International Trade Finance PDF

THE SCHOOL OF BANKING EXCELLENCE INTERNATIONAL TRADE FINANCE To expect from this course: 1. An understanding of what Cross Border trade is. 2. An understanding of some of the risks inherent in cross border trade and the ways to mitigate those risks. 3. A knowledge of the di...

THE SCHOOL OF BANKING EXCELLENCE INTERNATIONAL TRADE FINANCE To expect from this course: 1. An understanding of what Cross Border trade is. 2. An understanding of some of the risks inherent in cross border trade and the ways to mitigate those risks. 3. A knowledge of the different types of payment methods employed in cross border trade. 4. A knowledge of the trade documents that are called for in the settlement of transactions. 5. The in others and what it means for the importer and the exporter. 6. How to use the Bill of Lading as a collateral or security for lending to trade. 7. What a Bill of Exchange is and how banks use it as a financing tool. 8. The various types of Letters of credit, the uses, the risks inherent in them and the mitigants of these risks. 9. The collection method of payment 10. Identification of the parties, their responsibilities and liabilities. 11. The risks inherent and the mitigants. At the end of this course, participants can expect to have an appreciable knowledge of International Trade Finance. 2  Delivered at Place (DAP)........... 17 Table of Contents Delivered Duty Paid (DDP)........ 17 Key Terms............................................6 Sea and Inland Waterway Course Description.......................6 Transport....................................... 17 Course Duration............................6 Free Alongside Ship (FAS)....... 17 Course Topics................................7 Free on Board (FOB).................. 17 Top 10 Concepts for this course.....11 Cost and Freight (CFR).............. 18 Background Knowledge...................11 Cost, Insurance and Freight Internet References..........................11 (CIF)................................................ 18 Follow on training..............................11 Commercial Documents.... Error! Bookmark not defined. Exam...................................................11 Financial Documents......... Error! How to study for this course............12 Bookmark not defined. Successful learners...........................12 Transport Documents........ Error! INTRODUCTION...............................13 Bookmark not defined. RISK IN TRADE FINANCE..............14 Insurance Documents........ Error! Bookmark not defined. Payment Risk...............................14 Regulatory Documents...... Error! Performance Risk........................14 Bookmark not defined. Political/Country Risk................14 The Bill of Lading........................ 23 Transaction Risk.........................14 Order Bill of Lading.................... 24 Non-Acceptance Risk................14 Straight Bill of Lading................ 24 Transfer Risk................................14 BILL OF EXCHANGE....................... 27 Sovereign Risk.............................14 Acceptances................................. 27 Documentation Risk...................14 Trade Acceptance....................... 27 Legal Risk......................................14 Banker’s Acceptance................. 27 METHODS OF PAYMENT..............21 Risks............................................... 27 Advance Payment.......................21 Sample Instrument: Draft........ 28 Open Account..............................21 DYNAMICS OF AN LETTER OF Bills for Collection or Collection CREDIT.............................................. 29..........................................................21 Introduction.................................. 29 Letter of Credit or Documentary Documentary Letter of Credit or Letter of Credit.............................22 Letter of Credit............................. 29 Rules for any Mode of The Definition of a Letter of Transport-......................................15 Credit.............................................. 29 Rules for Sea and Inland Dynamics of an L/C.................... 30 Waterways Transport-................15 Issuance and Payment Ex Work..........................................16 Transaction Flows......................... 30 Free Carrier (FCA).......................16 The L/C Application Form........... 31 Carriage Paid To (CPT)..............16 3  Types of L/Cs – Notation / Advance Payment Guarantee – Notification.....................................32......................................................... 44 Irrevocable Letter of Credit –......32 Advantages of SBLC over Unconfirmed Letter of Credit –...32 Guarantees................................... 44 Confirmed Letter of Credit –.......32 Disadvantages............................. 44 Parties Involved In L/C Transaction Risks Associated with Various..........................................................32 Types of L/Cs............................... 45 Letter of Credit Process.................33 Revolving L/C-............................. 45 Responsibilities of Parties.......33 Risks............................................... 45 Sellers (Exporter): -....................34 Standby L/C-................................. 45 Issuing Bank: -.............................34 Risks............................................... 45 Confirming Bank.........................34 Advance Payment L/C-.............. 46 Advising Bank..............................34 Risks............................................... 46 Paying Bank..................................34 Transferable L/C-........................ 46 The Advantages Of L/C to Seller Risks............................................... 46..........................................................34 Back-to-Back L/C-....................... 46 The Advantages Of L/C to Buyer Risks............................................... 46..........................................................35 Unconfirmed L/C-........................ 46 Settlements Under A Letter of Dollar Usance L/C-...................... 46 Credit..............................................35 Confirming Line L/C-.................. 47 Sight L/C........................................36 Unconfirmed/Inoperative L/C-. 47 Term L/C (Deferred, Tenor).......37 Risks of Parties to an L/C......... 48..............................................................38 Applicant Risks........................... 48 Other Types of L/C......................38 The applicant is faced with the Advance Payment L/C................39 possibility of the following risks... 48 Standby Letter of Credit (SBLC) Goods –......................................... 48..........................................................39 Mitigants-...................................... 48 Transferable Letter of Credit....41 Foreign Exchange Risk –.......... 48 Back to Back L/C.........................42 Mitigant –....................................... 48 Similarities / Difference between the Transferable L/C and the Issuing Bank Risks..................... 48 Back-to-Back L/C........................43 Beneficiary Risks-....................... 49 Similarities:...................................43 Documentation Risk-................. 49 Differences: -................................43 Country Risk-............................... 49 Revolving L/C...............................43 Mitigants-...................................... 49 GUARANTEES..................................44 Advising Bank Risks.................. 49 Bid or Tender Bond –.................44 Confirming Bank Risks............. 49 Performance Bond –..................44 Nominated Bank Risks.............. 49 4  Other Uses of Letters of Credit Trust Receipt (T/R) Financing. 59..........................................................49 Seller’s finance (Suppliers’ COMMON DISCREPANCIES.........50 Credit)......................................... 59 Waive able.....................................50 Guarantees................................ 59 Non-Waive able............................51 Packing Loan............................. 59 Definition-......................................51 Invoice Discounting................... 60 Dynamics of Collection.............51 Forfaiting..................................... 60 Advantages of Collections.......53 Factoring..................................... 61 Advantages to Buyer..................53 Officially Supported Export Advantages to Seller..................54 Credits......................................... 62 Parties to a Collection................54 INTERNATONAL TRADE ORGANIZATIONS............................ 65 When to Use a Collection..........54 World Trade Organization (WTO)65 Types of Collections..................54 Formation of WTO.......................... 65 Documentary Collection –........54 The United Nations Conference on Clean Collection –.....................54 Trade and Development.................. 69 Documentation on Bills for Reports........................................... 70 Collection......................................55 The History of the International Responsibilities in a Collection Chamber of Commerce (ICC)... 71..........................................................55 The ICC’s Governing Bodies... 71 Exporter......................................55 The Africa Continental Free Importer.......................................55 Trade Area (ACFTA)................... 73 The Remitting Bank..................55 Objectives of AfCFTA................ 73 The Collecting Bank..................55 Opportunities of AfCFTA.......... 73 A case of need –..........................56 Challenges of AfCFTA.............. 73 Risks in a Collection..................56 Importer Risk................................56 APPENDIX 1 Exporter Risk................................56 Mitigants........................................57 UCP 600 DETERMINANTS OF FINANCING METHODS..........................................57 URC 522 Avalization......................................57 APPENDIX 2 Letters of indemnity..................58 Supplier’s credit.........................58 SAMPLE DOCUMENTARY CREDITS Post-export finance...................58 Factoring.....................................58 Bankers’ Acceptance (BA).......58 Confirmation Line......................58 Avalization..................................58 5 Key Terms Term Definition UCP Uniform Customs and Practices for Documentary Credit URC Uniform Rules for Collections EXW Ex Works FCA Free Carrier CPT Carriage Paid To CIP Carriage and Insurance Paid To DAT Delivered at Terminal DAP Delivered at Place DDP Delivered Duty Paid FAS Free Alongside Ship FOB Free on Board CFR Cost and Freight CIF Cost, Insurance and Freight CRI Clean Report of Inspection CCVO Combined Certificate of Value & Origin L/C Letter of Credit ITF International Trade Finance Course Description This course aims to take the participants through the process of financing cross border trade. In reaching this goal the participants are taken through the dynamics of cross border trade, identifying the risks inherent in this type of trade. The course delves into the payment methods used in cross border trade and the various types of documents that are used. Particular attention is paid on two specific methods of payment –The Documentary Credit and the Bills for collections. The Various Letters of credit are examined, focusing on when to use each one and the risks and mitigants to each. Emphasis is also placed on the legal implications of both the local and the international laws that govern cross border trade. Course Duration [2 Days] 6  Course Topics Module 1 Subtopics Related Concepts (On completing this Risks in Trade Finance The risks that are usually inherent module Trainees will be in financing any trade transaction. able to understand the This can affect both local and various risks that must be cross border transactions. The identified and the mitigants to the risks are identified mitigants to these risks Payment Risk before availing financing Performance Risk to cross border trade...) Political/Country Risk Transaction Risk Transfer Risk Non-Acceptance Risk Sovereign Risk Documentation Risk Legal Risk Module 2 Subtopics Related Concepts Methods of Payment The different methods of effecting payment in Trade Transactions (On completing this Advance Payment module Open Account Trainees will be able to Collections know Documentary Credit how these methods of payment are determined and the risk that is inherent in each method of payment.) Module 3 Subtopics Related Concepts On completing this The responsibility of the seller and module Trainees will be Incoterms 2010 the buyer in the transportation of able to identify the party goods. Who is responsible and that bears a risk at any who carries the risk? time and therefore who Rules for any mode of must procure insurance. Transport Ex-work/Ex- These are the rules that relate to Factory when goods are shipped via air, FCA road, rail or courier. It also CPT reflects the extent of seller’s CIP responsibility and liability into DAT buyer’s country 7  DAP DDP Rules for Sea and Inland Waterways Transport FAS These rules relate to when goods FOB are being transported by sea CFR alone. It also determines where CIF delivery of goods is said to have been made Module 4 Subtopics Related Concepts (On completing this Documents in Trade The Documents that are used in module Trainees will be Finance cross border trade to effect able to understand the payment. importance and use of Commercial Documents each trade document Financial Documents and the role that each Transport Documents play since banks deal in Insurance Documents documents and not in the Regulatory Documents goods and services. The The Bill of Lading The Bill of Lading as a collateral trainees will also or security to the ownership of the understand how to goods and protection for the bank secure the bank’s The Bill of Exchange The alternative financing tool for interest with the Bill of the bank Lading. The trainees will also learn to use the Bill of Exchange as a method of financing the customer...) Module 5 Subtopics Related Concepts (On completing this Dynamics of the Letter of The UCP 600 definition of the module Trainees will be Credit Credit able to understand how the various types of The Parties to the letter of The responsibilities and liabilities letters of credit work, the Credit of each party in the letter of credit parties to the letter of The Advantages and credit, the roles of each disadvantages to the party. The trainees parties would also be able to The differentiate one letter of Notations/Notifications on credit from another. The the Letter of Credit trainee will determine The Payment L/C The dynamics of each type of what Letter of Credit is letter of credit. What each is used 8 appropriate for a specific for? The risks inherent in each transaction). The trainee the mitigants to these risks would also be able to tell The Acceptance L/C the difference between The Deferred Payment the various guarantees L/C and the Standby Letter of The Advance Payment credit L/C The Standby L/C The Transferable L/C The Back to Back L/C Module 6 Subtopics Related Concepts (On completing this Risks of Parties to an L/C module Trainees will be Other Uses of Letters of able to understand the Credit various risks that each Common Discrepancies Each party in a letter of credit party bears in the letter of bears a risk and these risks must credit. The trainee will be identified to ensure that the also learn the other uses particular party is protected to which letters of credit Common discrepancies may be used for. The Waive able and Non- Some discrepancies are typical discrepancies that waive able Discrepancies determined to be immaterial and can occur in the credit some are determined to be and which is material and material. There is need for which are not.) understanding of the relevancy to the credit Module 7 Subtopics Related Concepts (At the end of this Bills for Collection The collection by banks, of a sum module, the trainee is of money, due from a buyer, with very knowledgeable on or without the delivery of the the flow of collection, the shipping documents level of responsibility of Dynamics of Collection the banks. The trainee Advantages to parties of understands the risk Collection inherent in collections Parties to a collection and how to finance a When to use a collection Making a choice between using customer using the the collection as a method of collection method- payment versus using the letter of financing using an off- credit balance sheet product of Types of Collection Avalization.) Documentation of Bills of Collection The responsibilities in a The responsibilities of parties in a collection collection compared with the 9  responsibilities of parties in a letter of credit Risks in a collection/Mitigants to the risks Module 8 Subtopics Related Concepts On completing this Letters of indemnity. The importance of Export Credit module Trainees will be Supplier’s credit. agencies able to identify the Post-export finance. various methods Factoring. financing methods Bankers’ Acceptance available to exporters (BA) and importers. Confirmation Line Trainees will also be Avalization introduced to the roles Trust Receipt (T/R) Export Credit agencies Financing play in International Seller’s finance Trade (Suppliers’ Credit) Guarantees Packing Loan Invoice Discounting Forfaiting Factoring Supply Chain Financing The participants and features of Benefits of Supply Chain Supply Chain Financing Financing How Supply Chain Financing works Module 9 Subtopics Related Concepts On completing this International Trade The origin, functions and benefits module Trainees will be Organisations of the various International Trade able to understand the World Trade Organisation Organisations roles the various listed (WTO) International Trade The United Nations Organisations play in Conference on Trade and facilitating trade globally. Development (UNCTAD) The International Chamber of Commerce African Continental Free Trade Area (AfCFTA 10 Top 10 Concepts for this course (1=highest 10=lowest) # Concept Rank by Rank by Importance Difficulty Understanding the risks and mitigants in cross 1 10 border trade Methods of Payment 2 6 INCOTERMS 10 5 Documents in cross border trade 3 8 The Bill of Lading 4 3 The Bill of Exchange 5 4 The letter of credit 6 1 The UCP 600 7 2 The URC 522 9 7 Collections 8 9 Background Knowledge The trainee does not require any previous knowledge in trade Internet References www.google.com Articles on financing import and exports Articles on opinions of the ICC Follow on training [Membership with the ICCN (International Chamber of Commerce Nigeria) FITS initiatives on line course The various online courses designed improve Trade Finance Knowledge Exam Type of Exam: A combination of Multiple Questions, Knowledge based questions and Case Study to test application of knowledge Total Number of Questions: Multiple Choice Questions usually between 14- 20 questions, various short answer knowledge based questions and 2 case studies to test application Time Allotted: Usually 3 hours Mark Distribution: MCQ – 2 marks for each question, short answer questions and case study – 15-20 marks (the total marks depend on the combination of questions) Sample Question: Not applicable 11 How to study for this course Read the manual before class Work on the practice questions made available to you Call facilitator for clarification on any subject that is not clear Read the manual after each class Study the UCP 600, INCOTERMS AND URC 522 It is important to focus in class and listen attentively. Participation is important, seeking to understand contents that seem complex. The class uses a lot of real life examples and trainees get more information from class lecture. This must be supported by after lecture study Put in the same dedication to the class exercises and group case studies. The class exercises employ the same format as the exam, that is, an exercise questions may be short essays of true or false. The other class exercise employs multiple choice questions and the group study takes trainee through the process of analysis of the issues and the application of the relevant UCP articles to proffer solutions. Successful learners Successful learners are trainees who are determined to dedicate extra time to study for this course as the challenge usually is the unfamiliar terms used in the course. Trainees who are attentive in the class and participate in class activities will succeed. 12 INTRODUCTION International Trade or Cross Border trade is the buying and selling of products and services across borders or between Countries. Trade finance is the provision of banking services to facilitate the movement of goods and the performance of trade related services. Importance of International Trade Finance: Risk Mitigation Payment Facilitation Working Capital Management Documentation and Compliance Currency Management Financing Trade Transactions Global Trade Relationships Economic Growth Global Supply Chain This type of trading is faced with various problems, which include: - 1. Language, laws, customs, and regulation differ. 2. Buyer and seller are unknown to each other. 3. Seller wants immediate payment. 4. Buyer wants to pay when goods arrive. 5. Payment is in foreign currency. 6. Political issues/transfer of funds. These issues have fundamental effect on trade across borders. It could affect the delivery of goods to the buyer and/or the payment to the seller. As in all lending activities, risks are the main issue of concern. The success of any type of lending is in the effective management of the inherent risks. Fortunately, the issue of risk in trade finance is that it is easily identified and mitigated. However, the income on trade transaction is directly related to the risk. Therefore, successful trade financiers are those that can reduce risks and still manage to maintain an acceptable return on capital. 13 RISK IN TRADE FINANCE The following are some of the problems that frequently occur in trade finance transactions: Payment Risk This is a risk that the exporter or seller may not receive payment due to inability of the buyer to fund at maturity date or inability to transfer funds due to the importing country’s policy. This risk is dominantly that of the seller. Performance Risk This is the risk that the exporter may not deliver goods at all or deliver goods that do not conform to the terms of the contract. This risk is borne by the buyer. Political/Country Risk This relates to the political environment, its stability, and its policies regarding cross border trade. Of course, a country that has political instability is a high risk. Transaction Risk The risk that the goods may be lost or damaged during transporting or may not clear customs at destination port (buyer’s risk- especially in import regulated countries like Nigeria. Non-Acceptance Risk Especially in the case of Bills for Collection where the buyer must accept the bill of exchange. Transfer Risk This involves the physical movement of funds from the paying country to the receiving country. Sometimes a buyer has the local currency, but the country does not have currency for the transfer. Sovereign Risk This is a risk in the direct lending or transaction with the government. This is deemed to be less risky than the country risk. Documentation Risk This risk is associated with the specific documentation that may be required for importation. It could include certificates, banned list or prohibited goods. Legal Risk This is the risk that in the case of non-performance by either party, which jurisdiction applies. The UCP (Uniform Customs and practices for Documentary Credit) and The URC (Uniform Rules for Collections) provide guidelines on the roles, responsibilities, and liabilities of the various parties under the letters of Credits and Collections. 14 Any of the above lists could hinder a supplier access to his funds. Therefore, it is important that these various risks are properly identified and mitigated in International Trade finance. INCOTERMS 2010 International Commercial Terms Provide a set of International Rules for the standard interpretation of the most used commercial trade terms. Show where the Seller’s responsibility ends and what transport costs are to be borne by him. (Currently 11 INCOTERMS in number.) Multimodal and Marine Categories Rules for any Mode of Transport- This class of Incoterms can be used irrespective of the mode of transport selected and irrespective of whether one or more than one mode of transport is employed. Also used where a portion of transport is by ship EXW FCA CPT CIP DAT DAP DDP Rules for Sea and Inland Waterways Transport- The point of delivery and the place to which the goods are carried to the buyer are both ports. FAS FOB CFR CIF The parties should clearly specify the point within the named place of delivery, as the costs and risks to that point are for the account of the seller. The buyer bears all costs and risks involved in taking the goods from the agreed point, if any at the named place of delivery. Under the Incoterms rules: Ex Works (EXW) Free Carrier (FCA) Delivered at Place (DAP) Delivered at Place Unloaded (DPU) Delivered Duty Paid (DDP) 15 Free Alongside Ship (FAS) Free on Board (FOB) The named place is the place where delivery takes place and where risk passes from the seller to the buyer. Carriage Paid To (CPT) Carriage and Insurance Paid To (CIP) Cost and Freight (CFR) Cost, Insurance, and Freight (CIF) The named place differs from the place of delivery. Under these four Incoterms rules, the named place is the place of destination to which carriage is paid. Ex Work The seller delivers when it places the goods at the disposal of the buyer at the seller’s premises or at another named place (i.e. works, factory or warehouse) The seller does not need to load the goods on any collecting vehicle, nor does it need to clear the goods for export, where such clearances is applicable. This represents the minimum obligation for the seller. Free Carrier (FCA) The seller delivers the goods to the carrier or another person nominated by the buyer at the seller’s premises or another. FCA requires the seller to clear the goods for export. Under the new rules, FCA (Free Carrier) has been updated to allow the exporter to receive an “On Board” multi-modal Bill of Lading after delivering the goods to the transporter (Banks often require the seller to present a Bill of Lading with an On- Board notation so the bank could recognize that the transaction was complete before making payment on the letter of credit. Incoterms 2010 did not provide for the option of an On-Board notation ; Incoterms 2020 does). Carriage Paid To (CPT) The seller delivers the goods to the carrier or another person nominated by the seller at an agreed place (if any such place is agreed between parties) and that the seller must contract for any pay the cost of carriage necessary to bring the goods to the named place of destination. When CPT, CIP, CFR, or CIF are used the seller fulfills its obligation to deliver when it hands the goods over to the carrier and not when the goods reach the place of destination. With CIP and CIF, the seller is required to clear the goods for export where applicable. However, the seller has no obligation to clear the goods for import, pay any import duty or carry out any import customs formalities. The seller must obtain cargo insurance complying at least with the minimum cover. 16 DPU – Delivered at Place Unloaded (replaces Incoterm® 2010 DAT) DPU replaces the former Incoterm® DAT (Delivered at Terminal). The seller delivers when the goods, once unloaded are placed at the disposal of the buyer at a named place of destination. The seller bears all risks involved in bringing the goods to and unloading them at the named place of destination. DPU requires the seller to clear the goods for export, where applicable. However, the seller has no obligation to clear the goods for import, pay any import duty or carry out any import customs formalities. This is the only INCOTERM that obligates the seller to unload goods at the buyer’s destination. Delivered at Place (DAP) The seller delivers when the goods are placed at the disposal of the buyer on the arriving means of transport ready for unloading at the named place of destination. The seller bears all risks involved in bringing the goods to the named place. The seller clears the goods for export, where applicable. However, the seller has no obligation to clear the goods for import, pay any import duty or carry out any import customs formalities. Delivered Duty Paid (DDP) The seller delivers the goods when goods are placed at the disposal of the buyer, cleared for import on the arriving means of transport ready for unloading at the named place of destination. The seller bears all the costs and risks involved in bringing the goods to the place of destination and has an obligation to clear the goods not only for export but also for import, to pay any duty for both export and import and to carry out all customs formalities. DDP represents the maximum obligation for the seller. Sea and Inland Waterway Transport Free Alongside Ship (FAS) The seller delivers when the goods are placed alongside the vessel (on a quay or a barge) nominated by the buyer at the named port of shipment. The risk of loss of or damage to the goods passes when the goods are alongside the ship, and the buyer bears all costs from that moment onwards. The seller clears the goods for export, where applicable. However, the seller has no obligation to clear the goods for import, pay any import duty or carry out any import customs formalities. Free on Board (FOB) The seller delivers the goods on board the vessel nominated by the buyer at the named port of shipment or procures the goods already so delivered. The risk of 17 loss of or damage to the goods passes when the goods are on board the vessel and the buyer bears all costs from that moment onwards. FOB requires the seller to clear the goods for export, where applicable. Cost and Freight (CFR) The seller delivers the goods on board. The vessel or procures the goods already so delivered. The risk of loss or damage to the goods passes when the goods are on board the vessel. The seller must contract for and pay the costs and freight necessary to bring the goods to the named port of destination. Cost, Insurance and Freight (CIF) In addition to CFR, the seller also contracts for insurance cover against the buyer’s risk of loss of or damage to the goods during the carriage. There are now different levels of insurance cover in CIF (Cost, Insurance and Freight – for sea and inland waterway transport) and CIP (Carriage and Insurance Paid To) i. For CIP shipments, the appropriate insurance clause is Institute Cargo Clause A ii. For CIF shipments, the appropriate cover would be Institute Cargo Clause 18 19 20 METHODS OF PAYMENT Buyers and Sellers must put a lot of factors into consideration before agreeing on the payment method to employ in a particular trade transaction. These considerations include: a) What is the product? - is the product already widely desired? e.g., product that is scarce but with a huge demand. b) Who is the supplier and who is the buyer? c) What are the risks inherent in the transaction? These factors that play a significant role in the method of payment. The common methods of payment include: - 1) Advance Payment 2) Open Account 3) Collections 4) Documentary Credit. Advance Payment The buyer remits payment to the seller before goods are shipped. There is the risk of payment not received or received late. Time must be allowed for payment to clear through the bank before shipment is made. From the buyer’s point of view, the seller prior to receipt of payment from the buyer may cancel the order. The goods may not be shipped, or the wrong goods may be shipped, or the shipping documents may be wrong. This method is employed when the exporter does not trust the importer. It is also used when the importer trusts the exporter to comply with the terms of the contract or when the importer wishes to advance funds to enable the seller to prepare the goods for shipment. Open Account The exporter ships goods and sends an invoice marked with the terms of payment. The risk is the payment risk as buyer may default in payment having received goods. It is quite suitable for circumstances where a valuable trading relationship has been set up and trust exist (usually this exists between parent company and subsidiary). This is also common is the United States where the Credit Bureau is highly effective. Bills for Collection or Collection The exporter would ship the goods and send the title documents to the importer’s bank through his own bank. The exporter would state the payment terms (Delivery of document against acceptance–D/A or Delivery of document against payment- D/P). This gives the exporter more control depending on the term of delivery he specifies. A high level of trust must exist here. It could be a clean Collection or Documentary Collection. 21  Letter of Credit or Documentary Letter of Credit The banks act as intermediaries for both the importer and exporter. The risk for the exporter is reduced significantly since this type of L/C deal in documents only. The higher risk is that of importer due to the same reason. The level of trust is not material here. METHODS OF PAYMENT (Terms of settlement/Trust league table) Open account trading COMPLETE TRUST Bill for collection Letter of credit Payment in advance NO TRUST COMMON DOCUMENTS IN A L/C The documents called for in an L/C could be divided into commercial (these are document that describe the goods, packaging, and prices), the financial document (these include demand notes, bills of exchange, promissory notes), transport documents (these evidence shipment of goods), insurance documents and regulatory documents (documents specified for importation of goods by a particular country. 22 Financial Documents Bill of exchange Promissory Note Bank Draft Insurance Documents Insurance Certificate Marine Insurance Insurance Policy Declaration under open cover Transport Documents Bill of Lading Airway Bill Seaway Bill Road Transport Bill Multi Modal bill of lading Rail Transport Bill Commercial Documents Proforma Invoice Commercial Invoice Sales Contract Packing List Regulatory Documents Import Duty Report Clean Report of Inspection (CRI) Combined Certificate of Value & Origin (CCVO) Attested Invoice The Bill of Lading The Bill of Lading is a more detailed transport document than the other transport documents. It may be straight (i.e., non-negotiable or may be to an order (i.e., negotiable). In addition, it serves the following purposes. 1. It is a receipt issued by the carrier or its representative to the exporter (shipper). 2. It is evidence of a shipping contract between the carrier and the Shipper 3. It represents a title document to the goods 4. As a receipt for the goods providing information about the condition of the goods being accepted for transportation – it can be “clean” if goods are in line with invoice or “Claused, dirty or foul” where it is defective either in the 23 goods or in the packaging. When a bill of lading is issued as “Received for shipment” or “Said to Contain” or “Shipper’s load and count” it means the shipmaster is unable to verify the quality or quantity of the goods. Order Bill of Lading The bill consigned to the order of a specified party usually the importer. The bill is negotiable since it may be used to transfer title by endorsement to another party e.g. the buyer’s bank may endorse the bill and deliver them to the buyer on certain condition. This type of bill allows the bank to retain control on behalf of the seller until payment or acceptance is made. It therefore is the title document for goods being shipped and it also permits title of the goods to be separated from the physical goods. The negotiable Bill of Lading is preferred in transaction that is financed – used as collateral. The full set is sent to the financial institution which endorse to the importer upon satisfaction of its financial obligation. Straight Bill of Lading The straight bill of lading is consigned to a specified party and cannot be transferred by endorsement to any other party. Banks usually would not accept this type of bill where the bank is financing. It is open to fraud as the physical bill is not necessary to clear goods. 24 25 26 BILL OF EXCHANGE An unconditional order in writing addressed by one party to another, signed by the party giving it (the drawer), requiring the party to whom it is addressed (the drawee), to pay on demand or at a fixed or determinable future time, a certain sum of money, to a specified party (the payee) or to order of a specified party or to bearer. It must be possible to determine the payment date without reference to other documents, e.g., 90 days from bill of lading date. A term bill must be accepted and signed to signify acknowledgement of the debt – ACCEPTED, signed, and dated on the face of the bill. Bills are usually issued in sets of two originals. This is to safeguard against loss of the bill in transit. Bills can be payable to a specific party or to order of a specified party or a bearer. A bank to give the seller security may “avail” (accept the bill) the bill. Acceptances An acceptance occurs when a bill of exchange is drawn by the drawer (usually the person owed) and accepted by the drawee (the person owing). The bill of exchange can be sight or tenured. The term can be based on sight or a specific event (e.g. Bill of lading date). An acceptance can also be a Trade Acceptance or a Bankers Acceptance. Trade Acceptance A bill of exchange that is drawn on and accepted by an individual or corporate. Banker’s Acceptance A bill of exchange that is drawn on and accepted by a bank. This type of bill is preferred in trade since it carries less risk than the trade acceptance and therefore can be discounted at a cheaper rate especially if the bank is a first class one. Risks The buyer has an obligation once acceptance takes place regardless of the condition of goods he eventually receives. The seller carries a payment risk. The acceptance of a Bill does not guarantee payment at maturity. 27 The bill of exchange states the YOU (the drawee) owe the drawer a certain sum of money to be specified. This is different from a promissory note, which states that the drawer (debtor) owes the beneficiary (the creditor) a certain sum of money to be specified. Sample Instrument: Draft Director 28 DYNAMICS OF AN LETTER OF CREDIT Introduction A document issued by a financial institution on behalf of a buyer stating the amount of credit the buyer has availed, and that the institution will honor drafts up to that amount written by the buyer. It gives the buyer the prestige and financial backing of the issuing institution and satisfies the requirements of the seller in completing the transaction. The accepting institution has a prior agreement as to how the buyer will pay for the drafts as they are presented. A commitment, usually by a bank on behalf of a client, to pay a beneficiary a stated amount of money under specified conditions. Documentary Letter of Credit or Letter of Credit The trust league table puts the L/C at the bottom, where little or no trust exists between buyer and seller. Instead, the two parties appoint the banks as intermediaries to secure or ensure the protection of their interest. The Definition of a Letter of Credit It is a written undertaking by a bank (The issuing bank), to the seller (the beneficiary), in accordance with the instructions of the buyer (applicant), to effect a payment, acceptance, negotiation or deferred payment up to a prescribed amount, with a certain time period, against prescribed documents, provided these are correct and in order (i.e. in compliance with the terms and condition of the L/C). The UCP 600 art. 2 define the credit and art. 3 reemphasis this definition. 29 Dynamics of an L/C. Buyer and Seller draw up a sales contract agreeing on quantity, price, packaging, date of dispatch, destination, latest date of shipping etc. The buyer approaches his bank (issuing bank). The issuing bank gives him an L/C Application Form to complete. He completes the form with details of the underlying contract. The issuing bank issues a letter of Credit on behalf of the importer, in favor of the exporter. The issuing bank instructs a bank in the exporter’s country to advice the L/C (This bank is the Advising bank). In case of a confirmed L/C, the advising bank is requested to add its confirmation before advising. The L/C is advised to the exporter, who checks to make sure it is okay with him. He secures the goods and ships and then presents documents to the paying / negotiating bank. The bank checks for accuracy, authenticity, and conformity on the face of it. If the bank is satisfied, pays, it accepts or negotiates on the document. The bank sends documents to the issuing bank. The issuing bank delivers documents to the importer, who uses the documents to clear his goods. The importer pays the issuing bank. Issuance and Payment Transaction Flows 30  1.Sales contract Importer/Applicant Exporter/Beneficiary 4. Reviews LC 5. Ships goods 2. Application 8c. Title 3b. sends for LC documents LC 8a 6. Draft, 8b Payment Reimburse documents Bank 3a. Issues LC 7. Examines documents The L/C Application Form A typical L/C application form will contain some or all of the following: Name of address Applicant Name and address of beneficiary Amount of the L/C and if any tolerance -/+10% (usually the upper value is provided for). Method of advising the L/C – mail, telex etc. Date and Place of expiry Whether the L/C is available by payment/ acceptance / negotiation or deferred payment and who with. Tenor of draft and who they are drawn on. Whether part shipment and transshipment are allowed or prohibited Port of dispatch and poor of destination Terms of shipment (FOB, CFR, CIF) Brief description and quantity of goods including unit prices if applicable. Documents required Latest presentation date of document Terms of the L/C contract between applicant and issuing bank. 31 Types of L/Cs – Notation / Notification A Letter of Credit is Irrevocable (under the UCP 600 art. 2). It can also be Unconfirmed or a Confirmed Letter of Credit. However, a letter of credit that is confirmed will necessarily be irrevocable. Irrevocable Letter of Credit – This letter of credit cannot be amended or canceled without the consent of all the parties. Unconfirmed Letter of Credit – Usually, the issuing bank of a letter of credit carries the obligation to pay upon presentation of documents that conform by the exporter. Therefore, this type of letter of credit only carries the guarantee of the issuing bank. It means the exporter is satisfied with the credit risk of the issuing bank (Remember, the issuing bank is in the importers’ country) Confirmed Letter of Credit – This Letter of Credit carries in addition to the issuing bank’s guarantee to pay, that of another bank (usually with a perceived superior financial status) in the exporter’s country. Therefore, the exporter’s credit risk shifts from the issuing bank to that of the confirming bank, who is in the exporter’s country and who the exporter is more comfortable with. Parties Involved In L/C Transaction The Applicant is the party that arranges for the letter of credit to be issued. The Beneficiary is the party named in the letter of credit in whose favor the letter of credit is issued. The Issuing or Opening Bank is the applicant’s bank that issues or opens the letter of credit in favor of the beneficiary and substitutes its creditworthiness for that of the applicant. An Advising Bank may be named in the letter of credit to advise the beneficiary that the letter of credit was issued. The role of the Advising Bank is limited to establish apparent authenticity of the credit, which it advises. 32  The Paying Bank is the bank nominated in the letter of credit that makes payment to the beneficiary, after determining that documents conform, and upon receipt of funds from the issuing bank or another intermediary bank nominated by the issuing bank. The Confirming Bank is the bank, which, under instruction from the issuing bank, substitutes its creditworthiness for that of the issuing bank. It ultimately assumes the issuing bank’s commitment to pay. Letter of Credit Process Responsibilities of Parties Buyer (Importer): - a. Buyer should ensure that the terms and condition of the L/C are explicitly stated. b. Buyer should ensure funds are available to pay upon presentation of documents. 33  Sellers (Exporter): - a. Goods exported conform to those called for in the L/C. b. Documents presented are correct and conform to terms and condition of L/C. c. Documents are presented within the stipulated time. d. Title documents sent to importer will allow him to take possession of goods. Issuing Bank: - a. State clearly in the L/C the terms and condition as instructed by the importer. b. They are bound by any amendments that are issued. c. The bank must stipulate the counters at which credit expires. d. The bank must pay upon presentation of document that conform or reimburse the paying bank for settlement made on its behalf. e. The bank must pay notify importer of any discrepancies on the L/C for refusal or acceptance. Confirming Bank a. The confirming bank has the right to refuse to add confirmation when requested to. b. If a bank refuses to add confirmation, it must notify the issuing bank and the beneficiary. Advising Bank a. The advising bank may advise a credit without engagement on its part, but must state it as such. b. It must check the apparent authenticity of the credit, which it advises. c. If it cannot establish the authenticity of the credit, it must inform the issuing bank immediately and the beneficiary if the advising bank chooses to advise the beneficiary. Paying Bank a. Must check documents for accuracy and that they conform to terms and condition of L/C. b. Must pay, acceptance or negotiate document as instructed. c. Has the right to be reimbursed for payment made on behalf of the issuing bank. The Advantages Of L/C to Seller The promise of payment by a bank to pay provided terms and conditions are complied with. An excellent financing document vides rediscounting of draft. Prompt payment in the case of sight L/C. Payment from a bank in his own county. A bank in seller’s country checks documents before being sent to issuing bank. 34 The Advantages Of L/C to Buyer He gets documents he needs to import/clear his goods. He receives goods and documents at the right time by stipulating latest shipment date. He controls payment by stating maximum days of presentation of documents. Documents are checked for correctness by a bank before receipt of goods. Settlements Under A Letter of Credit All commercial letters of credit must clearly indicate whether they are payable by sight payment, by deferred payment, by acceptance, or by negotiation. These are noted as formal demands under the terms of the commercial letter of credit. In a sight payment, the commercial letter of credit is payable when the beneficiary presents the complying documents and if the presentation takes place on or before the expiration of the commercial letter of credit. In a deferred payment, the commercial letter of credit is payable on a specified future date. The beneficiary may present the complying documents at an earlier date, but the commercial letter of credit is payable only on the specified future date. An acceptance is a time draft drawn on, and accepted by, a banking institution, which promises to honor the draft at a specified future date. The act of acceptance is without recourse as it is a commitment to pay the face amount of the accepted draft. Under negotiation, the negotiating bank, a third-party negotiator, expedites payment to the beneficiary upon the beneficiary’s presentation of the complying documents to the negotiating bank. The bank pays the beneficiary, normally at a discount of the face amount of the value of the documents, and then presents the complying documents, including a sight or time draft, to the issuing bank to receive full payment at sight or at a specified future date. At Sight Payment Credit Deferred Payment Credit Payment Methods Under LC Negotiation Payment Credit Acceptance Payment Credit 35 Sight L/C The simplest form of a letter of Credit is this L/C. This L/C terminates upon receipt of payment by the exporter (usually within 5 banking days of receipt of documents) and there is no recourse. 36 Term L/C (Deferred, Tenor) A term L/C is one that the payment is not immediate instead it is at some future stated date e.g. 30days, 60days, 90days etc from Bill of lading date. It could be with or without a drawn draft. (Usance L/C). When the letter of credit calls for presentation of a tenured Bill of Exchange by the seller, the relevant party (in the case of a confirmed L/C, the drawee is the confirming bank and in the case of an unconfirmed L/C, the drawee is the issuing bank) will accept the Bill. The bill of exchange becomes A Banker’s Acceptance. In some cases, the seller does not draw a bill to avoid paying stamp duty or the country does not encourage the drawing of a bill as a payment instrument. In this case, the seller asks the bank to issue a Deferred Payment Undertaking. The advantage of the issuance and acceptance of a bill of exchange is the flexibility of discounting the bill before maturity, where the seller has need for money before maturity of the instrument. 37 Other Types of L/C There are several forms of a letter of Credit. These are called derivatives of the L/C. They are structured to finance particular type of transactions and it is the terms and conditions that differentiate them. They include: - a. Advance Payment L/C b. Standby L/C c. Transferable L/C d. Back to Back L/C e. Revolving L/C 38 Advance Payment L/C It is a letter of credit, which allows the exporter to draw an advance before shipment. It is a financing of some stages of the export transaction by the importer. It is usually accompanied by a simple receipt and in some cases an undertaking to effect shipment on or before in conformity with the terms and conditions of L/C. The various document called for in the terms and conditions of the L/C must be complied with before balance payment is made. The L/C must state the % or amount of advance payment. When the seller has shipped and presented documents, the value of the advanced drawing is deducted from the value of documents presented. The seller is then paid the difference of the value of documents presented and the advance drawing. Standby Letter of Credit (SBLC) It is an L/C issued by banks on behalf of an applicant in favor of a beneficiary, which acts as a guarantee of payment by the applicant to the beneficiary. It is not related to default on delivery of goods on the part of the exporter instead it is made in relation to a default or other non-performance on the applicant’s part. The applicant of a standby letter of credit could be the seller or the buyer depending on the nature of the transaction. For example, the buyer under an Advance Payment letter of credit may ask for the seller to present a standby letter of credit as a condition to the seller accessing the advance payment (if the buyer believes that performance risk exists). 39 It is simple and requires very little documentation to collect upon. The document called for includes a statement from the beneficiary stating that the obligation for which the letter of credit is issued remains unpaid or that risk has crystallized. It also requires that a draft be drawn for the value of the outstanding obligation. Like all letters of credit, it carries an expiry date and can be just as expensive as a regular letter of credit especially if a confirmation is required. THE STANDBY FLOW CHART 40 Transferable Letter of Credit This type of letter is used in cases where the supposed exporter is not the primary exporter or producer of the goods. Instead, he is a middleman. or he contributes only a portion of the goods. It can be transferable in parts or whole to secondary beneficiary(ies). This allows the first beneficiary to ask the advising bank to transfer the L/C to any other beneficiary of his choice. The subsequent beneficiaries are entitled to be paid upon submission of their individual documents to the paying bank. The terms and conditions will generally be the same for all the participants in the transaction. However, amendment may or may not be advised to secondary beneficiary. There are a number of unique conditions that apply to this type of letter of credit. The parties must fully understand these conditions. The UCP article 38 emphasizes the importance of this type of L/C. 41 Back to Back L/C This L/C is also used when the situation is similar to that of the transferable L/C. However, the importer is totally unaware of the existence of a secondary beneficiary. Instead, the first beneficiary utilizes the value of a prime or master L/C as an assigned security to a bank for that bank to issue its own L/C for a lesser value in favor of the ultimate producer of the goods. This type of L/C is very risky because changes in terms and condition of the first L/C may be unacceptable under the second L/C and as such may affect smooth flow of payment. This transaction involves two L/Cs. One (the original or Prime or Master) L/C issued in favor of a supplier and then a second (back-to-back) issued in favor of the ultimate supplier. Only the first supplier and the advising/ issuing bank of the second L/C are aware of the two L/Cs. The first L/C would likely be both confirmed and irrevocable. The terms and conditions must be well matched as to facilitate easy reimbursement under the first L/C. The expiry date of the second L/C would be earlier to allow for substitution of documents. The latest shipment and presentation dates would also be earlier. The value of the first L/C would be larger than that of the second L/C to allow for the margin to the first supplier. 42 Similarities / Difference between the Transferable L/C and the Back-to-Back L/C. Similarities: 1. Both L/Cs rely on the issuance of an original before transfer or issuance of a second L/C can be affected. 2. The terms and condition on these two L/C must be similar to the original one they are based on. 3. In terms of the value, tenor, latest shipment date, presentation dates- for both type of L/Cs they must be reduced or curtailed to the original L/C. 4. There is provision for the substitution of documents of second beneficiaries. 5. These L/C must carry insurance cover that will not be lower than the original. Differences: - 1 The transferable L/C must state it is transferable to enable the transfer. 2. While the transferable L/C is one single elongated transaction, the Back-to- Back L/C is two distinct transactions. 3. The involvement of the original Applicant under the transferable L/C makes it easier to make amendments while amendments under the back-to-back may be difficult. 4. The transferable L/C offers more security for all parties while the back-to- back is riskier for all the parties. 5. The back-to-back L/C is also more expensive than the transferable L/C. 6. The advising/issuing bank in the back- to- back L/C carries more responsibility than the advising/transferring bank in the transferable L/C. Revolving L/C The type of L/C is used where goods are to be purchased at regular intervals rather than in a single lot or shipment. The alternative is to open several L/Cs to cover the various shipments, which will be too expensive and cumbersome. Under the revolving L/C, the validity is automatically renewed after each shipment within the prescribed time limits for specific shipment (1, 2, 3, or more). It could be cumulative or non-cumulative (the L/C must specify which it is). If an L/C is cumulative, it means that the shortfall in shipment of any one month can be added on to shipment in subsequent months within the prescribed period. E.g. Buyer A has issued an L/C for import of USD 1 million. Each shipment will be at an interval of 60 days. There are to be a total of four shipments. Since the L/C is cumulative and in 1, exporter ships USD 200,000, it means that the shortfall of USD 50,000 can be shipped in subsequent months before expiry of the L/C. 43 Under the non-cumulative revolving L/C, the shortfall in shipment of a preceding month cannot be made up in subsequent months. Using the same example, each shipment must not exceed USD 250,000. It means each shipment cannot be more than USD 250,000, if there is an under shipment at any time, such difference cannot be added to the next. All documents must reflect the amount shipped at an interval. This L/C can be sight or tenored. GUARANTEES BONDS Because it is sometimes difficult for the buyer to assess either the financial standing or the proficiency of the supplier in performing under the terms of the contract – usually in connection with large scale, public sector infrastructure projects – the buyer would want a guarantee to cover against loss. Bid or Tender Bond – This is required to support an exporter’s offer to supply goods or a contractor’s offer to carry out a service. A bid bond is guaranteed by the seller’s bank and is usually 2%-5% of the value of the contract. Performance Bond – The Bid Bond is replaced by the Performance Bond to guarantee that the seller will perform in accordance with the required standard or be refunded any amount the buyer may have parted with, usually 10%. Advance Payment Guarantee – The buyer pays the seller an agreed percentage of the contract price as an advance payment, which can be claimed back if goods/services provided are not satisfactory. Advantages of SBLC over Guarantees SBLC means STANDBY LETTER OF CREDIT 1. They are protected by UCP 600 2. They are quicker to issue 3. As in all L/Cs, they bear expiry dates Disadvantages 1. They are more expensive especially when a confirmation is required. 2. Its acceptance internationally is restricted. 44 Risks Associated with Various Types of L/Cs The risks inherent in the different types of Letters of credit must be identified at the beginning of the facility. This also determines the type of facility structure. Revolving L/C- The revolving letter of credit is used for imports that are of regular intervals with the same values. It could be revolving non-cumulative or revolving cumulative. Risks 1. Inability to determine the actual value of documents presented at any drawing. 2. Difficulty in canceling the L/C in case of adverse turn in business especially in a confirmed irrevocable L/C. Standby L/C- The standby L/C serves as a guarantee against default of a financial obligation and it is not payment for import/export of goods. Risks 1. The risk of the issuing bank. 2. The crystallization of financial obligation after expiry date. 3. The conformity of documents presented under the letter of credit. 45 Advance Payment L/C- The advance payment L/C avails the exporter a certain sum of money or certain % of L/C in advance of performance under the L/C. Risks 1. Diversion of funds 2. Compliance with the terms/condition of the L/C. 3. The interest rate risk. 4. The credit strength of the guaranteeing bank Transferable L/C- This L/C allows the first beneficiary to source secondary suppliers without additional cash outlay on his part. Risks Performance risk of secondary suppliers. Compliance with quality standard Turnaround time/over-invoicing. Back-to-Back L/C- The back-to-back L/C provides cover for a secondary L/C using the first (master or prime) L/C. Risks Performance risk of secondary suppliers. Over invoicing L/C processing costs Unconfirmed L/C- An unconfirmed L/C has the undertaking of an issuing bank to pay upon compliance with the terms and conditions of the L/C. Therefore, the issuing bank must consider the following: The capability of the importer to pay upon presentation of documents. A definite source of repayment independent of sales from import specially in a sight L/C. The transaction cycle in the case of a term or deferral L/C. Dollar Usance L/C- The issuing bank is in effect lending dollars to the importer to import goods. The considerations here are: What is the bank’s financing source and the price? The transaction cycle in relations to the available dollar facility. 46  The exchange rate risk and the available hedge products. The legal environment in terms of exchange control regulations. The interest rate applicable. The capability of the importer to fund at maturity. Confirming Line L/C- The issuing bank is able to confirm its L/Cs by using the confirmation line with its correspondent banks. The considerations for the issuing bank are: The reimbursement clause. The ability of customer to pay immediately. The exchange rate risk. The foreign exchange policies. The pricing. Unconfirmed/Inoperative L/C- This should ordinarily be a pre-advice. The conditions would include that shipment cannot be effected before confirmation and activating the L/C or making it operative. Sometimes shipment is effected and documents presented without the L/C being operative or confirmed. Article 11 of the UCP 600 states that “A preliminary advice of the issuance of a credit or amendment (“pre-advice”) shall only be sent if the issuing bank is prepared to issue the operative credit or amendment. An issuing bank that sends a pre-advice is irrevocably committed to issue that operative credit or amendment, without delay, in terms not inconsistent with the pre-advice. This article can then be said to render a pre-advice L/C irrelevant since the issuing bank is irrevocably bound from the time of issuance. This is one of the riskiest L/Cs. The consideration here would include: A credit approval and defined limit of exposure. The source of repayment. Consignment of full set shipping document to the bank. Marketability of goods in case of default of payment. In structuring trade finance these identified risks must be put to consideration in relations to the particular type of transaction to be financed. The issues will include: 1. Equity contribution. 2. Method and time of payment. 3. Terms and condition on L/C. 4. Documents to call for. 5. Source of repayment-sales of existing stock, warehousing and sale of goods. 47 Risks of Parties to an L/C Besides the risks inherent in the different types of Letters of Credits, there are inherent risks to the parties to any L/C transaction. The identification and the mitigation of these risks are key to the success of a trade finance transaction. Applicant Risks The applicant is faced with the possibility of the following risks Goods – Goods may be non-existent. Since payment is likely to have been effected before arrival of goods, applicant may have paid on documents and not receive goods. Goods may be of inferior quality to that contracted or the quantity may be lower than agreed. The presentation of documents that complies with the terms and conditions of the credit would guarantee beneficiary payment. The applicant may suffer a loss on the sale of the goods. Goods may have arrived before presentation of documents. In such a case where the goods have been cleared, the applicant is obliged to pay beneficiary regardless of the discrepancies of the documents presented. Mitigants- The applicant must be sure of the reputation and capability of the seller in the industry. Foreign Exchange Risk – In situations where the currency of the applicant is not the same as the currency of transaction, then the risk of movement in rates exists. The exchange rate at the time of payment may move against the applicant to the extent that the transaction becomes a loss. In currency-controlled economies, policies may have changed that procuring the foreign currency become very difficult. In some cases, the original issuing bank has become insolvent at the time of presentation of document. The applicant is still obliged to pay on the L/C even though he had earlier deposited funds with the issuing bank. Mitigant – The buyer should always have a hedge product in place. Issuing Bank Risks Applicant – The applicant may not be in a position to pay on the goods at the time the document is presented (credit risk). The issuing bank must pay. 48 Beneficiary Risks- The beneficiary may present documents that are compliant, however, the goods do not exist or they are inferior. Documentation Risk- The beneficiary must present documents that comply with the terms and conditions of the L/C. If for any reason, there are discrepancies, which the applicant does not accept, he does not get paid. Country Risk- If the beneficiary accepts an L/C that is unconfirmed, and then any problem with either the issuing bank or the applicant’s country will hinder his ability to be paid. Mitigants- The beneficiary must ensure he is conversant with the documentation requirement of both his country and the country of import. The beneficiary should accept only confirmed L/Cs in the case of doubt of the importing country’s economic stability. Advising Bank Risks AUTHENTICATION RISK – The advising bank ordinarily does not carry a payment risk. However, it has an obligation to confirm the apparent authenticity of the credit before advising it. It can therefore be obliged to compensate losses arising from bogus L/Cs that it advised. Confirming Bank Risks PAYMENT RISK- Because the confirming bank is the first recourse on a confirmed L/C, it runs the risk of not been able to receive reimbursement if the issuing bank becomes insolvent. The same risk exists in the case where the policy of the issuing bank’s country changes and adversely affects transfer of funds. Nominated Bank Risks COMPLIANCE RISK- This bank may be required to pay beneficiary. However, its main risk is to ensure that the documents presented comply with the terms and condition of L/C. It may be sued if the issuing bank finds any unacceptable discrepancies. Other Uses of Letters of Credit It can be used to cover payments for commission, royalties, and legal fees etc., which do not directly relate to a trade transaction. 49 In the United States, financial organizations use the standby letter of credit instead of guarantees. An acceptance letter of credit can be discounted to provide finance for the exporter pending maturity of the L/C. The Advance Payment letter of credit provides financing for the exporter prior to shipment of the goods. The transferable letter of credit allows the 1st beneficiary to finance sourcing of goods without additional cash outlay on his part. The Back-to-Back letter of credit allows the 1st beneficiary to open a second letter of credit on the strength of the first. COMMON DISCREPANCIES These are discrepancies that occur frequently in a letter of credit due to typographical errors or incorrect or incomplete document. Late Shipment Late Presentation of Documents L/C Expired Invoices: goods description Inconsistent/missing documents Transport documents WAIVE ABLE AND NON-WAIVE ABLE DISCREPANCIES Waive able These are discrepancies that do not necessarily hinder the buyer’s ability to clear his goods. These discrepancies can be accepted or rejected by the importer. They include: Clear typographical errors e.g. L/C number wrongly typed on document. Number on CCVO embossed i.e. 1 instead of 2 or 3 …. CCVO = CERTIFICATE OF L/C expired. VALUE AND ORIGIN Late presentation of documents. L/C number not stated on Bill of Lading etc. L/C overdrawn (provided importer provides cover, and it is within 10% of original L/C value). 50 Non-Waive able These are discrepancies that the government of the importing country will not allow either by decree (embargo or sanctions) or circulars. They could also be discrepancies that will hinder the buyer from clearing his goods. They include: Bill of Lading/Airway Bill not presented by beneficiary or non- negotiable copy presented. Bill of Lading/Airway Bill not signed by the carrier or its agent. Clean Report of Inspection not presented, where applicable. No CCVO or embossed CCVO presented. Description of goods on L/C different from those on document presented. Rejected Documents - Options Correct if possible – Where the discrepancies are within the supplier’s control to correct, then it should be corrected. Accept payment under Reserve – The paying/accepting/negotiating bank transacts with an indemnity from the supplier. If the issuing bank refuses the documents then the supplier must reimburse the paying bank. Send all documents on a collection basis – Where the discrepancies are too many, the document may be forwarded to the issuing bank on a collection only basis. This means the issuing bank must examine the documents and determine whether it wants to honour or not. It may then instruct the nominated/paying bank to honour. BILL FOR COLLECTION Definition- The collection by banks, of a sum of money, due from a buyer, with or without the delivery of the shipping documents. Dynamics of Collection Exporter sells goods or renders services Exporter presents documents to its bank (Remitting Bank) Remitting bank prepares Collection Order – instruction on conditions of release of document (acceptance or immediate payment) Collecting Bank (usually in importer country) complies with instruction and releases document Collecting Bank monitors maturity in the case of acceptance (D/A) and forward maturity 51  Collecting Bank collects payment and remit to Remitting Bank for credit of exporter Documentary Collection Transaction Flow 1 Buyer Seller 2. 52  5 8 3 6 4 Buyer’s Bank Seller’s Bank 7 (Collecting) (Remitting) 1. Sales Contract 2. Shipment of goods to buyer 3. Seller presents trade documents to his bank 4. Remitting bank forwards Trade Documents with Collection order to presenting bank 5. Presenting bank presents BOE to buyer for payment or Acceptance 6. Buyer pays or accepts BOE 7. Collecting Bank advises payment or notice of Acceptance 8. Payment is made to the seller Advantages of Collections It is simple and inexpensive compared to the letter of credit It is often swifter than open account in terms of payment The seller has control of goods to a large extent Advantages to Buyer 1. The buyer may not have to pay or accept draft until goods arrive. 2. It much cheaper than letters of credits. 3. There is no contingent liability or no liability until Collection 53  Order arrives. 4. If the instruction is Deliver against Acceptance (D/A) terms, the buyer Can sell the goods and use the proceeds to pay. Advantages to Seller 1. The seller can retain control of the goods until payment or acceptance by importer. 2. The seller can borrow against receivables by discounting the draft. 3. It is less expensive than letters of credits. Parties to a Collection The parties to a collection include: Buyer (the importer) Seller (the exporter) The Remitting Bank (usually the seller’s bank) The Collecting Bank (usually the buyer’s bank) The Presenting Bank (the bank that delivers all the documents – commercial and financial to the buyer). When to Use a Collection Both parties know the other is reliable No doubt of buyer’s willingness to pay Stable political risk Types of Collections Documentary Collection – These usually involve the use of commercial documentation similar to that of an L/C. The transaction is also usually routed through a bank. It will also involve the drawing and acceptance of a bill of exchange. It is commonly used in the sale of goods between two parties who are used to doing business with a high level of trust. Clean Collection – These involve very little documentation – usually a bill of exchange. It is also more used in service delivery than the sale of goods. COLLECTIONS 2. Goods/Services Buyer A Seller B (Importer) (Beneficiary/exporter) 1. Commercial Contract 3.Submit Documents Acceptance 8. /Payment 54  5. 6. Payment Presentation 4. of Document Document + Collection Order Collecting Remitting Bank Bank 7. Payment Documentation on Bills for Collection The types of documents in the documentary collection are similar to those in the documentary credit. They include: Commercial Documents Transport Documents Bill of exchange: - It must state clearly the drawer, the drawee, the interest applicable, the value, the terms and date. Responsibilities in a Collection Exporter The exporter must submit documents that are complete. This is to enable the buyer to take possession. The exporter is to ensure that collection instructions are clear and concise. Importer The importer is to check and ensure that documents received are complete and correct. The importer is to ensure acceptance of bill of exchange in the case of a D/A and to pay in the case of a D/P The importer is to ensure payment on due date and payment of all charges thereon. The Remitting Bank The remitting bank is to deal with documents quickly The remitting bank must check to ensure that exporter’s instructions can be carried out The remitting bank must instruct the collecting bank clearly The Collecting Bank The collecting bank must carry out the instructions of the remitting bank It must keep the remitting bank informed of all developments on the transaction 55  The collecting bank has the responsibility of keeping the documents secured until acceptance/payment It should verify that documents listed on the collection order are present and, on the face, appear genuine. If not, to immediately notify the remitting bank The Remitting Bank and the Collecting bank in a collection act as agents for the buyer or seller to ensure acceptance, payment and delivery of document between both parties. They must, however, act with due diligence. As protection for the banks in a collection transaction, the URC has provided for the same disclaimers as in the documentary credit. These include the FORCE MAJEURE, DISCLAIMER OF EFFECTIVENESS OF DOCUMENT AND DISCLAIMER ON THE TRANSMISSION OF MESSAGES ETC. A case of need – This is a representative or an agent identified on a collection order to stand – in for the exporter in case of a default on payment or acceptance of Bill. The responsibilities of the case of need must be clearly identified. The collecting bank will relate with the case of need only to the extent instructed on the collection order. Risks in a Collection Both the seller and the buyer face risks under the collection like under the documentary credit. However, the seller faces the higher risk. Importer Risk The goods ordered may not arrive or they may arrive damaged or not of the quality ordered. The importer faces an exchange rate risk. The importer may be unable to pay against an immediate payment order. Exporter Risk The importer may default on payment or may refuse to accept the draft upon presentation The exporter faces a country risk – lack of release of funds due to internal exchange control The exporter may be faced with the issue of what to do if goods are rejected. The exporter faces a foreign exchange exposure especially where the currency of trade is different from the currency of his own country. There may be cash flow difficulties due to financing method chosen Clearly this method of payment if not as secured as the letters of credit 56  Mitigants The buyer and seller can mitigate against the above risks by the following: A credit insurance Provision for interest payment for late payment Foreign exchange hedge product COMPARISON- DIFFERENT METHODS Open Cash Documentary Documentary Account Advance Credit (Letter Collection of Credit) (Bill for Collection) Time of As agreed Before After shipping Upon Payment upon Shipment presentation of Draft Goods Before After Payment After payment After payment availability to payment buyer Risk to Relies on Nil Very little or Disposal of Importer buyer to pay None unpaid good as agreed upon None Relies on Needs Needs exporter to Exporter to Exporter to ship goods as ship goods. ship goods ordered Though shipment is assured DETERMINANTS OF FINANCING METHODS Financing methods depends on three (3) main variables: The party to be financed: Importer or Exporter? What is to be financed? Payment, trade receivable, refinancing of seller’s credit etc. Who is providing the financing? Bank(s), Export Credit Agencies, Discount House(s) etc. The applicable strategy will then devolve from the financing method chosen. Financing provided to the importer Import finance facility (IFF). Bankers’ Acceptance (BA). Term loan / Overdraft. Confirmation line / Usance. Payment guarantee. Avalization. Trust receipt (T/R) financing. 57 Letters of indemnity. Supplier’s credit. Financing provided to the exporter Pre-export finance. Performance guarantee. Packing loan. Post-export finance. Invoice discounting. Discounting of accepted bill of exchange. Forfaiting. Factoring. Bankers’ Acceptance (BA) “A BA is a draft drawn on and accepted by a bank, unconditionally ordering payment of a certain sum of money at a specified time in the future to the order of a designated party….” (CBN Circular BSD/PA/4/97 dd. 12/08/97). Features Negotiable. Marketable. Usually disbursed in Naira. Short term financing instrument. BA’s must be used to finance trade related activities. Confirmation Line A confirmation line facility (CLF) is a line of credit extended by a bank to the importer, for the purpose of opening and confirming letters of credit. Features Disbursed in dollars. Cheaper than Naira facilities. Could be based on offshore (Clean) line or bank dollar deposits (Deposit) line. The importer is expected to pay back either Upon presentation of documents by the beneficiary. At the expiration of the refinancing period. Avalization This is the process whereby the importer’s bank adds its payment undertaking to a bill of exchange (BOE) already accepted by the importer (drawee). The bank provides her undertaking by signing at the back of the accepted BOE. An Aval (i.e. an avalized BOE) provides the exporter with a strong payment undertaking. It is negotiable. The bank is the secondary obligor. 58 Trust Receipt (T/R) Financing This is the process whereby the importer’s bank lends shipping documents to the importer to enable access to the goods. The release of the documents is usually based on a written undertaking (called Trust Receipt) by the importer. Used in collections (D/P) and LCs (Cash against shipping document), where the importer ordinarily has to pay before accessing shipping documents. T/R should only be used to finance credit worthy importers such as blue-chip companies as it is a high-risk financing instrument. Seller’s finance (Suppliers’ Credit) The seller finances the importer by deferring payment for a specified period of time (usually an agreed period after transport document date). Used under a collection (D/A) or LC (Deferred payment) mode. The basis of the finance is based on the sales contract between the importer and exporter. It is usually the cheapest source of financing an importer can have access to. Guarantees Financing methods for exporter A letter of guarantee is an irrevocable undertaking by which the issuer (usually a bank) holds itself financially liable for the consequences of non-performance of the obligations by a third party towards the beneficiary. The basic parties to a guarantee are: Applicant / principal: The requesting party. Beneficiary: The party in whose favor the guarantee is issued. Guarantor: The party that issues the guarantee. Common types: Tender guarantee / bid bond. Performance guarantee. Advance payment guarantee. Direct guarantee. Indirect guarantee. Counter guarantee. Payment on guarantees are easy to claim and banks are advised to issue such instruments only to credit worthy third parties, only upon thorough credit assessment. Packing loan 1 Packing Loan This is a pre-export facility availed to the exporter against the security of the incoming payment instrument (usually an LC) from the importer’s bank. The bank availing a packing loan must fulfill the following: