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ORIGIN OF SHIPMENT

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Documentary Credit

Details of Documentary Credit – how it works in commodity transaction: ‘Sale Contract’ is the prima facie evidence of contract between a Seller and a Buyer to effect an international commodity transaction. A seller primarily starts negotiation with an overseas buyer for sale or export of any particular commodity in order to mutually finalize the undernoted fundamental issues connected with the contract of sale:

  • Description of the commodity to be traded highlighting the quantity, quality and unit price.
  • Details of shipment terms which include place and form of shipment, the place of final destination & delivery terms and other shipping issues like transhipment, partial shipment and the latest shipment date etc.
  • The full & correct description of the documents to be presented for payment including the information whether the payment to be made immediately (at sight) or at some future date ( after one months of acceptance of documents).
  • Detail terms and conditions of the letter of credit including the maximum amount payable, the expiry date, the type of credit to be applicable etc.

Once Sale Contract is finalized, between a Seller and a foreign buyer, it establishes a firm basis and guideline for the construction of any subsequent legal document needed for implementation of such business deal. If any flaws and loopholes exist in the Sale Contract it will have adverse effects on the construction of legal documents such as ‘Letter of Credit document’ which may result in trade disputes for settlement of payment.

We know that exporting and importing activities across the country involve risks. Exporters run the risks for not being paid by the buyers for their goods. On the other hand, importers take the risks of payment without receiving the contractual goods. To get rid of this uncertain situation, documentary credit or letter credit has been developed as an acceptable measure of security between the sellers (Exporters) and the buyers (Importers) to facilitate trade transactions. This is the logical perspective which led to the emergence of Documentary Credit or Letter of Credit as a viable financial instrument in the international trade.

What is Documentary Credit?

What is Documentary Credit? Why it is so important in international trade? As defined by International Chamber of Commerce (ICC) “Documentary credit or letter of credit is an undertaking issued by a bank (Issuing bank) for the account of the buyer (the Applicant) or for its own account, to pay the Beneficiary (the Exporter) the value of the Draft and/or documents, provided that the terms and conditions of the Documentary Credit are complied with”. The documentary credit system has been developed & used over a period hundred and fifty years, and still remains as an important tool for financing and settling international trade transactions. As per recent estimates, Letters of credit represents more than US$ one trillion in terms of banking obligation and covers approximately 60 per cent of the commodity trading in the international export/import business.

Documentary credit is an integral part of export process. It not only provides security to trade transaction but also reduces the risk of trade finance to reasonably low level. Under this credit system Bank plays a vital role as a third party between a Seller and a Buyer. The bank through the letter of credit instrument is empowered to assert sufficient pressure on both the sellers and buyers in case of any violation and non-performance of Sale Contract. Thus the bank creates a sense of security to both parties by assuring the seller that he will be paid if he provides the bank with the required documents, and by assuring the buyer that his money will not be paid unless the shipping documents evidencing proper shipment of his goods are duly presented. Basically three parties are involved in documentary credit viz the issuer (issuing bank), the account party (buyer/applicant), and the beneficiary (seller). Three agreements represent the relationship between the parties, a Sale contract between buyer and seller, the documentary credit between the issuing bank and the seller, and a reimbursement agreement between the issuing bank and the buyer. All the three agreements are independent and the breach of one agreement may not constitute breach of another agreement.

It is the International Chamber of Commerce (ICC) which developed comprehensive set of rules known as “ICC Uniform Customs and Practice for Documentary Credits (commonly called “UCP”) aiming to help formulate and govern the operation of letter of credit. UCP is used by bankers, lawyers, importers, and exporters, transport executives, educators, and everyone involved in letter of credit transactions worldwide.

The codified rules related to documentary credit were first promulgated by ICC in the year 1933 and since then the rules were updated on a regular basis to cope up with the changed trade & banking practices & procedures. In October 2006, the ICC announced the current revision of the rules – “the ICC Uniform Customs and Practice for Documentary Credits 2007 Revision (UCP 600). UCP 600 comes into effect on 01 July 2007. The new rules UCP 600 have replaced the UCPDC of 1994 – ICC publication no. 500. The main objective of the new revision was to address developments in the banking, transport and insurance industries and also to remove some wordings of previous UCP that could lead to inconsistent interpretation and application.

The importance of letters of credit in trade finance transactions is evidenced by its global acceptance. To highlight the importance, the English Courts described the letter of credit as “the life blood of international commerce”. It is important to note that the UCP is not law. It is a set of private rules that contracting parties choose to incorporate into the relevant contracts. The UCP can only apply to a letter of credit transaction by express inclusion and such inclusion must incorporate the applicable revision, i.e. UCP 600. Unless otherwise specified, the letter of credit is considered to be irrevocable. That means it cannot be changed unless both the buyer and the seller agree to make changes ( UCP 600- Article 2)