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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)

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The International Chamber of Commerce (ICC) is the largest, most representative business organization in the world.
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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
Institutes 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 ifs University College in the UK. Peter is an Associate and a
Fellow (ACIB & FCIB) of the Chartered Institute of Bankers, and also holds
the Institutes 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 worlds 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 has last
position at ABN Amro, he was the Global Trade Product Head based
in London. Gary is a Visiting Professor for ifs University College and a
contributing editor to the fourth 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

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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 1
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

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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.

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1: Introduction

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 todays 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 Chapter 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.

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1: Introduction

Table 1.1 Using Ricardos theory of comparative advantage


Wine Cloth Total
production
units for 1
litre/wine and
1 roll/cloth
Portugal: number of units 1 1 2
of production required to
produce 1 litre/ wine or 1
roll/ cloth
England: number of units 3 1 4
of production required to
produce 1 litre/ wine or 1
roll/ cloth

Table 1.2 A simplified illustration of Ricardos theory of comparative


advantage
Portugal England
Total number of units of 2 4
production used
Total output produced 2 litres of wine 4 rolls of cloth
Net output after exchange of 1 litre of wine and 2 rolls of cloth
2 rolls of cloth by England 2 rolls of cloth and 1 litre of wine
for 1 litre of wine from
Portugal
Net gain from comparative 1 roll of cloth 1 roll of cloth
advantage

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.

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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 clients 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.

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1: Introduction

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 owners 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.

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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 partnerships 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.

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1: Introduction

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 companys 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 companys 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 companys 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 companys
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.

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1: Introduction

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 sellers bank.

These aspects are discussed in detail at various stages of 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

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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 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, for example in Asia,
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 some countries at least there


seem to be signs that growth is beginning to return; other countries are,
however, not so fortunate.

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1: Introduction

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, 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 WTOs 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 worlds trading countries.

According to its website (WTO, 2013a):

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 into the middle to help the disputing
parties reach an agreement. There are a number of ongoing disputes where
the WTO is mediating (WTO, 2013b).

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.

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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 6m companies, chambers of commerce
and business associations in more than 130 countries. National committees

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1: Introduction

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 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 ICC 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 worlds leading arbitral institution.
Another service is the World Chambers Federation, the ICCs 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 inter-governmental
forums including the G20.

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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).

ifs University College 2014 15


1: Introduction

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 (no date) Overview [online]. Available at:
https://www.nafta-sec-alena.org/Default.aspx?tabid=88&language=en-US
[Accessed: 3 November 2013].

u Association of Southeast Asian Nations (ASEAN). See: ASEAN (2012) Joint


communiqu [online]. Available at: www.asean.org/news/asean-
statement-communiques?controller=zoofilter&task=dosearch&search_
id=66688&app_id=5 [Accessed: 2 November 2013].

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: 3 November 2013].

u The EU has a list of all ongoing bilateral trade agreements between itself
and other trading blocs or nations. See:
Europa (2013)The EUs bilateral trade and investment agreements
where are we? [online]. Available at: europa.eu/rapid/press-release_
MEMO-13-734_en.htm
[Accessed: 3 November 2013].

u The web page bilaterals.org gives details of many of the bilateral trade
agreements that currently exist. See:
Bilaterals. org (no date) www.bilaterals.org/spip.php?rubrique168
[Accessed: 3 November 2013].

References
ICC (2012) ICC commission on taxation [pdf]. Available at: www.iccwbo.org/Advocacy
Codes-and-Rules/Document-centre/2014/ICC-Commission-on-Taxation-Handbook/
[Accessed: 6 March 2014].
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: 6 March 2014].

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Review questions

WTO (2013a) About the WTO: A statement by former Director-General Pascal


Lamy [online]. Available at: www.wto.org/english/thewto_e/whatis_e/wto_dg_stat_e.htm
[Accessed: 2 November 2013]).
WTO (2013b) Current status of disputes [online]. Available at: www.wto.org/english/tratop_e/
dispu_e/dispu_current_status_e.htm [Accessed: 3 November 2013].

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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1: Introduction

18 ifs University College 2014


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.

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2: The international trade environment

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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Considerations of the risks involved in international trade

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 2.2.1section 2.2.7.

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2: The international trade environment

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 sellers
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.

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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 buyers
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 sellers 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

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2: The international trade environment

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, as sadly today some banks are
not as financially strong as others.

From the buyers point of view, the risk is that payment may be made but
the goods or services prove to be faulty. Hence the buyers 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 guarantees, 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 further 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 ifs University College 2014


Researching the market

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 Chapter 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 purpose, 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


Chapter 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: The international trade environment

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
departments 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

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Researching the market

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 Chinas largest trade fair; it is held
every April and October and displays a complete product range of Chinese
commodities. It is divided into three sections: machinery, electrical and
electronic products; home and decoration; textiles, garments and fashion
accessories.

2.3.4 Banks
Most banks have trade finance operations and some have managers who
are specifically targeted at 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 countrys 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 banks correspondent network (banks in overseas countries


with an established relationship with their bank) or the banks 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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2: The international trade environment

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.

If you cannot find the information, see:


HSBC (2013) HSBC launches Manifesto for British Exports [online].
Available at: www.newsroom.business.hsbc.co.uk/ press/release/hsbc_launches_manifest
[Accessed: 6 March 2014]. This website describes a typical bank service
offering.

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 customers or suppliers bank may be willing


to provide a status enquiry for a nominal fee. The information contained

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Researching the market

in the report will vary between the countries where they are issued. It
may contain just a few lines that comment on the credit worthiness 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
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, Moodys and Standard & Poors 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 and
Atradius. Further details on credit insurance are given in Chapter 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.

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2: The international trade environment

Social media, or business-related media such as LinkedIn, can provide


opportunities for low-cost promotion.

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

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Methods of entering an overseas market

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.

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

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2: The international trade environment

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
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 countrys law.

2.4.1.5 Co-marketing
Co-marketing is an arrangement in which one manufacturer agrees to
distribute a second overseas firms 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 companys 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

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Methods of entering an overseas market

territory or industry sector. They are often employed on a commission


basis and usually work for a number of non-competing companies. Often
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 Purchases the goods outright,
control of the goods, therefore is taking ownership and control,
not assuming risks 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 Usually has the authority to set the
price selling price of the goods
Would not usually provide after-sales Quite often provides after-sales
support support
Can be selective or sole
distributorships

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2: The international trade environment

2.4.3 Joint ventures


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. 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 countrys 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
McDonalds 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 companys
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.

2.4.4 International licensing and franchising


International licensing is where 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 franchisors name and business model. International
franchising has been very successful for many of the fast food outlets, such
as McDonalds, 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 franchisee would usually pay a lump sum up front and then a royalty

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2: The international trade environment

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;

36 ifs University College 2014


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 6 March 2014):

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


(www.koreaexim.go.kr/en/exim/glance/manage_01.jsp)

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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2: The international trade environment

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?

38 ifs University College 2014


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.

ifs University College 2014 39


40 ifs University College 2014
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

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3: Contracts

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
companys 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 (www.iccwbo.org/products-and
-services/trade-facilitation/model-contracts-and-clauses/). The ICCs 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 sides 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,

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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 resume 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 sub-standard 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 in the 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;

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;

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3: Contracts

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.

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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

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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 customers 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

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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 September 2013 it had been ratified by 80 countries, which accounts


for a significant proportion of world trade. A full list of signatories and their
current status can be found at: www.uncitral.org/uncitral/en/
uncitral_texts/sale_goods/1980CISG_status.html [Accessed: 6 March 2014].

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: Contracts

3.4.1 Content of the CISG


The CISG is divided into four parts.

Part I Sphere of application and general provisions (Articles


113)

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 1424)

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 2588)

Articles 2588 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

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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 Chapter 5 for further discussion of Incoterms).

Part IV Final provisions (Articles 89101)

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: 6 March 2014].

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: Contracts

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 others
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 principals 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.

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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 Courts website (www.iccwbo.org/about-icc/organization/


dispute-resolution-services/icc-international-court-of-arbitration/
[Accessed: 6 March 2014]) 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 . . .(13)

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.

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3: Contracts

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 (2014) Recommended clauses [online].
Available at: www.lcia.org/Dispute_Resolution_Services/LCIA_Mediation_Clauses.aspx
[Accessed: 6 March 2014].
UNCITRAL (1985) Model law on international commercial arbitration (2006 rev. edn.) [pdf].
Available at: www.uncitral.org/pdf/english/texts/arbitration/ml-arb/07-86998_Ebook.pdf
[Accessed: 6 March 2014].

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 ifs University College 2014


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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54 ifs University College 2014
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

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4: Intermediaries and how they operate

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. 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 sellers 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
counterpartys 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: www.transparency.org/cpi2012 [Accessed: 6 March
2014].

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 Chapter 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

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4: Intermediaries and how they operate

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 Sellers Buyers


hands of for risk risk
buyer before
(B) or after
(A) payment

Open account: Goods shipped and B As per Highest Lowest


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 High Low but


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 B As per Medium to Low*


with payment on D/A terms contract. The high
documents to be released against buyer will
acceptance accept a bill
of exchange
payable
after a fixed
number of
days

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The balance of risk between the seller and buyer

Table 4.1. (cont.) The balance of risk between the seller and buyer

Payment method contracted Goods in When paid Sellers Buyers


hands of for risk risk
buyer before
(B) or after
(A) payment

Collection through a bank with A On Low but Low*


documents released against presentation if buyer
payment of documents refuses
payment,
goods will
need to
be stored,
resold or
returned

Documentary credit Depends After Low 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
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.

For a perspective on documentary collections, visit a US government


website:
Export Gov (2012) Chapter 4: Documentary collections [online].
Available at: export.gov/tradefinanceguide/eg_main_043246.asp
[Accessed: 6 March 2014].

For a perspective on documentary credits, visit an Australian


government website:

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4: Intermediaries and how they operate

Export Finance Navigator (2013) Documentary credit [online]. Available


at: www.exportfinance.gov.au/Pages/Documentarycredit.aspx#content
[Accessed: 6 March 2014].

Make a list of the similarities and differences between a documentary


collection and a documentary credit. This will help you to prepare for
Chapter 7 and Chapter 8.

4.5 Intermediaries involved in the


export transaction
Once the seller and buyer are satisfied as to each others 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
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


Chapter 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
Chapter 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.

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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 sellers premises and
delivered to the carrier at the appropriate time and can liaise with its overseas
offices to co-ordinate delivery to the buyer.

Freight forwarders 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.

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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.

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 (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 EXW applies, the sellers 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 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

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The range of services provided by banks

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.

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 customers 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

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4: Intermediaries and how they operate

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;

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 banks 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.

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Correspondent banking

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).

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 todays 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 it 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,

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4: Intermediaries and how they operate

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
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


banks 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.

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Correspondent banking

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 banks 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.

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.

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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: www.assignmentpoint.com/business/finance/
assignment-on-nostro-and-vostro-accounts.html [Accessed: 6 March
2014].

4.9.3 Use of BIC and IBAN


Banks require all transfers within the EU must 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).

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).

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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
countrys own RTGS systems.

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 banks 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.

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4.9.6 Bank drafts and customer cheques


Payments can also be made with bank drafts, a form of cheque drawn by
a buyers bank, payable to the seller and drawn on the buyers banks
correspondent in the sellers country. If the draft is in the sellers own
currency, the funds can be credited directly to the sellers account. If the
draft is not in the sellers 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 sellers bank may either agree to negotiate the
cheque credit the sellers 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 sellers account to recover the amount originally negotiated.
Negotiation facilities are therefore at the banks discretion.

A collection means that the seller will only get funds when its bank receives
payment from the buyers bank.

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 buyers government. The buyers bank and the
beneficiarys 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 buyers 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 buyers 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

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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 sellers 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 (2013) Lockbox, cheque negotiation and collection [online].
Available at: www.business.hsbc.co.uk/1/2/international-business/
international-payment-processing/lockbox [Accessed: 6 March 2014].

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.

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
USA banks. Prior to CLS, the UK Bank plc would have needed nostro /
vostro relationships with each USA bank, the alternative being to face

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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 USA 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, which 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;

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 message 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?

a. Open account.

b. Documentary collection.

c. Documentary credit.

d. Payment in advance.

3. 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:

The system known as describes payment systems


that transfer and settle payments electronically in real time
(instantaneously) on a one-to-one basis between banks.

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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 Chapter 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. All

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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 had
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.

5.1.2 Sale and purchase of goods to and from


the rest of the world
Each country will need to be considered individually and / or as part of
another trading bloc such as the North American Free Trade Agreement
(NAFTA), the trading bloc of the USA, Canada and Mexico. Some countries

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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: 21 February 2014]). 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 2014) 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. 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.

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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

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 drawers 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 below.

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 buyers 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.

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.

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Figure 5.1 Example of a term draft

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 person from whom
the holder took it. 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
draft is payable on presentation to the drawee and therefore the issue of
acceptance does not arise.

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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 drawers
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 acceptors 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.

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 holders legal rights. It is common that within
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

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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.

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.

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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, as explained above hence the
description quasi-negotiable.

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
discharge. Banks usually require a bill of lading to be made out to the banks
order, ie To order of [name of bank] or to the shippers 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 Chapter 7) or for payment by documentary credit (see
Chapter 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) below.

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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 who 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 ships 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.

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 Chapter 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 importers
bank.

There is a current 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.

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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-electronic
-bills-of-lading-frequently-asked-questions-faqs-6167/
[Accessed: 5 February 2014].

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
buyers 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 banks 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.

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.

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They are documents issued by carriers or their agents that describe the
goods and contain a contract of carriage, but do not evidence title to the
goods and are not negotiable.

The goods will be released to the consignee specified on the document


against simple identification. For journeys of short duration, non-negotiable
sea waybills are essential, since there will not normally be time for a
negotiable bill of lading to arrive for prompt clearance of the goods.

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
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 todays 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.

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5.3.2 Commercial and other documents


In the negotiation stages, a contract, purchase order or pro forma invoice
(see Chapter 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);

u describe the merchandise, often itemised by price and quantity;

u include all charges and costs for the buyers account and specify the
Incoterm (see section 5.4 below) 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 Chapter 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 importers 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 exporters country.

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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.

Not all importing countries require production of consular invoices, but


those that do almost always charge a fee for certification. When a consular
invoice is not available, the consulate will authenticate the exporters 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 details 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.

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 exporters 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

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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
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
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 selected clarifies which party or parties
are responsible for arranging and paying for insurance. Banks that advance

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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.

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;

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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);

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 sellers 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 buyers order. Under a
documentary credit, such endorsement will be completed according to the
terms of that credit.

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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 sellers premises to a carrier or its agent within the sellers
country;
u from the carrier or its agents premises in the sellers country to a named
point in the buyers country (eg a port, airport or container depot);
u from the port, etc, in the buyers country to the buyers own premises.
It is vital to establish a clearly defined point of delivery of the goods,
to indicate where the sellers responsibility ends and where the buyers
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.
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

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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. Table 5.1 below explains 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.

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Table 5.1 EXW


Incoterm Standard ICC abbreviations
Ex works [named place of delivery, EXW
eg Adderley Road, Hackney]
Obligations of Speirs and Responsibilities of Woldal Ltd
Wadley Ltd (exporter) (importer)
Make the goods available for Take delivery from Adderley Road.
collection from Adderley Road, Make all arrangements at own cost
Hackney, by Woldal Ltd. Once to take goods to own premises. It
collected by Woldal, all responsibility is in Woldals interests to arrange
of Speirs and Wadley is ended. A appropriate insurance to cover this
commercial invoice or electronic journey. The obtaining of relevant
equivalent electronic message will export and / or import licences
be provided for Woldal. Goods will and also the completion of any
be suitably packed, unless it is the customs formalities and payments
norm for the goods involved to be for the export of the goods is the
delivered unpacked. responsibility of Woldal.

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Table 5.2 FCA


Incoterm Standard ICC abbreviations
Free carrier [named place of FCA
delivery, eg Hackney container
depot]
Obligations of Speirs and Responsibilities of Woldal Ltd
Wadley Ltd (exporter) (importer)
Make the goods available to Make all arrangements at own cost
Hackney Containers at the inland and risk to cover transport of goods
container depot on the exporters to own premises from Hackney
means of transport, not unloaded. container depot. It is in Woldals
(Note: If the goods were to have interests to arrange appropriate
been made available at the premises insurance to cover this journey.
of Speirs and Wadley, delivery would Woldal should obtain any import
be incomplete until the goods had licence and perform any customs
been loaded onto the carriers own requirements necessary for the
transport.) Advise delivery of the import of the goods, including
goods at Hackney container depot paying all costs, duties and taxes.
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.

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Table 5.3 FAS


Incoterm Standard ICC abbreviations
Free alongside ship [named port of FAS
shipment, eg Tilbury]
Obligations of Speirs and Responsibilities of Woldal Ltd
Wadley Ltd (exporter) (importer)
Complete export and customs Make arrangements with a shipping
requirements, including obtaining company for transport of goods by
any export licence and paying any sea to Hong Kong. Notify Speirs
costs, duties and taxes. Supply and Wadley of the day and time
Woldal with commercial invoice or that delivery is required at the
its equivalent electronic message, port of Tilbury and the name of
together with proof of delivery, the nominated vessel. Woldal is
eg a transport document. Deliver responsible for all risks from the
goods to the quayside alongside quayside in Tilbury to the delivery of
the nominated vessel at the port of the goods to their final destination.
Tilbury, after which the liability of It is in Woldals interests to arrange
Speirs and Wadley basically ends. appropriate insurance to cover this
Goods will be suitably packed, journey. Woldal should obtain any
unless it is the norm for the goods import licence and perform any
involved to be delivered unpacked. customs requirements necessary for
FAS terms are mainly used in the the import of the goods, including
bulk and break-bulk trade (ie where meeting all costs involved, duties
goods such as coal are shipped and taxes.
loose in bulk).

Table 5.4 FOB


Incoterm Standard ICC abbreviations
Free on board [named port of FOB
shipment, eg Tilbury]
Obligations of Speirs and Responsibilities of Woldal Ltd
Wadley Ltd (exporter) (importer)
As for FAS, but Speirs and Wadleys As for FAS, but with the exception
delivery liability does not end until that Woldal does not assume
the goods have been loaded on responsibility for the goods until
board a named vessel at Tilbury. 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 CFR
destination, eg Hong Kong]
Obligations of Speirs and Responsibilities of Woldal Ltd
Wadley Ltd (exporter) (importer)
Arrange and pay for transport of Woldal should obtain any import
goods to Hong Kong port. Loading licence and perform any customs
and unloading costs should be requirements necessary for the
met, if they form part of the charge import of the goods, including
for carriage. Complete export and meeting all costs involved, duties
customs requirements, including and taxes. It is in Woldals interests
obtaining any export licence and to arrange and pay for insurance
paying any costs, duties and taxes. of the goods from when they are
Advise Woldal of delivery of the on board the vessel in Tilbury. If
goods on board the carrying vessel unloading costs are not covered by
and also details of the voyage. the charge for carriage, Woldal must
Supply Woldal with a commercial also pay these.
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.

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Table 5.6 CIF


Incoterm Standard ICC abbreviations
Cost, insurance and freight [named CIF
port of destination, eg Hong Kong]
Obligations of Speirs and Responsibilities of Woldal Ltd
Wadley Ltd (exporter) (importer)
As for CFR but, in addition, Speirs As for CFR, but insurance risk falls
and Wadley must insure the goods on Woldal only when the goods have
as far as the port of Hong Kong and been offloaded from the vessel at
supply Woldal with evidence of this, Hong Kong.
eg an insurance policy or certificate.

Table 5.7 CPT


Incoterm Standard ICC abbreviations
Carriage paid to [named place of CPT
destination, eg Kowloon]
Obligations of Speirs and Responsibilities of Woldal Ltd
Wadley Ltd (exporter) (importer)
Similar to CFR, except that Speirs Woldal should obtain any import
and Wadley must arrange and pay licence and perform any customs
for transport to the named place requirements necessary for the
of destination, which could be an import of the goods, including
inland container depot in Hong meeting all costs involved, duties
Kong, as opposed to Hong Kong and taxes. It is in Woldals interests
port. Speirs and Wadley must advise to arrange and pay insurance for the
Woldal of details of the shipment goods from when they are delivered
and the name and address of the into the custody of the carrier at
shipping company into whose Tilbury. If unloading costs at place
custody the goods have been of destination are not covered by
given, so that Woldal can arrange the charge for carriage, Woldal must
insurance. Complete export and pay them. Also it must pay all costs
customs requirements, including of transport from Kowloon freight
obtaining any export licence and yard to its own premises.
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.

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Table 5.8 CIP


Incoterm Standard ICC abbreviations
Carriage and insurance paid [to CIP
named place of destination, eg
Kowloon]
Obligations of Speirs and Responsibilities of Woldal Ltd
Wadley Ltd (exporter) (importer)
Similar to CPT, except that Speirs Similar to CPT, except that Woldal
and Wadley must pay insurance does not have to arrange and pay
charges during the carriage. insurance charges, which are met by
The relevant insurance policy or Speirs and Wadley.
certificate must be supplied to
Woldal.

Table 5.9 DAT


Incoterm Standard ICC abbreviations
Delivered at terminal [named DAT
terminal at port or place of
destination, eg Terminal 2A Hong
Kong Port]
Obligations of Speirs and Responsibilities of Woldal Ltd
Wadley Ltd (exporter) (importer)
Similar to CIF, except that the Similar to CIF. The liability of Woldal
liability of Speirs and Wadley does exists from the time when goods
not cease until the goods have been are placed at its disposal in the
placed at the disposal of Woldal destination terminal, and they must
by unloading the goods from the take delivery of the goods from that
arriving means of transport and time. The insurance risk falls on
placing them at the disposal of the Woldal once the goods are unloaded
buyer at a specific terminal at the at the terminal.
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.

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Table 5.10 DAP


Incoterm Standard ICC abbreviations
Delivered at place [named place of DAP
destination, eg Kowloon]
Obligations of Speirs and Responsibilities of Woldal Ltd
Wadley Ltd (exporter) (importer)
Deliver the goods to the agreed Woldal should obtain any import
place of destination ready for licence and perform any customs
unloading. Supply Woldal with a requirements necessary for the
commercial invoice or its electronic import of the goods, including
equivalent together with the meeting all costs involved, duties
relevant transport document or and taxes. Accept delivery of goods
delivery order. Arrange any export at the named place of destination.
licence and complete export Woldal is liable for goods and
customs requirements, including costs from the time the goods are
payment of costs, duties and taxes. placed at its disposal at the place
Arrange and pay for contract of of delivery. The insurance risk is
carriage to the named point of Woldals once the goods have been
destination. Advise Woldal of the delivered to the agreed place.
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.

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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 Responsibilities of Woldal Ltd
Wadley Ltd (exporter) (importer)
Deliver the goods not unloaded to Woldal must take delivery of
the named place of destination, the goods at the named place
and bear costs and risks involved of destination and is liable for
in carrying the goods to that place. all risks from then on. Woldal
Advise Woldal of despatch in is not responsible for all import
sufficient time for the company requirements and payments.
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.

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/trade-facilitation/incoterms-2010
[Accessed: 6 March 2014].

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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
can 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 Chapter 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 banks name
or deliverable to the banks 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: 6 March 2014].
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: 6 March 2014].

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;

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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 The risk ladder

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Documentary collection

As a buyerseller 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 sellers point of view (payment
in advance) to the most risky from the sellers 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 Chapter 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 Chapter 7.

Documentary collections are governed by the International Chamber of


Commerces (ICCs) publication Uniform Rules for Collections 522 (1995)

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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
(2013) a new instrument, the bank payment obligation (BPO), intended to
support open account trade.

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 SWIFTs Trade Services
Utility (TSU). ISO 20022 is the International Organization for Standardization
standard covering financial messaging definitions.

As of November 2013, around 50 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 buyers 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 sellers bank for relaying to the
seller for checking and agreement. Agreement will create an established
baseline that incorporates a BPO, and the buyers bank (as obligor bank)
or another named obligor bank will undertake that it will pay the sellers
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 sellers bank may be more inclined to
offer its client pre-shipment finance, if required.

Once the goods have been shipped, the sellers 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 ICCs Uniform Rules for Bank Payment Obligations
(Publication No. 750E) (2013) and are discussed in more detail in Chapter 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 buyers 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 buyers 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 ICCs publication Uniform Customs and
Practice for Documentary Credits 600 (2007) (known as UCP 600).

Documentary credits are covered in more detail in Chapter 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 sellers 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

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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 sellers
merchant processor may reclaim the money from the sellers account.

From the buyers 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;

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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 Chapter 9.

In Chapter 5 we looked at some of the documents that are used in


international trade finance. Chapter 7 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
buyers 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

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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 sellers bank
will ask a correspondent bank in the buyers 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 . . .in accordance with


instructions received, in order to:

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 sellers own country and is invariably the sellers own bank.

u The collecting bank, normally a correspondent of the remitting bank


based in the buyers 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.

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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.

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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 58
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 banks prior agreement. Where no prior

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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 they have
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, then they 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 definition
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 1619
Articles 1619 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.

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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 banks
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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Although every banks documentary collection instruction form will differ


slightly, you would expect to see the following information included on the
form:

u the sellers name, address and contact details;

u the buyers 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 buyers 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 buyers bank


or any other bank unless prior arrangements have been agreed.

2. Drafts drawn to the sellers 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.

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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
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 sellers 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 banks 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 buyers 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 banks (or any local banks)
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 banks 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 banks 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

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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
buyers 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 Chapter 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.

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Chapter 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 buyers bank to provide a guarantee to the carrier on the buyers behalf
and against the buyers 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 banks interests and
hence that of the seller, when payment or acceptance is not forthcoming,
by arranging for storage and insurance at the remitting banks expense.
URC 522 sub-article 10 (b) states that a collecting bank has no duty to
store and insure the goods, unless this is particularly stated in the collection
instruction, usually with details of who will be responsible for the costs
involved. This is where a case of need, who may be the sellers 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 be 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.

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In a negotiation, the sellers bank will agree to pay the seller immediately
the value of the draft. This type of arrangement would be with recourse to
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 buyers bank, by way of
an advance to the buyer, to help pay the sight or term draft.

The buyers 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 on the draft
with the words Bon pour aval. Clearly, with the collecting banks 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 banks
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 buyers 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 Chapter 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 buyers bank: the collecting
bank.

The collecting banks duty is to the remitting bank in an agency role.

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Chapter summary

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 Chapter 5);

u insurance against non-payment or country risk such as non-availability of


foreign exchange (see Chapter 12);

u currency fluctuation risks (see Chapter 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 buyers bank may also make funds available to its customer, so that it can
meet its payment obligations before they have processed and / or sold the
imported goods.

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?

a. A documentary collection.

b. A commercial collection.

c. A clean collection.

d. A financial collection.

4. 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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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 Chapter 6 we looked very briefly at documentary credits. Chapter 8 will


now look at how the documents described in Chapter 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 Chapter 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).

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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:

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

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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 Chapter 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 applicants 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
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

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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.

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.

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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.

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

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Article 7
Article 7 covers the issuing banks 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.

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

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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 ICCs
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 below). 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

c. that the bank is returning the documents; or

d. that the bank is acting in accordance with instructions previously received


from the presenter.

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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;

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;

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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.

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.

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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% of the CIF or CIP value of the goods (see Chapter 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.

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.

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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 banks 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
definition 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 below). 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;

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.

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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: 6 March 2014]) 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 ICCs 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.

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

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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 5060 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 applicants 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
to the credit standing of the beneficiary, or it may accept an indemnity
from the beneficiarys own bank. This will indemnify the nominated
bank against any claims from the issuing bank, and will incorporate an
authority to debit the beneficiarys account with any amount claimed
or to claim from the beneficiarys bank. (This course of action may
be prohibited by the terms of some documentary credits and is not a

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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;

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;

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u the description of the goods;

u the insurance requirements;

u whether the credit is to be confirmed by a bank in the exporters 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 buyers


assets and guarantees of the directors;

u security provided through the documents (see Chapter 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.

Charges over a companys 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 banks benefit.

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Assuming that the issuing bank agrees to issue the documentary credit, the
buyer will need to complete the banks 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 sellers 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.

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.

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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 the 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
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

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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 applicants 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 Chapter 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
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.

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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
companys 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
beneficiarys 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 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).

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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 may need to train specialist staff to prepare


documentation.

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.

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).

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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 sellers 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).

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 applicants name may be substituted by the
name of the first beneficiary.

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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 beneficiarys 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 beneficiarys 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 suppliers 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 beneficiarys 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,
with one credit acting as part or full security for the issuance of the
other. If an intermediarys supplier insists upon a documentary credit, the
intermediarys 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

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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 credits 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
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 banks order pending shipment. The funds
are advanced against warehouse receipts in the lending banks name. Such
green clause credits are rare nowadays.

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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 Chapter 11.

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.

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Risk review

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 ICCs 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-and-
ADR/DOCDEX/Rules/DOCDEX-Rules-in-several-languages/ [Accessed: 6 March
2014]. At the time of writing (February 2014), the DOCDEX rules are under
revision.

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

Participants The participant undertakes . . . Risks to the participant


in a
documentary
credit

Applicant 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.
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. The first beneficiary does not


beneficiary of arrange for transfer or any required
a transferable amendment and then the risks
credit are as for the first beneficiary.

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 banks undertaking to pay against complying


documents is a protection to the beneficiary, in practice discrepancies
are very frequent and potentially numerous.

u A banks 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. 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.

2. 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 sellers own country?

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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 companys 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

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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-shipment 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 companys domestic currency as well
as in foreign currencies. Foreign currency overdrafts would normally be
provided when a company has both payments and receipts denominated

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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 Chapter 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 sellers 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 banks 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 8595 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
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.

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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 8090 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 sellers 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.

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

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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 sellers 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 sellers business; too much concentration on one buyer,
say more than 30 per cent of turnover, will make the sellers 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 it might be costly for the seller to

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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 sellers 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, say 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.

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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 (2013) Invoice factoring export invoice finance [online]. Available
at: www.business.hsbc.co.uk/1/2/international-business/international-
loans-finance/international-invoice-factoring[Accessed: 6 March 2014].

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 sellers 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),
is discussed in Chapter 15.

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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.

If you cannot access a local bank, visit:


Barclays (2013) Supplier finance [online]. Available at:
www.barclayscorporate.com/products-and-solutions/financing/
supplier-finance.html [Accessed: 6 March 2014].

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
buyers 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 buyers 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 buyers 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

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decision to negotiate would be made by the bank like any other lending
decision.

Once agreed, the bank would immediately credit the customers account
with the full value of the draft and would debit a negotiation account. The
sellers 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 sellers account.

If the draft is dishonoured, the sellers 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 sellers 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 banks 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


beneficiarys 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.

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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 terms and conditions of the documentary credit (see Chapter 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 banks 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 banks 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 sellers local suppliers.

The sellers 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.

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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
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 stock-holding
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 buyers bank to advance funds against the security of goods
and / or their sale proceeds.

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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,
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 customers current account with the agreed amount
of the advance and makes a corresponding debit entry on a produce loan
account in the customers 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 banks
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 the time comes 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 be repossessed of the goods or any
documents of title.

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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.

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 long-


term 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 get financing in their domestic country, either due to the size of the
transaction or the associated risk of long-term projects.

Each countrys 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.

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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.

There will also be international agreements that must also 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-export-
finance-eu-state-aid-law.htm [Accessed: 6 March 2014].

Reflect: is there any similar situation regarding your own countrys


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 exporters bank lends the money direct to
the seller. It is a form of post-shipment finance.

Buyer credit is where the sellers 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 buyers 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.

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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 sellers bank that lends the money, they have the comfort that
a government agency will insure or guarantee the debt in the event of
default.

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 sellers 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 banks facility letter, duly signed.

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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.

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 buyers 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 agencys 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.

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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 sellers 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
from the sellers country. The basic difference from the individual sellers
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 sellers bank to the overseas buyer or procurement
agent. The buyer can split up the loan, using it to pay various suppliers in
the sellers 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.

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9.10 Forfaiting (structured trade


finance)
The word forfaiting derives from a French term 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 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 forfait arrangements. The forfaiting bank is therefore taking on the
sellers non-payment risk.

Unless the acceptor of a draft or drawer of the promissory note is


of undoubted international credit standing, a guarantee of the buyers
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 buyers 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

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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
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 sellers 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 buyers liabilities. The guarantor institution might charge
a high commitment fee, unless the buyer is considered to be totally
creditworthy.

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9.10.3 Uniform Rules for Forfaiting (URF 800)


The International Chamber of Commerces (ICCs) Uniform Rules for
Forfaiting (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 (2012b):

The newly-adopted forfaiting rules are the latest example of ICCs


leadership in writing rules that govern international trade and
investment and highlight the crucial role forfaiting plays in securing
financing for exporters and importers.

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;

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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.
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

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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
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 sellers 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 buyers 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.

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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.

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 get 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 section 9.12.1section 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 sellers behalf.

Pure barter transactions are not common.

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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.
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 sellers
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.

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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.

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 buyers country, counter-trade enables the central bank to


conserve scarce hard currency.

u The buyers 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 sellers 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.

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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
may also be required: the manufacturer in Figure 9.1 may have to wait to
get 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 buyers 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:

u Australia Austrade (www.austrade.gov.au/export-assistance)

u France Coface (www.coface.com/)

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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


(www.koreaexim.go.kr/en/exim/glance/manage_01.jsp)

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)

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: 6 March 2014].

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 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.

2. A bank has granted a produce loan to a buyer and the relevant goods
are currently warehoused in the banks 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.

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Name:

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 sellers bank is asked to negotiate a documentary collection. From the


banks 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 USD1.3tr at the end of 2013, representing approximately
13 per cent of global banking assets.

While demand comes primarily from the worlds 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 citys
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.

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Ethical investors too are attracted by the emphasis in Islamic finance on


justice and on the promotion of publicly beneficial activity and services.

With an estimated annual growth rate of 1015 per cent, Islamic finance is
likely to become an increasingly important financial market in the future.
Industry forecasts estimate that Islamic investments might grow to USD2tr
by the end of 2014 and be worth nearly US$2.5tr by 2015 (Dar, 2014).

Such significant growth potential is underpinned by the fact that ten of


the worlds 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
individuals 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 individuals own rational judgement; on the other
hand, Islam has subjected human activities to a set of principles that have
eternal application.

The raison dtre 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. This attitude has allowed a number
of practices that cause imbalances in society, such as the activities that led
to the 20082009 financial crisis and then to a worldwide recession.

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

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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.

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 Quran, whose words have not changed since its revelation over 1,400
years ago and which Muslims believe will be preserved for eternity and

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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 Quran, 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 Quran), verse 275, is:

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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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 10.2.1section 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
below) 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 below) and istina has been suggested by contemporary
scholars. (Istina is used to provide a facility for financing the manufacturing

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or 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 below. 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 A basic illustration of musharaka

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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.

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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

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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

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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
US$1.3tr 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 worlds largest exporters of strategic
commodities, such as oil, gas, petrochemicals and palm oil. They are also
some of the worlds 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).

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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 buyers 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 buyers 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.

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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 banks


client wishes to buy the goods.

2. The client submits a musharaka application, accompanied by a sellers


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).

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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
partnerships 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 banks 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 banks 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

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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 USD1.813tr industry.

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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 [pdf].
Available at: https://www.hsbc.ae/1/PA_ES_Content_Mgmt/content/uae_pws/pdf/en/
newsroom/mena-essential-trade-hub-en.pdf [Accessed: 10 March 2014].

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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.

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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 clients 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
Chapter 7) and UCP 600 for documentary credits (see Chapter 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 guarantors agreement) and the guarantors duties, to name but a few.

From a banks 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.

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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.

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 March 2014] 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 Bs claim is
unpaid by A can the guarantor be called upon.

Furthermore, any amendments to the contract made without the guarantors


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.

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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.

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 identifying the issued guarantee or counter-


guarantee;

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.

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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 issuers 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.

u However, the applicant is less fortunate, as it is at risk of an unjustified


or disputed claim being made.

u The applicants 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 applicants working capital is unaffected by the issue of a guarantee,


unless the applicants bank requires a cash deposit to support their
involvement and / or it reduces the applicants 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,

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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, say 3 per cent.

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 1025 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 notarys 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 applicants
bank or it may be issued by a bank in the beneficiarys country, supported
by a counter-guarantee from the applicants bank. In the latter case,
the guarantee will usually be subject to local laws and customs in the
beneficiarys 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.

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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

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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 banks 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
documentary credits (see Chapter 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 on behalf of an 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, therefore, must either 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
issuers obligations under a standby cannot be amended or cancelled

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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 issuers right or ability to obtain reimbursement from the


applicant;

the beneficiarys 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 issuers 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 issuers 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 5.015.07), 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

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financial difficulties (see Rules 6.116.14). 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
beneficiarys 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 notarys signature confirming that a bill of exchange is unpaid;

u an independent engineers or architects 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

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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 sellers / contractors 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 contractors 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 banks 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 banks customer is truly in default. Either way,
reimbursement for the bank can only come from a claim on its customers
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 banks
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 banks experience with the applicant and the country with
respect to guarantees being called without justification?

u Are the sums involved within the applicants 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 banks credit officer will be aware that one of the commonest 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 banks
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 above, 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 beneficiarys 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

Amendment Yes, with consent of beneficiary. Yes, with consent of beneficiary.


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.

Issuance 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 beneficiarys country that
authenticity) that may or may not issues the guarantee against
be a confirming bank. A second a counter-guarantee from the
advising bank may be involved. applicants bank.

Expiry 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 banks customers will be reimbursed
in the event that the banks 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 issuers 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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11: Guarantees and standby letters of credit

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?

a. URDG 758

b. URC 522

c. ISP98

d. URBPO

4. 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. Complete the missing word:

A guarantee, while it remains valid, is regarded as a liability


on the applicants balance sheet.

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226 ifs University College 2014
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.

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12: Export credit insurance

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

Changes to import rules or Credit insurance


Sovereign governments, licences
government agencies and
local governments Changes to export rules or Credit insurance
licences

Changes to regulations for Credit insurance


importers to acquire hard
currencies

War, civil unrest, coup dtat 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 customers 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 customers
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 dtat or a local war;

u an inability to convert local currency receipts into hard currency;

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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 insurers
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 Chapter 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
insurers and / or a factors 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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12: Export credit insurance

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 buyers 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 buyers 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 buyers 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 suppliers 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. 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.

2. Credit insurance is always recommended for sellers who sell on


confirmed documentary credit terms. True or false?

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12: Export credit insurance

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:

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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13: Foreign currencies and the exchange risk

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.

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The spot rate and the forward rate

For example, for the sterling / EUR quote you could see:

u EUR / GBP0.8900; or

u GBP / EUR1.1200.

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.

Visit the International Organization for Standardization website, which


publishes a list of standard currency codes, referred to as the ISO 4217
currency code list.

XE (2014) ISO 4217 currency codes [online]. Available at:


www.xe.com/iso4217.php [Accessed: 10 March 2014].

Look for the code for your own countrys currency and the code for the
two countries with which your country trades most often.

13.2 The spot rate and the forward


rate
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
banks 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.

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13: Foreign currencies and the exchange risk

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).

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 customers account.

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Foreign currency accounts

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 customers 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
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.

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13: Foreign currencies and the exchange risk

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 banks 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.

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.

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Currency options (pure options)

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.
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.

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13: Foreign currencies and the exchange risk

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
Foreign currency exposure is usually categorised into one of three types:

1. translation exposure;

2. economic exposure;

3. transaction exposure.

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

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Considerations in hedging foreign exchange transaction exposure

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.

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.

So to sum up, 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.

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13: Foreign currencies and the exchange risk

So every business needs to 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, say weekly, for purchases or sales;

monthly, quarterly or annually for foreign currency loans; or

in infrequent but large sums for, say, the repatriated profits of a


subsidiary company?

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.

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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.

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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14: Financial crime

Figure 14.1 Increase in volume of world trade in goods and services,


19692011 ($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
below). These bodies promote a risk-based approach to managing financial
crime.

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Major forms of financial crime

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 below), 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 below) 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 to do this will be the same as techniques used to disguise
the sources of the proceeds of crime.

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International bodies with a remit to prevent financial crime

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 below).

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 (2010) Guidance Paper on the Use of Sanction Clauses for Trade
Related Products (e.g. Letters of Credit, Documentary Collections and
Guarantees) Subject to ICC rules [pdf]. Available at: www.iccwbo.
org/Advocacy-Codes-and-Rules/Document-centre/2010/Sanction-
Clauses-Guidance-Paper [Accessed: 10 March 2014].

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

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14: Financial crime

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 20122020. 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.

At the time of writing (February 2014), the FATF currently has 36 members
(34 jurisdictions and two regional organisations) that represent the major
financial centres in the world, as listed in Table 14.1.

Table 14.1 FATF members (as of February 2014)


Argentina Finland Japan Singapore
Australia France Luxembourg South Africa
Austria Germany Mexico Spain
Belgium Greece New Zealand Sweden
Brazil Gulf Co-operation Netherlands Switzerland
Council
Canada Hong Kong, China Norway Turkey
China Iceland Portugal UK
Denmark India Republic of Korea USA
European Ireland Russian Federation
Commission
Italy
Financial Action Task Force 40 Recommendations (2012)

In addition, there are 31 international and regional organisations that are


associate members or observers of the FATF and participate in its work.

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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 March 2014]) 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-money-


laundering 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.

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14.2.2 The Wolfsberg Group


The Wolfsberg Group is an association of 11 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 Tokyo Mitsubishi -UFJ;

u Barclays;

u Citigroup;

u Crdit Suisse;

u Deutsche Bank;

u Goldman Sachs;

u HSBC;

u JP Morgan Chase;

u Socit Gnrale;

u UBS.

They came together in 2000 at Chteau 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


(2002a);

u Wolfsberg anti-money-laundering principles for correspondent banking


(2002b);

u Wolfsberg statement on monitoring screening and searching (2003);

u Wolfsberg trade finance principles(2011);

u Principles on intermediaries and beneficial ownership (2012).

The Wolfsberg Groups recommendations and papers are considered by


many banks worldwide and not just the 11 banks in the group. For the

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latest details on its activities, see www.wolfsberg-principles.com [Accessed:


10 March 2014].

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 March


2014):

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. For clarification, practitioners should be aware that KYC refers
broadly 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

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14: Financial crime

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 banks 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?

If a member of bank staff is suspicious of a transaction on a bank account


they should follow their banks 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.

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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 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 alerting the suspicions 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.

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;

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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-use 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;

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.

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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.

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 commonly a 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.

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: www.wolfsberg-principles.com/pdf/standards/Wolfsberg_
Trade_Principles_Paper_II_(2011).pdf [Accessed: 10 March 2014].

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 peoples
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

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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.

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

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Regulation

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
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 Peoples Bank of China, the central bank of the Peoples Republic
of China, also has the power to control monetary policy and regulate

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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 worlds 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
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.

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Chapter summary

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
AGP (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 March 2014].
Basel Committee on Banking Supervisions (2014) Sound managemetn of risks related to
money laundering and financing of terrorism [pdf]. Available at:
www.bis.org/publ/bcbs275.pdf [Accessed: 24 March 2014].
FATF (2010) Combating proliferation financing: A status report on policy development and
consultation [pdf]. Available at: www.fatf-gafi.org/media/fatf/documents/reports/Status-
report-proliferation-financing.pdf [Accessed: 10 March 2014].
FATF (2012) About the FATF [online]. Available at: www.fatf-gafi.org/trash/aboutfatf/
whatisfatf/aboutthefatf.html [Accessed: 10 March 2014].
Organisation for Economic Co-operation and Development (2012) OECD Stats [online]
https://stats.oecd.org [Accessed: 25 March 2014].
The Wolfsberg Group (2002a) Wolfsberg statement on the suppression of the financing of
terrorism [pdf]. Available at: www.wolfsberg-principles.com/pdf/standards/Wolfsberg_
Statement_on_the_Suppression_of_the_Financing_of_Terrorism_(2002).pdf [Accessed: 10
March 2014].
The Wolfsberg Group (2002b) The Wolfsberg anti-money laundering principles for
correspondent banking [pdf]. Available at: www.masak.gov.tr/media/portals/masak2/files/
en/Legislation/LaunderingProceedsofCrime/international_legislation/WG/correspondent_
banking_pr.pdf [Accessed: 10 March 2014].
The Wolfsberg Group (2003)Wolfsberg statement on monitoring screening and searching
[pdf]. Available at: www.wolfsberg-principles.com/pdf/standards/Wolfsberg_
Monitoring_Screening_Searching_Paper_(2003).pdf [Accessed: 10 March 2014].
The Wolfsberg Group (2011) Wolfsberg trade finance principles [pdf]. Available at:
www.wolfsberg-principles.com/pdf/standards/Wolfsberg_Trade_Principles_Paper_II_(2011)
[Accessed: 10 March 2014].
The Wolfsberg Group (2012) Wolfsberg anti-money-laundering principles for private
banking [pdf]. Available at: www.wolfsberg-principles.com/pdf/standards/Wolfsberg-
Private-Banking-Prinicples-May-2012.pdf [Accessed: 10 March 2014].

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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. 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 inter-governmental 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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Review questions

6. 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 Chapter 7 and Chapter 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

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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 an additional USD17
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 below),
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 Chapter 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 SWIFTs
Trade Services Utility, while interacting with the banks 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).

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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 buyers bank uses the purchase order data to submit a baseline, and
the sellers bank uses the purchase order data to resubmit the baseline.
This enables the transaction to become established.

2. Both the buyers bank and the sellers bank receive a baseline match
report, to confirm that the two baselines match.

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How does a BPO work?

Figure 15.1 Interactions outside the scope of the URBPO

Source: SWIFT

3. Once the goods are shipped, the sellers 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
worlds 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.

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Figure 15.2 Interactions inside the scope of the URBPO where the buyers
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

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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.

15.3 How does the BPO compare with


existing tools?
The closest comparable tool to a BPO is the documentary credit (see
Chapter 8), which guarantees payment by the issuing bank or confirming
bank, as long as certain documentary conditions are met. However,
promoters of BPOs are 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 sellers 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

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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 sellers 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.

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

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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.

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 sellers bank are
compliant with the agreed terms.

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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
buyerseller 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
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 to the supply chain.

A seller can get financing from its bank at different stages in the transaction
life cycle. The BPO can be used to sustain the sellers 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 sellers continued ability to trade.

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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 buyers bank and a
sellers bank. The goal is to help buyers to reach multiple suppliers through
selected banks in the existing correspondent banking network.

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;

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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 Chapter 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.

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
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.

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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 sellers bank or recipient bank (depending


upon its role at any given time), a buyers bank, an obligor bank or a
submitting bank;

u the recipient bank is the beneficiary of the BPO and will always be the
sellers bank;

u the buyers 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.

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.

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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.

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.

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.

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Chapter summary

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 use of 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.

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15: Bank payment obligations (BPOs)

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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Review questions

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 600
Credits (UCP 600)
ICC Uniform Rules for Bank-to-Bank Reimbursements 725E
Under Documentary Credits (URR 725)
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 811
Resolution Expertise (DOCDEX)
ICC Uniform Rules for Forfaiting (URF 800) 800E
International Standard Banking Practice for the 745E
Examination of Documents under Documentary
Credits (2013 Revision for UCP 600) (ISBP)
ICC Supplement to the Uniform Customs and
Practice for Documentary Credits for Electronic
Presentation (eUCP version 1.1)
Incoterms 2010 715E
International Standby Practices (ISP98) 590

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:

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Appendix B
Answers to review questions

Chapter 1 Introduction 289


Chapter 2 The international trade environment 290
Chapter 3 Contracts 291
Chapter 4 Intermediaries and how they operate 291
Chapter 5 Documents used in international trade and the
Incoterms 2010 rules 291
Chapter 6 Methods of settlement 292
Chapter 7 Documentary collections 292
Chapter 8 Documentary credits 293
Chapter 9 Short-, medium- and long-term trade finance 293
Chapter 10 Islamic trade finance 294
Chapter 11 Guarantees and standby letters of credit 294
Chapter 12 Export credit insurance 294
Chapter 13 Foreign currencies and the exchange risk 295
Chapter 14 Financial crime 296
Chapter 15 Bank payment obligations (BPOs) 296

Chapter 1 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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B: Answers to review questions

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 exporters 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. The correct answer is d.

2.
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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B: Answers to review questions

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 companys 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 applicants 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


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

USD 100,000 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 customers 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 Bank payment obligations


(BPOs)
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 (e.g. the Buyers
Bank) matches the baseline submission message of another bank (the
Sellers 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
sellers 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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