subject to stricter conditions than other types of sale: 1. The buyer is required to pay the full price to the seller at the time of contracting. 2. Salam can only be effected on those commodities whose quality can be fully specified, leaving no ambiguity, and whose quantity is agreed upon in clear terms. Commodities whose quality and quantity are not determined by specification cannot be sold through salam. 3. The precise date and place of delivery must be specified. This is by no means an exhaustive set of conditions; there are other conditions too, which are outside the scope of this study text.

10.4.4 Murabaha It is often assumed that Murabaha is synonymous with ‘financing’ but in fact it is a particular kind of sale, where the seller expressly mentions to the 198

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Structures in Islamic finance

buyer the cost of the goods purchased and adds a profit to it to arrive at the final selling price. So, for instance, if a customer wants to purchase a car, they would approach their bank; the bank would purchase the car, and sell it at a mark-up to the customer. The key point is that at some point, the bank took the risk on the car between the time when the bank purchased it and sold it. Murabaha attracts a lot of criticism, as the structure is used by most financial institutions to create a debtor and creditor relationship (see Figure 10.3, which shows an ‘organised’ murabaha structure, known as tawarruq). In the example above of the customer wanting to purchase the car, there was an actual interest in the underlying goods itself − the car. It has now become commonplace for murabaha structure to be used where there is no underlying interest in the commodity, aside from using it to create a debt obligation. This is the main reason for many calls from various quarters of the industry to move away from the overuse of the murabaha structure, as it impedes the advance of Islamic finance from an ideological perspective. Figure 10.3

Tawarruq − an organised murabaha structure

As murabaha is effectively a type of sale (with the cost of goods being disclosed), the ‘basic rules of sale’ that we discussed earlier apply to a © The London Institute of Banking & Finance 2016

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murabaha transaction. As mentioned in the example of the car, the key element of murabaha is that the underlying goods remain at the risk of the institution that purchases the goods before selling them on. It is important to note that the murabaha price may be paid: u at spot; u in instalments; u in a lump sum after a certain time. Hence murabaha does not necessarily imply the concept of deferred payment.

10.5

Islamic trade finance

10.5.1 Overview Given the recent global development in Islamic finance, Islamic trade finance could serve as one of the key growth drivers to help the Islamic finance industry to double in size. In an increasingly globalised world, with rising trade flows, this is all the more apparent, considering the natural synergy between conventional trade finance and Islamic finance. Conventional trade finance is a historically low-risk activity with an underlying commodity, while Islamic finance promotes real economic activity, transparency and risk aversion. From a financial point of view too, the potential for Islamic trade finance is huge, given that the 57 member countries of the Organisation of Islamic Cooperation, are some of the world’s largest exporters of strategic commodities, such as oil, gas, petrochemicals and palm oil. They are also some of the world’s largest importers of products such as soft commodities, white goods and a host of IT, electronic, transport and other machineries. While global trade is estimated to increase by 86 per cent between 2012 and 2026, according to a study by HSBC, trade in the Middle East and North Africa region is expected to grow by 131 per cent (HSBC, 2012). The widening trade corridor between the Middle East and Asia, as well as growing trade flows to and from Africa, should translate into a rise in demand for Islamic trade finance solutions.

10.5.2 Murabaha documentary credits As a murabaha is sale-related financing, many Islamic banks use the structure with ease with documentary credits in the following way (as illustrated in Figure 10.4). 200

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Figure 10.4

A murabaha structure

1. A buyer and seller agree on goods to be purchased. 2. The buyer requests the bank to purchase the goods and promises to purchase the goods from it. (Such a promise would give the bank comfort that it would not be burdened with the goods.) 3. The buyer submits a documentary credit application and a ‘promise to purchase’ agreement to the bank. 4. The buyer’s bank issues the documentary credit in favour of the seller as an invitation to purchase the goods. 5. The bank calls for documents (such as invoice, bill of lading, certificate of origin, packing list and the insurance policy) in its name. 6. The invoice gives evidence of ownership, while the bill of lading provides the bank with title to the goods. 7. The seller ships the goods to the buyer’s country. 8. The seller prepares the documents and sends them to the issuing bank in exchange for accepting the offer. 9. The bank purchases specified goods from the seller, by sending to it payment or acceptance as per the documentary credit terms. 10.The bank resells the goods to the ultimate buyer at cost plus agreed profit, after obtaining and signing a murabaha sale contract. 11.The bank delivers the original documents to the ultimate buyer, duly endorsed in favour of the buyer, which gives them ownership and title. © The London Institute of Banking & Finance 2016

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12.The buyer takes delivery from the carrier or port authority. 13.The buyer repays the amount of financing as per terms agreed with the bank.

10.5.3 Murabaha documentary collection For inward documentary collections, no Islamic structure is required if the payment terms are documents against payment (D/P). If the payment terms are documents against acceptance (D/A), an Islamic structure is required because this represents a form of financing to the importer. There is no requirement for Islamic structures to be used for outward documentary collections.

10.5.4 Musharaka documentary credits In the context of trade, musharaka means at least two parties putting up capital, in agreed shares, and using it to buy goods with the objective of selling the goods at a higher price − usually on a deferred payment or instalments basis. Musharaka is ideal for use with import and export documentary credits. The process involving import documentary credits is outlined below as an example. 1. Commercial parties negotiate a transaction on the basis that the bank’s client wishes to buy the goods. 2. The client submits a musharaka application, accompanied by a seller’s offer / pro forma invoice, etc. 3. The financing bank reviews the application. If acceptable to the bank, it agrees to enter into musharaka arrangements. The client and the bank sign a musharaka contract and put up capital in agreed proportions. The two parties become ‘partners’. 4. The financing bank issues a documentary credit on behalf of the ’partnership’. 5. The advising bank advises the documentary credit to the beneficiary (the seller). 6. The beneficiary ships the goods and presents documents to a nominated bank. 7. The nominated bank forwards the documents to the financing bank (the issuing bank). 202

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8. Upon taking up documents and paying their value at sight, the ‘partners’ sell the goods at a profit on a deferred payment basis. 9. At maturity, the ‘partners’ receive payment. Each party receives back the capital contributed and its share of profit in accordance with the partnership’s agreement.

10.5.5 Salam pre-shipment export financing Salam pre-shipment export financing comprises the following steps: 1. The bank receives an export documentary credit in favour of its client, covering the shipment of certain goods. 2. The client gives the documentary credit under the bank’s lien, thus allowing the bank to assume the role of seller to the foreign buyer. 3. The bank agrees to buy the goods from its client under a salam contract and makes an upfront payment to it. The salam contract should include a specific delivery date and place. 4. The place of delivery should be the port of destination mentioned in the documentary credit. Submission of in-order shipping documents (ie invoice, bill of lading and certificate of origin) by the client may be deemed equivalent to the satisfactory delivery. 5. The agreed payment (pre-shipment finance) made by the bank to its client is lower than the amount of the export documentary credit. The difference is the bank’s profit.

10.5.6 Islamic finance and UCP 600 The scope for product innovation in Islamic trade finance is limited, as Islamic trade finance tools (similar to the conventional instruments from which they are derived) must adhere to International Chamber of Commerce guidelines and UCP 600. Consequently, conventional and Islamic trade finance must evolve within parallel rule-making parameters. For instance, the UCP 600 articles mentioned below are in conflict with Islamic finance.

Article 2: Negotiation Article 2 states: The purchase by the nominated bank of drafts (drawn on a bank other than the nominated bank) and / or documents under a complying © The London Institute of Banking & Finance 2016

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presentation, by advancing or agreeing to advance funds to the beneficiary on or before the banking day on which reimbursement is due to the nominated bank.

Sub-article 6 (b): Availability, expiry date and place for presentation Sub-article 6 (b) states: ‘A Credit must state whether it is available by . . . negotiation’.

Sub-article 12 (b): Nomination Sub-article 12 (b) states: By nominating a bank to accept a draft or incur a deferred payment undertaking, an issuing bank authorizes that nominated bank to prepay or purchase a draft accepted or a deferred payment undertaking incurred by that nominated bank.

10.5.6.1

Why are these UCP 600 articles incompatible with Islamic finance?

It is impermissible for a bank to undertake transactions under a documentary credit − either for itself or on behalf of another, as a client or institution, or by way of collaboration − when the credit: u pertains to goods that are prohibited by Sharia; u is based on a contract that is void or irregular (according to the Sharia) due to vitiating conditions or that it includes interest, either charged or paid, whether explicit or implied, as in the case of discounts or trading (payment) on drafts with deferred or delayed payments. It is also impermissible for a bank to discount accepted drafts or deferred payment undertakings, ie to purchase drafts or to prepay undertakings before maturity at less than their nominal value. Additionally, it is impermissible for a bank to act as an intermediary, whether by payment or notification, between the beneficiary and the issuing or confirming bank to facilitate such dealings.

10.5.7 Leading the way With many governments − Muslim and non-Muslim alike − making a foray into Islamic finance, the market for Sharia-compliant products is rising. As one of the key aspects of Islamic finance is that financing should be asset-backed, trade finance is a natural fit for the industry. 204

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Chapter summary

The widening trade corridor between the Middle East and Asia, as well as growing trade flows to and from Africa, will therefore greatly increase cross-border trade flows, resulting in larger market share for Islamic trade finance. The ability of Islamic finance to take ownership of assets may result in Islamic trade finance leading the way for the burgeoning Islamic finance industry and moving towards achieving the real objectives of Islamic finance.

10.6

Chapter summary

In this chapter, we have considered: u the core principles of Islamic finance and how it fits within Islam; u key structures in Islamic finance including musharaka, salam and murabaha; u using Islamic financing structures with documentary credits and documentary collections; and u how Islamic financing structures relate to UCP 600.

References Dar, H. (ed) (2014) Global Islamic finance report 2014. London: Edbiz Consulting. HSBC (2012) Mena region an essential trade hub for global economic recovery. Available at: http://www.hsbcinvestments.ae/1/PA_ES_Content_Mgmt/content/uae_pws/pdf/en/ newsroom/mena-essential-trade-hub-en.pdf [Accessed: 10 August 2016]. ICC (2007) Uniform customs and practice for documentary credits. ICC Publication No. 600LE. Paris: ICC.

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Review questions The following review questions are designed so that you can check your understanding of this chapter. The answers to the questions are provided at the end of these learning materials.

1.

To which of the following terms does riba refer? a. Lending

b. Depositing

c. Interest

d. Insurance

2.

The ideal instruments of financing in Islamic finance are those based on profit-and-loss sharing concepts, namely and .

3.

A key objective of Islamic finance is to promote equitable distribution of wealth. True or false?

4.

UCP 600 is entirely compliant with Islamic finance. True or false?

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Chapter 11

Guarantees and standby letters of credit

Learning objectives By the end of this chapter, you should have an understanding of: u the role of guarantees in international trade; u the various types of guarantee (often called ‘bonds’); u the differences between conditional and unconditional guarantees; u the content of URDG 758 and ISP98; u standby letters of credit; u unfair calling and options to insure this risk; u credit considerations for issuing a guarantee or standby letter of credit.

11.1

Introduction to guarantees

In some countries and banks, the term ‘bond’ may be used instead of the term ‘guarantee’. These terms can be used interchangeably but for the purpose of this chapter we will refer to ‘guarantee’. A guarantee is usually issued by a guarantor (mainly a bank or an insurance company) in favour of the buyer (the importer) on behalf of the seller (the exporter). However, a guarantee can also be issued by the bank of the seller in favour of the buyer, as in the case of an advance payment guarantee (see section 11.3.2). It is a guarantee that in the event that the exporter fails to complete their contractual duties, the guarantor will reimburse the buyer with a sum of money that can be anything between 1 per cent and 100 per cent of the guarantee value. © The London Institute of Banking & Finance 2016

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As far as the bank issuing the guarantee is concerned, such documents are ‘contingent liabilities’, which may require the bank to pay out on behalf of its client at some future date. The bank will therefore treat the situation as a credit facility, requiring a covering limit, or the deposit of cash cover by the client. The bank will take a counter-indemnity from its client, usually incorporating an authority to debit the client’s account in respect of any claims upon the guarantee.

11.2

Uniform Rules for Demand Guarantees (URDG 758)

In earlier chapters we examined the role of International Chamber of Commerce (ICC) rules − URC 522 for documentary collections (see Topic 7) and UCP 600 for documentary credits (see Topic 8). The ICC has also produced a set of rules for demand guarantees. Guarantees may be made subject to the ICC Uniform Rules for Demand Guarantees − ICC publication no. URDG 758 − that came into force on 1 July 2010. URDG 758 is a set of contractual rules that apply to a demand guarantee and counter-guarantee when such transaction expressly indicates that it is subject to those rules, and covers obligations and interpretations relating to the parties involved, the drafting and wording of the guarantee, its irrevocability, the non-assignability (Article 33 allows for assignment subject to the guarantor’s agreement) and the guarantor’s duties, to name but a few. From a bank’s perspective, the most important articles are as follows.

Article 8: Content of instructions and guarantees Article 8 can act as a checklist for both the guarantor when issuing a guarantee, and the applicant when negotiating its terms and conditions.

Article 10: Advising of guarantee or amendment Article 10 contains information and instructions for the advising party, when it receives instructions to advise a guarantee without any obligation or engagement on its part.

Article 11: Amendments Article 11 provides instructions on how to handle an amendment to a guarantee.

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Article 14 (Presentation) and Article 19 (Examination) Articles 14 and 19 both explain how a guarantor should treat a presentation and how it should examine the presented demand.

Article 20: Time for examination of demand; payment Article 20 stipulates that a guarantor has five business days following the day of presentation to examine the demand and to determine if it is a compliant demand.

Article 23: Extend or pay In the event of a complying demand being presented, the guarantor is now faced with two choices: 1. pay immediately; 2. suspend payment for a specified period (not more than 30 calendar days following the receipt of the demand) and the automatic paying of the demand at the end of that period, if an extension has not been granted.

Article 24: Non-complying demand, waiver and notice Article 24 explains the requirements when a demand has been refused by the guarantor. As with documentary credits, a guarantor deals with documents and not with goods, services or performance to which the documents may relate. The effect of this is that in the event of a claim, even if the applicant states that it has performed and considers that the claim is unjust, the guarantor is obliged to pay if the presented demand is compliant. The only circumstance in which the guarantor would not pay is if the applicant has strong proof that it is an unfair calling of the guarantee (see section 11.10), and then it would probably need to seek an order from a court to support its action. Guarantees not subject to URDG 758 (2010) (or URDG 458 (1992) for legacy transactions prior to 1 July 2010) will invariably be subject to the local law of the issuer.

Example of a guarantee If A contracts with B to build a bridge for B, then B may require a guarantee to be issued by the banker of A that A will build the bridge specified in the underlying contract.

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Under URDG 758: u A is known as the ‘applicant’ or ‘instructing party’ and will be the provider of a ‘counter-indemnity’ to its bank to secure the issuance of the guarantee; u B is known as the ‘beneficiary’ of the guarantee; u The bank of A is known as the ‘guarantor’. There are two broad types of guarantee, with significant legal differences: conditional guarantees and unconditional guarantees.

11.2.1 Conditional guarantees A number of specialist businesses and insurance companies provide performance guarantees as ‘conditional guarantees’ under the normal rules of English contract law. (The Association of British Insurers − https://www.abi.org.uk/ [Accessed: 10 August 2016] − provides a model form for such guarantees.) The normal position in English law is that the issuer of a guarantee − the bank of A (the guarantor) in the above example − has a secondary obligation. This means that the beneficiary of the guarantee (B) must seek payment / claim first from the person or business with which they have a contract (A) and demonstrate that the terms of the contract have been broken or ‘breached’, before they can claim upon the guarantor. Only if B’s claim is unpaid by A can the guarantor be called upon. Furthermore, any amendments to the contract made without the guarantor’s prior agreement could invalidate the guarantee. A contract guarantee issued with a similar legal position to an ordinary guarantee is called a ‘conditional guarantee or bond’. Such guarantees are specifically excluded in the URDG rules − the introduction states: ‘These rules do not apply to suretyship or conditional bonds or guarantees . . . [where the] duty to pay arises only on actual default by the principal’ (ICC, 1992).

11.2.2 Unconditional (demand) guarantees Banks normally issue only what are known as ‘demand’ or ‘unconditional’ guarantees, where the obligation of the bank issuing the guarantee is independent of the underlying contract or reason for default. 210

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URDG 758 states that the guarantor, like the issuer of a documentary credit, deals with documents and not with goods, services or performance to which the documents may relate. A bank guarantee is a primary obligation. A claim may be made under it without a prior claim having been made upon the contracting party for whom the guarantee was provided. As a minimum, a guarantee issued subject to URDG 758 must include the following information: u names of the applicant and of the beneficiary; u name of the guarantor; u reference number or other information identifying the underlying relationship; u reference number guarantee;

identifying

the

issued

guarantee

or

counter-

u amount or maximum amount payable and the currency in which it is payable; u expiry of the guarantee (date or an ‘expiry event’); u terms for demanding payment; u how demand is to be made, paper and / or electronic format; u the language of any documents specified; u the party liable for payment of charges.

11.2.2.1

Advantages and risks associated with unconditional guarantees

u Unconditional guarantees can be quite straightforward, being independent of potentially complex commercial contracts and contract disputes. u They can be issued under a set of universally accepted rules such as URDG 758, UCP 600 or ISP98. u However, the majority of guarantees are issued subject to local law and may therefore involve unfamiliar legal jurisdictions and / or may be subject to the onerous legal requirements of the issuer’s country. u The beneficiary has the satisfaction of knowing that a simple claim may be all that is required to obtain payment from a bank. © The London Institute of Banking & Finance 2016

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u However, the applicant is less fortunate, as it is at risk of an unjustified or disputed claim being made. u The applicant’s position with respect to a demand guarantee is, in many cases, only marginally less risky than leaving a deposit of cash, unless the guarantee stipulates payment dependent upon documentary requirements that include those provided by independent assessors or entities. u The applicant’s working capital is unaffected by the issue of a guarantee, unless the applicant’s bank requires a cash deposit to support their involvement and / or it reduces the applicant’s overdraft facilities. u While working capital may be unaffected, there will be a contingent liability created that could impact on the availability of additional or existing banking facilities. Guarantees (supported by counter-guarantees) are often required to be issued in the local language, subject to either a standard format adopted by the bank that is being requested to issue it or in a standard format that is applicable to the concerned industry. There is often little room for the banks to change the wording, or even to insert standard wording required by that bank.

11.3

Types of guarantee

There are various stages before and during the performance of a contract, at which a guarantee may be required. A business tendering or bidding for a contract may be requested to provide a guarantee, which guarantees that, if successful, a contract will be established and that it will provide any further guarantees covering its performance and / or warranties. The following sections outline the various types of guarantee.

11.3.1 Tender or bid guarantees When a company or government invites bidders to submit offers to deliver goods or to complete a contract, it will be concerned to receive bids only from those genuinely capable of fulfilling − and willing to sign − a contract, if its bid is selected. To protect themselves, potential buyers may ask bidders to put up a guarantee that can be called in the event that the bidder does not contract and / or fails to meet the other bonding requirements of the purchaser − see the following descriptions. The value of such guarantees is typically a small percentage of the contract value, eg 3 per cent.

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11.3.2 Advance payment guarantees Should the bidder be successful, they may incorporate an advance payment into the contract, to enable the bidder to purchase materials and undertake design or other preparatory work. The bidder may be asked to provide a guarantee, payable on demand, against its failure to perform and for recovery of any money advanced. An advance can be up to 100 per cent of the contractual value, but the more common level is 10−25 per cent. Similar guarantees may be required throughout the contract in respect of progress payments.

11.3.3 Performance guarantees Once a contract to supply equipment or to undertake a construction has been agreed, the purchaser may require some assurance that the equipment will do what is claimed or that a construction will be finished on time and in accordance with the agreed specification. A performance guarantee may therefore be required. Performance guarantees can be for any value: often this is 10 per cent of the contract amount, but anything up to 100 per cent is possible.

11.3.4 Warranty and retention guarantees Warranty guarantees may be required by a purchaser, once a performance guarantee has expired. Alternatively, if the purchaser has held back a percentage of the contract price, the supplier might require a retention guarantee, to guarantee that the money retained will be paid. Retention guarantees are often issued to release funds that are held by the buyer. The issuance of the guarantee provides an alternative security to a cash deposit.

11.3.5 Other guarantees Guarantees may be required to secure legal costs in the event of a case being lost, to secure the obligations of businesses to official bodies or to guarantee payment of duties, ie customs duties or VAT.

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11.4

Documents required under a guarantee

As has been stressed already, the party issuing a guarantee, whatever type of guarantee it may be, is concerned only to pay against a demand that complies with the requirements specified in the guarantee. URDG 758 discourages terms that attempt to bind a guarantee into the terms of an underlying contract. The minimum documentation required under a URDG guarantee is the documentation specified in the guarantee together with a statement by the beneficiary indicating in what respect the applicant is in breach of its obligations. This may be incorporated in the formal demand documentation or in a separate accompanying document. At the other end of the scale, the documentary requirements could include one or more of the following: u a notary’s confirmation of the dishonour of a bill of exchange; u a certificate from an independent expert (eg an engineer or architect); u an award statement from an arbitrator or court of arbitration; u a copy of a judgment from a court. As with the other ICC rules for collections and documentary credits, URDG 758 establishes that a party issuing a guarantee is not liable for the accuracy, genuineness or validity of documents. Nor is it liable for delays beyond its control. URDG 758 sub-article 20(a) specifies that, unless the presentation indicates that it is to be completed later, guarantors are required to examine a demand within five business days following the day of presentation, to determine whether it is a complying demand. If they decide to refuse the demand due to it being non-compliant, they must immediately inform the presenter.

11.5

Issuance of guarantees

A guarantee may be issued direct to the beneficiary by the applicant’s bank or it may be issued by a bank in the beneficiary’s country, supported by a counter-guarantee from the applicant’s bank. In the latter case, the guarantee will usually be subject to local laws and customs in the beneficiary’s country, and may not be subject to URDG 758. Banks will often work closely with correspondent banks in those countries, to agree on acceptable wording for such guarantees. 214

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Expiry

Some industries, such as construction, often require standard forms of guarantees, drawn up to the requirements of any professional bodies involved. Banks have specimen documents acceptable to them, which they are prepared to counter-guarantee, subject to the usual client credit assessment.

11.6

Assignment

URDG 758 allows for guarantees to be assigned, if specifically stated in the terms. Beneficiaries may assign proceeds that they may be, or may become, entitled to receive under the guarantee, but a guarantor shall not be obliged to pay an assignee unless it has agreed to do so (URDG 758 sub-article 33(g)).

11.7

Demands

When a demand is made under a guarantee, the instructing party (or, where applicable, the counter-guarantor) must be informed without delay. Once the guarantor has examined the demand and found it to be compliant, the sum demanded and paid will be deducted from the total sum available under the guarantee.

11.8

Expiry

Guarantees issued subject to URDG 758 must specify an expiry date or an expiry event (for example, hand-over of a new hospital). Where the guarantee has expired, been cancelled or paid upon, its retention by the beneficiary does not preserve any rights. However, where guarantees are not subject to URDG 758, expiry can become a contentious issue where the beneficiary is located in a country that does not accept guarantees with an expiry date, eg in some countries in the Middle East. Under some laws, where a guarantee is subject to a local law, that law may dictate that the expiry date is ignored to the extent that expiry will occur upon surrender of the original guarantee, after a certain period of time after expiry, ie 30 days or after a designated grace period. This causes real difficulties to both the applicant (or instructing party) and the guarantor. Not only does a potential risk remain but, under accounting rules, a contingent liability must also remain on the balance sheet of either applicant (or instructing party) and guarantor, until the beneficiary gives a written consent to cancellation or returns the guarantee. In addition, as long as the guarantee remains outstanding, the client must pay regular © The London Institute of Banking & Finance 2016

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(usually quarterly) commission charges to the bank − so the sooner it can be cancelled, the better. It should be noted that most banks have sets of standardised wording for use in the more commonly issued types of guarantee. If a client requests a guarantee that does not comply with such ‘templates’, then the wording may need to be vetted by the bank’s legal experts or senior personnel within the guarantees department before issue, taking additional time before issuance.

11.9

Standby letters of credit

You will already be familiar with UCP 600 and the concept of documentary credits (see Topic 8) that enable buyers and sellers to exchange documents relating to a cargo, this being the evidence that the exporter has fulfilled its contractual obligations, for either ‘sight’ payment or a future payment commitment. The remaining sections of this chapter cover a variation on this theme: the standby letter of credit. Any type of guarantee discussed earlier in this chapter can also be issued in the form of a standby letter of credit. Typical uses of a standby letter of credit include: u as an undertaking that a loan will be repaid; u as a back-up undertaking that a buyer will meet some other pre-agreed payment obligation, such as settlement of a sight bill attached to a documentary collection or an open account settlement; u where protection against a failure to perform under a contract is required. A standby letter of credit may be issued by an applicant’s bank on behalf of the applicant to a beneficiary, who may be, for example: u a creditor; u the party to a contract; u a bank that has issued a performance guarantee in favour of the purchaser under a contract in another country. Confirmation may be added to a standby letter of credit just as in the case of a commercial documentary credit. Documentation under a standby letter of credit is usually much less complex than that for a commercial documentary credit. Given the guarantee-type nature of a standby letter of credit, all that is normally required is a sight

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draft and a statement issued by the beneficiary that the applicant, for example: u has not met the terms of a contract; u has not paid a loan on the due date; u has not paid for goods shipped; u has not built a bridge successfully or on time. Other documents, such as a certificate of non-performance from an independent assessor or a ruling from an arbitration court, may also be appropriate, depending on the underlying transaction. Standby letters of credit may be issued subject to UCP 600 (as stated in UCP 600 Article 1), but are used differently to commercial letters of credit. A standby letter of credit is used to protect against non-performance or non-payment. Standby letters of credit are not a primary means of making a payment. A standby letter of credit is a powerful tool in the hands of a beneficiary. Being covered by the terms of UCP 600 (or ISP98 − see below), there is no possibility for the applicant or its bank to refuse to make a payment, even if the applicant has a strong case for resisting payment, should a complying presentation be made. For example, in a building contract, the applicant might argue that the labour supplied by the beneficiary was inadequate and give this as a reason for non-performance. But this will give the applicant or the issuing bank no grounds to refuse payment under the standby letter of credit, as the issuing bank will pay against presentation of the specified documentation. The applicant may, however, be able to prevent payment, if fraud is involved. Although standby letters of credit may be issued subject to UCP 600, many of the articles of UCP 600 are not relevant to a standby letter of credit. Therefore, the Institute of International Banking Law & Practice (IIBLP) drafted a set of internationally accepted rules (International Standby Practices) specific to standby letters of credit, known as ‘ISP98’. ISP98 rules are being increasingly used by banks globally. A standby letter of credit must therefore state clearly whether it is subject to UCP 600 or ISP98.

11.9.1 ISP98 rules ISP98 rules (1998) include reference to standby letters of credit in the following terms: u Irrevocable − Rule 1.06b says: ‘Because a standby is irrevocable, an issuer’s obligations under a standby cannot be amended or cancelled © The London Institute of Banking & Finance 2016

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. . . except as provided in the standby or as consented to by the person against whom the amendment or cancellation is asserted’. u Enforceable − Rule 1.06c goes on to make it clear that the enforceability of a standby is not affected by: − ‘the issuer’s right or ability to obtain reimbursement from the applicant’; − ‘the beneficiary’s right to obtain payment from the applicant’; − ‘any knowledge the issuer may have of a breach of contract’. u For payment against documents − Rule 1.06d sets down the principle that the issuer’s obligation to pay is to be decided upon only by the examination of required documents. Rule 4.08 states: ‘If a standby does not specify any required document, it will still be deemed to require a documentary demand for payment’. Rule 4.11 goes on to make it clear that any terms of a standby that do not refer to documents may be disregarded. u Limited as to the issuer’s responsibilities − Rule 1.08 makes it clear that the issuer is not responsible for breaches in the performance of the underlying contract or for ‘the accuracy, genuineness or effect of any document’. u Undertakings − Rule 2.01 sets out the undertakings of the issuer and confirmer to honour a compliant presentation by payment of a sight draft or acceptance in immediately available funds and in a ‘timely manner’. Rule 2.05 makes it clear that the advising bank is only responsible for the authenticity of the standby. u Capable of amendment − as with commercial documentary credits, amendments to standby letters of credit are binding upon the issuer and confirmer when issued, but may be rejected by the beneficiary. However, ISP98 provides for ‘automatic amendment’ clauses. A standby letter of credit subject to automatic amendment may be increased or decreased in value, or may have the expiry date extended without the need for consent. ISP98 also contains rules in the event of dishonour (Rules 5.01−5.07), notice of which must be given in a timely manner − more than seven days being considered unreasonable. Standby letters of credit may be stated to be transferable, but ISP98 rules differ from UCP 600 rules, in that they may not be partially transferred but may be transferred more than once (see Rule 6.02b). There are also rules covering situations where a standby letter of credit can be transferred by ‘operation of law’. This might include transfer to a receiver of a company in 218

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Unfair calling of guarantees and standby letters of credit

financial difficulties (see Rules 6.11−6.14). The more likely event is that due to the often long expiry dates for a standby letter of credit, the beneficiary may merge with (or be acquired by) another company. The proceeds due from claims under a standby letter of credit may be assigned by the beneficiary, if the issuer and confirmer agree to − and acknowledge − the assignment. As with other forms of documentary credit, an applicant must indemnify the issuer, by reimbursing it for any payments made and by paying any appropriate charges.

11.10

Unfair calling of guarantees and standby letters of credit

Applicants of guarantees and standby letters of credit are at a real risk of them being ‘called’ (ie demand being made) unfairly; that is without there having been a genuine failure on their part to have performed a contractual obligation. Since banks deal with documents only, they are in no position to refuse a claim, if the correct documents are to hand. Guarantees issued in a foreign country will, in many cases, be subject to the laws of that country. These may be difficult to understand, or the administration of the law may be prone to bias in favour of the local beneficiary; in some instances, there may be no laws applicable to the situation. To minimise the risk of a guarantee or a standby letter of credit being called unfairly, both the applicant and the bank will consider what documentary requirements could be included to minimise this risk. Of course, in many cases the applicant may be constrained by the regulations in the beneficiary’s country and the relative bargaining strength of the two contracting parties. What the applicant and the bank will try to achieve is some independent documentation, such as: u a notary’s signature confirming that a bill of exchange is unpaid; u an independent engineer’s or architect’s certificate that a contract has not been performed to specification and / or on time. Instead of actually unfairly calling a guarantee or a standby letter of credit, a beneficiary may threaten applicants with having the guarantee or standby letter of credit called upon unless an amendment, such as an extension to the expiry date, is agreed to. This practice is called ‘extend or pay’, and each case will need to be carefully considered before action is taken. If the © The London Institute of Banking & Finance 2016

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beneficiary is refused an extension on the expiry of a guarantee or standby letter of credit, it may be able to produce the documentation required to claim on the document, which would mean that payment would have to be made immediately. Extending the guarantee or standby letter of credit avoids this, or perhaps simply postpones eventual payment. Issuing banks and their clients will be mindful of the fact that extension of the facility will involve a fee and ongoing regular commissions (usually charged quarterly on a pro-rata basis for as long as the facility is outstanding) for the remainder of its validity.

11.10.1 Insurance against unfair calling risks Some insurance companies offer protection against some of the unfair calling risks that exporters and contractors face when providing guarantees or standby letters of credit. Typically, cover includes protection against: u a foreign government purchaser arbitrarily calling for payment; u a call for payment that is ‘legitimate’ but the seller’s / contractor’s failure is due to political events, wars or revolutions; u a failure by the beneficiary to honour an arbitration award. Other insurance cover may be taken out against, for example, the expropriation of a contractor’s plant and equipment. The services of a local office or agent working for the principal can mitigate these risks.

11.11

Standby letters of credit and guarantees − credit considerations for the issuing bank

As can be seen, the issuing bank’s undertaking contained in a standby letter of credit or guarantee is given with less inherent security in the transaction, as there are no documents giving title or control that can be held by the bank. With a guarantee or a standby letter of credit, a demand may be supported by very little more than a written statement of default or, at best, by independent proof that the bank’s customer is truly in default. Either way, reimbursement for the bank can only come from a claim on its customer’s counter-indemnity.

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Comparison between standby letters of credit and demand guarantees

Therefore, issuing guarantee and standby letters of credit poses a very real credit risk for the bank. The following issues will be in the mind of the bank’s credit officer as well as that of the applicant for the guarantee or standby letter of credit. u What experience does the applicant have in this specific trade? u What experience does the applicant have in the country concerned? u Can the applicant insist on a certificate from an independent body or arbitrator? u Is a guarantee subject to URDG 758 acceptable to all parties? u Is insurance against unfair calling available or required? u What is the bank’s experience with the applicant and the country with respect to guarantees being called without justification? u Are the sums involved within the applicant’s capacity to meet them, without a devastating impact on its business? u What protection can be provided for the currency exchange risk? u What security can the applicant offer, or should the bank hold a cash deposit as security? The bank’s credit officer will be aware that one of the most common reasons for a bond being called is the insolvency of the applicant. If the applicant is unable to pay or deliver to the beneficiary under the contract, they are unlikely to be able honour the counter-indemnity to the bank. When the applicant is given approval, they will have to sign the bank’s counter-indemnity, acknowledging, where applicable, that the guarantee will be issued subject to URDG 758. This may also be evidenced by the wording that appears in the application form for the issuance of the guarantee and that is signed by the applicant. In practice, many standby letters of credit are issued subject to local laws (see section 11.5 covering locally issued guarantees) and in such cases may not be covered by URDG 758.

11.12

Comparison between standby letters of credit and demand guarantees

Table 11.1 compares standby letters of credit and demand guarantees.

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11: Guarantees and standby letters of credit Table 11.1

Comparison of standby letters of credit and demand guarantees

Issue

Standby letter of credit

Guarantee

Usage

Wide range: loan guarantees,

Mainly confined to

back-up to other payment terms

non-performance.

or any form of guarantee. Governing rules

UCP 600 or ISP98.

URDG 758, UCP 600 or ISP98 or specified jurisdiction or local laws of beneficiary’s country.

Irrevocable

Yes.

Yes.

Documentary

Yes, but no liability for

Yes, but no liability for

genuineness or validity of

genuineness or validity of

documents.

documents.

Yes, with consent of beneficiary.

Yes, with consent of beneficiary.

Amendment

Automatic amendment clauses permitted under ISP98. Transfer and / or

ISP98 permits transfer to more

URDG 758 permits assignment

assign

than one party, but does not

of the bond if specifically stated

allow for partial transfers. This

in its terms. Proceeds may, in

differs from UCP 600 transfer

any event, be assigned, but the

rules (see chapter 8).

guarantor shall not be obliged

The proceeds of a claim may be

to pay an assignee unless it has

assigned.

agreed to do so.

May be issued direct to the

May be issued direct to the

beneficiary, via an advising bank

beneficiary or by a bank in

(that only confirms apparent

the beneficiary’s country that

Issuance

authenticity) that may or may not issues the guarantee against

Expiry

be a confirming bank. A second

a counter-guarantee from the

advising bank may be involved.

applicant’s bank.

UCP 600/ISP98. All standby

Should be clear-cut under URDG

letters of credit must state an

758 rules (should refer to an

expiry date.

expiry date or an expiry event). Where not issued under URDG 758 rules, some countries do not accept expiry dates or the application of the expiry date is subject to other provisions, ie return of the guarantee or a grace period.

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Chapter summary

Chapter summary This chapter has been concerned with those banking products and services that provide an undertaking that a business or government organisation importing from, or contracting with, a bank’s customers will be reimbursed in the event that the bank’s customer fails to perform. u There are two types of bank undertaking, both of which are irrevocable: 1. A standby letter of credit, which has many characteristics similar to a commercial documentary credit and may be issued subject to the same UCP 600 rules or the similar but specific standby rules: ISP98. 2. Unconditional bonds, such as bid bonds, performance bonds and advance payment guarantees, which may be (and preferably should be) issued subject to URDG rules but in many instances are not. Unconditional bonds are primary obligations to pay. u Conditional guarantees are secondary obligations and are subject to the usual rules concerning guarantees. They are offered by insurance companies and others but not generally by banks. Such guarantees are specifically excluded by URDG 758. u Both standby letters of credit and unconditional bonds are documentary, in that the issuer’s payment obligation is subject only to presentation of compliant documents within the expiry of the standby or guarantee (or, additionally, the expiry event for a guarantee). u Both products pose real risks to an applicant and to the issuing bank, both of whom will want to be certain that they understand the risks involved, the record of the beneficiary and the tendency for unfair calling. u Where possible, applicants should require independent documentary evidence of non-performance.

References ICC (1992) Uniform rules for demand guarantees. ICC Publication No. 458E. ICC (1995) Uniform rules for collections. ICC Publication No. 522. ICC (1998) ISP 98

− International standby practices. ICC Publication No. 590E.

ICC (2007) Uniform customs and practice for documentary credits. ICC Publication No. 600LE. ICC (2010) Uniform rules for demand guarantees (URDG) including model forms. ICC Publication No. 758E.

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Review questions The following review questions are designed so that you can check your understanding of this chapter. The answers to the questions are provided at the end of these learning materials.

1.

A company asks its bank to issue a guarantee on its behalf. In this process the company would be called the ‘issuer’. True or false?

2.

What type of guarantee might a company need, when bidding for a new contract from a client?

3.

Standby letters of credit may be subject to which one of the following sets of rules in addition to UCP 600?

4.

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a. URDG 758

b. URC 522

c. ISP98

d. URBPO

If a guarantee is not specifically described as being covered by any specific set of rules, it will be subject to what?

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Review questions

5.

What is the purpose of an advance payment guarantee?

6.

Insert the missing word: A guarantee, while it remains valid, is regarded as a on the applicant’s balance sheet.

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liability

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:

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Chapter 12

Export credit insurance

Learning objectives By the end of this chapter, you should have an understanding of: u the role of credit insurance in international trade; u the risks covered by export credit insurance; u the different types of credit insurance policy.

The previous chapters have been mainly concerned with bank services, in particular with the processes that banks have developed to provide assurance to exporters that payment for goods or services supplied will be forthcoming. This chapter is about an alternative method: insuring against non-payment by the use of credit insurance.

12.1

Credit risk summary

This is a good point to remind you of the main types of risk that a seller should consider (see Table 12.1). The possible sources of risk protection are set against each risk. Broadly, the market for such insurance falls into two groups: 1. short term, being cover for credit terms provided by the seller of up to 180 days, offered by commercial insurers that specialise in these risks; 2. long term, where the risk extends for more than 180 days. Credit insurance can be provided by either the private sector or by government-backed bodies. Usually, government-backed bodies will provide insurance in approved cases that private sector insurers will not cover. © The London Institute of Banking & Finance 2016

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Table 12.1

Main areas of credit risk and sources of risk protection

Main area of risk

Subsections of main areas Sources of risk protection of risk Unable or unwilling to pay

Credit insurance

‘public buyer default’ Lack of foreign exchange

Credit insurance

with which to pay ‘Sovereign’ governments, government agencies and local governments

Changes to import rules or

Credit insurance

licences Changes to export rules or

Credit insurance

licences Changes to regulations for

Credit insurance

importers to acquire hard currencies War, civil unrest, coup d’état

Credit insurance

Inability of buyer to pay, or

Credit insurance

bankruptcy / liquidation of

Documentary credits

buyer

Bank payment obligation Guarantee / standby letter of credit Advance payment

Credit risk

Buyer refuses to take up

Credit insurance

what has been purchased

Documentary credits Bank payment obligation Guarantee / standby letter of credit Advance payment Arbitration

Credit insurance is appropriate to cover buyer and country risk in connection with open account or documentary collection terms. There is less need for the facility in the case of documentary credits issued or confirmed by reputable banks. Obviously, for payment in advance, credit insurance is unnecessary. Finally, lending bankers can take an assignment of a credit insurance policy as security for lending. In the event of default by the borrower, the bank would take over any rights under the insurance policy. Such an assignment would protect the bank, where repayment of a facility was to come from the proceeds of a customer’s contract. However, if the customer could not claim

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Types of export credit insurance

under the policy, the bank would have no claim either. Thus this security would not be ‘absolute’.

12.2

Types of export credit insurance

Export credit insurance is a specialist field with several providers, including commercial entities as well as government credit agencies, such as UK Export Finance in the UK, Coface in France and Export-Import Bank of the United States (EXIM Bank). A number of insurance brokers also specialise in arranging cover for clients. A good broker will endeavour to find the best match between a customer’s needs and premium rates. A variety of policies are now available to suit different needs. In addition to those outlined below, there are specific policies such as those taken out by a contractor against unfair calling of a bond.

12.2.1 Whole turnover policies Whole turnover insurance covers all sales on credit terms and is the traditional form of credit insurance. Policies can be written to cover both domestic and export sales. u The advantage to the insurer of such policies is the ‘spread of risk’. The insurer is not being subjected to a selection by the seller of weaker buyers. u Policies are usually provided for between 80 and 95 per cent, ie the seller is left with between 5 and 20 per cent of the risk. u However, the insurer will impose limits on each buyer and may restrict cover in certain ‘high risk’ markets.

12.2.2 Specific or key customer policies Sellers / exporters sometimes ask the insurer to write a policy specifically covering the default risk of one customer or of a small number of key customers where the seller / exporter has the largest part of its turnover. u Policies are offered at about the same level of cover, but premiums may reflect the higher risk of a smaller spread of risk. For the seller with one

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12: Export credit insurance

or two large buyers that are crucial to its business, this may be the best option, particularly where a default could be catastrophic to its business. u Cover can be written to include ‘work in progress’ cover, where a buyer defaults on a contract before goods are ready for shipment.

12.2.3 Excess or ‘catastrophe’ policies Excess or ‘catastrophe’ policies are similar to the other policies above, but are designed for the financially strong seller with good in-house credit control and with turnover of several million pounds. u Once a certain pre-agreed level of loss has been sustained, the remaining losses in the policy period will be insured. u Because the seller is accepting a significant risk by agreeing to an excess (the seller will cover 100 per cent of losses until a threshold is reached), the premiums will be lower.

12.3

Risks covered in export credit insurance policies

The risks covered in such policies will depend upon what is actually agreed, but the following are typically available.

12.3.1 Political or country risks A domestic business selling goods, providing a service, contracting to build or investing in a foreign country will be subject to the laws and government powers of the country concerned. With two countries trading within the same region, the risk is low and there are often detailed inter-government agreements and treaties that facilitate the ‘single market’. But in less stable political regimes the risks can be substantial. A business operating overseas might face any of the following situations: u confiscation or expropriation of machinery, goods or whole factories; u violence caused by civil unrest, a coup d’état or a local war; u an inability to convert local currency receipts into hard currency; 230

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Risks covered in export credit insurance policies

u an embargo placed on imports, or the arbitrary cancellation of an import licence after the exporter has been involved in contractual costs; u an intervention by the government that ‘frustrates’ the contract, by imposing impossible rules or insisting upon involvement of a new local ‘partner’; u an unfair calling of a performance or similar guarantee; u in rare cases, the kidnap of expatriate staff. The premium and limitations on cover will depend upon the insurer’s view of economic and political stability in the areas for which cover is required. Cover for some of the above risks may not be available even from government-backed agencies, depending on the circumstances of each case.

12.3.2 Credit risk of buyer default For a business to have 40 per cent of the total assets of the business tied up in receivables is not uncommon. Therefore a business must have good credit control procedures, providing detailed understanding of the extent of money due to it from its customers − and particularly the sums overdue. Nonetheless, the risk of a large default (or several defaults) remains, and can destroy a good business. The option of using ‘without recourse’ invoice discounting or factoring was covered in Topic 9. However, taking out credit insurance is an alternative − and indeed many of the specialist insurers provide both factoring and credit insurance services. One of the key advantages of using specialist insurers and factors, apart from the peace of mind provided, is the access that a business has to an insurer’s and / or a factor’s database, which can give an early indication, before a contract is negotiated, of risks that are best avoided. The nature and premium cost of any credit insurance purchased will take account of: u whether or not the business has an existing policy covering domestic credit risk; u the countries where a default may occur; u the names of the buyers;

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u the spread of risk − the more countries and customers offered to the insurer, generally the lower the average premium; u whether the business is both willing and able to accept a higher ‘excess’ than average − see ‘key customer’ and ‘excess’ policies described above. In the event of non-payment due to buyer insolvency, the insurer will pay once the insolvency is proved. For other reasons for non-payment, the insurance payout may be delayed, eg until after goods have been disposed of, when the buyer has refused to take delivery.

12.4

Insurance from government-backed export support agencies

In many countries, government-backed export support agencies provide insurance for sellers, especially in cases where commercial insurance may not be available. In a typical example, a policy available from a government agency would cover the following risks, in relation to occurrences outside the UK: u buyer insolvency; u the buyer’s failure to pay within six months of the due date; u default by the buyer or guarantor in meeting a final judgment or award within six months of its date; u default in payment or default in performance of the contract by the buyer, which prevents the supplier from carrying out its part of the contract; u statutes introduced in the buyer’s country that discharge the debt if it is paid in currency other than that of the contract; u political or economic moves that prevent the transfer of contractual payments (this would include a general moratorium on debt repayment enforced by the buyer’s government); u any action by a foreign government that prevents the performance of the contract; u any natural disasters, wars or civil strife that prevent the performance of the contract.

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Review questions

In relation to events within the country of the government agency, the policy might cover: u the non-renewal or cancellation of a supplier’s export licence; u measures introduced after the contract date that hamper the performance of the contract. The policy will not normally provide 100 per cent cover. Typically, the policy will provide cover for 95 per cent of the insured risk, with the seller bearing the remaining 5 per cent.

Chapter summary In this chapter, you have learned about: u the risks that export credit insurance can help mitigate; u the types of policy available; u both private sector and government-backed sources of insurance provision.

Review questions The following review questions are designed so that you can check your understanding of this chapter. The answers to the questions are provided at the end of these learning materials.

1.

2.

Which of the following insurable risks is not classed as a sovereign government risk? a. Inability of buyer to obtain hard currency with which to pay the seller.

b. Changes to import rules and licences.

c. Changes to export rules or licences.

d. Refusal of a buyer to take up goods and pay for them.

Credit insurance is always recommended for sellers who sell on confirmed documentary credit terms. True or false?

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3.

Credit insurance could be appropriate from the point of view of a seller in which of the following circumstances? a. Where ‘without recourse’ factoring is used.

b. When sales are on payment in advance terms.

c. When sales are on open account terms.

d. When there is a risk of damage to the goods while in transit.

4.

A financially strong seller with good in-house credit control and with turnover of several million pounds requires a product that will protect them against buyer default if the total loss in the financial year exceeds GBP5m. However, there is no product that can help here, as any credit insurance must cover the whole turnover. True or false?

5.

Name one advantage to a seller of taking out credit insurance, apart from the obvious one of having cover for bad debts.

6.

Damage from natural disasters, such as flooding:

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a. will be covered by credit insurance.

b. will be covered by commercial insurance.

c. is not covered by any insurance.

d. is covered only by government-backed agencies.

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Chapter 13

Foreign currencies and the exchange risk

Learning objectives By the end of this chapter, you should have an understanding of: u the foreign exchange market; u spot and forward rates; u currency options; u the factors that determine whether a business should hedge its foreign exchange risks; u how forward exchange contracts and foreign currency options can be used by businesses to reduce the foreign exchange rate risks.

This chapter introduces you to the services that banks provide to minimise the risks that customers face when currency values go up and down. Buyers, sellers, businesses that buy and sell goods or services overseas, and people and businesses who invest in factories, markets or property are all directly concerned with the change in value of the domestic currency against a foreign currency. The value of currencies against each other has historically been very volatile. The customer is exposed to this volatility if they do nothing to protect the business against currency movements. This exposure is often termed the ‘exchange risk’.

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Many businesses have little choice when the currency of a contract is selected, because of: u the relative commercial bargaining power of the parties during negotiations before the contract is agreed; u convention − some trade, such as crude oil, is always quoted in US dollars; u regulation − some countries may insist on certain currencies being used: in particular, developing countries may insist that their trade is conducted in a ‘hard’ currency, such as the US dollar.

13.1

Terminology and foreign exchange conventions

There are conventions about the way currencies are expressed and how quotations for exchange rates are given. Firstly, each currency has a three-letter code, for example: u GBP for pounds sterling; u USD for US dollars; u EUR for euro; u CNY for Chinese yuan; u JPY for Japanese yen. The conventions for giving quotations follow this pattern: the first currency named in an exchange rate quotation is known as the ‘base currency’ and the second currency is known as the ‘underlying’ or ‘term’ or ‘quote’ currency. For example, if you were looking at the EUR / USD currency pair, the euro would be the base currency and the dollar would be the underlying currency. The price represents how much of the underlying currency is needed for you to get one unit of the base currency; quoted this way, a EUR / USD rate of 1.2132 means that USD1.2132 is needed to buy EUR1.0000. For some exchange rates, the quotation for the same currency pair can be shown in two different ways, the first quote showing one currency as the base and a second showing the other currency as the base. For example, for the sterling / EUR quote you could see: u EUR / GBP0.8900; or u GBP / EUR1.1200. 236

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Spot and forward rates

The key point to remember is that the first currency is always the base currency and the second one is the underlying currency. Most foreign exchange rates are quoted to four decimal places, as above, and the fourth decimal place is called a ‘basis point’ or sometimes a ‘pip’.

The International Organization for Standardization publishes a list of standard currency codes, referred to as the ‘ISO 4217 currency code’ list, available at: www.xe.com/iso4217.php [Accessed: 10 August 2016]. Look for the code for your own country’s currency and the code for the two countries with which your country trades most often.

13.2

Spot and forward rates

The ‘spot’ rate is concerned with buying or selling a currency on the day it is required or received. It is the rate that applies for a deal that will be settled on the same day, or within two working days. The bank will quote a rate, as above, and will ‘settle’ the transaction within two business days. This means that the exact day when the currency will be made available, if purchasing, must be established with the bank. For most day-to-day transactions, a bank will accept a foreign payment instruction and provide a foreign currency quotation at the same time. Customers can therefore either visit their branch or provide an electronic instruction on the bank’s system to make a payment and accept an exchange rate quote at the same time. For large sums, the delivery of the currency may be on the second business day, and that will have to be taken into account when making payments. A business that permanently relies on the spot market for its foreign exchange transactions is not taking any form of hedge against possible future movements in the exchange rate. The alternative for the customer is to fix the rate immediately they know that a payment is to be made or funds are to be received in the future. The most common fixing instrument is the forward exchange contract (forward contract).

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A forward exchange contract is a firm and binding contract between a bank and a customer, whereby they agree a rate of exchange immediately for a specific foreign exchange rate transaction that is set to take place on a preset future date or during a preset future period. Both bank and customer are bound by this agreement, and the transaction must take place on the due date in accordance with the agreement and irrespective of what the actual spot rate is at that time.

13.2.1 Advantages of forward exchange contracts The advantages of forward exchange contracts for the customer are: u simplicity; u availability in most currencies; u that quite small sums can be protected; u certainty − the customer knows exactly what they will get.

13.2.2 Disadvantages of forward exchange contracts However, there are disadvantages for the customer: u Forward contracts are of limited flexibility, being legally binding. u The customer does not have an opportunity to profit from favourable exchange movements, as the contract cannot be cancelled. This is sometimes called an ‘opportunity cost’. u For sellers, if the foreign currency is not received at the maturity date of the forward contract, the bank will ‘close out’: it will sell the currency to the customer at the spot rate and immediately repurchase it at the agreed forward rate. The resultant gain or loss will appear as a debit or a credit on the customer’s account. u Similar close-out principles will be applied to buyers who have arranged a forward contract and who then find that they do not need to make the payment. Again, the resultant gain or loss will appear as a debit or credit on the customer’s bank account. u Thus, if a customer cannot fulfil the terms of the forward contract, the close-out procedure will apply. This procedure will result in either a gain 238

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Foreign currency accounts

or a loss, depending on the spot rate at the date of the close-out. If the customer made a loss on a close-out and would not or could not reimburse the bank, the bank would incur a ‘bad debt’. Thus banks treat forward contracts as a contingent liability, based on the maximum likely loss that could arise on a close-out. This means that the amount the customer could have borrowed on conventional loans or overdrafts is reduced by the amount of the contingent liability during the life of the forward contract.

13.3

Foreign currency accounts

Where a business has regular two-way flows of foreign currencies, it is often preferable to manage the foreign exchange exposure by keeping funds in a foreign currency account. Accounts are available in euro, US dollars and most major currencies. Banks today offer a range of foreign currency accounts, accessible online, that allow customers to monitor movements on their accounts, transfer money between accounts and make payments to their foreign sellers. A business that is regularly trading in Europe, for example, may have a euro account to which euro receipts are credited and from which payments can be made to suppliers. This will act as its own partial ‘hedge’ at relatively little cost or risk. This is because the customer can match and net their exposures. A company trading with several buyers and sellers in the eurozone (and indeed with others who are willing to trade in euro as one of the two most used international currencies) can arrange that money received from sales is credited to the euro account from which payments to suppliers will also be made.

13.3.1 Main advantages of a foreign currency account The main advantages of a currency account are: u ease of access and operation for the major currencies; u that interest may be earned on the account but the rate, at times, may be lower than paid on the home currency account; u a significant reduction in the charges, as fewer purchases and sales of currency are required and the bank’s bid / offer spread is avoided; u that borrowing facilities may be agreed in foreign currencies, subject to normal lending criteria; this may be a useful strategy, when future currency proceeds are anticipated. © The London Institute of Banking & Finance 2016

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13.3.2 Main disadvantages of a foreign currency account The main disadvantages of a currency account can be summarised as follows: u At some point, a surplus on the account will have to be brought back into home currency or an overdrawn account put into funds and, unless the timing and amount required can be predicted and a forward contract booked, the balance is exposed to movements in spot exchange rates. u There will be charges for operating the account.

13.4

Currency options (pure options)

Pure options are contracts that operate more like an insurance policy. The customer pays a premium in exchange for a right to buy or sell a currency at an agreed price. When the customer has purchased their right, they have no obligation to exercise it. The following are key terms used in relation to options: u An ‘American option’ is one where the option may be exercised at any time before the option matures. u A ‘European option’ may only be exercised on the maturity date. u A ‘call option’ gives the customer / purchaser the right to buy the currency. u A ‘put option’ gives the customer / purchaser the right to sell the currency. u The ‘strike price’ is the price agreed for the call / purchase or the put / sale. u The ‘grantor’ or ‘writer’ of the option is the bank or other organisation that writes the option contract and undertakes to sell or buy at the strike price, if called upon to do so. u The ‘premium’ is the price paid by the purchaser for their call or put option. u ‘Expiration’ is the expiry date. The price or premium is determined by: the spot price or the intrinsic value; the time period of the contract; and the volatility of the currencies involved. 240

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The mathematics of calculating the price is therefore complex and it is beyond the scope of this syllabus.

Example of a pure option contract A quotation for an American option might look like this: u A put option for USD against GBP for USD35,000 u Strike price: 1.75 u Period: 180 days u Premium: GBP586.89 If the customer exercises the option at maturity, they will receive GBP20,000 for USD35,000 and will have already paid the premium of GBP586.89. If the spot value of the USD35,000 at maturity exceeds GBP20,000, the option will be allowed to lapse and the holder will sell at spot. The premium is non-refundable, irrespective of whether the option is subsequently exercised or whether it is allowed to lapse. To buy an option contract, a customer can use the services of the bank or can trade on an exchange through a broker acting on their behalf. The advantage to the customer of an option contract is flexibility and the opportunity to take a profit on the spot market when that exists, while insuring against a large loss. Options may typically be used to cover pre-contract exposure on tender to contract, where the option can be allowed to lapse if the customer fails to win the contract. However, options will not suit all customers, particularly for small trades (say less than GBP10,000 per trade), either because the premium will be relatively high for small sums or because traded option contracts are not available for small amounts.

13.5

Considerations in hedging foreign exchange transaction exposure

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Translation exposure relates to the accountancy treatment of changes in the reported values of foreign currency denominated assets, liabilities and profits. Economic exposure relates to the effect on the competitiveness of a business of movements in foreign exchange rates over the long term. These two types of exposure are outside the scope of this syllabus, and will not be considered any further here. Transaction exposure relates to the effects of changes in foreign currency rates on cash flows or profits of a business.

13.5.1 Post-transaction exposure Post-transaction exposure (often simply referred to as ‘transaction exposure’) occurs whenever a business has a contractual obligation to pay or receive a known amount of foreign currency at a known future time. The risk to the business is that it does not know − and has no means of knowing − what the relevant rate of exchange will be on the future date when the currency is actually received or paid out. In this situation, the business can: u do nothing and convert the currency at whatever the spot rate of exchange is on the date the transaction actually takes place; u hedge, ie reduce the risk by using a bank product such as a forward contract or a currency option. Doing nothing is effectively a gamble. When the transaction actually takes place, the business may be pleasantly surprised, because the rate has moved in its favour. Conversely, the surprise may be unpleasant, if the rate has moved adversely. On the other hand, hedging will introduce an element of certainty, since the rate will be fixed at the time the business enters into a forward exchange contract or the worst possible rate will be known if it buys a currency option from its bank.

13.5.2 Pre-transaction exposure The term ‘pre-transaction exposure’ applies in two instances: 1. where a business has published price lists for its products denominated in foreign currency; 2. where a business has put in a tender for a contract denominated in foreign currency and does not know whether the contract will be awarded or not. 242

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This is a more difficult exposure to manage, because the business does not know how much it will sell at the published prices, or whether it will receive any foreign currency at all in the case of tenders, since the contract may not be awarded.

13.5.3 Deciding whether to hedge transaction exposure Every business is different, so there can be no single set of criteria that determine whether a business should hedge its transaction exposure. Some studies claim that in the long run the gains and losses from unhedged currency exposure would balance out, so companies need not hedge. The studies claim that for a period that could be well in excess of five years, a policy of hedging may give the same result as a policy of not hedging. However, unhedged foreign currency exposures result in volatility of cash flows or profits. As a general rule, stakeholders in a business prefer stability of cash flows and profits. The purpose of hedging is to provide stability and predictability. In addition, large losses from unhedged foreign currency exposures could result in liquidation of the business, as bankers and creditors will not be willing to wait until exchange rates move favourably. Financially strong companies can afford not to hedge, or choose to hedge only part of the exposure, because they have the financial resources to cope with short-term foreign currency losses. However, businesses that are not as financially strong will need to hedge, as they may not be able to survive a short-term foreign currency loss. Therefore every business should have a strategy and policy for managing the risk from the movement of exchange rates. A business will need to answer the following questions to formulate its policy: u To which currencies are we exposed in our business? u Is the value and volume of each currency exposure likely to change? u How often are payments made and / or received for each currency: − regularly, eg weekly, for purchases or sales; − monthly, quarterly or annually for foreign currency loans; or − in infrequent but large sums for, eg, the repatriated profits of a subsidiary company?

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u How expensive could unhedged foreign exchange exposure be for the business? u Can the business absorb any short-term foreign exchange transaction exposures or could any potential loss seriously damage the business? u Do our competitors hedge their foreign currency risks? u Are there payments in and out in the same currency? It is possible to undertake a sensitivity analysis to show the effect on cash flow or profits of a given change in the exchange rate. It is also possible to use a technique called VaR (value at risk) to forecast the probability of the change applied in the sensitivity analysis occurring. Such techniques can help a business to assess the extent of its potential risk from foreign exchange rate movements. Once a business has a clear picture of where the main exposure lies, it can draw up a strategy to mitigate the risks, using the products outlined in this chapter. With pre-transaction exposures, hedging with a forward contract is in itself a risk: if the currency is not received, the bank will close out, which will result in either a gain or a loss depending on the spot rate at the relevant date. Hedging with options is safer, but the cost of the premium may be considered too high.

Chapter summary u The conventions for quoting currencies place the base currency before the underlying / quote currency so, for example, EUR / USD 1.3400 means that USD1.34 must be provided to buy EUR1.00. u Spot rates are available for immediate delivery (within two working days) on all major currencies, but always buying or selling ‘spot’ provides no risk protection. u Banks will quote a forward exchange rate, so that customers can remove the risk of exchange rate movements between the commercial contract date and actual receipt of the currency. u Every business should have a strategy for dealing with its risk to currency movements. This strategy should take account of the extent and timing of exposures, the potential cost of not covering the risks and the competitive position of the business. u Forward exchange contracts can be used to hedge foreign exchange transaction exposure. 244

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u Foreign currency bank accounts can be used. They provide convenience and a partial hedge where a business receives and pays regularly in the same currency. u Pure options are a form of insurance where, for a premium, a customer can buy a right to sell (‘put’) or buy (‘call’) a currency. Should the rate be more favourable on the spot market when the currency is to hand, the option may be allowed to lapse.

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Review questions The following review questions are designed so that you can check your understanding of this chapter. The answers to the questions are provided at the end of these learning materials.

1.

One very simple method of avoiding foreign currency risk between the completion of a commercial contract and receipt / payment of the foreign currency is to insist that all prices and invoice amounts are denominated in home currency. Why does this not always happen?

2.

Can a foreign currency option purchased by a bank customer create a contingent liability for a close-out, as applies with a forward contract?

3.

A UK customer has hedged a future USD100,000 currency receipt by a put option with a strike rate of GBP / USD1.4325. The dollars are received as expected on the expiry date of the option when the spot rate is GBP / USD1.4500. Will the customer exercise the option or abandon it?

4.

A bank customer will always lose and be debited with the net settlement in any close-out on a forward contract. True or false?

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5.

A small exporting business that has tight profit margins has its entire turnover denominated in foreign currency. Give one argument for hedging this exposure.

6.

Assuming that the business referred to in question 5 decided to hedge, which bank product would be the simplest for it to use?

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Chapter 14

Financial crime

Learning objectives By the end of this chapter, you should have an understanding of: u the risks that money laundering, terrorist financing and other forms of financial crime present to banks; u the international bodies with a remit to tackle financial crime; u the operational procedures that banks must follow; u key warning signs of potential criminal activity relating to trade finance transactions; u the regulatory framework relating to the prevention of financial crime.

Over the past few decades, there has been a dramatic increase in the volume of international trade, as Figure 14.1 indicates. Crucial to this meteoric rise in international trade is the role of banks, which offer the services and products that allow buyers and sellers to increase their trading activity. In any trade transaction, it is likely that one or more banks will be involved at some point. However, banks never come into physical contact with the goods being traded; they deal only with documentation, and the type and amount of documentation provided varies according to the type of transaction. For example, with documentary credits the bank may have access to inspection certificates, commercial invoices, packing lists and other documentation. In contrast, with open account trade, there may be very little or no documentation available. As a result, international trade involves an inherent risk of financial crime, particularly in relation to money laundering.

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Figure 14.1 Increase in volume of world trade in goods and services, 1969−2011 ($US bn)

Source: Organisation for Economic Co-operation and Development (2012)

Financial crime − which includes terrorist financing − can have devastating effects, expanding beyond the financial implications to include people, communities and countries. For banks themselves, the following are two key risks that arise from becoming parties − however unwittingly − to financial crime. 1. Reputational risk − a bank that becomes involved in a major money-laundering or terrorist-financing incident will suffer damage to its reputation that may prove more costly than any actual fines imposed. Furthermore, the more that a bank is perceived to be weak in its control of financial crime risks, the more attractive it becomes to criminals, and the less attractive it becomes to other banks as a correspondent. 2. Legal risk − the penalties for breaching regulations relating to financial crime can range from fines to imprisonment. A bank must ensure that employees are informed of their obligations under the law. Each bank must have written policies and procedures for escalating suspicions related to financial crime. Practitioners must be aware of these and know to whom they must report suspicions. Financial crime is a global problem, and a number of international bodies have been created to pool resources in the fight against it (see section 14.2). These bodies promote a risk-based approach to managing financial crime.

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The key factors that should be considered when applying a risk-based approach include: u product type; u jurisdiction; u customer type; u volume and value of transactions. Applying a risk-based approach means that banks can ensure that their systems and controls will focus greater effort on high-risk areas. Practitioners are advised to refer to the Financial Action Task Force (FATF) Recommendations (see section 14.2.1.1), the Wolfsberg Group paper (2000) on the risk-based approach, and other industry bodies.

14.1

Major forms of financial crime

14.1.1 Money laundering ‘Money laundering’ is the term used to describe the offence of trying to conceal money that has been obtained through offences such as drugs trafficking. Money laundering is the means by which assets (for example cash, bank accounts, cars, machinery, houses) that are the proceeds of crime have their ownership changed or disguised, so that they appear to come from a legitimate source. The term ‘money laundering’ is said to have originated in the USA in the 1930s during Prohibition, when Al Capone used laundries to hide his ill-gotten gains. He acquired a number of laundries and secured contracts with hotels to launder their linen. As this was a cash business, it was easy to include money derived from his illegitimate activities into the banking system through the laundry accounts. Another belief about the origin of the term ‘money laundering’ is that the term simply means that ‘dirty money’ is made ‘clean’. Historically, the term ‘money laundering’ was applied only to financial transactions relating to organised crime; however, its definition today covers matters such as tax evasion and false accounting.

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There are three recognised phases to money laundering. 1. Placement − cash generated from crime is introduced into the financial system. 2. Layering − money passes through several transactions and locations so as to hide its origins. 3. Integration − once the origin of the funds has been obscured, the funds are invested in legitimate funds and assets. Money launderers are becoming ever more sophisticated and it is becoming increasingly difficult to spot transactions. For example, if a documentary credit is used as a means to ‘clean’ money, all of the three phases could take place at the same time. In the introduction we alluded to the vulnerability of international trade transactions to the risks of money laundering and general financial crime. The Financial Action Task Force (FATF − see section 14.2.1) defines trade-based money laundering (TBML) as follows (APG, 2012): TBML and terrorist financing . . .refer to the process of disguising the proceeds of crime and moving value through the use of trade transactions in an attempt to legitimise their illegal origin or finance their activities. All banks are required by law to have in place procedures, including appropriate staff training, to forestall money laundering.

14.1.2 Terrorist financing The reputational risk to any bank that becomes involved in terrorist financing is potentially huge. The implications are not just financial but may be devastating in human terms. There are a number of common features between money laundering and terrorist financing. u The destination of money used to support terrorism has to be disguised, in the same way that the source of laundered funds must also be disguised. u Both activities involve the financial sector. Even if the source of funding for terrorist activity is legitimate, terrorists will often attempt to disguise it in order to preserve future funding. Many of the techniques used will be the same as techniques used to disguise the sources of the proceeds of crime. 252

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Banks also face the difficulty of how to identify assets that are derived from legitimate sources but are destined to fund future acts of terrorism. The key to the prevention of both money laundering and terrorist financing is the adoption of adequate customer due diligence procedures, both at the commencement of a relationship and on a continuing basis (see section 14.3.1).

14.1.2.1

Sanctions relating to terrorist financing

The United Nations (UN) issues a list of known terrorist organisations and individuals to the regulatory agencies of governments and banks around the globe. Some countries also apply financial sanctions against targeted individuals and countries. Banks will be subject to these sanctions to the extent that their laws require. Financial institutions will migrate these lists into their payment and trade transaction centres and systems. As SWIFT messages go through these centres, they will be screened against these lists to check for individuals and organisations subject to sanctions.

Review the following International Chamber of Commerce (ICC) guidance: ICC (2014) Guidance Paper on the Use of Sanction Clauses 2014. In trade-finance related instruments subject to ICC Rules (version 1238) [pdf]. Available at: http://www.iccwbo.org/Advocacy-Codes-andRules/Document-centre/2014/Guidance-Paper-on-the-use-of-SanctionsClauses-2014/ [Accessed: 10 August 2016]. Note that sanctions regulations overrule UCP. Additionally, note that the use of sanctions clauses causes confusion, especially where confirmation is required.

14.2

International bodies with a remit to prevent financial crime

14.2.1 Financial Action Task Force (FATF) The Financial Action Task Force (FATF) is an intergovernmental body whose purpose is ‘the development and promotion of national and international © The London Institute of Banking & Finance 2016

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policies to combat money laundering and terrorist financing’ (FATF, 2012). Established by the G7 summit held in Paris in 1989, its current mandate covers the period 2012−2020. The FATF states that its mandate: u deepens global surveillance of evolving criminal / terrorist threats identified by the FATF; u responds to new threats that affect the integrity of the financial system, such as proliferation finance (ie finance related in any way to the development, manufacture, export or storage of nuclear, biological or chemical weapons in contravention of national laws or international obligations); u builds a stronger, practical and ongoing partnership with the private sector, which is at the frontline of the global fight against money launderers and terrorist financiers; u supports global efforts to raise standards. Under the UN Organisation for Economic Co-Operation and Development, the FATF sets the standards that all competent authorities follow. As of April 2016, the FATF has 37 members (35 jurisdictions and 2 regional organisations) that represent the major financial centres in the world, as listed in Table 14.1. Table 14.1

FATF members (as of April 2016)

Argentina

Finland

Japan

Singapore

Australia

France

Luxembourg

South Africa

Austria

Germany

Malaysia

Spain

Belgium

Greece

Mexico

Sweden

Brazil

Gulf Co-operation Council

Netherlands

Switzerland

Canada

Hong Kong, China New Zealand

Turkey

China

Iceland

Norway

UK

Denmark

India

Portugal

USA

European Commission

Ireland

Republic of Korea

Italy

Russian Federation

Financial Action Task Force members (2016)

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Several other countries belong to various regional groupings that do similar work. As the list of member countries increases regularly, you are advised to visit the FATF website (www.fatf-gafi.org [Accessed: 10 August 2016]) to check the current membership.

14.2.1.1

The FATF Recommendations

Having been given the task of examining the techniques used by launderers and trends in money-laundering activity, the FATF published a report in 1990 containing 40 recommendations for the prevention of such activity. These recommendations have regularly been updated so that they remain relevant; recommendations relating to terrorist financing have also been added. The latest update was completed in 2012, and is now referred to as the FATF ‘40 Recommendations’. In this paper they are defined as ‘international standards on combating money laundering and combating financing of terrorism and proliferation’ and are intended to be of universal application. The FATF Recommendations are used to: u guide governments on the activities that their anti-money-laundering regulations should cover; u guide regulators on how companies in their jurisdiction should comply with the standards, guidelines and overall international framework; u cover the requirements for customer due diligence (CDD), anti-moneylaundering measures, financial crime reporting and countermeasures; u demonstrate what financial crime is, and what firms, regulators and law enforcement agencies should do. The FATF Recommendations cover: u terrorist financing and proliferation finance; u customer due diligence; u additional measures for specific customers and activities; u Financial Institution Groups − including reliance on third parties, international controls and higher-risk countries; u reporting of suspicious transactions; u legal processes and beneficial ownership; u guidance for regulators and enforcement agencies. © The London Institute of Banking & Finance 2016

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14.2.2 The Wolfsberg Group The Wolfsberg Group is an association of 13 global banks, whose aims are to develop industry standards and related products for ‘know your customer’, anti-money-laundering and counter-terrorist financing policies. The banks are: u Banco Santander; u Bank of America; u Bank of Tokyo-Mitsubishi UFJ; u Barclays; u Citigroup; u Crédit Suisse; u Deutsche Bank; u Goldman Sachs; u HSBC; u JP Morgan Chase; u Société Générale; u Standard Chartered Bank; u UBS. They came together in 2000 at Château Wolfsberg in Switzerland to work on drafting anti-money-laundering guidelines for private banking. The Wolfsberg Anti-Money-Laundering Principles for Private Banking were published in October 2000, with regular revisions since, the latest being in June 2012. The group has also published a number of papers and recommendations, including: u Wolfsberg statement on the suppression of the financing of terrorism (2002); u Wolfsberg statement on monitoring screening and searching (2003); u Wolfsberg trade finance principles (2011);

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u Principles on intermediaries and beneficial ownership (2012); u Wolfsberg anti-money-laundering principles for correspondent banking (2014). The Wolfsberg Group’s recommendations and papers are considered by many banks worldwide and not just the 11 banks in the group. For the latest details on its activities, see http://www.wolfsberg-principles.com/ [Accessed: 10 August 2016].

14.2.3 Financial intelligence units Many countries have a financial intelligence unit (FIU) that will provide information on current money laundering and terrorist financing trends. Examples of FIUs include the following (all websites accessed 10 August 2016): u UK: www.nationalcrimeagency.gov.uk u USA: www.fincen.gov u Hong Kong: www.jfiu.gov.hk u Singapore: www.cad.gov.sg u Australia: www.austrac.gov.au u Canada: www.fintrac.gc.ca The Egmont Group is a group of FIUs that aims to facilitate international co-operation. They meet regularly to find ways to co-operate, especially in the areas of information exchange, to train, and to share expertise.

14.3

Prevention of financial crime

14.3.1 Account opening and maintenance Banks handle their legal responsibilities on a ‘risk assessment’ basis. That is, they examine the nature of the businesses they deal with and the processes involved and apply a risk assessment to each business and process. Opening an account for a new customer is clearly an activity in which there is a real risk of taking on a customer involved in criminality. To minimise this risk, customer due diligence (CDD) and ‘know your customer’ (KYC) procedures are required. © The London Institute of Banking & Finance 2016

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For clarification, practitioners should be aware that KYC broadly refers to the initial gathering of information, whereas CDD broadly refers to the assessment of the information gathered and continous monitoring. The better a bank knows its customers and understands the basics of its commercial relationship with them, the less likely it is to be associated with a firm that will attempt to carry out money-laundering or terrorist-financing activity. CDD requirements are broadly based on the following procedures: u Account information must include all address information, contact details and taxation information on the customer. u Account information must be retained and accessible in trade finance processing systems. u Changes in customer information must be made immediately to computer databases. u Material changes in ownership must be noted in customer information files. Regulators expect CDD to be carried out by a bank on the customer who is classified as the ‘instructing party’ for the purpose of the transaction. They also expect relevant information to be available to trade finance operations staff, so that they can ensure that the transaction meets these parameters of the account. Parties included as ‘applicant or beneficiary’ or ‘drawer or drawee’ will be designated as ‘instructing parties’ by most regulators. Additional due diligence on other parties to the transaction should be performed, as dictated by the bank’s own financial crime risk management policies and procedures. Once the account is open and transactions are passing through the account, bank staff should be aware of money-laundering techniques. Transactions that might put staff ‘on notice’ include: u requests that do not seem to make commercial sense; u unusual sums in cash being paid in or transferred; u the involvement of third parties − if the customer is acting for someone else, then the bank needs to know who they are and be satisfied that they are bona fide; u transactions that involve ‘inappropriate assets’ − for example, why would a company selling computer parts from China to France suddenly want to ship an expensive car to Colombia?

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If a member of bank staff is suspicious of a transaction on a bank account, they should follow their bank’s procedure to report their suspicions. Each bank should have a designated money laundering reporting officer. Trade practitioners need to be aware of their customers’ business and business patterns to ensure that no ‘irregular’ transactions are processed without appropriate review.

14.3.2 Main methods used in trade-based money laundering A 2011 paper from the Wolfsberg Group (Wolfsberg Trade Finance Principles) highlighted the use of trade finance to ‘obscure the illegal movement of funds, including methods to misrepresent the price, quality or quantity of goods’ (The Wolfsberg Group, 2011). The main methods identified in the paper are outlined below. u Over-invoicing − by misrepresenting the price of the goods in the invoice and other documentation (stating it at above the true value), the seller gains excess value as a result of the payment. u Under-invoicing − by misrepresenting the price of the goods in the invoice and other documentation (stating it at below the true value), the buyer gains excess value when the payment is made. u Multiple invoicing − by issuing more than one invoice for the same goods, a seller can justify the receipt of multiple payments. u Short shipping − the seller ships less than the invoiced quantity or quality of goods, thereby misrepresenting the true value of goods in the documents (this is similar to over-invoicing). u Overshipping − the seller ships more than the invoiced quantity or quality of goods, thereby misrepresenting the true value of goods in the documents (this is similar to under-invoicing). u Deliberate obfuscation of the type of goods − parties may structure a transaction in such a way as to avoid raising the suspicion of banks or other third parties that become involved. This may simply involve omitting information from the relevant documentation or deliberately disguising or falsifying it. This activity may or may not involve a degree of collusion between the parties involved and may be for a variety of reasons or purposes. u Phantom shipping − no goods are shipped and all documentation is completely falsified.

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14.3.3 ‘Red flags’ Certain features of international trade transaction are ‘outside the norm’ and therefore warrant additional scrutiny. Such ‘red flags’ include the following: u no transport documents evidencing movement of goods; u description of goods on the transport document not matching the documentary credit terms and / or actual invoice; u customers resubmitting documents that have already been rejected due to financial crime or suspicion of financial crime; u military goods; u goods such as sugar, cement, urea, precious gemstones, luxury cars, mobile phones, tobacco / cigarettes, liquor, and scrap metals; u dual-purpose goods (ie products and technologies normally used for civilian purposes but that may have a military application); u bill of lading consigned to a ‘to be advised party’ chosen between applicant and beneficiary; u request for proceeds of the transactions to be paid to an unrelated or unexplained third party; u change of a beneficiary name and address; u trade-related standby letter of credit claim made within a short time or immediately on / after issuance; u direct claim to issuer, where the trade-related standby letter of credit is advised through another bank with the claim to be routed via a nominated bank; u invoice showing other / undefined charges as being greater than a percentage variance (to be determined by the individual bank) of the total transaction value; u documentary credit overdrawn / overshipped by more than a percentage variance (to be determined by the individual bank) of the original value / quantity; u bill of lading describing containerised cargo but without container numbers or with sequential container numbers; u intermediary trade where price difference / arbitrage is greater than a percentage variance (to be determined by the individual bank) of the transaction value; 260

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u transaction requires referral; u suspicious client contact; u pre-accepted discrepancy(ies) by the applicant; u applicant is overly keen to waive discrepancy(ies); u shipment locations of the goods or shipping terms are inconsistent with the documentary credit. Each bank will identify appropriate ‘red flags’ through its own risk-based assessment process, or will have them defined by a regulator. The list above is only indicative. BAFT published its updated guidelines on international suspicious activity in 2015. The guidelines are designed to provide clarity for banks when combating money laundering and financial crime, and implementing trade compliance policies. The details of Guidance for Identifying Potentially Suspicious Activity in Letters of Credit and Documentary Collections can be found on this link: www.baft.org/policy/library-of-documents/ suspicious-activity-guide—citf [Accessed: 10 August 2016].

14.3.4 Issues relating to other types of financial crime There are also many other instances where a fraud can take place through the banking system. The following are some issues of which practitioners need to be particularly aware. u Forged signatures − a bank has virtually no chance of recovering on a draft, cheque or promissory note from any party whose signature has been forged. u Fake, faulty or non-existent goods − banks often rely on the goods for security in a trade transaction and if the goods themselves have no value, the bank has no security. u Fraudulent claims − a particular problem in the insurance industry. A common example is the inflated claim, where either the value of what is lost is exaggerated or the claim is ‘added to’ by including other goods that were not damaged.

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Take a look at the process flows and points at which checks should be made: The Wolfsberg Group (2011) Wolfsberg trade finance principles [pdf]. Available at: http://www.wolfsberg-principles.com/pdf/standards/ Wolfsberg_Trade_Principles_Paper_II_(2011).pdf [Accessed: 10 August 2016]. Nowadays some of the main dangers to the world banking system tend to come from criminals intent on stealing money from banks or their clients by illegally accessing (‘hacking’) banks’ IT systems, and often diverting funds and information for their own benefit. ‘Phishing’ exercises, where emails purporting to come from banks persuade clients to reveal passwords and other private information to criminals, are regularly found in many people’s inboxes and often succeed in their purpose. For fraud related to trade, practitioners are directed to look at sources of information such as Lloyds of London Sea-Searcher Checks and publicly available information from shipping companies that identifies vessel journeys.

14.4

Regulation

Breaches in compliance with regulations and laws have cost many banks heavily over the past few years, with banks paying multibillion-pound settlements for alleged cases of money laundering, sanctions breaking or misleading clients. Increasingly, legislation is aimed at the criminal prosecution of individuals involved in processing or facilitating each transaction.

14.4.1 International regulation The FATF cannot impose fines or enforce legislative actions. However, its recommendations are used internationally to guide government regulators, who can then impose fines or enforce legislative actions as appropriate. Furthermore, a variety of international standards exist. The Bank for International Settlements (BIS) in Switzerland, for example, has recently released a paper (2014) on the ‘Sound management of risks related to money laundering and financing of terrorism’.

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14.4.2 Regional regulation Banks in countries that are members of regional trade groupings are often required to obey laws and regulations made outside their own countries. In the European Union, for example: u banks are controlled by the European Securities and Markets Authority, covering the securities industry and trading infrastructure; u the European Banking Authority regulates and enforces EU rules on capital requirements, credit and market risk, liquidity, leverage and resolution of institutions in case of collapse; u the European Insurance and Occupational Pensions Authority will have an interest in banks operating in those areas; u the European Central Bank in Frankfurt controls banks in areas of the EU that use the euro. In the USA, many organisations exist to regulate elements of banks, including the Office of the Comptroller of the Currency, the Federal Reserve System, the Office of Foreign Assets Control (OFAC), and the Department of Justice.

14.4.3 Domestic regulation The FATF releases assessments on how certain countries are managing money-laundering and terrorist-financing risks within their domestic economies and legal systems. Countries that are found to be deficient in their countermeasures are named by the FATF through the issuance of public statements. There are many domestic organisations controlling the activities of banks in their own countries. u UK − the Bank of England has wide responsibilities for monitoring the soundness and suitability of banks operating in the country, and the Prudential Regulation Authority assesses the risks being taken by UK and foreign banks. The Financial Conduct Authority polices all financial markets in the UK, watching out for mis-selling and financial crime. Legislation, such as the Bribery Act 2010, has had a great effect on banks, as bribe funds are often transmitted through the banking system. u USA − the Federal Reserve is the central bank of the United States. It is responsible for regulating the US monetary system, as well as monitoring the operations of holding companies, including traditional banks and banking groups. The US Department of the Treasury was originally © The London Institute of Banking & Finance 2016

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created to manage government revenues, but has evolved to encompass several different duties, including recommending and influencing fiscal policy, regulating US imports and exports (including managing OFAC), and collecting US revenues such as taxes; it also designs and mints all US currency. u Hong Kong − the principal regulators are the Hong Kong Monetary Authority, the Securities and Futures Commission, the Office of the Commissioner of Insurance, and the Mandatory Provident Fund Schemes Authority. They are responsible respectively for regulation of the banking, securities and futures, insurance, and retirement scheme industries. u Singapore − banks are regulated by the Monetary Authority of Singapore (MAS). The MAS is the central bank of Singapore, as well as the financial regulatory authority, and its main role is to administer the various statues pertaining to money, banking, insurance, securities, and the financial sector in general, as well as currency issuance. u China − the China Banking Regulatory Commission regulates banks. The People’s Bank of China, the central bank of the People’s Republic of China, also has the power to control monetary policy and regulate banks in mainland China. The State Administration of Foreign Exchange is responsible for drafting rules and regulations governing foreign exchange market activities and managing the state foreign exchange reserves.

14.4.3.1

Domestic regulation with international implications

There are some examples of domestic regulation that has implications for businesses operating internationally. For example, the US Sarbanes-Oxley Act (SOX) 2002 was passed after the Enron collapse to oblige companies and their officials to work to higher standards of honesty and accuracy. However, as most banks around the world need to have US dollar accounts to deal with international trade, they need to comply with SOX provisions, and increasingly, with the requirements of the Dodd-Frank Act 2010; otherwise, they risk being unable to trade in US dollars or even risk facing criminal charges in the USA. Another important piece of legislation in the fight against money laundering is the USA PATRIOT Act 2001. The acronym stands for Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001. The USA has always taken a robust approach to money laundering, and when this Act was signed by George W. Bush on 26 October 2001, the world’s governments paid attention. The Act reduced restrictions on law enforcement agencies’ ability to search telephone, email, medical, financial and other records. It also gave them 264

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the authority to regulate financial transactions, particularly those involving foreign individuals and entities.

14.5

Environmental and sustainability compliance

Many banks have environmental and sustainability targets, as part of their corporate social responsibility policies. As this area becomes increasingly scrutinised, it adds another layer of potential regulation.

Chapter summary In this chapter we have provided an overview of financial crime, focusing on money laundering and financing of terrorist activity. We have considered the international bodies that have a remit to prevent financial crime, in particular the FATF and the Wolfsberg Group. We have outlined the measures that banks must put in place in order to prevent financial crime and some of the warning signs relating to international trade finance transactions of which practitioners should be aware. We have also looked briefly at other common types of financial crime that sometimes take place through the banking system. Finally, we have given an overview of the regulatory environment in which banks must operate.

References APG (2012) APG typology report on trade based money laundering [pdf]. Available at: www.fatf-gafi.org/media/fatf/documents/reports/Trade_Based_ML_APGReport.pdf [Accessed: 10 August 2016]. Basel Committee on Banking Supervisions (2014) Sound management of risks related to money laundering and financing of terrorism [pdf]. Available at: www.bis.org/publ/bcbs275.pdf [Accessed: 10 August 2016]. FATF (2010) Combating proliferation financing: A status report on policy development and consultation [pdf]. Available at: www.fatf-gafi.org/media/fatf/documents/reports/Statusreport-proliferation-financing.pdf [Accessed: 10 August 2016]. FATF (2012) About the FATF [online]. Available at: http://www.fatf-gafi.org/about/ [Accessed:1 April 2016]. Organisation for Economic Co-operation and Development (2012) OECD Stats [online] https://stats.oecd.org [Accessed: 10 August 2016].

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14: Financial crime The Wolfsberg Group (2002) Wolfsberg statement on the suppression of the financing of terrorism [pdf]. Available at: http://www.wolfsberg-principles.com/pdf/standards/ Wolfsberg_Statement_on_the_Suppression_of_the_Financing_of_Terrorism_(2002).pdf [Accessed: 10 August 2016]. The Wolfsberg Group (2003) Wolfsberg statement on monitoring screening and searching [pdf]. Available at: http://www.wolfsberg-principles.com/pdf/standards/Wolfsberg_ Monitoring_Screening_Searching_Paper_(2003).pdf [Accessed: 10 August 2016]. The Wolfsberg Group (2011) Wolfsberg trade finance principles (2011) [pdf]. Available at: www.wolfsberg-principles.com/pdf/standards/Wolfsberg_Trade_Principles_ Paper_II_(2011).pdf [Accessed: 10 August 2016]. The Wolfsberg Group (2012) Wolfsberg anti-money-laundering principles for private banking (2012) [pdf]. Available at: www.wolfsberg-principles.com/pdf/standards/WolfsbergPrivate-Banking-Prinicples-May-2012.pdf [Accessed: 10 August 2016]. The Wolfsberg Group (2014) The Wolfsberg anti-money laundering principles for correspondent banking [pdf]. Available at: http://www.wolfsberg-principles.com/pdf/ standards/Wolfsberg-Correspondent-Banking-Principles-2014.pdf [Accessed: 10 August 2016].

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Review questions

Review questions The following review questions are designed so that you can check your understanding of this chapter. The answers to the questions are provided at the end of these learning materials.

1.

Which of the following is not a stage in the money-laundering process? a. Placement

b. Layering

c. Integration

d. Folding

2.

What is the name of the intergovernmental body charged with developing and promoting policies to combat money laundering and terrorist financing?

3.

How many recommendations did the above organisation make? a. 30

b. 40

c. 50

d. 60

4.

UCP overrules sanctions regulations. True or false?

5.

What is the name given to a financial transaction where no goods are shipped and all documentation is completely falsified?

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6.

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Which organisation acts as a central bank for the USA?

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Chapter 15

Bank payment obligations (BPOs)

Learning objectives By the end of this chapter, you should have an understanding of: u what is meant by a bank payment obligation (BPO); u how BPOs work and what tools are required; u the benefits of BPOs to sellers and buyers; u the International Chamber of Commerce Uniform Rules for Bank Payment Obligations (URBPO).

In Topic 7 and Topic 8 we looked at documentary collections and at documentary credits respectively. These provide more security to sellers than selling on open account terms where, for example, the buyer may not be well known or may not be financially sound. As the names suggest, both of these settlement terms rely on the physical transmission of documents, with the inherent risk of increased cost and time delays. This chapter looks at a new type of payment instrument: the bank payment obligation (BPO).

15.1

How was the concept of the BPO developed?

The finance of trade is a long-established, highly specialised branch of banking that is critical to the successful and efficient flow of commerce. Traditional mechanisms and instruments, such as documentary collections and documentary credits, are so well established and trusted that there has © The London Institute of Banking & Finance 2016

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been limited innovation in this domain over the last several decades, if not hundreds of years. While technology has evolved to enable faster and more efficient processing, the fundamental nature of traditional trade finance has remained largely unchanged. Continuing evolutions in technology, together with shifting priorities and preferences of buyers and sellers, have to some extent driven a move away from traditional instruments, underpinning a search for new business models and new solutions in support of trade. The widespread adoption of trade on open account terms is a direct consequence of the changes in global sourcing and supply chains, challenging banks to deliver more creative and cost-effective solutions for the mitigation of risk and financing. If industry forecasts for growth prove correct, by 2020 not only will the value of world trade have doubled, but there will also be at least an additional USD20 trillion worth of business, all being conducted on open account. In the face of these changing market dynamics, the effective management of credit and liquidity is of growing importance as a powerful strategic tool, not only in the context of risk mitigation and payment assurance, but also in having ready access to cost-effective working capital finance. To achieve these goals, it is recognised that there needs to be enhanced process efficiency, enabling clear visibility into the physical supply chain (the movement of goods from one place to another), linking to the financial supply chain (the movement of money in the opposite direction) and facilitating the fast exchange of data and speedy resolution of disputes. The International Chamber of Commerce (ICC) Banking Commission is the trusted rule-making body for the banking industry. SWIFT is the trusted platform for banks around the world to exchange structured messages securely, not only in support of traditional trade but also in related payments, foreign exchange and financing. Given these trusted positions, the ICC and SWIFT have been able to collaborate closely with a broad range of industry stakeholders, including leading members of the banking and corporate communities, to develop the bank payment obligation, backed by new technology, new messaging standards and a new set of industry rules that together provide a fresh response to the evolving needs of businesses engaged in international commerce. It should be noted that the BPO is not a product, but rather a framework, complete with processes, rules, standards and practices aimed at the provision of solutions in trade and supply chain finance. It can be used by financial service providers to enhance a broad range of financial supply chain product offerings.

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How does a BPO work?

15.2

How does a BPO work?

A BPO is an irrevocable undertaking given by one bank to another bank that payment will be made on a specified date after a successful electronic matching of data according to an industry-wide set of rules. The successful establishment and completion of a BPO transaction require the close interaction of three critical components: 1. the transaction matching application (TMA), which provides the platform for the exchange of messages; 2. the ISO 20022 tsmt messaging standards (see section 15.2.2), which enable the data to be presented and matched in a structured way, according to accepted industry practice; 3. the ICC Uniform Rules for Bank Payment Obligations (URBPO), providing a framework for BPO transactions in much the same way as UCP 600 provides a framework for documentary credits (see Topic 8). If we consider a documentary credit as placing an obligation on an issuing bank to pay, subject to the physical presentation of compliant documents, then the BPO places a similar obligation on an issuing bank (known as the ‘obligor bank’) to pay, subject to the electronic presentation of compliant data. These data are presented (and matched) through a central transaction matching application (TMA). To develop new products based around a BPO, a bank must: address its product positioning relative to existing open account and documentary solutions; and deploy a technology platform that can support communication not only with the corporate client but also with a central TMA, such as SWIFT’s Trade Services Utility, while interacting with the bank’s own accounting, credit, capital reporting and payment applications. To make these products successful, a bank must also develop its own commercialisation plan. A BPO is made up of the following data elements: u the bank that must make payment under the BPO (the obligor bank); u the bank that receives payment under the BPO (the recipient bank); u the maximum amount that will be paid under the BPO; u the date of expiry of the BPO; u the amount of charges to be taken by the obligor bank; u the country whose law governs the transaction; u payment and settlement terms (at sight or deferred). © The London Institute of Banking & Finance 2016

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The BPO allows for a variety of features and commercial scenarios, including the acceptance of mismatches and amendments, the engagement of multiple banks in one BPO transaction, the ability to handle partial shipments, and the option to share risk among banks through the distribution of obligations under the BPO. The BPO transaction life cycle formally begins with an ISO 20022 message called an ‘Initial Baseline Submission’. The counterparty bank must resubmit an identical version of the baseline in order for the transaction to become established. The transaction cannot be established, and therefore the BPO cannot be established, unless both sides agree. As soon as the two baselines match, the BPO becomes an irrevocable undertaking conditional on the matching of the specified data.

15.2.1 BPO workflow From a corporate perspective we can think of a BPO transaction in four distinct stages (see Figure 15.1). 1. The buyer and seller contract to use a BPO as the method of payment. 2. The relevant purchase / sales order data are passed to each bank. 3. After shipment, the seller provides commercial and transport data to its bank. 4. When the commercial and transport data have been matched to the purchase order data, the BPO is due and payment (or an undertaking to pay at an agreed future date) will follow. All of these steps involve interactions between buyers, sellers and their respective banks without touching the TMA. These steps are therefore outside the scope of the TMA service and outside the scope of the URBPO. There are no rules governing the way in which data are exchanged between a corporate customer and a bank. This is purely a matter for negotiation between the customer and its selected service provider. From a bank perspective, we can also think of a BPO transaction in four stages (see Figure 15.2). 1. The buyer’s bank uses the purchase order data to submit a baseline, and the seller’s bank uses the purchase order data to resubmit the baseline. This enables the transaction to become established. 2. Both the buyer’s bank and the seller’s bank receive a baseline match report, to confirm that the two baselines match.

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Figure 15.1

Interactions outside the scope of the URBPO

Source: SWIFT

3. Once the goods are shipped, the seller’s bank submits the invoice and transport data to the TMA. 4. The data set match report confirms that the invoice and transport data match the baseline and the BPO is due.

15.2.2 ISO 20022 standards The International Organization for Standardization (known as ISO) is the world’s largest developer and publisher of International Standards, with a membership of more than 160 national standards bodies. ISO 20022 is a set of standards developed by ISO for use in the financial industry. Usage of ISO 20022 messages results in consistency and uniformity of format and terminology through use of a common data dictionary. The adoption of structured ISO 20022 tsmt messaging standards is mandatory to support the exchange of BPO data through a recognised TMA. © The London Institute of Banking & Finance 2016

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Figure 15.2 Interactions inside the scope of the URBPO where the buyer’s bank is the only obligor bank

Source: SWIFT

ISO 20022 standards are the methodology established by ISO for message development and specify the format for commercial, transport, insurance and certificate data sets to be submitted by a bank in relation to an underlying BPO transaction. ISO 20022 organises financial message definitions by business area, each one of which is uniquely identified by a four-character business area code. In the case of trade services management, the business area code is tsmt. As is the case with other ISO standards in the area of financial services, ISO 20022 standards for tsmt messages are publicly available and are not proprietary to any technology provider or financial institution. The Initial Baseline Submission message can be submitted either by a bank acting on behalf of a buyer or by a bank acting on behalf of a seller. The BPO is an optional part of a baseline, which can be established from the outset or added later by way of an amendment. The baseline contains all of the details of the data-matching terms and conditions that must be met in order for the BPO to be enforced. In order to establish a baseline − and in so doing to establish the BPO − the counterparty bank must resubmit the baseline to the TMA as a confirmation 274

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How does the BPO compare with existing tools?

that both banks agree on what the baseline looks like. This also confirms that both banks agree on the data-matching terms and conditions. As soon as the two baselines match, the BPO becomes an irrevocable undertaking conditional on the matching of the specified data. Later in the transaction life cycle, the goods will be shipped and the physical documents sent directly from the seller to the buyer (as in a conventional open account environment). At the same time, the seller will provide to its bank the relevant data elements that have been extracted from the underlying documents. The bank acting on behalf of the seller will submit those data sets into the TMA for matching.

15.2.3 Combining the BPO with an electronic bill of lading Running in parallel with the development of the bank payment obligation as a new financial instrument, a number of initiatives designed to support the dematerialisation of trade documents, including the bill of lading, have been put forward. These initiatives may be viewed in the overall context of the digitisation of trade whereby banks are required to rely much less on physical collateral and far more on data analytics and associated business intelligence to support their business value propositions. In the early stages, market adoption of both the BPO and the dematerialisation of trade documents has been relatively slow. There is, however, a popular belief that by combining the digital concept of a BPO with an electronic bill of lading, it is possible to create a more compelling proposition for the corporate market. The way in which such a proposition is designed to work is simple. First, the corporate counterparties will agree upon the BPO as a method of payment. Having taken the appropriate steps to establish the BPO via the transaction matching application, the seller will then create an electronic bill of lading to be held in escrow, pending submission of the requisite data sets. When the data sets are submitted and successfully matched, the obligation of the buyer bank to pay is crystallised and the electronic bill of lading may be released to the buyer.

15.3

How does the BPO compare with existing tools?

The closest comparable tool to a BPO is the documentary credit (see Topic 8), which guarantees payment by the issuing bank or confirming bank, as long as certain documentary conditions are met. However, promoters of BPOs are © The London Institute of Banking & Finance 2016

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keen to differentiate the two instruments and do not wish BPOs to be seen as an electronic form of a documentary credit. It is emphasised that, although BPOs and documentary credits are both conditional payment instruments, with the BPO the payment is triggered by presentation of electronic data, rather than hard-copy documents such as invoices and bills of lading. It is important that BPOs are perceived to be a more secure alternative to pure open account trading, requiring (possibly) less use of credit insurance. Another advantage is the speed of the transaction. The BPO has the potential to remove several days from the seller’s ‘days sales outstanding’ (DSO), thus improving its cash flow and working capital positions. In this context, it should be noted that a common measure of management effectiveness is the cash conversion cycle, combining activity ratios related to accounts receivable, accounts payable and inventory turnover. The cash conversion cycle is based upon a combination of DIO (days inventory outstanding) plus DSO (days sales outstanding) minus DPO (days payables outstanding). In other words, it calculates the number of days working stock is held as part of inventory plus the number of days it takes to collect payment from debtors whilst taking away the number of days taken to pay creditors. The lower the net result, the more efficient the organisation is in its deployment of cash. Some retailers are able to work to a negative cash conversion cycle by selling stock before paying suppliers. One material difference between a BPO and a documentary credit is that the BPO is given by a bank (the obligor bank) in favour of another bank (the recipient bank), whereas a documentary credit is issued by a bank in favour of a corporate client − the seller and ultimate beneficiary. Consequently, it is not technically possible for a BPO to be ‘confirmed’ in the traditional sense. Hence, the role of a ‘confirming bank’, which is commonly used in documentary credit transactions, does not apply in the case of a BPO transaction. When and how value is passed to the seller is outside the scope of the URBPO, and will form part of a separate agreement between a recipient bank (the seller’s bank) and its customer. Included in the terms of such an agreement, the recipient bank can issue another contingent obligation towards the seller, based on the BPO received. This can have the same effect as a silent confirmation of a documentary credit, whereby a beneficiary can enter into a separate arrangement with a negotiating bank to commit to negotiate the documentary credit on its due date.

15.4

What are the benefits of BPOs?

15.4.1 Benefits for the seller The following sections outline the benefits of using BPOs for the seller. 276

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15.4.1.1

Assurance of payment

A BPO provides an assurance of being paid in full on the due date, according to the terms of the contract, provided the requisite data are presented and matched.

15.4.1.2

Cash flow forecasting and working capital management

Day-to-day cash flow can be managed in an efficient manner, as can treasury forecasts, anticipating in advance any opportunities to invest or requirements to borrow.

15.4.1.3

Dispute resolution

The BPO process for handling mismatches and other data issues presents an attractive alternative to the often time-consuming and expensive business of resolving discrepancies in physical documentation. Data mismatches are identified and reported quickly, providing the opportunity for such mismatches to be accepted or rejected without delay. The definition of a data mismatch is less subjective than a discrepancy in a paper document, since in the case of a data element it either matches or does not match.

15.4.1.4

Amendments

The terms and conditions attached to a BPO transaction can be amended quickly and easily by mutual agreement between the involved banks. This includes the ability to: create a transaction without a BPO but then add the BPO later by way of an amendment; or change the due date of the payment. Such flexibility can provide additional advantages in relation to the cost of capital and hence the cost of financing.

15.4.1.5

Risk mitigation

A BPO establishes a baseline agreement, so that everyone involved can share a common view and level of comfort, hence facilitating the mitigation of risk. Having multiple BPOs for a single transaction creates a wider opportunity for trade asset distribution, for example in a lead bank model where one bank may invite other obligor banks to participate in a risk. If multiple obligor banks are involved in a single TMA transaction, the amount due by each obligor bank is proportional to its share of the total of all BPO amounts. No joint and several obligations are created.

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15.4.1.6

Finance

In the absence of a documentary credit, sellers lack the collateral to obtain finance under open account. Available options may be limited to factoring or invoice discounting. With a BPO, a comprehensive range of financing options can be made available, including pre-shipment and post-shipment finance.

15.4.2 Benefits for the buyer The following sections outline the benefits of using BPOs for the buyer.

15.4.2.1

Securing the supply chain

The BPO allows the buyer to provide key suppliers with an assurance of being paid on time according to the agreed payment terms. This assurance of payment comes from the obligor bank (or banks) being legally committed to pay on the due date, provided the data submitted by the seller’s bank are compliant with the agreed terms. From a cash management point of view, this is beneficial to both buyers and sellers alike, since it delivers certainty on cash flow in and out. The ability to provide such an absolute level of payment assurance clearly strengthens the buyer−seller relationship, possibly resulting in the opportunity to negotiate improved terms and conditions. Buyers who engage in a BPO contract with one or more sellers will contribute to the streamlining of supply chain processes, resulting in enhanced risk mitigation and improved efficiency. This may be turned into a competitive advantage over other buyers, resulting in improved payment terms.

15.4.2.2

Finance

From a buyer perspective, a BPO is obviously safer than pre-payment. It allows the buyer to confirm that the goods have been shipped on or before the due date according to the required specification, before committing to pay. Because the electronic processing of data is faster, the buyer can potentially get quicker access to banking services, including financing where required. Because the BPO provides banks with greater visibility into the trade transaction, the buyer can also benefit from specific financing services (eg extended payables finance), tailored to working capital needs at any stage of the transaction life cycle. This feature is similar to what is available through the existing documentary credit practices, but offers a wider spectrum of financing opportunities in a more timely fashion. Because it can be created 278

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What are the benefits of BPOs?

at any time during the life cycle of a transaction, and for an amount that can differ from the total value of the goods, the BPO offers greater flexibility than a documentary credit. It can also help to spread payment risk across several obligor banks, for example by instructing a lead bank to allocate the risk according to a trade asset distribution model. This flexibility could result in lower financing costs as well as reduced costs for the seller, creating more value in the supply chain and potential opportunities for higher degrees of accuracy and objectivity. For critical suppliers, a buyer may decide to offer a BPO in order to ensure that the goods ordered continue to be delivered on time and that there are no interruptions in the supply chain. A seller can obtain financing from its bank at different stages in the transaction life cycle. The BPO can be used to sustain the seller’s working capital in support of, for example, production (pre-shipment finance, inventory finance), product shipment (packing and distribution loans) or business development and growth. Failure to have access to these facilities could prove detrimental to the seller’s continued ability to trade.

15.4.2.3

Process efficiency

While the manual documentary credit process implies a detailed verification of documents, including a line-by-line examination of some of the shipping documents, the BPO requires only the matching of a limited number of relevant data elements to guarantee the payment or to support a proposition for financing. At the same time, there is the added flexibility that in the event of data mismatches being found, the buyer has the immediate discretion to accept or reject such mismatches, so reducing the risk of extended disputes and delay. Buyers trade with multiple sellers across the globe, often in different jurisdictions resulting in a variety of payment terms, and potentially using more than one supply-chain finance platform. These platforms use different exchange mechanisms, from electronic proprietary data formats, to fax and email. The cost of integration with corporate back-office applications becomes prohibitive, when the number of trading players grows or varies over time. It also implies significant on-boarding costs (ie the process of bringing suppliers ‘on board’ to participate in the financing scheme) and lengthy ‘know your customer’ processes. The BPO is designed for a four-corner business model, involving a buyer, a seller, a buyer’s bank and a seller’s bank. The goal is to help buyers to reach multiple suppliers through selected banks in the existing correspondent banking network.

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15.5

In what circumstances should a BPO be considered?

The following are some of the circumstances where the use of a BPO in international or domestic trade may be considered appropriate. Where: u a buyer and a seller wish to trade on open account terms, but seek bank assistance to help with the mitigation of risk; u a buyer and a seller wish to trade on open account terms, but the seller additionally seeks an assurance of payment from the bank; u a buyer and a seller wish to trade on open account terms, but bank assistance may be required to support short-term working capital financing arrangements; u a buyer and a seller wish to trade on open account terms but to keep open the possibility of obtaining bank assistance for financing at any time during the transaction life cycle; u the costs associated with alternative forms of trade or supply chain finance are unacceptable to one or both parties and threaten to compromise the trading relationship; u the exchange of paper documents is mandated as between buyer and seller, but such documents are not required to be physically presented through the banking system.

15.6

ICC Uniform Rules for Bank Payment Obligation (URBPO)

The ICC Banking Commission has adopted BPOs as an accepted market practice, in the same way that documentary credits became accepted under the ICC Uniform Customs and Practice for Documentary Credits rules (UCP − see Topic 8). Having worked jointly with SWIFT on the development of the rules, the ICC approved the Uniform Rules for Bank Payment Obligations (URBPO), publication no. 750, version 1.0 in April 2013, with an implementation date of 1 July 2013 (ICC, 2013). While some banks have already conducted transactions with the use of a BPO, others are currently involved in developing their own solutions and have clients trying to identify potential counterparts. The foreword to the URBPO states clearly that the use of BPOs is aimed as a solution to supply-chain financing problems. It is hoped that banks and 280

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ICC Uniform Rules for Bank Payment Obligation (URBPO)

non-bank providers will respond with financing services to complement BPOs and meet their clients’ needs, whether in international or domestic trade. There are 16 articles in the URBPO, and the areas covered are outlined below.

Article 1 Article 1a defines the scope of the URBPO as follows: The ICC Uniform Rules for Bank Payment Obligations (URBPO) provide a framework for a Bank Payment Obligation (BPO). A BPO relates to an underlying trade transaction between a buyer and seller with respect to which Involved Banks have agreed to participate in an Established Baseline through the use of the same Transaction Matching Application (TMA).

Article 2 Article 2 describes the applicability and binding nature of the URBPO subject to specific version numbering and mandatory use of ISO 20022 messaging standards.

Article 3 Article 3 provides a list of general definitions and how these should be interpreted in the context of the URBPO. For example: u an ‘involved bank’ means a seller’s bank or recipient bank (depending upon its role at any given time), a buyer’s bank, an obligor bank or a submitting bank; u the recipient bank is the beneficiary of the BPO and will always be the seller’s bank; u the buyer’s bank may or may not act as an obligor bank; u a submitting bank is a bank whose only role is to submit data.

Article 4 Article 4 provides a list of message definitions, describing all such ISO 20022 tsmt messages as may be used in a BPO transaction.

Article 5 Article 5 provides specific interpretations within the scope of the rules, eg that branches of a bank located in different countries are considered as separate banks.

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Article 6 Article 6 indicates the separate nature of a BPO from the underlying contract.

Article 7 Article 7 describes how BPO data may be extracted from the physical documents which, in the majority of cases, may still exist. Banks involved in a BPO transaction deal in data, not documents or the goods, services or performance to which the data or documents may relate.

Article 8 Article 8 covers the expiry date for the submission of data sets. The use of Universal Time Co-ordinated (UTC) allows for the adoption of a consistent and standard timing protocol on a global basis. UTC is recognised as the primary standard by which world time is regulated: it is commonly used in the synchronisation of computer systems and the internet.

Article 9 Article 9 covers the role and responsibilities of an involved bank, including the obligation to act without delay on receipt of a message from a TMA.

Article 10 Article 10 covers the undertaking of the obligor bank, including those scenarios in which there may be more than one obligor bank.

Article 11 Article 11 covers the subject of amendments, again including scenarios where there may be more than one obligor bank.

Article 12 Article 12 covers the use of a disclaimer clause, consistent with other ICC rules.

Article 13 Article 13 addresses the concept of ‘force majeure’, also consistent with other ICC rules.

Article 14 Article 14 specifies that an involved bank cannot be held liable if a TMA is unavailable.

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Chapter summary

Article 15 Article 15 specifies applicable law (being that of the country where the branch or office of the obligor bank is situated).

Article 16 Article 16 confirms that a recipient bank has the right to assign any proceeds under a BPO.

15.7

Guidelines on BPO Customer Agreements

In light of the fact that the bank payment obligation is a bank-to-bank instrument only, and not a bank-to-corporate obligation, it should be noted that both the prescribed ISO 20022 tsmt messages and the ICC Uniform Rules for Bank Payment Obligations are limited in scope to cover bank-to-bank communications and obligations only. There are no equivalent messaging standards or rules governing the relationships between the corporate and the bank. This is considered by some to be a gap. In order to address some of these concerns, the International Chamber of Commerce has published a set of guidelines covering the creation of BPO customer agreements (ICC, 2015). It is emphasised that these are ‘guidelines’ and not ‘rules’. The document does not therefore provide a suggested text of a contract or agreement since such agreements should always remain within the domain and control of the bank concerned. The guidelines contain a list of categories and components to be considered. There is also an appendix relating to specific bank financing products and services but it remains the responsibility of each bank to assess the legal and operative feasibility in each case.

Chapter summary This chapter has looked at the subject of bank payment obligations (BPOs) and the ICC rules covering them: u BPOs are designed to enable faster, cheaper payments and enhanced working capital management. They are an addition to the existing toolkit of solutions available to buyers and sellers engaged in ongoing trading relationships. u BPOs have been created in response to the changing nature of international trade, particularly the growth of open account trade. © The London Institute of Banking & Finance 2016

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u The BPO transaction life cycle formally begins with an ISO 20022 message called an ‘Initial Baseline Submission’. The counterparty bank must resubmit an identical version of the baseline in order for the transaction to become established. The transaction cannot be established, and therefore the BPO cannot be established, unless both sides agree. As soon as the two baselines match, the BPO becomes an irrevocable undertaking conditional on the matching of the specified data. u Benefits of BPOS to the seller include: − assurance of payment; − cash flow forecasting and working capital management; − dispute resolution; − amendments; − risk mitigation; − finance. u Benefits of BPOs to the buyer include: − securing the supply chain; − finance; − process efficiency. u There are a number of situations in which buyers and sellers wishing to trade on open account terms might consider the use of a BPO, for example risk mitigation or support for working capital financing arrangements. u The Uniform Rules for Bank Payment Obligations (URBPO) have been effective since 1 July 2013. Appropriate situations for the use of a BPO have been examined. A summary of the ICC URBPO rules has been provided.

References ICC (2013) Uniform rules for bank payment obligations. ICC Publication No. 750E. ICC (2015) ICC Guidelines for the Creation of BPO Customer Agreements [pdf]. Available at: http://www.iccwbo.org/Advocacy-Codes-and-Rules/Document-centre/2015/ICCGuidelines-for-the-Creation-of-BPO-Customer-Agreements/ [Accessed: 10 August 2016].

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Review questions

Review questions The following review questions are designed so that you can check your understanding of this chapter. The answers to the questions are provided at the end of these learning materials.

1.

In the world of trade finance, what does the term ‘BPO’ mean? a. Business process outsourcing

b. Bank payment obligation

c. Broker price opinion

d. Bank payment order

2.

What are the three components that must interact with one another to facilitate the successful completion of a BPO transaction?

3.

How can a BPO become established?

4.

Who is the beneficiary of a BPO?

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5.

How can a BPO be confirmed?

6.

If a transaction contains multiple BPOs, what is the obligation of each obligor bank?

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Appendix A

Bibliography

The publications listed below are available from the ICC online store: store.iccwbo.org/ Title

Publication No.

ICC Uniform Customs and Practice for Documentary Credits (UCP 600)

600

ICC Uniform Rules for Bank-to-Bank Reimbursements Under Documentary Credits (URR 725)

725E

ICC Uniform Rules for Bank Payment Obligations

750E

ICC Uniform Rules for Collections (URC 522)

522

ICC Uniform Rules for Demand Guarantees (URDG 758)

758

ICC Rules for Documentary Instruments Dispute Resolution Expertise (DOCDEX)

811

ICC Uniform Rules for Forfaiting (URF 800)

800E

International Standard Banking Practice for the Examination of Documents under Documentary Credits (2013 Revision for UCP 600) (ISBP)

745E

ICC Supplement to the Uniform Customs and Practice for Documentary Credits for Electronic Presentation (eUCP version 1.1) Incoterms ® 2010 International Standby Practices (ISP98)

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Appendix B

Answers to review questions

Chapter 1 Chapter 2 Chapter 3 Chapter 4 Chapter 5 Chapter 6 Chapter 7 Chapter 8 Chapter 9 Chapter 10 Chapter 11 Chapter 12 Chapter 13 Chapter 14 Chapter 15

Introduction The international trade environment Contracts Intermediaries and how they operate Documents used in international trade and the Incoterms® 2010 rules Methods of settlement Documentary collections Documentary credits Short-, medium- and long-term trade finance Islamic trade finance Guarantees and standby letters of credit Export credit insurance Foreign currencies and the exchange risk Financial crime Bank payment obligations (BPOs)

Chapter 1

289 290 291 291 291 292 292 293 293 294 294 294 295 296 296

Introduction

1.

True. Ownership and management are the same with sole traders and small partnerships. Ownership and management are not the same for public limited companies, so there is potential for conflict, known as ‘agency theory’ here.

2.

Because the value of the foreign currency may change, which can lead to unexpected financial gains or losses unless managed very closely.

3.

True. Canada should cease to produce clothing and should switch the resources to car production. China should cease to produce cars and should switch resources to clothing production. The two countries should then trade cars from Canada in exchange for clothing from China. This is referred to as the theory of comparative advantage.

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4.

Reduction of trade costs by cutting red tape in customs procedures.

5.

The three main activities of the ICC are rule setting, dispute resolution and policy advocacy.

Chapter 2 The international trade environment 1.

Here are two typical examples: An exporter agrees to sell goods priced in foreign currency and grants two months’ credit to the buyer. When the exporter receives the foreign currency, the amount of home currency into which it is converted may be more or less than expected, depending on the exchange rate at the time. An importer agrees to buy goods priced in foreign currency and is allowed two months’ credit by the seller. When the importer pays the foreign currency, the amount of home currency required to obtain the funds for payment may be more or less than expected, depending on the exchange rate at the time. Note: The exchange rate could move either way, so there is the possibility of making gains on favourable foreign exchange rate movements as well as of making losses.

2.

Once the goods are assembled, it could then take a number of weeks for them to be shipped before they arrive at their destination. In addition, in order to secure an export sale, the exporter may have to grant extended sales terms. This additional time may put a strain on the working capital facility of a business and it may need additional finance in order to fund the time gap between shipment and receipt of payment.

3.

Trade missions are co-ordinated overseas visits by a group of business individuals representing their company. The aim is for them to meet potential overseas buyers or sellers.

4.

An exporter’s bank can obtain credit information and reports on potential customers.

5.

Direct through to the end user; appointment of an agent or distributor; a joint venture; international franchising or licensing.

6.

A joint venture (JV) is a legal entity formed between two or more parties, sometimes referred to as a co-operative agreement. The company wishing to export would find a local overseas company with which it would look to work together in the targeted country.

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Chapter 5

Documents used in international trade and the Incoterms® 2010 rules

Chapter 3

Contracts

1.

The correct answer is a.

2.

Accept the offer as presented, make a counter-offer or reject the offer completely.

3.

False. India, South Africa and the UK are three major nations that have not ratified the CISG.

4.

False. The CISG is divided into four parts: Sphere of application; Formation of contract; Sale of goods; Final provisions.

5.

Decisions made by courts can be inconsistent between different contracting countries (due to local laws); multiple-language versions sometimes appear inconsistent with each other (local language problems − some languages lack certain terms); and it does not yet cover all aspects (eg electronic contracts).

6.

The London Court of International Arbitration; the American Arbitration Association International Centre for Dispute Resolution; the Hong Kong International Arbitration Centre.

Chapter 4 Intermediaries and how they operate 1.

True.

2.

The correct answer is a.

3.

The correct answer is d.

4.

False. For the French bank it is a nostro account; for the US bank it is a vostro account.

5.

‘The system known as Real-time gross settlement (RTGS) describes payment systems that transfer and settle payments electronically in real time (instantaneously) on a one-to-one basis between banks’.

Chapter 5 Documents used in international trade and the Incoterms® 2010 rules 1.

The Bills of Exchange Act 1882.

2.

False. Norway, Iceland, Liechtenstein and Switzerland are EFTA members.

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B: Answers to review questions

3.

An unconditional promise in writing made by one person to another signed by the maker, engaging to pay, on demand at a fixed or determinable future date a sum certain in money to, or to the order of, a specified person or bearer.

4.

False. There are three levels (A, B and C) in the General Cargo Clauses.

5.

Written agreements between a bank holding specific goods pledged to the bank as security, and a borrower or buyer.

6.

1 January 2011.

Chapter 6

Methods of settlement

1.

False. Advance payment poses the highest risk for the buyer.

2.

Documentary collections.

3.

Documentary credits.

4.

Open account.

5.

True. Any participants in large cash transactions risk being investigated in relation to potential money laundering; such payments are therefore inadvisable.

Chapter 7

Documentary collections

1.

The correct answer is b.

2.

False. The principal is usually the seller of the goods involved.

3.

The correct answer is c.

4.

No, but it should check that documents listed on the covering schedule are indeed enclosed.

5.

Nothing. The goods will already have been released to the importer when the bill was accepted.

6.

Issue an indemnity to the shipping agents at the port of arrival, enabling them to release the goods to the buyer client without presentation of a bill of lading. A counter-indemnity or cash cover for the value of the goods will be required from the client.

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Chapter 9

Short-, medium- and long-term trade finance

Chapter 8

Documentary credits

1.

The correct answer is d.

2.

The correct answer is a.

3.

False. The bank deals only in documents.

4.

21 calendar days.

5.

A transferable documentary credit.

6.

The local confirming bank will ensure that the exporter received funds in return for a compliant presentation of documents. This is useful when the overseas bank that opened the documentary credit is not well known, or is in a country where the authorities might interfere with payments out of the country.

Chapter 9 Short-, medium- and long-term trade finance 1. 2.

The correct answer is d. a. The document that the importer will be required to sign and which the bank will retain is a trust receipt. b. The document that the bank will give to the customer in order to allow him to obtain possession of the goods from the warehouse is a delivery order.

3.

False. Factoring is only suitable where the terms of trade are simple and straightforward. This effectively means open account terms. In addition, it should be easy to negotiate a term bill of exchange drawn under a documentary credit, once the bank has checked that the documents conform to its terms (assuming that the issuing bank is sound). Thus the documentary credit can provide post-shipment finance anyway.

4.

Supply chain finance.

5.

True. Documents against payment are less risky. With ‘documents against acceptance’ collections, the goods will have been released on acceptance. With documents against payment, the negotiating bank will retain control of the goods until payment is made by the buyer.

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Chapter 10

Islamic trade finance

1.

The correct answer is c.

2.

The ideal instruments of financing in Islamic finance are those based on profit-and-loss sharing concepts, namely musharaka and mudaraba.

3.

True.

4.

False.

Chapter 11 Guarantees and standby letters of credit 1.

False − the company’s bank would be the issuer. The company is known as the ‘applicant’ or the ‘principal’.

2.

A bid (or tender) bond.

3.

The correct answer is c.

4.

Local laws and practices.

5.

If the purchaser makes an advance payment to the seller before goods or services are delivered, then the bond will enable the purchaser to claim back the advance in case of non-delivery.

6.

A guarantee, while it remains valid, is regarded as a contingent liability on the applicant’s balance sheet.

Chapter 12

Export credit insurance

1.

The correct answer is d.

2.

False. The confirmed documentary credit is a guarantee of payment, provided the issuing and confirming bank are sound. Failure to be able to claim on the credit would mean that there was some flaw in the documents. In that case, it would be unlikely that there would be any valid claim under any credit insurance policy either.

3.

The correct answer is c.

4.

False. See ‘Excess or “catastrophe” policies’ in section 12.2.3.

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Chapter 13

Foreign currencies and the exchange risk

5.

The insurer will have a vast database, which will track the creditworthiness of potential overseas buyers, and can advise the exporter of the status of any new potential buyers who want credit.

6.

The correct answer is b.

Chapter 13 Foreign currencies and the exchange risk 1.

It may not be possible to insist on all pricing being denominated in home currency, because: u the counterparty may be in a stronger commercial bargaining position; u convention − some trade, such as crude oil, is always quoted in US dollars; u regulation − some countries may insist on certain currencies being used: in particular, developing countries may insist that their trade is conducted in a ‘hard’ currency such as the US dollar.

2.

No. An option gives the purchaser the right, but not the obligation, to do something. Hence, once the premium has been paid, the option holder has no obligations, only rights.

3.

USD100,000 converted at the strike rate = 100,000 / 1.4325 = GBP69,808.03 USD100,000 converted at the spot rate = 100,000 / 1.4500 = GBP68,965.52 So the option will be exercised to obtain more sterling.

4.

False. A close-out of a forward exchange contract could result in a net debit to the customer’s account or in a net credit. It is the spot rate at the date of close-out that will determine whether there is a loss or a gain on the close-out for the customer.

5.

‘Small’ and ‘tight’ margins imply that there will not be the financial resources to cope with any foreign currency losses. Hence hedging would be recommended.

6.

Forward exchange contract.

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B: Answers to review questions

Chapter 14

Financial crime

1.

The correct answer is d.

2.

Financial Action Task Force (FATF).

3.

The correct answer is b.

4.

False.

5.

Phantom shipping.

6.

The Federal Reserve Bank.

Chapter 15 (BPOs)

Bank payment obligations

1.

The correct answer is b.

2.

The Transaction Matching Application (TMA) must interact with ISO20022 tsmt messaging standards and the URBPO.

3.

One way in which a BPO can become established is when an initial baseline submission message submitted by one bank (eg the buyer’s bank) matches the baseline submission message of another bank (the seller’s bank) and the baseline contains a BPO. Another way could be for an established baseline to be amended by mutual agreement in order to add a BPO.

4.

The beneficiary of a BPO is always the recipient bank, which is always the seller’s bank.

5.

A BPO is a bank-to-bank obligation and not a bank-to-corporate obligation. As such, it cannot be confirmed in the normal way.

6.

In the case of multiple BPOs, the obligation of each obligor bank is proportional to its share of the total of all BPO amounts. No joint and several obligations are created.

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