Vous êtes sur la page 1sur 97

Author: Maciej Makowski MSc in European Union Business and Law

Supervisor: Ren Franz Henschel Department of Law

MASTERS THESIS

International trade: Cost and efficiency of selected payment instruments

Aarhus School of Business, April 2007

ABSTRACT
The increasing globalisation of companies, which we experience in recent times, brings about not only many new opportunities for such companies to increase their wealth, but also dozens of new threats. Payment risk is one of them. It is much higher in case business partner is located overseas. In order to reduce it, traders on both sides of transaction need to have more in-depth knowledge on specific features of export financing means and their advantages and drawbacks under different business circumstances. Since such a complex guidebook to international payments is hardly available, the aim of the thesis is to shed some light on this issue. Below I am going to describe main payment instruments employed in international trade. The main point is, however, a SWOT based analysis of the instruments in questions. For the purpose of the thesis I have compared export financing instruments to marketing strategy tools. As a result I have been able to assess their usefulness for exporters and importers itemizing their strength, weaknesses, opportunities and threats. Such the analysis has allowed me to determine which instrument and in which configuration is most suitable under different business circumstances, which is to be indicated in conclusion to this thesis.

2 / 97

TABLE OF CONTENT
I. INTRODUCTION................................................................................................. 5 1) Background ............................................................................................... 5 2) Problem statement ..................................................................................... 7 3) Delimitations ............................................................................................. 8 4) Methodology ............................................................................................. 8 5) Literature overview ................................................................................... 9 II. Chapter I : BANK TRANSFERS........................................................................ 11 1) Introduction ............................................................................................. 11 2) Clearing and Settlement Organisations ................................................... 11 3) SWIFT address........................................................................................ 12 4) The use of SWIFT ................................................................................... 13 5) SWOT analysis........................................................................................ 14 6) Summary ................................................................................................. 23 III. Chapter II : CHEQUES AND BANK DRAFTS................................................. 25 1) Introduction ............................................................................................. 25 2) What is a cheque?.................................................................................... 25 3) Cheque requisites .................................................................................... 26 4) Independence of cheque obligation......................................................... 28 5) Issuing cheques ....................................................................................... 28 6) Cheque endorsement ............................................................................... 29 7) Aval ......................................................................................................... 30 8) Cheque stoppage ..................................................................................... 30 9) SWOT analysis........................................................................................ 30 10) Summary ................................................................................................. 41 IV. Chapter III : DOCUMENTARY COLLECTIONS............................................. 43 1) Introduction ............................................................................................. 43 2) Definition ................................................................................................ 43 3) Subject of the collection.......................................................................... 44 4) Parties to the collection ........................................................................... 44 5) Types of collection .................................................................................. 45 6) Modus operandi....................................................................................... 46 3 / 97

7) SWOT analysis........................................................................................ 49 8) Summary ................................................................................................. 60 V. Chapter IV : DOCUMENTARY CREDITS ....................................................... 62 1) Introduction ............................................................................................. 62 2) Definition ................................................................................................ 63 3) Parties to a documentary credit transaction............................................. 63 4) Modus operandi....................................................................................... 64 5) Two fundamental principles of documentary credits.............................. 65 6) Documents tendered to the bank ............................................................. 66 7) Types of LC............................................................................................. 67 8) SWOT analysis........................................................................................ 71 9) Summary ................................................................................................. 86 VI. FINAL ASSESSMENT AND CONCLUSIONS............................................... 89 VII. LITERATURE................................................................................................... 93

4 / 97

INTRODUCTION
1. BACKGROUND The share and significance of international trade in global commercial turnover is constantly increasing, and so does its importance for development of economies and wealth of societies. National governments are well aware of the benefits of international trade for their budgets and implement export-promoting policies. The exporters, in turn, concentrate their activities on cross-border sale. This happens for many reasons. Most importantly, such internationalised companies are able to diversify the risk arising when dealing only on one market, whereby, in case of a downturn, they need to face much decreased profits that cannot be made-up for by cross-border transactions. When selling to more than one country or region, the goods that have not been distributed within the domestic market may be directed to other countries which economies are not in a crisis. Additionally, domestic markets, particularly those of developed countries, are usually well saturated and there are fewer opportunities for golden deals. The profit margin, too, is usually fixed by the market as the competitive pressure of other companies is considerable. In the global scale such limitations do not exist and it is always possible to strike a very profitable transaction. For all these reasons, the share of export in the total of commercial turnover increases all over the world. This is a long-lasting and constant trend. However, in recent years, the increase has been more considerable than ever. Table 1 on the following page shows the rise of the total share of international trade throughout the world. The increasing volumes of international trade covering export, import, and re-export transactions directly translate into ever more common employment of export finance instruments. In case of cross-border transactions, particularly with an overseas partner, an exporter will often transport goods on large distances and across many national borders. Under such circumstances, that exporter has a great interest in ensuring that he will receive payment for goods sold once they leave his possession and control, and the importer has a corresponding interest to ensure that the seller has dispatched conforming goods before making payment in terms of the sale agreement1. Consequently, employment of efficient settlement instruments which reduce payment and commercial risk for both parties is deemed indispensable. Using same payment techniques in case of domestic deal and an overseas transaction is not feasible or at least not practical. The most popular instruments are: SWIFT
1

Coutsoudis, Basil (2005)

5 / 97

bank transfers, cheques, documentary collections, and documentary credits. Each of them has its weaknesses and strengths, and is appropriate under certain circumstances, whereas it is not under others. Additionally, certain instruments are preferred in some geographical zones, which stems from many reasons, such as tradition, need to minimize risk or transfer time, legal regulations, foreign exchange restrictions, etc. Table 2 on the following page presents what instruments dominate in each region of the globe.

TABLE 1 : World merchandise trade by major region: 2001 2004 (billion dollars and percentage)

Source: World Trade Organisation 2

WTO (2005)

6 / 97

TABLE 2 : Export finance instrument use by region:

Source: SITPRO3

As it may be seen on the drawing above, instrument that provide higher level of commercial security (such as documentary credits or collection) are preferred in region which are generally perceived as high risk areas. Similarly, less secure but cheaper instrument are preferred in more developed region such as European Union or North America.

2. PROBLEM STATEMENT Given the increasing volumes of cross-border trade and, consequently, increasing popularity of export payment instruments, it has become of paramount importance to provide merchants with objective and as accurate as possible information on such instruments. Most of the literature provides only a general description of main tools of export financing, ignoring completely any assessments of their usefulness under different business circumstances. As a

SITPRO (2002)

7 / 97

result, many traders are well aware of availability of various payment instruments, whereas they do not quite know how to use them. Most importantly, they do not have sufficient knowledge on risks and opportunities inherent to each payment instrument. Consequently, they are not able to unequivocally assess which instrument is most suitable under given business circumstances and their choices are not optimal. Such an inexperienced trader does not only need to bear additional costs of his decision, whether financial or non-financial, but additionally he is particularly exposed to unfair or even illegal practices of overseas business partners, which may take advantage of his ignorance. The in-depth practical knowledge of efficient and secure export financing is one of the key skills each exporter and importer should possess if he wants to survive on the market. Therefore, the purpose of the thesis is to provide such information to all concerned parties in order to allow them choosing an optimal financing strategy adjusted to the nature of their business and circumstances of each single business transaction.

3. DELIMITATIONS This thesis is concerned only with four most popular whole-sale export financing instruments: bank transfers, cheques, documentary collections, and documentary credits. Other modes of payment or any supporting tools, such as bank guarantees, are not a part of this thesis. The main aim of the thesis is to present practical advantages and disadvantages of these instruments from business perspective. Consequently, purely legal matters, such as courts of law verdicts, case law in general or similar are not discussed in the thesis.

4. METHODOLOGY The purpose of the thesis is to provide concerned parties with information on the most important features of payment instruments employed in international trade. As a result, the thesis should allow them to understand the rules governing functioning of such instruments, their advantages and disadvantages. They should be able to choose the instrument mostly adjusted to their needs and hence allowing them to optimize their export financing strategy. In order to achieve this objective, the thesis has been divided into four chapters, whereby each of them is concerned with one of the following payment instruments: bank transfers, cheques, documentary collections, and documentary credits. Each chapter, in turn, is divided into three parts: descriptive, analytical, and conclusions. The objective of the first one is to briefly describe the main features of each payment instrument. The following one, analytical part, involves a SWOT analysis of this same instrument. For the purpose of the thesis, I have 8 / 97

decided to treat export financing instruments as marketing strategy tools. Consequently, I am able to clearly show their weakness, strengths, as well as threats and opportunities they may create for exporters and importers. The difference between strengths and weaknesses and opportunities and threats lies in the likelihood of their occurrence. The former are concerned with intrinsic features of a payment instrument. They may be either objective (such as security in case of SWIFT transfers) or relative (such as higher cost of documentary credits in comparison to other payment instruments). In case of the latter, opportunities and threats, they are concerned with certain features of payment instruments creating opportunities or threats for both importer and exporter. This means events, whether positive or negative, which may, but do not need to, happen. To give an example, increasing trend of introducing international conventions governing bank transfers worldwide may in future result in introduction of a unified regulatory framework for such transfers. If this happens so, it will directly translate into much more secure and easier use of these means of payment however, it is not yet sure if and when this happens. The SWOT based methodology described above allows readers to unequivocally realise which risks they need to face and which opportunities may off-set these risks. It must be noted, however, that features considered strength for one party (eg. exporter) may be deemed weakness by the counterparty (eg. the importer). For instance, short validity of cheques is definitely a drawback for exporter, as he has only limited time to realise the cheque. For the importer, on the contrary, it is a way to reduce his risk as the payee will be able to cash the cheque only within limited time, after which the cheque may be stopped4. Lastly, the purpose of the conclusions is to summarise observations collected under the SWOT analysis and propose certain recommendations with regard to the optimal uses of each payment instrument under given business circumstances.

5. LITERATURE OVERVIEW A very broad collection of literature on export financing can be found in libraries and on the internet. This includes both academic books and guide books for non-academic readers. Nevertheless, most of the literature is rather of purely descriptive nature and disregards or touches upon only very briefly the discussion on appropriateness of each payment instrument for an overseas business transaction depending on its characteristics. The conclusions drawn in the thesis are based on information derived from four main sources: academic books, discussion papers, practical guides, and my own experience as an export trader.

For details please refer to Chapter II of the thesis.

9 / 97

With regard to academic books, I have used books of general nature concerned with export financing in general, such as: Schmitthoffs Export Trade (2000), Marciniak-Neider (2002), as well as book touching upon only the subject of one payment instrument, such as Hipolitanska (2002 and 1997). Discussion papers, in turn, are issued mainly by academics (such as Zambakhidze) and by concerned institutions, such as UNCITRAL or SITPRO. Other important sources of information are practical guides issued by banks and financial institutions such as Commonwealth Bank of Australia or related newspapers such as Documentary Credit World or LC Monitor. Last but not the least, legal codes such as UCP500 or URC522 were also a very import source of information.

10 / 97

CHAPTER I: BANK TRANSFERS


1. INTRODUCTION Bank transfers are one of the oldest and most commonly employed methods of payment in international commerce. Certain types of bank transfers were used already in the ancient times. The bank transfers we know today, i.e. instantly executed wiring of funds from one account to another by means of telecommunication, has been used at the wholesale level since the mid-1900s following the introduction of the electric telegraph. This type of bank transfers is called telegraphic transfer5 or wire transfer6. Alternatively it may be also called a cable transfer. It is an arrangement whereby one bank, on request of payer having his/her account in this bank, transfers funds instantaneously from the payer account to another account in the same or different bank. The actual transfer is done by the bank, and neither the sender nor the recipient of the money sees or touches the actual funds7. In the case of international bank transfer, the payer is usually the importer and the payee is the exporter.

2. CLEARING AND SETTLEMENT ORGANIZATIONS SWIFT In order to realise such a transfer, a common system of clearing and settlement of funds must be established between banks worldwide. The most wide-spread international system for inter-bank communication is S.W.I.F.T. (SWIFT).8 It is a cooperative society established in 1977 by common agreement of major international banks. According to its Articles of Association, The object of the Company is for the collective benefit of the Members of the Company, the study, creation, utilisation and operation of the means necessary for the telecommunication, transmission and routing of private, confidential and proprietary financial messages.9 The headquarters of SWIFT is located in Brussels. For almost 30 years of its functioning SWIFT has developed dynamically both in terms of new messaging services rendered and number of its members. The organization is currently10 used by over 7,970 institutions (banks, brokers, investment managers, exchanges, trading institutions and others)

5 6

Sometimes the abbreviation T/T is used instead. Primarily in the US. 7 eHow: How to conduct a wire transfer?; http://www.ehow.com/how_2817_conduct-wire-transfer.html 8 SWIFT stands for Society for Worldwide Interbank Financial Telecommunications more information on www.swift.com 9 SWIFT web-site; http://www.swift.com/index.cfm?item_id=41961 10 as of September 2006.

11 / 97

in more than 200 countries, with new members joining every half-year11. SWIFT offers solutions covering virtually full range of financial transactions, including, among others, bank transfers, financial instruments, securities trading and settlements.12 It is considered a very stable and reliable system with the availability rate of 99.999%13. The most common of its services is the so called FIN (Financial Application). It is a user-to-user (i.e. bank to bank) service. The FIN covers services offered by banks to international traders, including but not limited to documentary credits, documentary collections, wire transfers or bank guarantees.

Other settlement organizations Other common organizations, alternatives to SWIFT, include, among others FedWire and Chips. The former, FedWire stands for Federal Reserve Wire Network. It is a high-speed electronic communications network that links the Federal Reserve Board of Governors, the 12 Federal Reserve Banks and the 24 branches, the U.S. Treasury Department, and other federal agencies (together 9,500 participants). FedWire is used by users requiring large volume and time sensitive payments, for fund transfers between reserve banks, sales of US government securities and many others.14 The Clearing House Interbank Payments System (CHIPS) is a real-time electronic payment system that transfers funds and settles transactions in US dollars. The CHIPS allows banks to transfer and settle international payments more quickly by replacing official bank checks with electronic bookkeeping entries15. Currently CHIPS processes over 285,000 payments a day with a gross value of $1.4 trillion. It is a premier payments platform serving the largest banks from around the world; representing 19 countries world wide16.

3. SWIFT ADDRESS Each SWIFT member bank has its unique SWIFT address which is a subset of Bank Identification (BIC) code17. The address is bestowed by SWIFT to each new member upon joining the organization. The following table shows the general format of a SWIFT type BIC address:

The detailed SWIFT statistics can be found on http://www.swift.com/index.cfm?item_id=4329 SWIFT web-site; http://www.swift.com/index.cfm?item_id=1008 13 SWIFT web-site; http://www.swift.com/index.cfm?item_id=43232 14 Fraud-aid.com; http://www.fraudaid.com/How-To-Deal-With-Having-BeenConned/Wire_Transfers/Fedwire01.htm 15 Federal Reserve Bank of New York; http://www.ny.frb.org/aboutthefed/fedpoint/fed36.html 16 CHIPS web-site; http://www.chips.org/home.php 17 There are SWIFT-BICs and non-SWIFT-BICs.
12

11

12 / 97

AAAA Bank

BB Country

CC Location

(D) LT

(EEE) Bank

Source: Century24 Solutions18

The first four characters (AAAA) represent the bank code, for example DABA (Danske Bank) or DEUT (Deutsche Bank). The next two characters (BB) stand for the ISO country code, for instance DK (Denmark), GB (United Kingdom), or DE (Germany). The following two characters (CC) are the location code (e.g. KK Copenhagen) with some larger financial centres such as London and New York having two: 2L and 22 or 33 and 3N respectively. These characters, meaning the first 8, represent the mandatory part of each SWIFT address. The examples may be DABADKKK (Danske Bank Copenhagen), DEUTDEFF (Deutsche Bank Frankfurt). Optionally, a three character branch code (EEE) can be added at the end of the address. For example DABADKKKAAR stands for Danske Bank Aarhus branch, and NDEADKKKAAL is Nordea Bank Aalborg branch. It may alternatively identify a separate department with the same bank in the same country. The code may be alphabetical or numerical. It must be noted, however, that the branches or departments using the 11-character SWIFT address do not have connection to the network and communicate through the main dbranch19. The last 3 characters are therefore used only for internal purposes. The Logical Terminal ID in position 9 (D) is also optional and identifies the logical channel connection to S.W.I.F.T., which are referred to as A, B, C, etc (e.g. NWBKGB2LA).

4. THE USE OF SWIFT In order to realize a SWIFT based international bank transfer, a payer needs to approach his/her bank and fill-in relevant application (paper based or electronic). The following information must be included in such the application: payer name and his account number, beneficiary name and his account number, beneficiarys bank name and its SWIFT address, amount of money to be transferred, and the currency. On the basis of the application, an electronic message is sent to the beneficiarys bank (directly or through a network of correspondent banks). The money transfer messages are classified under FIN MT 103 or 103+ SWIFT categories Single Customer Credit Transfer. The FIN 103 transfer print-out is received by the payer in the paper form and serves as
18 19

Century24 Solutions; http://www.c24.biz/library_swift.htm#address Anasys The Message Management Company: The programmer's S.W.I.F.T. objects library: S.W.I.F.T. Standards 2006; http://www.anasys.com/swifthandbook/swift.html?fmt103.html

13 / 97

evidence of the transfer. The final confirmation is, however, received only once the beneficiarys account has been credited.

5. SWOT ANALYSIS The SWOT analysis presented below lists main features of SWIFT-based bank transfers between two countries.

STRENGTHS
a) relatively low cost in case of substantial amounts b) quick execution time c) security d) simplicity

WEAKNESSES
a) unclear division of costs b) relatively high cost in case of small amounts c) necessity of routing transfers via the bank established in the home country of the transfer currency

OPPORTUNITIES
a) decreasing cost of transfers b) increasing popularity c) unification of costs within Euro-zone d) international conventions e) broad range of services offered

THREATS
a) incorrect or delayed transfer in case of imprecise data submitted to the bank b) high risk in case of down payments c) delays

STRENGTHS Relatively low cost in case of substantial amounts SWIFT offers three options of dividing transaction fee between the parties to the transfer: applicant, beneficiary, or shared20. The transfer cost includes: fee of the applicant bank, fee of the beneficiary bank, and fees of intermediary banks, if applicable. In case of the first option, all the costs are born by the applicant, while in case of the third option, it is the beneficiary who covers all the fees. If the shared option is applied, applicant bears the costs incurred by
20

Hansa Bank, Sweden: http://w.hansa.ee/eng/arikliendile_arv_valismaksekulud.html

14 / 97

his bank while the beneficiary is charged with all the remaining costs, i.e. of beneficiary bank and intermediaries. The charges to be born by the beneficiary are deducted from the amount credited to this account. The exact total cost of a SWIFT transfer depends on each bank tariff, the existence of intermediaries, the currency, and the transfer priority21. To give an example, the total cost of a EUR 100,000 transfer from one bank to another amounts to 70 EUR22, while paying the same amount via an LC will raise the cost up to 250 EUR23. Consequently, SWIFT based money transfer is definitely the cheapest of all means of export payments described in the thesis.

Quick execution time The SWIFT offers definitely the speediest way of global funds transfer. The messages are normally sent from the applicant bank within the same day as the application submission. In order to have a guarantee, however, the application for foreign funds remittance should be received by the bank, whether online or in paper form, until around 2 3 pm24. In case the application is submitted after that time, it is processed on a best efforts basis, or on the following business day. It must be had in mind, however, that the message sent by the applicant is just a request to credit beneficiary account and there is no guarantee of the time when the beneficiary account will be credited. For this reason, most of the delays that occur usually relate to the day on which the beneficiarys account is credited by the receiving bank and hence are independent on the sending bank. Transfers that are destined to countries roughly within the same time zone25 are usually transmitted with a value date26 within two days. Further destinations cannot reasonably be expected to process payments so quickly due to time difference and hence other working hours27. Furthermore, in the case of transfers made in EUR or USD, it is also possible to apply for two types of transfer priority: urgent (value date within one day) and express (value date in the same day)28. In order for the transfer to be completed quickly, the receiving bank should have an account at the head office of the sending bank. This means that the two banks should be correspondents of each other. As a general rule, major banks have direct accounts at the head offices of other banks and thus
Different types of SWIFT priorities are described further in the chapter. Providing only one intermediary bank participates in the transaction. 23 Basing on a tariff in force in one of major Polish banks, BRE BANK SA www.brebank.com.pl 24 The exact deadline hour (called cut-off time) depends on each particular bank. 25 i.e. three time zones plus or minus 26 i.e. the date on which the beneficiary account is credited and therefore the date of currency exchange time and rate, if required. 27 Intrust Bank web-site, http://www.intrustbank.com/Business/International/HowTo021.aspx 28 In that case, the transfer cost will of course be accordingly higher.
22 21

15 / 97

an interbank transfer can be made directly. However, if the receiving bank does not have such an account, the wire transfer must go through an intermediary institution that can link the sending and the receiving banks. It is sometimes necessary to call upon several intermediaries to transfer the funds to the final receiving bank. This may take longer and besides each intermediary will normally ask for a commission. Additional SWIFT requirement is that each international transfer must be directed through a bank established in the country which is the issuer of the currency being subject of the transfer29. Consequently, the operation may take longer, depending on the currency.

Security SWIFT is one of the most secure international payment instruments. Since neither the payer nor the beneficiary actually has any physical contact with the funds; the risk of forgery, fraud, or any other type of illegal activity causing financial harm to the parties of the transaction is virtually eliminated. Additionally, since the funds may be only transferred from one account to another, it is always possible to track the beneficiary through its bank. The communication network and the computer terminals used by SWIFT members are equipped with latest security software and hence provide a high level of protection of the parties sensitive data. Owing to this SWIFT network is characterized by highly flawless performance and has the uptime of 99.999%30.

Simplicity SWIFT is a very easy to use instrument. Alternative means of payment, such as documentary credits or documentary collections require both the payer and the payee to prepare significant amounts of papers, which is a quite time consuming and burdensome operation. In case of SWIFT, the paper work is completely eliminated for the beneficiary and reduced to a minimum for the applicant. The payer needs to simply submit an application to his bank, whether in paper form or online, indicating necessary data, such as: the beneficiary, beneficiary bank, amount and currency of the transfer, priority, and cost option. The whole operation may take as little as 5-10 minutes. The beneficiary just waits for his account to be credited.

29

For instance, a SWIFT transfer in US dollars made from Denmark to a Polish bank must pass through an intermediary bank in the United States. 30 As has already been mentioned earlier in the thesis.

16 / 97

WEAKNESSES Unclear division of costs As it has been mentioned earlier in the thesis, SWIFT transfer cost includes three categories: fee charged by the sending bank, by intermediary banks, and by beneficiary bank. These costs are usually calculated as a percentage of the amount transferred with some minimum threshold31. When applying for a transfer, particularly in the case of new destinations, currencies, etc., applicant has actually no idea on the intermediary banks taking part in the transaction. Neither has he an idea on the fees that these banks normally charge for their service. Consequently, it is virtually impossible to predict the transfer cost for the applicant or the final amount that will be credited to the beneficiary account32. Also, in case of using higher transfer priorities, the transaction cost will increase to an unknown level. Furthermore, if it has not been clearly agreed between the remitter and the beneficiary prior to the transfer, it is customary that the remitter chooses the cost option that envisages division of costs between the former and the letter. In this case, the amount received by the beneficiary will actually be lower than agreed, as the receiving bank transaction fee will be deducted from the amount credited to the beneficiary bank. This amount is usually around 0.2 0.5% of the amount transferred, but has usually certain minimum level which in case of smaller amounts may account for significant portion of the transfer. In order to avoid threat of being charged for transfer receipt, it must be unequivocally agreed with the remitter as to who is going to bear the fees of sending bank, intermediary banks and the receiving bank.

Relatively high cost in case of small amounts Despite the fact that SWIFT transfer cost is relatively low in comparison to other payment modes, it is still high in case we transfer smaller amounts. This is because the cost is not merely a percentage of the transferred amount, but there are some minimum fixed fees charged independently on the amount. Hence in case of small values, the transaction cost forms a big share of the amount transferred. For instance, in case we want to transfer EUR 500 by SWIFT, the transaction fee may reach even EUR40 for the remitting bank, which accounts for 8% of the transaction amount33. Additionally, usually the beneficiary bank also charges a fee for receiving the transfer. This may be the same or even bigger than the
31 32

For instance: 1% and min. EUR 10. As has been mentioned earlier, in the case of shared cost option, the beneficiary bears the cost of his bank and the intermediaries. 33 The assumption is made for express SWIFT transfer.

17 / 97

remitting bank fee. Also, in case some mistakes are done in the transfer application and amendments are required, the remitting bank additionally charges the remitter34. It must be had in mind that the costs do not include the fees that may possibly be charged by intermediaries if these participate in the transaction. The total transfer cost may in that case be much higher.

Necessity of routing transfers via the bank established in the home country of the transfer currency As it has been mentioned earlier, a SWIFT rule is that each transfer made in a currency which is not the national currency of either the applicant bank or the beneficiary bank, must be routed via a bank domiciled in the country issuer of the currency35. Hence, in case we want to make a transfer in USD from Denmark to Australia, the transfer must be routed via a US bank. This has two drawbacks: additional cost and time. Firstly, the US intermediary bank will of course charge the applicant/beneficiary for his intermediation services. The exact cost depends on the bank tariff. Secondly, the need to route the transfer via a US bank requires some additional time for the bank to process the transfer. Bearing also in mind the time difference, this may increase the transfer time substantially.

OPPORTUNITIES Decreasing cost of transfers As has already been mentioned, SWIFT was established in 1977. Since that time, it has been continuously striving to improve not only its efficiency and security, but also its competitiveness against other settlement institutions. One of the key factors influencing the organization competitiveness is transaction fee, and SWIFT has proved very competitive in this field. Since the date of its establishment the cost of a transfer has constantly decreased and it is certain that this trend is going to continue. Over the past ten years SWIFT message prices have been reduced by over 70%36 and by 50% in the period between 2002 and 2006. Consequently, we may envisage that SWIFT is going to maintain this trend and that effecting international transfers will become much cheaper in future.

34 35

In case of Danske Bank, this charge amounts to EUR8.00, www.danskebank.dk Century24 Solutions, op. cit. 36 SWIFT web-site, http://www.swift.com/index.cfm?item_id=43232

18 / 97

Increasing popularity The SWIFT has the most widely developed network of members. No other institution has its members on all the continents in almost all countries. At present, there are 7,970 financial institutions in more than 200 countries around the world. SWIFT's worldwide community includes banks, broker/dealers, investment managers, as well as their market infrastructure in payments, securities, treasury and trade. There are around 1.16 billion messages transferred each year with the annual growth rate of around 16%37. The ever increasing number of SWIFT members not only widens the geographical area within which it is possible to realize a transfer. It also allows making transfer quicker as the bigger number of banks increases the likelihood of one bank being correspondent to another.

Unification of costs within Euro-zone SWIFT transfers realized within the euro zone, because of its specificity, are governed by slightly different rules. The so called Single Payment Area38 has been established within the euro zone. One of its implementing acts, the European Parliament and Council Directive 97/5/EC of 27 January 1997 on cross-border credit transfers39, established that the fund transfers within the zone are to be no more costly, time consuming or complicated than domestic transfers40. Additional rules apply with regard to: lost payments, delayed payment and the avoidance of double charging. Regarding the lost payments, the beneficiary is entitled to a money back guarantee of max. 12,500 plus interest and charges (larger sums need to be reclaimed through court proceedings). As for the delayed payments, in case the transfer does not arrive at the beneficiarys account within 6 working days at the latest, the beneficiary is entitled to compensation (interest on the delayed payment). Finally, special rules exist with regard to the distribution of charges to avoid double charging. Unless otherwise specified, the remitter bears all the costs of the transfer. If charges are nevertheless levied from the beneficiary, these unlawful charges are to be refunded41. The rules apply also to transfers made between a euro zone member state and a non-euro, but an EU zone state, where the transfer is made between two euro accounts. It should be noted that the Cross-Border Credit
SWIFT web-site, http://www.swift.com/index.cfm?item_id=4329 More information on EU Portal:http://europa.eu.int/comm/internal_market/payments/framework/index_en.htm 39 European Parliament and Council Directive 97/5/EC of 27 January 1997 on cross-border credit transfers [Official Journal L 43 of 14.02.1997] 40 For transfers not exceeding EUR50,000 (regulation 2560/2001/EC on cross-border payments in euros) 41 EU Gateway, http://www.europa.eu.int/comm/internal_market/payments/docs/guide-transfers/guide-crossbtransf_en.pdf
38 37

19 / 97

Transfer Directive facilitates consumer complaints and redress. Owing to the directive, the consumer has to deal with only one partner, i.e. his own bank, in case something went wrong with the cross-border credit transfer42. This process of law unification is very favourable for the traders. It provides them with additional security when resorting to this mode of payment. Furthermore, it may serve as a beginning of such the unification at international level.

International conventions In recent years we have been able to notice a substantial growth of cross-border banking activities. Consequently, many new branches of multinational banks have been established in the countries where banking sector had previously been underdeveloped. These developments have resulted in greater uncertainty as regards the rules and standards applicable to international transfers, jurisdiction and execution of court rulings. Despite the clear trend towards globalisation of markets and commerce, there are still considerable discrepancies in the rules applicable in different jurisdictions (the so-called fragmentation of legal rules). As regards contract law, a multitude of legal rules are potentially applicable to single international commercial transaction. With regard to public law, it is not always clear which supervisory authority is primarily responsible for: overseeing each individual bank, payment system as a whole, determination of responsibility for effecting settlements in domestic currency lies, or for ensuring cooperation among all relevant supervisory authorities, if more than one.43 Consequently, international traders often need to face conflicts of law and the so called forum shopping.44 Fortunately, certain steps have already been taken in order to remedy these problems. In 1992 the United Nations Commission on International Trade Law (UNCITRAL) adopted and issued a Model Law on International Credit Transfers45. The Model Law was prepared in response to a major change in the means by which funds transfers are made internationally. This change involved two elements: increased use of electronic orders in comparison with paper based transfers, and shift from the generalized use of debit transfers to the generalized use of credit transfers. The Model Law offers the opportunity to unify the law of credit transfers by enacting a text that is drafted to meet the needs of modern

EU Gateway; http://www.europa.eu.int/comm/internal_market/payments/credittransfers/dir-97-5summary_en.htm 43 World Bank; http://wbln0018.worldbank.org/html/FinancialSectorWeb.nsf/(attachmentweb)/ InternationalInitiativestowardsharmonisation/$FILE/InternationalInitiativestowardsharmonisation.pdf 44 Forum shopping is the process by which a plaintiff chooses among two or more courts that have the power, technically, the correct jurisdiction and venue to consider his case. This decision is based on which court is likely to consider the case most favourably. 45 Lex Mercatoria, http://www.jus.uio.no/lm/un.credit.transfers.model.law.1992/doc.html#151

42

20 / 97

funds transfer techniques. However, the Model Law has not so far gained popularity. No country adopted it as an integral part of its legal system. As a result, as for now, the Model Law serves rather as a base and another step towards further discussion on the unification of laws related to cross-border funds transfer46.

Broad range of services offered SWIFT offers a complete range of end-to-end solutions covering almost every aspect of financial services processing. These include: payments & cash management, treasury & derivatives, trade services, securities pre-trade/trade, pre-settlement, clearing & settlement, custody services and reporting. Owing to this an entrepreneur using SWIFT system for international funds transfer may also avail himself of advantages of these services. This will give him an opportunity to combine all services under supervision of one company.

THREATS Incorrect or delayed transfer in case of imprecise data submitted to the bank In practice sometimes the information submitted by the payer to his bank is incorrect. This applies mainly to the designation of the beneficiarys bank such as SWIFT code, but this may well be the address or name of the bank branch office. The reason for that usually is either applicant negligence or imprecise or incorrect information given by the beneficiary. If the payer determines that the beneficiary account has not been duly or timely credited he should first verify the information provided to the sending bank in its application. If the data submitted to the sending bank is found to be in order, he should encourage the beneficiary to research the matter with the receiving bank47. If a payment is not processed accordingly because of incomplete or incorrect remittance instruction, the sending bank should be contacted at the earliest opportunity. In the event the beneficiary claims non-receipt of funds and the receiving bank is unable to establish the reasons of the problem, the remitter may request the so called enquiry or tracer service. Their purpose is to determine the actual situation of the transfer. Most banks send one such a tracer without charge but charge a fee for subsequent inquiries. If this does not solve the problem, the beneficiary is also able to apply for funds transfer modification or payment cancellation. It must be noted, however, that the sending bank is able to return the

46 47

The Model Law served as a base for Commission Directive on cross-border transfers in euro zone. Intrustbank; http://www.intrustbank.com/Business/International/HowTo021.aspx

21 / 97

funds to the remitter only provided the beneficiary and his bank agree to return the funds sent to him.

High risk in case of down payments, SWIFT is definitely the most secured payment mode in terms of protection against forgery or fraud. On the other had, however, it gives no commercial security against beneficiary performance for the money paid. This means that in case our transfer is a prepayment for any goods to be delivered or a service to be rendered, we must be aware of the fact that after we transfer the funds, we have no way to make sure that the beneficiary will perform according to the agreement. The only protection we have is the underlying contract, and SWIFT itself gives no additional security as for instance an LC does. Once the beneficiary account has been credited in accordance with payers instruction, it is not possible to get the money back in case of the former default without his and his bank prior consent. It this case we can only litigate before the courts, as agreed in the contract or any other form of agreement. In view of the above, SWIFT should not be used for settling large sums in connection with execution of complicated contract, as inherent risk is too high.

Delays Since SWIFT acts merely as a network for transferring of messages, it may in no way guarantee the performance of its member banks. Once the application is submitted to the sending bank, the bank guarantees that the relevant SWIFT message is going to be sent on the same day (if submitted before the cut-off time) or on the following working day. However, after the message has been sent, further processing time depends on other bank participating in the transaction. This may be particularly problematic in case the money is routed via exotic countries. In such the countries, we need to take account of two factors: time difference and labour force mentality. With regard to the time difference, it must be had in mind that once a SWIFT message is sent from one country in the evening, it may already be morning in the country of destination or intermediary bank. Therefore, the transfer may be processed only on the following day. Additionally, in some countries it is difficult to guarantee the performance and work effectiveness of the bank staff, which may cause further delays. Also, a labour day in one country may be a holiday in another. All these differences may cause unexpected delays in the SWIFT transfer processing and hence cause the beneficiary to have his account credited much later than it was originally expected.

22 / 97

6. SUMMARY SWIFT based electronic international bank transfers are one of the newest and most quickly developing means of cross-border payments. In order to assess its appropriateness the following most important factors should be assessed: transaction cost, preparation time, execution time, risk of fraud, and commercial risk. As regards the transaction cost, SWIFT transfers are one of the cheapest ways of global fund transfers. As it has been described earlier in this chapter, the relative cost of a SWIFT transfer is the lowest in comparison to other means of payment. The ratio obviously differs depending on the amount transferred. Also, depending on the transfer currency and the beneficiary bank, the transfer may need to be routed via one or more intermediary banks, where each of them charges a commission which is usually born by the payer. Nevertheless, in terms of cost SWIFT is the most attractive instrument of cross-border payments. As for the preparation time, meaning the time that needs to be devoted by the payee to arrange for the transfer is also very attractive. The paper-work is limited to absolute minimum, and the absence of physical documents greatly speeds up the application time as it enables use of electronic communication. Again, in terms of preparation time, SWIFT based transfers are deemed the best instrument for traders. Since SWIFT is entirely an electronic based means of payment, its execution, unlike other instruments, does not involve any checking or verification of papers. Consequently, its execution is much quicker. It involves only preparation and transfer of an electronic message from one bank to another. Sometimes, the message must be routed via intermediary banks, which stems from the lack of agreements between the banks or transfer currency. In such cases the execution time is longer and in the worst case scenario the payer may face unexpected delays and needs to wait for an unknown period of time until the beneficiary account is credited. Anyway, SWIFT is still the quickest payment instrument used for crossborder fund transfers. Risk of fraud is also very limited in case of SWIFT transfers. This is because neither the remitter, nor the beneficiary has actual physical contact with the funds or with the documents. The application is send in electronic form and so does the relevant SWIFT message. The relevant amount is credited to the beneficiary account also in electronic form. As a result, there is virtually no risk of fraud. Unlike the previous factors, SWIFT must be assessed very poorly in terms of commercial risk. The payer (importer) faces the risk obviously only in case of down payments, meaning that the funds, or some part of them, are transferred to the beneficiary (exporter) account prior 23 / 97

to the actual delivery of products or services in exchange for which they payment is made. Once the funds are transferred, the payer completely loses control over the money. This means he has no power to cancel or revoke the transfer. He can only request the beneficiary to send the money back, which is completely up to the latter. Consequently, when sending a down payment by means of SWIFT, one needs to be aware that we do so entirely at own risk, and except legal actions, there is no effective instrument allowing us to get the money back in case of beneficiary default. Conversely, the exporter faces considerable risk in case he accepts an open account payment, meaning he agrees that the importer transfers the money after the importer obligations are fulfilled. In such a case, SWIFT as such does not provide the importer with any security against the exporter non-payment. The only agreement he can rely on is the underlying contract. In view of the above, in terms of commercial risk, SWIFT should receive the lowest rank meaning it is the most risky payment instrument for both exporter and importer depending on the payment terms agreed upon.

24 / 97

CHAPTER II: CHEQUES & BANK DRAFTS


1. INTRODUCTION The history of cheques dates back to the first century B.C. when banks in the Middle East issued letters of credit called Sakks48. Banks accepted orders made by their clients to pay a specified amount of money to a third party, called payee. This system eliminated the need of carrying large quantities of financial resources by merchants (e.g. gold) to pay for the goods purchased. As a result, the threat of being robbed when in journey was eliminated. A Cheque was originally called a "check" in reference to the counterfoil used to check against forgery and alterations. The spelling "cheque" seems to have been introduced by J. W. Gilbart in 182849. He explains in a footnote 'Most writers spell it check. I have adopted the above form because it is free from ambiguity and is analogous to the ex-chequer, the royal treasury. It is also used by the Bank of England "Cheque Office". At present, it is customary to use either of the two forms: check (for the US) and cheque (for the UK and the Commonwealth).

2. WHAT IS A CHEQUE? Cheque is a paper form received usually from banks. It serves as a written order by an account holder to his banker to pay a specified sum of money stated on the cheque to the bearer or named recipient50. Cheques are governed by different legal regulation across the world. These regulations impose distinct requirements in regard to; inter alia, definition of the cheque itself, its validity, obligatory data it is to contain, and the rules of cheques endorsement. The three main legal systems are established by or based on the following legal acts51: - Convention providing a Uniform Law for Cheques /the Geneva Convention/ (Austria, Belarus, Belgium, Bosnia & Herzegovina, Bulgaria, Croatia, Czech Republic, Denmark, Estonia, Finland, France, Greece, Spain, The Netherlands, Japan, Lithuania, Luxemburg, Latvia, Macedonia, Monaco, Germany, Norway, Poland, Portugal, Russia, Romania, Slovakia, Slovenia, Switzerland, Sweden ,Turkey, Ukraine, Italy). - Uniform Commercial Code /the UCC/ (United States, Colombia, Panama, Philippines, and Puerto Rico).

Wikipedia web-site, http://en.wikipedia.org/wiki/Cheque Wilson, Effingham (1828). 50 APACS web-site, http://www.apacs.org.uk/about_apacs/htm_files/chequecred.htm 51 Heropolitaska (1997)
49

48

25 / 97

- Bills of Exchange Act /the BEA/ (United Kingdom, Australia, Bahamas, Barbados, China, Cyprus, Fiji, Ghana, Guyana, India, Ireland, Island, Israel, Jamaica, Canada, Kenya, New Zealand, Pakistan, South Africa, Sierra Leone, Singapore, Sri Lanka, Sudan, Taiwan, Uganda). For instance, under the Geneva Convention, cheque is considered a separate payment instrument governed by a separate legal act. Under the BEA and the UCC, cheques are not separate financial instruments, but a special type of a bill of exchange drawn on a bank, and payable on demand52. These rules, legal conflicts, and the ways of solving them will be described further in this chapter. However, the emphasis will be put on rules enacted by the Geneva Convention for international cheques.

3. CHEQUE REQUISITES Each cheque issued according to the Geneva Convention must have the following information written on its face: the word cheque, unconditional payment order, paying banks name, place of payment, data and place of cheque issuance, payer signature53.

An example of a cheque written pursuant to the Geneva Convention:

Source: http://personal.telefonica.terra.es/web/mundocaracol/Cheque%20falso1.jpg

The word cheque (or its equivalent in national languages) must be written in a visible place on the face of the cheque. Without the word, the cheque is liable to be considered invalid by the collecting bank. As regards the unconditional payment order, the cheque must contain a written order to the bank to pay certain amount of money to the payee. The order must be
52 53

ibidem ibidem

26 / 97

unconditional, i.e. it may not be subject to completion of any previous activity. The paying banks name is also required as the collecting bank must know to which bank the cheque is to be sent for collection54. Place of payment of the cheque is obligatory, too. However, if there is no such place on the cheque, the place in which the paying bank is located is deemed the place of payment. If the latter is not written on the cheque, either, the place of cheque issuance is considered the place of payment. If there are many places of payment written on the cheque, the one which is written earlier is considered valid. The date and place of issuance are also considered mandatory under the Geneva Convention. In the absence of the place of issuance, the cheque is considered to have been issued in the place indicated at the payer name55. Cheques issued in Canada, the US and the UK have the so-called MICR account number (Magnetic Ink Character Recognition) pre-printed on their face. The MICR is a special kind of optical character recognition (OCR) technology that was adopted mainly by the three countries banking industry to facilitate the processing of cheques.

In the US, the MICR has the following format:

Source: Wikipedia56 Almost all U.S., Canadian and U.K. cheques include MICR characters at the bottom of the paper. Its purpose is to facilitate the cheques recognition.

this is however always written on the cheque blanks Heropolitaska (2003) 56 Wikipedia web-site: http://en.wikipedia.org/wiki/MICR
55

54

27 / 97

An example of a cheque written pursuant to the British BAE (the MICR at the bottom):

Source: North-West Chinese Council57

4. INDEPENDENCE OF CHEQUE OBLIGATION It should be mentioned that one of the basic principles which greatly influences cheques usage is the so called principle of independence of cheque obligation58. The principle says that to consider a cheque valid, it is not important whether any obligation (e.g. completion of contract, delivery of goods) from which the cheque stems does or did exist. A person making out a cheque cannot cancel the cheque on the ground that any such obligation has not been fulfilled properly by the payee. Similarly, in case of a cheque signed by the drawer and many endorsees and/or avals59, each of them is equally responsible for paying the cheque amount, even if the previous signatures of the endorsers were invalid or forged. As a consequence, the payee may require any of the persons signed on the cheque to pay the cheque amount to him. Their responsibility is equal and it is up to the payee which of them he selects as the payer.

5. ISSUING CHEQUES As has already been mentioned, when issuing a cheque, the drawer usually puts the following information on its face: the payee name, date and place of issue, amount to be paid, place of payment, drawer signature. The payee is the beneficiary of the cheque, i.e. the person/institution which is entitled to cash the cheque. Unless the cheque is a bearers cheque, the person/institution must be clearly stated on the face of the cheque. In case the bearer is stated on the cheque but the word or to the bearer (or equivalent in national languages) are

57 58

http://212.67.202.185/~cshelpline/nwcc/images/Resize%20of%20cheque.JPG Heropolitaska (1997) 59 the terms endorsees and avals will be explained further in this chapter

28 / 97

not clearly crossed-out, the cheque is considered a bearers cheque60. The date of issuance is the day on which the cheque was issued. Due to legally regulated validity of the cheques under the Geneva Convention, the date must be indicated on the cheque. The place of issue must be also stated on the cheque, as it determines the law to which the cheque is subject. In case of absence of the place of issue, the location given next to the drawer name in considered the place of issue61. Unless the cheque is the so called in-blanco cheque, the sum of money must also be stated on the cheque. For security reasons, it is advisable to write the sum in digits and in words62. Pursuant to the Geneva Convention, if any discrepancy appears between the sum written in digits and in letters, the latter one is valid. In case of two values written in digits or letters, the smaller one is valid63. Regarding the place of payment, in case of its absence on the cheque, it is understood that the cheque is to be paid in the place of issue64. In order to confirm authenticity of the cheque, a drawer signature must be given on the face of the cheque. The signature must correspond to the pattern in the paying bank records. If there are any doubts as to the authenticity of the signature, the bank may refuse to accept the cheque. If the cheque has been issued by a person not authorized to this, such a drawer is legally responsible for paying the cheque. The same rules apply to persons who have exceeded their legal authorizations when issuing a cheque65.

6. CHEQUE ENDORSEMENT Any cheque, save these which hold the clause non-transferable or the word only directly after the payee name, maybe transferred to other beneficiary by means of an endorsement. The endorsement maybe twofold: to the order and to the bearer, where the latter is called the in-blank endorsement. In order to endorse a cheque to a third party (the new beneficiary called the endorsee), the owner of the cheque (the endorser) needs to put an endorsement clause on the face, back, or on the slip attached to the cheque. The clause must be accompanied by the endorsers signature. The endorsement clause is usually put on the back of the cheque. The endorsement clause must not be conditional, i.e. it may not be subject to any conditions. The endorsement of the cheque may be full or partial. This means that only a part of the cheque amount (e.g. 50%) maybe transferred (endorsed) to a third party, while the remainder remains with the endorser.
60 61

Article 5 of The Geneva Convention. Article 2 of The Geneva Convention. 62 British Bankers Association web-site, http://www.bba.org.uk/bba/jsp/polopoly.jsp?d=263&a=5603 63 Article 9 of The Geneva Convention. 64 Article 2 of The Geneva Convention. 65 Atricle 11 of The Geneva Convention.

29 / 97

7. AVAL The payment of the cheque amount can be wholly or partly guaranteed by an 'aval'. This guarantee can be given by a third party other than the drawee, or even by a person who has signed the cheque. The aval, as the endorsement, may be full or partial. Similarly to the endorsement, the aval clause must be put on the face, back or the attached slip of the cheque. The guarantor signature must accompany the aval clause. The aval is responsible for satisfying the cheque obligations equally to the payer.

8. CHEQUE STOPPAGE The cheque which validity has already expired may still be cashed by its holder. In order to avoid this, it is possible to stop the cheque. The stoppage can be, however, exercised only after the cheque validity has expired. In order to stop a cheque, the drawer needs to inform the issuing bank providing all the details of the cheque (i.e. the payee, endorsees if applicable, the cheque number, date and place of issue, date of payment, etc.). If the cheque has not been presented prior to the date of stoppage, the bank will cancel it precluding its holder from cashing it66. This provides the payer with additional protection, as he is able to cancel cheque obligation to prevent cashing by unauthorized persons.

9. SWOT ANALYSIS The SWOT analysis presented below lists main features of cheques used to settle payments between parties located in two different countries

66

British Bankerss Association, op. cit

30 / 97

STRENGTHS
a) legal security due to well established legislation b) autonomy of cheque obligation c) flexibility due to variety of types available d) possibility of receiving proceeds immediately by discounting a) b)

WEAKNESSES
time consuming and costly cashing short validity

OPPORTUNITIES
a) electronic cheques (eCheques) a) b) c) d) e) f)

THREATS
conflicts of laws insufficient resources of the payer high risk in case of down payments decline of cheques popularity lost of cheque high possibility of fraud

STRENGTHS Legal security due to well established legislation As has already been noted, cheques are one of the oldest payment instruments in the world. For many years they were also one of the most widespread means of financial settlement in international trade. Given the popularity, the legal regulation of cheques was very well developed. Although there is no common international set of rules applicable to cheques and three different systems exist (Geneva Convention, UCC and BEA), they are in general similar to one another. The biggest advantage, however, is the fact that both law and court practice is very well developed. Therefore, payment by cheque is characterized by relatively high level of legal certainty, as all parties to such the transaction may reasonably envisage court ruling in case any dispute arises.

31 / 97

Autonomy of cheque obligation As has already been mentioned in the chapter, the drawer of a cheque, due to its autonomy, cannot refuse to pay or cancel the cheque on the ground of insufficient performance of the payee. The latter, in case of any payment problems or default of the drawer, has a highly effective legal instrument in his hands. The payee does not have to in any way explain the background of cheque issuance or prove that the cheque obligation is justified. This is because cheque obligation is separated from any underlying contract. This provides the payee with great deal of protection, as he can easily obtain a favourable court ruling.

Flexibility due to variety of types available Because of cheques long tradition as a payment instrument in international trade, many types of cheques have been developed in order to meet the needs of traders. Consequently, cheques provide a great deal of flexibility to payers. They can select appropriate type of cheque most fit into the needs of each particular business transaction. Many different types of cheques may be distinguished. The cheques may be divided, among others, according to: the payer and the payee67. With regard to the distinction according to the payer, we may distinguish an ordinary cheque issued by an account holder and the so called bankers cheque. The latter, also called bank draft or bankers draft is issued by a bank, usually on request of that banks client, in favour of a third party and drawn on other bank (usually a well known internationally recognized bank which is a correspondent of the issuing bank). When applying for a bankers cheque, relevant sum of money is debited to the applicant account in advance. Such cheques are obviously characterised by greater security as this is the issuing bank, and not an individual, which guarantees the payment to the beneficiary68. A bankers cheque cannot be stopped once it has been submitted to the beneficiary. The bankers cheques are governed, in principle, by the same laws as ordinary cheques. As far as the distinction by the payee is concerned, we may distinguish cheques for the bearer and cheques made to the order. The former type does not indicate the beneficiary (payee) name on its face69 and may thus be paid to any person that brings the cheque at the banks counter. It is considered a cash equivalent (of course provided the payer has sufficient amount of money on his account). This type of cheques is inherently connected with a high level of risk if the cheque is lost. The second type, the so called order cheque indicates the payee name on its face and may thus be
67 68

Heropolitaska (1997) It has to be noted that ordinary cheques are paid only if applicant has sufficient amount of money on his account at the issuing bank. 69 or the phrase or to the bearer is not crossed-out

32 / 97

paid only to this person/institution (of course provided the payee has not transferred the cheque into a third party). Another distinction of cheques may involve the so-called crossed cheques and ordinary cheques. Crossing off cheques is regulated in a very similar way under the three legal systems mentioned earlier in the chapter70. Crossing of a cheque consists in drawing two parallel and usually traverse lines across the face of the cheque. There are many types of crossing which can be used: crossing without any clause, crossing with a nontransferable clause, crossing with a non-negotiable71 clause, or crossing with a combination of the clauses.

Crossing without any clause A crossed cheque should only be paid into a bank account. This means that the person to whom the cheque is made out (i.e. the payee) must have a bank account into which the money can be paid. This helps to prevent fraud, since it is usually possible to trace the person to whom the cheque has been paid. If a cheque is not crossed, a person can receive payment in cash across the counter. It is not permitted to cancel a crossing.

Non-transferable crossed cheques Crossing a cheque with 'not transferable', 'account payee' or 'a/c payee' phrases means that the cheque cannot be cashed by someone else72. Such cheques can only be paid into the bank account belonging to the person it is made out to (i.e. the payee written on the face of the cheque). In case the bank negligently pays to any other person, the drawer may place a claim against this bank. Once the cheque is marked with one of the three phrases mentioned above, this may not be cancelled and the law requires that any purported cancellation should be declared void and ignored. An example of a cheque crossed with account payee phrase:

Source: Central Muray Credit Limited web-site73

There are however, certain countries, like Germany, that do not acknowledge the cheques crossing. or equivalent in national languages 72 Fraud Investigator web-site, http://www.fraudinvestigator.co.za/cheque_fraud_-_faq.htm 73 Central Muray Credit Union Ltd. web-site; http://www.cmcu.com.au/cheque.html
71

70

33 / 97

Non-negotiable crossed cheques The non-negotiable crossing is different to the non-transferable one. If a cheque is crossed with this phrase, the person to whom the cheque has been made out may still transfer the cheque to someone else. However, if the cheque gets stolen, the thief - or anyone taking the cheque from the thief has no claim against the drawer. This means that it is possible to stop the cheque and nobody can successfully sue the drawer for payment. If the bank pays the cheque before it has been stopped, the true owner (either the payee or the drawer) has the right to recover any loss from the person who came into possession of the cheque after the theft. An example of a cheque crossed with non-negotiable phrase:

Source: Central Muray Credit Limited web-site74

Clause combinations It is possible to issue a cheque with a combination of the clauses described above. For instance, a cheque paid to the order of a specified person and crossed with clauses nonnegotiable and non-transferable may be issued. Such a cheque can only be paid to the bank account of the payee indicated on the face of the cheque. The cheque cannot be transferred to any other person. If lost or stolen, the person acting fraudulently may not benefit from the cheque as it can be only paid to the specified payee and only to his account (the nontransferable crossing). However, assuming a fraudulently acting person uses some forged documents or a bank negligently pays to this person, the clause non-negotiable protects the drawer and the lawful beneficiary from financial losses. It is then possible to have recourse against the party that accepted the stolen / lost cheque as a payment.

Possibility of receiving proceeds immediately by discounting In case the payee needs to receive the payment instantly, he may avail himself of the institution of cheque discounting. Similarly to a bill of exchange, discounting involves
74

ibidem

34 / 97

reducing the face value of a cheque by a percentage to realise immediate payment e.g. on post-dated cheques. The reduction is the commission that bank charges for such a service. This gives the drawee opportunity to collect money from cheques which would normally not be possible to cash yet. The proceeds may be used to maintain beneficiary liquidity or cover certain expenses he needs to bear.

WEAKNESSES Time consuming and costly cashing When receiving a cheque from a foreign importer, an exporter may receive proceeds in two ways: by negotiation or by collection. The first way involves transferring the cheque ownership to the paying bank by means of an endorsement. In exchange for that the bank pays the cheque amount to the owner. If an outdated cheque is presented for sale, before paying the cheque amount bank verifies whether or not the cheque has been cancelled by the drawer. If such a cheque has not been paid by the drawer, the bank has the right to demand the retrieval of the cheque amount paid to the previous owner of the cheque. Banks generally buy only certain types of cheques due to the inherent risk of such a purchase. These are mainly bankers cheques75. Collection of cheques allows the cheque owner to receive the proceeds only after the money has been paid to the collecting bank. The collecting bank sends the cheque to its clearing centre, where the cheques are read and sorted according to the issuing bank and sent to the issuing bank clearing centre (directly or through a network of correspondent banks). If the cheque validity has been confirmed by the issuing bank, the drawers account is debited accordingly and the funds are transferred to the collecting bank. Once the funds are received by the collecting bank, relevant amount is received by the cheque owner (in cash or as a credit to his account, depending on the cheque type and his requirement). Generally banks are obliged to accept all types of cheques for collection. The collection arrangement, in case of international cheques is a costly and time consuming manner of cheque clearing. The time required may amount even to 30-45 days76. The costs of collection amounts to approximately 2% (with a certain minimal amount) of the collection amount, depending on the bank. For the above reasons cheques are inappropriate for low volume business transactions, as its cost would form a significant share of the transaction amount.

75 76

British Bankers Association web-site, op. cit. Herapolitaska (2003)

35 / 97

Short validity Pursuant to the Geneva Convention, cheques are valid only for a specified amount of days77. A cheque paid in the same country holds valid 8 days. A cheque paid abroad in a country located in the same part of the world (e.g. a cheque issued and payable in Europe) is valid for 20 days, and if the foreign country is located in different part of the world (e.g. cheque issued in the US and payable in Denmark) it is valid for 70 days from the date of issuance written on its face78. However, it must be noted that the regulation of cheques validity is different depending on the legal system it is subject to. Under the US UCC and the British BEA, the cheque is payable within a reasonable time. The amount of days available to cash cheques may under certain circumstances be insufficient. Consequently, the limited time for cashing a cheque is connected with higher risk for traders.

OPPORTUNITIES Electronic cheques (eCheques) In present fast-pace business environment cheques do not seem to be quick enough payment mode and hence they are unsuitable for most of cross-border business transactions. In order to remedy the problem, an electronic version of cheques has been developed. The eCheque is a new payment instrument which has many advantages over traditional paper based cheques. This involves higher security, speed of processing, and lower cost. In the same time such eCheques take advantage of familiar and well-developed legal infrastructure and business processes associated with paper cheques79. The eCheque works in the same way as traditional cheques do. The cheque issuer "writes" the eCheque using a computer and sends the eCheque to the payee via an electronic channel. The payee "deposits" the eCheque, receives credit, and payee's bank clears the eCheque with the paying bank. The paying bank validates the eCheque and then debits cheque issuer account accordingly. The main advantage of electronic cheques is that they significantly reduce operating costs and losses associated with cheque payments. They employ Internet as a means of communication, and eliminate most of the manual steps required by paper cheques. eCheques also enable payment information to flow directly between payer and payee with the cheque. The eCheque system substitutes a higher up front cost in customer identification and provides high security

77 78

Article 29 of The Geneva Convention. Herapolitaska (2003) 79 eCheck web-site, www.echeck.org

36 / 97

to reduce the costs associated with fraud80. Since the eCheque system is fully automated, it is protected against forgery or alteration and hence significantly reduces fraud while remaining easy to reconcile due to payer assigned check numbers. The eCheques are still in introductory phase and hence are still not common in business practice. However, it is expected that eCheques will substitute paper based cheques in near future. For instance already now eCheques are the first and only electronic payment mechanism chosen by the United States Treasury to make high-value payments over the public Internet81.

THREATS Conflicts of laws In international commerce exporters are likely to receive payments by cheques issued in various countries, where the rules related to cheques differ from those in force in the exporters country. In general, international legislation in the field of cheques is divided into three main legal systems (as has already been described in this chapter). According to the Geneva Convention, certain aspects of cheques validity are governed by the law of the place of issue, while others by law of the place of payment. This refers, inter alia, to cheque validity in general, validity of endorsements, crossings, capacities of parties to check transactions, and cheques validity period. The first factor, cheque validity, should be assessed pursuant to the rules in force in country where the cheque has been issued. However, it is also sufficient for a cheque to be considered valid if it complies with the requirements imposed by the law of the country where it is presented for payment82. With regard to validity of cheque endorsements, it should be assessed pursuant to the rules of the country where the arrangement was made83. It is, however, sufficient to consider the endorsement valid if it fulfils the requirements of the country where the cheque is to be presented for payment. Validity of cheque crossings, in turn, is determined according to the rules of the country of cheque payment. It should be noted that in the US and in Germany cheque crossing is not recognized. Therefore, crossed cheques presented for payment in these countries will be considered ordinary cheques and the crossing will be deemed void. As far as cheque issuer right to issue cheques and the payee right to receive the proceeds are concerned, they should be evaluated pursuant to the law of the country of the issuer/payee citizenship. In case the issuer/payee is a legal entity, this is established according to the rules of the country in which
80 81

eCheck web-site, op. cit. ibidem 82 Herapolitaska (2003) 83 ibidem.

37 / 97

the entity has its statutory seat. In most cases, therefore, it is the law of the place of the cheque issuance. Lastly, cheque validity time should be established pursuant to the rules of the place of payment. It should be noted that cheques validity differs under distinct legal systems. Also, among the countries signatories of the Geneva Convention significant differences exist84. As a consequence, if an exporter accepts as a payment a cheque issued under different legal system than that of his place of business, he needs to be aware of the rules applicable under that different legal system. There may be certain details on the cheque that may render it invalid and useless. Also, a threat of conflicts of rules under the three conventions is highly likely. Such an unclear situation deteriorates legal certainty of cheque as a means of payment, particularly if such the cheque comes from exotic locations.

Insufficient resources of the payer In the case where the drawer funds do not suffice to cover cheque obligation (or the drawer does not exists), the issuing bank dishonours the cheque (it is then said that the cheque bounces). Such a dishonoured cheque is returned directly to the collecting bank branch and the collecting bank puts special statement on the cheque informing about its dishonour. If this has not been done, the cheque owner should file a formal protest on the cheque, which must be legalized by a public notary. Once this has been done, the cheque owner should immediately inform the drawer, avals, and endorser, if applicable, about the cheque dishonour (save the persons who did not provide their address). The cheque owner is entitled to demand the cheque amount (plus interests and the costs of formalities incurred) from any of the persons signed on the cheque85. He may start legal proceedings against all the persons at the same time. The threat of dishonour is an inherent risk that every trader needs to face when accepting payment by cheques. This is a considerable risk which decreases attractiveness of cheque as a payment instrument.

High risk in case of down payments Cheques, as in the case of SWIFT, give no commercial security of exporter sufficient performance for the amount paid. This means that in case cheque is sent to the beneficiary (exporter) before his obligation has been fulfilled, there is virtually no way to make sure that the beneficiary will perform according to the underlying agreement. Once such the exporter

For example, a cheque to be paid in different part of the world is valid 70 days in most of the Geneva Convention countries, while when presented for payment in Spain it would be valid only for 60 days. 85 Herapolitaska (2003)

84

38 / 97

receives the cheque before it becomes invalid, its cashing cannot be prevented. Any instructions to this effect will be ignored by the payers bank, as banks are obliged to collect cheques providing they do not hold signs of a fraud. In view of the above, cheques should not be used for settling large sums, particularly in connection with execution of complicated contracts, as the inherent risk is too high.

Decline of cheques popularity Cheques have been in decline for many years, both for so-called point of sale transactions (for which credit cards and debit cards are increasingly preferred) and for third party payments (e.g. bill payments), where the decline has been accelerated by the emergence of telephone banking and online banking. In some European countries cheques are now very rarely used, even for third party payments86. According to a recent study conducted by APCAS87, there were just over 6 million cheques issued in the UK each day in 2003 compared to 11 million in 1991. Only one in six regular bills is paid by cheque, compared with one in three as recently as 1995. Also, in 2014 it is estimated that personal cheques will account for only 6% of all non-cash payments made by individuals, and by the year 2020 they will disappear completely. Being paper-based, cheques are costly for banks to process in comparison to electronic payments. Hence, banks in many countries try to discourage the use of cheques either by charging additionally for cheques or by making alternatives more attractive to customers. Additionally, cashing a foreign cheque is a quite lengthy arrangement as it takes several days for the beneficiary to receive the funds due. This is because most of the private foreign cheques are not purchased by banks and they may be cleared by collection only. There is also a significant amount of time required for a cheque to be sent by post from the importers country to the beneficiary. Consequently, we may envisage that paper based cheques will become less and less popular as a means of payment in business transaction. They will probably remain as a niche product for personal use.

Lost of cheque A quite significant threat associated with paying by cheques is that they may be lost or stolen. It has to be noted that such a threat does not exist in case of SWIFT payments or documentary credits or collections. Once the cheque has been issued, the slip of paper is the only document proving the existence of financial obligation. Consequently, if cheque is lost, unless the
86 87

Wikipedia web-site, http://en.wikipedia.org/wiki/Cheque Association for Payment Clearing Services by APACS (Administration) Limited, London, UK

39 / 97

drawer agrees to issue another one, it is not possible to receive the proceeds. Also, in case the cheque has not been made non-transferable, the drawer will face the threat of being forced to pay the cheque to the person which does not have the right to the proceeds (such as an ordinary thief). Furthermore, if the cheque is sent to the beneficiary by post or courier, it is likely that the cheque may be lost or destroyed. In such the case, the payee will not be able to receive the proceeds, either. For the aforesaid reasons, a great care should be taken when sending a high value cheque by post or courier.

High possibility of fraud It is a well known fact that cheques are not the most secure way of payment and are connected with a considerable threat of forgery. According to the ACFE's Encyclopedia of Fraud88, about two million bad cheques are accepted in the United States every day, with cheque frauds averaging $15 billion in losses annually. According to the recent study carried-out by the UK APACS association in 2004 cheque fraud losses totalled 46.2 million, an increase of 2.7% to 2003. Cheque fraud is usually committed in one of four ways: forgery, counterfeiting or alternation, paperhanging, or kiting.89 With respect to forgery, forged checks usually include those written for under $300 in order to avoid suspicion. They are subsequently cashed at retail stores and check-cashing businesses, which have looser security controls than financial institutions. These forgeries occur when a fraudulent employee issues a cheque without proper authorization, or criminals steal personal cheques and use fake identification to endorse them. Another form includes payroll cheque fraud in which blank cheques are stolen and then replicated. Regarding counterfeiting and alteration, counterfeit cheques are created either by using computer, scanner and printer or by duplicating a cheque with photocopiers. Also, fraudsters use bleaching agents to remove inked handwriting from stolen checks. When the cheque dries, a new amount of greater value is written and the cheque is cashed. As far as paperhanging is concerned, this scam involves writing and reordering cheques from closed accounts. Paperhangers pass cheques at retail stores where they write cheque for more than the purchase amount. Alternately, the fraudsters might make a fake deposit at a bank and ask for cash back. Last but not the least, cheque kiting involves opening accounts at two or more banks and using the "float time" it takes for cheques to clear at each institution to create fraudulent balances. However, cheque kiting cases are now reduced by the recent shortening of float time in most of the banks. As a result
88 89

ACFE; http://www.acfe.com/home.asp ACFE; http://www.acfe.com/fraud/view.asp?ArticleID=463

40 / 97

of the high possibility of forgery, an exporter who receives cheque from abroad should particularly carefully verify whether the cheque is authentic. The cheque may be forged, outdated, or there may be many other reasons precluding its clearing. In view of the above, it is recommendable to avoid using cheques in high volume export/import transactions. A greater deal of security, lower time of clearance, and lower fees may be achieved using such instrument as documentary credits or documentary collections. For smaller payment, a SWIFT transfer seems to be a cheaper, quicker and much more secure and convenient payment method.

7. SUMMARY Cheques for many years were the most popular way of settling financial obligations among individuals and legal entities. However, nowadays, under fast pace business environment, cheques no longer meet the requirements of most of the merchants. To confirm the assessment, the following factors will be summarised: transaction cost, preparation time, execution time, risk of fraud, and commercial risk. The transaction cost is significant in case of cheques. It depends on cheque cashing manner but usually amounts to 2% of the transaction value and involves fees of collecting bank and the issuing bank. The cost may additionally rise should any intermediary bank occurs. Therefore, cheque as a payment instrument is the most expensive manner of settling crossborder financial obligations. On the other hand, cheque preparation is very simple. Only the most important points must be placed on the cheque blank, whereas others depend on the issuer. However, a great care must be attached when issuing a cheque. Despite the relatively small amount of data that needs to be written on the cheque, it must be put with a great care and in the unequivocal way to avoid risk of fraud. Unlike the preparation time, cheque execution time is quite lengthy. Two alternative manners may be distinguished. However, the most common one, meaning collection, may take up to 30-45 days. As a result, cheque is the least efficient instrument in terms of settlement time. Similarly, cheque is the instrument which is most vulnerable to frauds. Since it is a paperbased document, information contained on its face may be altered, erased, or superscripted, and consequently misused. Additionally, cheque may be simply lost when it is being sent from the remitter to the beneficiary. Therefore, cheque is considered the least secure instrument.

41 / 97

As far as the commercial risk is concerned, cheques provide only a slightly higher level of security than SWIFT transfers. The payer (cheque issuer, importer) when sending the cheque to payee (exporter) under a down payment arrangement needs to face the threat that the latter, after taking possession of the cheque, may simply cash it or discount it with his bank. After this has been done, there is no way for the importer to reclaim funds in case the latter did not fulfil his obligations. A legal action is the only resort. For the exporter, in turn, cheques are not a very secure instrument, either. This is because upon receipt of a cheque, he cannot be sure of its authenticity. The cheque might have been altered, counterfeited, or in any other way changed. Furthermore, even if it is authentic, the payer may not have sufficient amount of money on his account, as a result of which the cheque may bounce. This means it will be completely useless for the payee.

42 / 97

CHAPTER III: DOCUMENTARY COLLECTIONS


1. INTRODUCTION Collection arrangements in various forms have been used in international commerce for long. Until documentary credit was introduced, collections had been a very popular payment manner among merchants. This is because they provided a much higher level of security than cheques or other settlement instruments. Participation of a bank in the collection process, which are generally trust worthy institutions, and the existence of a bill of exchange secured to greater extent proper completion of both importers and exporters obligation. On the other hand, however, the variety of rules related to the collection arrangements around the world was causing uncertainty as to the payment in case of a legal dispute. It was not always clear which law shall prevail or which court has the jurisdiction to judge the dispute. In the light of this, after the Second World War, when the considerable development of international trade was experienced, a unification of rules pertaining to the collection arrangements was deemed unavoidable. As a result, International Chamber of Commerce90 in 1956 issued the so called Uniform Rules for Collection (URC). The document has been amended few times so far. The latest version currently in force is URC no. 522, which has been in force since January 1996. These rules are internationally recognized by all major banks and will serve as a reference document in the thesis.

2. DEFINITION In international trade, collection is an arrangement whereby a trusted institution (usually a bank91), on request of one party (usually the seller - exporter) collects funds92 from the second party (usually the buyer - importer) in exchange for goods or documents of title delivered by the first party93. The documents of title from the legal point of view are equal to the possession of goods. The risk connected with the payment process is born entirely by the applicant (i.e. the exporter). The bank participating in the collection arrangement fulfils only the instructions contained in the collection application and does not take any decisions at its discretion. Such a bank is not bound by any contract or other forms of legal agreement between the parties to the collection. Documentary collection is somehow similar to
90 91

more information on can be found on www.iccwbo.org this may well be a freight forwarder, a shipping company, a commercial agent, or any other representative agreed by both parties 92 or undertaking to pay the funds at a future date as it is in the case of D/A clause. 93 World Trade Ref web-site, http://www.worldtraderef.com/WTR_site/documentary_collections.html

43 / 97

documentary credit. There are, however, two basic differences: (1) the draft involved in the collection is not drawn by the seller (the drawer) upon a bank for payment, but rather on the buyer itself (the drawee), and (2) the sellers bank has no obligation to pay upon presentation but, more simply, acts as a collecting or remitting bank on behalf of the seller, thus earning a commission for its services94.

3. SUBJECT OF THE COLLECTION The collection arrangements may be employed by traders to exchange various documents or as a means of payment. Consequently, many types of collection may be distinguished. There are, however, two main categories: collection of financial items95 and documentary collection. The former type of collection is employed in order to exchange financial documents, such as bills of exchange, drafts, cheques, or financial receipts. In other words, this collection deals with financial documents only and serves as an instrument of trading in securities. It is therefore not commonly used in international trade in goods. The latter type, documentary collection, is in turn widely used in international commerce. It involves collection of either commercial documents only (such as invoice, packing list, etc.) or commercial documents accompanied by financial documents (e.g. draft). This chapter will be devoted to documentary collection.

4. PARTIES TO THE COLLECTION The following parties usually participate in the documentary collection: principal, remitting bank, collecting bank, presenting bank, drawee96. The principal is the person who submits application for collection to his bank stating clearly all the terms of the collection. This is usually the exporter. The remitting bank receives the principals application and forwards the collection instructions along with the documents of title to the collecting bank. Depending on the geographical location of the principal and the drawee, as well as the network of corresponding banks, there may be one or more collecting banks. The collecting bank may present the collection to the drawee or pass it on to another bank. The last collecting bank, which present the documents to the drawee is called presenting bank. The drawee (usually the importer) is the person who fulfils the collection instructions in exchange for the goods or documents of title to the goods (such as a bill of lading).
94
95

Hinkelman (2003) Also called a clean collection. 96 Article 3 of URC522.

44 / 97

5. TYPES OF COLLECTIONS While financial collections in most cases are uniform and include similar instructions, documentary collections may differ significantly depending on the agreement between the parties. This stems from wide use of the mode of payment in international commerce and the need of adjusting to particular requirements of different transactions. The main differences lie chiefly in the mode of payment, i.e. the way the drawee is to pay for the draft drawn on him under the documentary collection. Four main types of a documentary collection may be distinguished: documents against payment (D/P), documents against acceptance (D/A), acceptance documents against payment, and the so called documentary collection with a bank guarantee. The first one, the D/P, envisages payment at sight against receipt of the documents of title. This means that the presenting bank is allowed to pass the documents to the drawee only provided the latter has paid the full amount of the collection. Under the D/P terms the documents may, but do not need to, include a sight draft drawn on the importer97. With regard to the D/A terms, the drawee is allowed to receive the documents of title once he has accepted a time draft drawn on him which is usually sent along with other collection documents. The payment is then made on or before the term indicated on the draft (usually 90 or 120 days after acceptance of the draft)98. In this case, the drawee may take possession of the goods immediately after the acceptance, and the principal receives a payment promise secured by the accepted draft (which in general serves as a fair legal guarantee). As for the next type of collection arrangement, i.e. the acceptance documents against payment, it bears features of both: the D/P and D/A types. The modus operandi is as follows99: the presenting bank presents a time draft to the drawee for acceptance (as under D/A). Once the draft has been accepted, together with the documents of title it remains at the bank disposal up to the date of draft maturity. Once the drawee has paid the draft on maturity, the presenting bank releases the documents of title to the buyer who then takes possession of the goods. Such the solution gives the drawee time to pay for the shipment and in the same time provides the principal with guarantee that the goods will not be handed over until payment has been made. If the importer refuses acceptance of the draft or does not honour payment at maturity, the principal
97

It should be noted here that under these terms, a draft is not required, as the bank passes documents of title to the importer only upon receipt of the full amount due. However, in case the importer refuses to pay, the bank may, on request of the principal, protest the draft. This serves as an additional discouragement for the drawee of fraudulent behaviour. This case will be described in details further in the chapter. 98 Export911 web-site, http://www.export911.com/e911/export/docColle.htm#docCollection 99 World Trade Ref web-site, op. cit.

45 / 97

makes other arrangements to sell his goods100. This type of collection is, however, seldom used in actual practice. This is because importers usually do not agree to delay the reception of goods for so long as this would mean considerable storage costs which would have to be born by them (according to UCR522, ownership of the goods is transferred to the importer once he accepts the draft). Such the situation is nevertheless possible in case the shipment of goods takes as long as, or longer, than the draft maturity period. The importer then accepts the draft immediately after shipment by the exporter and pays it once the goods arrive in the port of destination. The last type, the collection with bank guarantee, is very favourable mode of payment for exporters. It involves additional costs, though. Under this arrangement the payment of accepted draft is guaranteed by a bank. In case the drawee fails to pay the draft on its maturity, the guarantying bank bears the full responsibility for paying the money due to the exporter. In such a case, the collection secured by bank guarantee is similar to a documentary credit101.

6. MODUS OPERANDI The collection process begins when an agreement on the terms of the collection in the form of a contract is reached between the exporter and the importer. The exporter (the principal) then executes the contract and ships the goods obtaining a negotiable transport document (bill of lading) from the shipping firm/agent. Subsequently the exporter places a collection order with his bank (remitting bank). It usually contains the following data: sender (exporter, applicant, principal, payee), drawee (importer, payer), drawee bank (presenting bank), collection amount and currency, terms of payment, list of documents being subject of the collection, description of goods, instructions to the bank, notation concerning payment of charges for the documentary collection, instructions for the lodging of a protest in the event of nonacceptance or non-payment, instructions for notification of agent or representative in the importers country (the so called case of need)102. A sample of such the order is shown on the following page. The presenting bank should be indicated by the exporter. In other case, the exporters bank is free to choose the drawee bank at its discretion. The amount and currency to be collected must be indicated unequivocally, too (e.g. USD150,000.-). The terms of payment are usually the D/P or the D/A. This clause is sometimes also referred to as tenor. The documents which are to be collected must be listed in the collection order (e.g.

ibidem. The documentary credit is described in details in the following chapter. 102 IntrustBank web-site, http://www.intrustbank.com/Business/International/HowTo012.aspx#13
101

100

46 / 97

invoice, packing list, certificate of origin). The documents should also include a draft (particularly in the case of the D/A terms). Under the case of need, the principal nominates a party in the importer's country who may assist in obtaining payment or acceptance of draft or who may be empowered to act fully on the principal behalf waiving protest, allowing a discount, etc. The protest is the legal action to be undertaken by the presenting bank, on instructions of the principal, in case the drawee does not pay a sight draft, or does not accept a term draft, or does not pay an accepted draft on maturity. The interest charge, if any, normally is agreed upon between the exporter and importer. It is either built into the export price or collected separately.

Source: World Trade Ref web-site, op. cit.

47 / 97

After the collection order has been submitted to the principal (exporter) bank, it verifies the order and the documents as to whether they are in conformity with each other (correct delivery terms, drawee, cargo description, etc.). If required, the principal is requested to correct the order accordingly. The collection process looks as follows:

Source: Hinkelman (2003)

The remitting bank sends the documentation package by mail or by courier to the designated collecting/presenting bank in the importer's country with instructions to present them to the drawee (importer) and collect payment. The presenting bank reviews the documents making certain they are in conformity with the collection order. If this is the case, it then notifies the importer about the terms and conditions of the collection order and releases the documents once the payment conditions have been met. The importer makes a cash payment (signing the draft), or if the collection order allows, signs an acceptance (promise to pay at a future date), receives the documents of title, and takes possession of the shipment. In case the delivery was addressed to the bank, the importer needs to first obtain an endorsement from the bank on the 48 / 97

document of title103. The presenting bank pays the remitting bank either with an immediate payment or, at the maturity date of the accepted bill of exchange. The remitting bank then pays to the principal (exporter).

7. SWOT ANALYSIS The SWOT analysis presented below lists main features of documentary collections used to settle payments between parties located in two different countries.

STRENGTHS
a) existence of a trusted intermediary and a draft b) uniform rules applicable worldwide c) variety of types available d) application of SWIFT communication e) low cost in comparison to documentary credits

WEAKNESSES
a) application limited to transactions involving a document of title b) high cost in comparison to bank transfers c) relatively long time of preparation

OPPORTUNITIES
a) possibility of earning additional profits under D/A based transactions b) possibility of partial payment c) possibility of nominating an assistant in importers country (case of need) d) possibility of examining goods before payment is made importer

THREATS
a) commercial risk for exporter and

b) fraud of documents c) limited liability of banks d) risk of bearing additional bank charges e) high risk in case of shipping goods directly to the importer f) difficulties with import clearance g) negligent conduct of intermediary banks h) delays in importer action i) influence of importer country

103

Which is realized by the bank in exchange for a fee.

49 / 97

STRENGTHS Existence of a trusted intermediary and a draft The characteristic feature of each documentary collection is that commercial documents are forwarded through one or more intermediaries (usually two: one in the importer country and one in the exporter country). These are usually big and well known banks that are well familiarised with their customers, which serves as an additional security against any frauds or unfair conduct of parties to the collection. It is quite risky for any company to conduct fraudulently when a local institution such as a bank is involved, while it does not have to be so towards an overseas customer. The existence of draft provides the payee with even bigger deal of security. In case the buyer refuses to pay for the goods or honour the previously accepted draft, the exporter may resort to the legal institution of protest. The protest is the legal action to be undertaken by the presenting bank, as per instructions of the principal, in case the drawee does not pay a sight draft, or does not accept a term draft, or does not pay an accepted draft on maturity. In certain countries, failure to protest may cause the exporter to lose the legal right against the importer as regards the payment of the draft. In case whereby the collection instruction is 'do not protest', it may encourage inaction or deferred payment by the importer104. In some countries, particularly in the Western Europe, a protest against the importer may spoil his/her credit standing. Hence, the importer is encouraged to act promptly if 'protest' is instructed by the exporter105.

Uniform rules applicable worldwide Documentary collections are governed by uniform rules (International Chamber of Commerce Uniform Rules for Collection) virtually all over the world. Owing to this, they are characterized by considerable level of legal certainty and clarity with regard to the rules applicable in case of any potential conflicts between the parties to the collection. Also, cases of conflicts of laws are virtually eliminated. The URC522 defines most of the legal aspects of collections, such as content of collection instructions, types of collections, form of presentation of collection documents, responsibility of banks, form of payment, and the way of settling charges, interests and expenses. Therefore, it is relatively easy for the parties to a collection arrangement to envisage any possible court rulings in case a dispute arises.

104 105

IntrustBank web-site, op. cit. ibidem

50 / 97

Variety of types available As has already been mentioned in the chapter, there are three basic types of documentary collection available: D/A, D/P, and acceptance against documents106. Additionally, it is possible to apply for a collection that includes a bank guarantee, which is, in terms of security provided, similar to a documentary credit. These various types allow both sides of a collection arrangement to flexibly choose the terms which are most convenient for them, given the nature of transaction. The documentary collection allows selecting among different levels of security for exporters and importers, allowing both sides to balance the risk each of them has to bear. Also, the payment period may be adjusted accordingly to meet the needs of transaction and cash flow of the parties. Owing to the possibilities, documentary collections are considered a very flexible and convenient manner of settling export payments.

Application of SWIFT communication At present, in order to communicate important information pertaining to the collection process banks use SWIFT system107. The following SWIFT messages may be sent from the presenting bank to the remitting bank108: MT 400 Advice of Payment (confirmation that the drawee has paid the collection amount), MT 405 Clean Collection (concerns financial collections), MT 410 Acknowledgement (acknowledgement of receipt of collection documents), MT 412 Advice of Acceptance (confirmation of acceptance of draft), MT 416 Advice of Non-Payment/Non-Acceptance (confirmation of refusal to pay or accept draft), MT 420 Tracer (sent by the remitting bank to request information on the current status of the collection), MT 422 Advice of Fate and Request for Instructions. Upon receipt of such a SWIFT message, the remitting bank immediately informs the principal on the fact and requests proper action to be taken. The use of SWIFT greatly speeds up the whole process of information exchange between the parties to the collection.

106

UBS Bank web-site, http://www.ubs.com/1/e/ubs_ch/bb_ch/finance/trade_exportfinance/documentar_inkasso/inkassoarten.html 107 the SWIFT system has been already described in Chapter II of the thesis. 108 AnSys web-site, http://www.anasys.com/swifthandbook/swift.html?fmt103.html

51 / 97

Low cost in comparison to documentary credits In terms of transaction cost documentary collection have two advantages over LCs. Namely, lower cost and no need of collateral. Since under documentary collections banks do not guarantee the payment, the whole transaction is much less risky for them. Hence, the fees they charge are much lower than in the case of an LC. For the same reasons, unlike LC, banks do not require the principal to provide them with any type of collateral. Consequently, the applicant is not forced to freeze significant amounts of funds until he receives the goods. Depending on the bank, the total fee charged by the principal banks is usually to around 0.2%109 of the amount collected with certain minimum ceiling. Owing to this, documentary collections are the payment instruments which provide traders with reasonable balance between the cost and security.

WEAKNESSES Application limited to transactions involving a document of title One of the drawbacks of documentary collections is their limited application. Namely, they can only be used once a transport document of title is involved in a transaction110. Such the document serves as evidence for the buyer that the goods have been in fact loaded on board the vessel. Also it is a prove for the seller, that the buyer will not be able to come into possession of the goods before it pays or accepts the draft as in that case he will not receive the document of title from its bank. On the other hand, however, the requirement of document of title limits the use of documentary collections virtually only to transactions involving a bill of lading, hence those that involve a shipment by a vessel. Neither CMR (road transport) nor AWB (air transport) are considered documents of title.

High cost in comparison to bank transfers Despite being cheaper than documentary credits, collections are still far more expensive than SWIFT transfers. Usually the collection commission amounts to approximately 0.2% of the amount to be paid. It has to be noted, however, that this commission needs to be paid by both parties to the transaction (i.e. the importer and the exporter), which doubles the overall cost of the transaction. Additional fees for amendments, draft protests, tracers, endorsement of documents of title, assignment of proceeds, etc. apply. As a result, traders need to decide
109 110

basing on my research of bank fees in major Polish banks it has to be noted, however, that it is possible to use documentary collection in case there is no document of title (such as AWB or CMR). In this case, the collections will not fulfil its main purpose, which is providing the exporter with additional security of payment and the importer with right to the goods delivered.

52 / 97

between the greater security, which documentary collections provide, against higher cost that they involve, comparing to, for instance, SWIFT transfers.

Relatively long time of preparation In order to prepare an application for documentary collection, far greater deal of time is required than in the case of a SWIFT application. This is because many more terms needs to be agreed with the contractual party and communicated to the bank. Also, the exporter needs to prepare collection document fully in conformity with the collection application. Any discrepancies, including even minor literal errors, may force the bank to reject the documents. In such the case, the applicant needs to obviously make corrections, which always requires him to devote some additional time and pay extra bank fees for documents examination. Furthermore, in case the discrepancy concerns a document which is not issued by the applicant (such as a bill of lading or certificate of origin) it may be impossible or at least very costly and time consuming to correct such the document. As a result, it may cause unnecessary delays in the whole transaction and result in big losses for both parties.

OPPORTUNITIES Possibility of earning additional profits under D/A based transactions When using a documentary collection, both importer and exporter are able to adjust the payment terms to optimize their profits. The exporter (payee) may resort to draft discounting and the importer (payer) may avail himself of delayed payment facility (D/A) selling the goods to his customer before the draft maturity date. Regarding draft discount, this undertaking means that the beneficiary transfers his title under the draft to his bank and receives the draft amount before its maturity. In exchange for the service, he needs to pay certain rate of discount interest to the bank. The draft discount should be based on real trade background111. Owing to this, in case of, for instance a 180 days D/A terms, the beneficiary needs to wait 6 months until his account is actually credited. If he receives the funds immediately or well before the draft maturity, he may invest the proceeds and make additional profit. Depending on the circumstances, the profit may actually be higher than the discount fee charged by the bank. Such the possibility gives exporters greater flexibility to adjust to the needs of their current operations and cash flows. It has to be noted, however, that

111

Shanghai Pudong Development Bank web-site; http://www.spdb.com.cn/docpage/c187/200312/1222_187_7304.aspx

53 / 97

in case of draft which is not accepted by a bank, but by a merchant (the so-called trade acceptance draft)112, it may be quite difficult and costly to discount such the draft with a bank. Regarding the opportunities for importer, he may avail himself of the fact that once he accepts draft, he becomes the owner of the goods and hence may freely dispose of them. Consequently, the importer is also able to sell the goods to a third party at a profit. If he agrees upon favourable terms of payment, he may actually receive the payment from that third party before the draft maturity date. Owing to this, such the importer may use the proceeds obtained from the third party in question to pay the draft, earning his margin on the sale. This gives a knowledgeable importer a very useful tool to do business, in the same time bearing virtually no risk of payment. For the same reasons, exporter is able to negotiate better financial terms, as importer will not have to take any credit to satisfy the exporters financial obligations. Possibility of partial payment In case the collection instructions under D/P arrangement allow so, the importer may be able to pay the draft only partially to get the document of title and be able to take control over the goods. Also, a payment in instalments is possible to be arranged. This gives both sides additional flexibility to agree upon terms most convenient for them. Possibility of nominating an assistant in importers country (case of need) The case of need is a party in the importer's country named by the exporter (principal) who may assist in obtaining payment or acceptance of draft or who may be empowered by the exporter to act fully on his behalf113. Such the case of need entity may waive protests; allow a discount to the importer and so forth. The case of need assistant may be for guidance only or may have the right submit additional instructions to the presenting bank. Such a possibility serves as a great opportunity to decrease the exporter risk, particularly if he has a local agent or other trusted institution in the importer country114. In case of exotic locations, it may be difficult for the exporter to tackle problems directly once they occur, not knowing well local language, laws, customs, etc. It may be also much easier for importer to communicate with such the nominated local entity should any disputes arise. Therefore, the institution of the case-of-need greatly increases the security of documentary collections from both exporter and importer point of view.
112 113

which is usually the case. Article 25 of URC522. 114 Export911 web-site, op. cit.

54 / 97

Possibility of examining goods before payment is made In practice, the collecting bank may allow the importer to take temporary possession of the collection documents for inspection before payment115. The collecting bank, however, assumes responsibility for the documents until redemption. In the above case, the importer should immediately return the entire set of documents to the collecting bank if he is unwilling or unable to meet the agreed terms upon payment procedure. In any case, this is a great opportunity for the importer to actually check whether or not the exporter has shipped conforming goods. If this is the case, then the importer assumes no risk accepting or paying the draft. For the exporter, however, it creates a risk that the buyer may purposefully pick on certain details of the cargo in order to get additional discount before accepting or paying the draft.

THREATS Commercial risk for exporter and importer In case documentary collections are employed both exporter and importer assume considerable risk connected with no guarantee of the counterparty conduct. With regard to the exporter, his main concern is whether or not he receives payment from the importer. As has already been mentioned in chapter, in case of documentary collection, the draft is accepted not by a bank but by the importer only. Hence, presenting bank is not liable for the payment and exporters always face the threat of the importer fraudulent conduct, meaning that the latter will not pay the accepted draft on its maturity. Additionally, before the payment is made (D/P) or the draft is accepted (D/A), the ownership right (i.e. the document of title) is not transferred to the buyer. Hence, it is the exporter who assumes liability for shipping, insurance, and storage while the goods are in transit. He is also liable before custom authorities in the importers country. If the importer does not pay the draft the exporter is still responsible for these matters. He may have the goods shipped back or try to sell them to another buyer. If the importer takes no action, customs may seize the goods and auction or otherwise dispose of them. Under D/A terms if the importer signs the acceptance, takes possession of the goods, and then refuses to pay the draft at maturity, the exporter does not already have the title to the goods and the only recourse he may have is to the importer and not the bank116. Therefore, exporters need to be aware of the fact that in case they sell goods
115 116

Marciniak-Neider (2002). Schmitthoff (2000)

55 / 97

basing on documentary collection, they never have a 100% guarantee that they will receive the payment. Consequently, documentary collections should be used only providing exporter knows his partner well and trusts him to a reasonable extend. Similarly, the importer faces number of risks under a collection arrangement. Apart from the main risk that the exporter ships inferior cargo in terms of quality or quantity, he should be well aware of any documentation, certifications, or authorizations that may be required for customs clearance or for eventual sale of the goods in his country117. Otherwise, such the importer may realize that he cannot clear goods and sell it even though he has already paid for them. The import clearance requirements should be checked carefully and all documentation required should be specified in the agreement between importer and exporter. Upon presentation of the documents, the importer must carefully inspect the documents to make certain they meet all specifications for customs clearance and for eventual sale in his country. In a documentary collection the importer is generally in a secure position because ownership or responsibility for goods does not have to be assumed until documents have been paid for or a time draft accepted118.

Fraud of documents The risk of fraud has to be born chiefly by the importer, as he is the party that will deal with documents accompanying the shipment. Since the payment is done or draft is accepted upon examination of documents and not the cargo itself119, there is always a threat that the documents are forged and do not reflect the real condition of the goods. This may apply to the bill of lading (e.g. the cargo has not been in fact loaded on board), certificate of inspection (the inspection has not factually been done or has been done negligently), invoice, packing list or any other type of document required under the documentary collection instructions. The result may be that the importer receives worthless cargo or goods that are inferior in quality or quantity. If the money has already been paid to the bank (D/P terms) and the fraudulent exporter account has already been credited, it is virtually impossible to receive them back. Unfortunately, even in case of D/A terms, after accepting a draft, it may be very difficult to convince the court of law that the draft has been signed basing on forged documents and that the exporter acted in bad faith120. This is because of the so-called principle of autonomy of

World Trade Ref, op. cit. ibidem. 119 With some exceptions, as described earlier in the chapter. 120 Marciniak-Neider (2002)
118

117

56 / 97

draft obligation, meaning the court is not concerned with the circumstance under which the draft has been accepted (such as the underlying contract and the fact that its terms have not been duly fulfilled by the exporter). Unless the importer is in the possession of hard evidences, he may be forced to pay the draft anyway. Consequently, it is advisable that importer always cheques collection documents carefully before he accept or pays a draft. It is also recommendable to ask bank to allow him prior inspection of cargo, if it has already arrived121.

Limited liability of banks When using documentary collections as a means of payment, special attention has to be drawn to the scope of bank responsibility for any problems that may arise during the collection process. Pursuant to the article 9 of URC522, banks shall act in good faith and exercise reasonable care when executing collection instructions. Nevertheless, the articles that follow limit considerably the liabilities and responsibilities of banks with regard to the goods delivered to them (article 10). Their responsibility for insufficient performance of other banks participating in the collection process, even if chosen by them, is limited, too. It is important to note that documentary collection procedures are not infallible122. Since banks act as intermediaries between buyers and sellers, both parties look to the banks as protectors of their interests. However, while banks have clear responsibilities, they are also protected from certain problems arisen as a result of events deemed to be out of their control or responsibility. The principal, therefore, should exercise great care in preparing the collection order so that it gives complete and unequivocal instructions. Banks are required to act in good faith and exercise reasonable care to verify that the documents submitted appear to be as listed in the collection order. They are, however, under no obligation to confirm the authenticity of the documents submitted. Banks are not liable nor can they be held accountable for the acts of third parties123. Third parties include freight forwarders, forwarding agents, customs authorities, insurance companies and other banks. Furthermore, they are not responsible for delays or consequences resulting from Acts of God or other causes beyond their control. Banks also assume no liability for loss arising out of delays or loss in transit of messages, letters, documents, etc. Banks take no responsibility regarding the

121 122

refer to page 55 for more details. Worl Trade Ref web-site, op. cit. 123 ibidem.

57 / 97

quantity or quality of goods shipped124. They are only concerned that documents presented appear on their face to be consistent with the instructions in the collection order. Any dispute as to quality or quantity of goods delivered must be settled between the importer and the exporter. In view of the above, traders need to be aware of the limited liability of banks in the collection process and bear in mind that they are principally responsible for the transaction. Therefore, both exporter and importer should take great care to assure flawless realization of collection.

Risk of bearing additional bank charges The rules pertaining to the charges and interests have been stipulated in articles 20 and 21 of the URC522. In case the drawee refuses to pay the charges even though the collection instructions so specify, the bank may nevertheless deliver the documents to the drawee without requesting the payment of charges. In such the case, however, the charges are to be born by the applicant and may be deducted from the proceeds of the collection. If the collection instruction clearly specifies that the charges may not be waived by the drawee, the presenting bank detains the documents and informs the remitting bank about the fact125. As a result, the exporter may be forced to bear the charges that have been preliminary agreed to be covered by the importer. It has to be noted that this unfair practice is often used by importers to get additional discount of the price, as they know the exporter will have no choice but to accept to bear the charges if the latter want to get the collection proceeds.

High risk in case of shipping goods directly to the importer If the exporter sends goods directly to the importer address, the shipment will be handed over without the latter first making payment. The exporter, therefore, should usually address the shipment to his agent in the importer's country or to the collecting bank if it is known to him and prior agreement has been obtained to do so126. In such the case, the exporter will usually have to bear additional costs for transferring the right to the document of title from collecting bank to the importer after the latter makes the payment or accepts the draft. In case, however, the goods are sent directly to the importer, it must be noted that the latter will not be able to clear the goods in import unless he receives the originals of transport document and invoice. This slightly decreases exporter risk in case of direct shipments to the importer.

124 125

ibidem. which should be done with no delay. 126 Hinkelman (2003).

58 / 97

Difficulties with import clearance Before agreeing upon documents required under the documentary collection, the exporter should make sure that they include everything what is necessary for custom clearance in the importers country127. Otherwise, the importer may refuse to accept the collection or, if unknowingly accepts it; he may find that he cannot clear the goods through customs. Although the importer is legally responsible for payment, he may be unable to pay because he never received the goods which were detained in custom warehouse. Therefore, it is recommendable to carefully check with custom authorities what documents will be required for given products to be able to clear them in import.

Negligent conduct of intermediary banks In accordance to the article 5 of URC522, for the purpose of giving effect to the instructions of the principal, the remitting bank should utilise the bank nominated by that principal as the collecting bank. In the absence of such a nomination, the remitting bank should utilize any bank of its own, or another banks choice in the country of payment or acceptance or in the country where other terms and conditions have to be complied with. In case, however, the bank chosen by the remitting bank fails to fulfil its obligation or acts negligently causing any harm to the importer or exporter, the remitting bank bears no responsibility for the choice and all the consequences have to be born by the principal. Therefore, it is advisable that the principal (exporter) selects the intermediary bank which he trusts.

Delays in importer action In practice, an importer often delays acceptance or payment of draft after it has been presented by the presenting bank. This is because importers wish to delay the payment to the maximum possible extent. In order to avoid such delays, the collection instruction should state the exact period of time within which any action is to be taken by the drawee (importer)128. This should be done in accordance with article 5b of URC522, meaning that the period within which the importer action is expected should be indicated clearly in the collection instruction. For this reasons, expressions such as prompt, immediate or first should not be used and will be disregarded by the banks.

127 128

Export911 web-site, op. cit. USB bank web-site, op. cit.

59 / 97

Influence of importer country legislation It should be born in mind that exporter should agree to a documentary collection payment not only if he does not doubt the importers willingness or ability to pay. Another important criterion is the importers country economic and legal situation129. This means whether the importer country is politically, economically, and legally stable, whether there are no foreign exchange restrictions, or all licenses for foreign exchange have already been obtained (if applicable). Also, it should be carefully checked if the goods being subject of the collection are easily re-marketable in that country. Otherwise, in the event the documentary collection is found not operational because of specific rules in force in the importer country, and even despite the importers acting in good faith, it may prove impossible for such the importer to pay for the goods delivered. In such the case, the exporter may need to ship the cargo back to re-sell in other countries. Therefore, exporters should carefully check with importer whether in the latters country there are any specific rules pertaining to the cargo that is to be shipped.

8. SUMMARY Documentary collections are still a quite popular means of payment in international trade. They provide traders with high flexibility in exchange for a reasonable cost. The overall attractiveness of documentary collections will be assessed, as mentioned previously, basing on the following factors: transaction cost, preparation time, execution time, risk of fraud, and commercial risk. In terms of transaction cost, documentary collections should be placed in the middle way between bank transfers and documentary credits. They are much more expensive than the former, whilst not as much costly as the latter. It must be emphasised, however, that in case of collection arrangement the cost structure is much more complicated than in case of cheques or bank transfers. This is because a bank fee must be born by both the exporter and the importer. The same rule applies to LCs. The main difference, however, lies in the fact that importers are not required by their banks to freeze any amounts of money as collateral of draft obligation. This gives them much greater flexibility to invest the capital and eliminates the so called lost opportunity cost. With regard to the preparation time, again, collection arrangements should be located between bank transfers and LCs. In order to submit an application for documentary collection significant amount of documents need to be issued. Each such a document needs to be

129

Export911 web-site, op. cit.

60 / 97

prepared with great care, as there may be no discrepancies between the documents attached to the application and the application itself. As a result, the application process is quite time consuming. It must be emphasised, however, that unlike documentary credits, collection applications are prepared by the exporter and the role of importer is to examine the documents and accept or pay the draft. The documentary collection execution time itself is relatively short. It depends, however, to great extent on the importer conduct. The inter-bank communication concerning collection issuance, possible amendments and confirmation of draft acceptance is carried-out usually by means of SWIFT network. It is therefore very quick and it should take no more than three labour days from the moment of payment of the draft by importer to the moment when exporter account is credited. The total collection time depends mainly on the collection type (whether D/P or D/A), the deference period, and whether the importer fulfils his payment obligation in due time. Since the collection arrangement is carried-out by a trusted intermediary, usually a bank, the risk of fraud is negligent. In case of documentary collection sent in paper form by post, it was possible, though unlikely, that the package might have been intercepted by third parties and in some way altered. Nowadays, however, majority of communication is done by secured SWIFT network, which virtually eliminates the risk of fraud. Therefore, it may be said that documentary collection are equally secured against frauds as SWIFT based bank transfers. As regards the commercial risk, documentary collections are a much more secure instrument than cheques or bank transfers. The main reason for that is threefold: the existence of trusted intermediary, existence of a draft, and a uniform legislation worldwide. Commercial banks acting as intermediaries, who are located in the same country of even city as the importer, serve as a disincentive for importer to act fraudulently as the latter may not allow loosing his reputation in front of such banks. The fact that importers sign and accept drafts serves as additional legal security for exporters. This is because of legal actions which may be taken in case an entity does not fulfil its obligation under a draft. Such legal proceedings are facilitated by uniform worldwide legislation in the form of URC522. Hence using documentary collections exporters have an effective legal tool allowing them to reduce their commercial risk.

61 / 97

CHAPTER V: DOCUMENTARY CREDITS


1. INTRODUCTION Documentary credits (also called letters of credit, LC or LOC) are definitely one of the most popular payment instruments in international trade. They have been considered standard for international transactions since 1933. Nowadays they are accepted in over 197 countries and can be issued by any international bank. Many countries require imports to be made on Letters of Credit if they are over a fixed dollar amount. According to recent estimations by US Department of Commerce130, 14% of world trade was paid for by letters of credit. This accounts for as much as one trillion dollars. In the United States alone, almost $40 billion in commercial letters of credit issued by US banks and US branches of non-US banks were outstanding at the close of third or fourth quarter 2005131. Letters of credit are, however, not equally popular across the word. In some regions they are preferred means of payment, while in others traders tend to use other instruments. According to a recent study132, the usage of letters of credit by region is as follows: European Union 9% Rest of Europe 20% North America 11% Latin America 27% Middle East 52% Asia Pacific 43% Africa 49% Asia 46% Australia & New Zealand 17% From the above study, one may notice a clear trend that in the more developed regions, where legislation, legal enforceability and business culture are better developed, share of LCs is relatively lower than in high-risk regions. As far as the legislation governing functioning of letters of credit is concerned, regardless of the part of the world, they are subject to the so called UCP500. The UCP500 stands for the Uniform Customs and Practices for Documentary Credits, 1993 Revision, International Chamber of Commerce Publication Number 500. This
130 131

IOMA, Business Intelligence at Work web-site; http://www.ioma.com/audioconferences/732.html Documentary Credit World (February-March-April 2006) 132 Ninth Survey of International Services Provided to Exporters, commissioned the Institute of Exporters, http://www.sitpro.org.uk/reports/lettcredr/lettcredr.pdf

62 / 97

publication is the current set of rules applicable to letters of credit governing its functioning and rights and obligation of parties to an LC transaction. It became effective on January 1, 1994. In this chapter, I am going to focus on LC subject to UCP500.

2. DEFINITION A documentary credit is a document issued by a bank which acts as an irrevocable133 guarantee of payment to a beneficiary. The payment is to be realised once specific conditions of the documentary credit are met, meaning the beneficiary submits conforming documents to the issuing or negotiating bank. In such the case, the bank is obliged to pay irrespective of any instructions of the applicant to the contrary134. In other words, the point of the documentary credit is that the obligation to pay is shifted from the applicant to the issuing bank135. Nowadays, letters of credit are used almost exclusively in international trade transactions of significant value, for deals between a supplier in one country and a wholesale customer in another, which is because of their relatively high cost. Specific types of LCs are also used in land development projects as a guarantee that approved public facilities (streets, sidewalks, storm water ponds, etc.) will be duly built.

3. PARTIES TO A DOCUMENTARY CREDIT TRANSACTION Each LC transaction usually involves the following parties: applicant, issuing bank, advising bank, confirming bank, and beneficiary. The applicant (usually the importer) is the person/entity that applies for the LC with the issuing bank. The issuing bank subsequently informs the advising bank of the LC issuance. The advising bank then advises the beneficiary (usually the exporter) of the LC opening. This may be done directly by advising bank or though another intermediary bank136. In case of confirmed LCs, a confirming bank appears. This may well be the same bank as the advising bank. Its task is to guarantee the LC payment to the beneficiary137. As it may be noticed, the parties to an LC transaction are generally the same as for a documentary collection. The only difference exists in the transaction route. In case of LC this is the payer (importer) that applies for its issuance, whereas in case of a

save revocable letters of credit, which are, however, not in common use. Wikipedia website, http://en.wikipedia.org/wiki/Letter_of_credit 135 This is also the main factor distinguishing LCs from documentary collections. 136 Export911 website, op. cit. 137 The confirmed LC and the role of confirming bank will be described further in the chapter.
134

133

63 / 97

documentary collection, it is the beneficiary (exporter) that needs to submit relevant application138.

4. MODUS OPERANDI The LC procedure begins with the importer submitting an LC application to his bank. The application should contain such details as: applicant name, beneficiary name, type of documentary credit139, payment terms, type of LC transmission, documents required, latest date of shipment, expiry date, info on transhipments and partial shipment, currency and amount of the LC, loading part, port of discharge, name of advising bank, confirming bank (if any), detailed description of goods. Whereas most of the data listed above is clear, some of them require further explanations. As regards payment terms, the LC amount may be paid to the beneficiary immediately on presentation of commercial documents conforming to the LC terms to the issuing bank (the so called at sight payment). The other possibility is a deferred payment, meaning that the exporter is paid on draft maturity which is certain number of days from the date of transport document (for instance 90 days of bill of lading date)140. As for the LC transmission type, it may be transferred by post or by electronic transfer (SWIFT). The documents that need to be submitted by the exporter to the bank in order to receive the LC proceeds are agreed upon by both parties in the underlying contract. These are usually: an invoice, packing list, certificate of origin, and a bill of lading/CMR/AWB141. It must be noted, however, that in case of discrepancy between the LC terms and the underlying contract, the bank will in no case take into account the conditions of the contract142. Regarding the latest date of shipment, it is the last date at which the goods may be loaded on board a vessel or a plane/truck. In other words, this is the latest date which may appear on the transport document. In case a later date is indicated, the bank will reject the document and the exporter will not receive the LC proceeds. The latest date of shipment is usually 21 days before the LC expiry date. This 21-day period is habitually accepted as the time which exporter needs to prepare documents and submit them to the advising bank. Transhipment means that the goods which are in voyage from the port of loading to the port of discharge may be reloaded from one vessel onto another in an intermediate port. It must be noted however, that according the article 23 of UCP 500, in case of container shipments, such the change of vessel is not
Tradeport website, http://www.tradeport.org/how_to_import/import_finance.html types of LC will be described further in the thesis. 140 Schmitthoff (2000) 141 depending on the mode of transport of goods being subject of the LC 142 it is the so called principle of autonomy of letter of credit transaction, which is going to be described further in this chapter
139 138

64 / 97

considered transhipment, providing the goods are covered by one bill of lading during the whole voyage. Partial shipment means that the exporter is allowed to ship only part of the goods being subject of the LC. This may for instance be 50 out of 100MT of a commodity, or it may well be full quantity of 2 items out of 4 indicated in the LC. Once the issuing bank receives such an LC application, it is checked carefully as regards its integrity and conformity with the contract between the parties. If no errors have been detected, then the LC is opened. The issuing bank arranges with the advising bank at the locality of the importer to negotiate, accept or pay (depending on the payment terms) to the exporter upon delivery of conforming documents143. The advising bank then informs the beneficiary on the issuance of the LC. Subsequently, the exporter ships the goods, obtains a transport documents, and prepares all the other documents in strict conformity with LC instructions. Once this has been done, the documents are submitted to the negotiating bank. In case they are deemed confirming, the beneficiary receives the LC proceeds (from the negotiating bank or advising bank depending on the type of credit).

5. TWO FUNDAMENTAL PRINCIPLES OF DOCUMENTARY CREDITS There are two fundamental principles of LC which distinguish it from other payment instruments, and in the same time render LC one of the most secure tools for exporters. These are the principle of autonomy of the credit, and the doctrine of strict compliance144. According to the former, LC is separated and independent on the underlying contract of sales and any other agreement from which the LC stems. As a result, the bank that checks documents is concerned only with whether these documents are in conformity with the instructions stipulated in the LC. The bank does not take into account nature of the contract or any whereabouts of the agreement between the LC applicant and the beneficiary. Its task is only to verify the conformity of the documents tendered by the beneficiary with the LC instructions of the applicant. The only one exception when bank may refuse to pay the LC proceeds to the beneficiary despite the documents being in conformity is when it is proved that the documents are forged and that the beneficiary was involved in the fraud145. It must be emphasised, however, that both these conditions must be met at the same time. As regards, the doctrine of strict compliance, it is a rule whereby banks are entitled to reject documents tendered by the beneficiary which do not strictly conform to the instructions of the LC applicant, even if the
143
144

Hinkelman (2003) Schmitthoff, op. cit. 145 ibidem.

65 / 97

discrepancies are insignificant. This rule stems from the principle of autonomy mentioned above, which says that banks are concerned with documents only and not with underlying contract or goods. This rule is applied very strictly by banks and by courts of law. Therefore, even very minor discrepancies may serve as a ground to refuse to pay the LC proceeds to the beneficiary. These discrepancies may include, for instance, literal errors, lack of spaces or comas in goods description, difference in description of goods between the invoice and the bill of lading, and many other very minor errors.

6. DOCUMENTS TENDERED TO THE BANK The documents which are usually submitted to banks under an LC are: a transport document, an invoice, a draft, a packing list, a certificate of origin, an inspection/quality certificate, an insurance document146. The transport document usually is: marine ocean bill of lading, charter-party bill of lading, air-way bill, or CMR (road transport document). These documents serve as evidence that the goods have been taken over by the carrier. They indicate the goods description, date and place of loading. The transport document is one of the most important documents under LC, as they evidence that the seller has fulfilled its obligations under the contract. As regard the invoice, it is the most important document issued by the beneficiary. It contains a detailed description of the goods, price, the Incoterms, the seller and the buyer description. The invoice must be in full conformity with the LC conditions and no discrepancies are accepted by banks. As regards the draft, it is a necessary for bank to be able to realise payment to the beneficiary. A draft is defined as a written order whereby one party writing it orders another party to pay money to a third party147. A draft may also be called a bill of exchange. Two main types of drafts may be distinguished: sight draft and time draft. The former is payable as soon as it is presented for payment by the beneficiary. Banks are allowed certain time to review the documents before making payment. The latter time, time draft, is payable after some period lapses. The period is always stated on the face of the draft. The bank is required to accept the draft as soon as the documents comply with credit terms148. The issuing bank is obligated to accept drafts and pay them at maturity. As regards packing list, it is similar in its nature to the invoice. The main difference is that the packing list does not indicate commercial terms (price, etc.), but details of packing (for instance number of pallets, wooden cases, their net and gross weight, etc.). The certificate of origin is usually

146 147

ibidem Credit Research Foundation, http://www.crfonline.org/orc/cro/cro-9-1.html 148 ibidem.

66 / 97

issued by a custom office or a chamber of commerce in the country of the exporter and evidences the origin of goods (e.g. EU origin). This is used by the importer to tackle custom formalities once he comes into possession of the goods149. In some cases, however, if the LC terms so allow, the certificate of origin may be issued by the beneficiary himself. The inspection/quality certificate may be issued by the exporter quality control department or by an independent expert. Since banks deal in documents and not in the goods and hence do not verify the quality of goods delivered, the purpose of the certificate is to evidence that the goods are of sufficient quality that conforms to the contract of sales. Depending on the delivery basis stipulated in the contract, the beneficiary must also submit an insurance document covering the goods to be delivered150. The generally accepted rule is that the insurance should cover the amount of 110% of the CIF value of the goods being subject of the LC. The documents appearing in the LC instruction should normally be in full conformity with those agreed in the underlying contract between the exporter and the importer. Therefore, beneficiary should pay great attention to LC instructions listing the documents, their content, the issuer, and any other conditions applicable to them. This is because he may later realise that he is unable to prepare conforming documents. This would mean bearing costs of LC amendments and a threat that the importer may refuse to agree to the LC amendment, which would preclude the exporter from receiving money for the cargo that might have been already shipped. 7. TYPES OF LC151 Revocable Letter of Credit This type of LC allows the applicant to amend or cancel it at any time. The instruction to this effect needs to be simply communicated to the issuing bank. This means that the exporter (beneficiary) cannot be sure that that LC terms will remain unaltered until such an LC expires. A revocable LC is a negation of the basic feature of LC, meaning the principle of autonomy. Therefore, this form is nowadays very rarely used in trade transactions.

Irrevocable Letter of Credit This is the basic type of LC. It cannot be cancelled or in any manner amended unless both buyer and seller agree to this152. Pursuant to UCP500, each L/C is regarded as irrevocable

In many cases the import duty amount is contingent upon the country of origin of the goods. In case of CIF deliveries. 151 Based on information from Credit Research Foundation; http://www.crfonline.org/orc/cro/cro-9-2.html
150

149

67 / 97

unless otherwise specified153. In view of this, irrevocable letters of credit are very attractive to exporters as even in case the importer refuses to fulfil its obligations, the importer bank will still be obliged to satisfy the exporter154.

Confirmed Letter of Credit If the exporter cannot or does not wish to bear the credit risk associated with the issuing bank or if the country where the issuing bank is located is economically, legally or politically unstable, then he can request that the L/C be confirmed. Confirmed LCs provide the exporter with additional security as this is the exporter bank which now takes the responsibility for making payments, even if no remittance is received from the issuing bank on due date. Additionally, in case of any dispute arising in connection to the realisation of the LC obligations, the exporter has the right to litigate against the confirming bank. The confirming bank is usually located in the exporter country, which renders the litigation and enforceability of court verdicts much cheaper, quicker and simpler.

Unconfirmed L/C In contrast, an unconfirmed credit does not require the advising bank in the exporter country to guarantee the letter of credit. Therefore, it is only the issuing bank in the importer country which is liable for the payment. The advising bank acts only as a messenger between the issuing bank and the exporter. Nevertheless, because of its lower cost, it is the irrevocable unconfirmed letter of credit which is the most popular type of LC in international trade.

Standby Letter of Credit This type of letter of credit serves mainly as a payment or performance guarantee used primarily in the United States. Such LCs are often called non-performing letters of credit because they are only used as a backup in the event the importer fails to effect payment as agreed. Hence, a stand-by letter of credit allows the importer to show that he can fulfil its payment commitments towards the exporter. Standby letters of credit are used, for example, to guarantee repayment of loans, to ensure fulfilment of a contract, and to secure payment for goods delivered by third parties155. The beneficiary to a standby letter of credit can cash it on

SME Global Business Marketplace web-site; http://www.sme.in/ExportDocumentation.aspx?PageID=1 By the 1993 revision of the UCP, credits are deemed irrevocable, unless there is an indication to the contrary. 154 Tradeport website, op.cit. 155 UBS website, op.cit.
153

152

68 / 97

demand. Stand-by letters of credit are generally less complicated and involve far less documentation requirements than irrevocable letters of credit.

Red Clause Letter of Credit The purpose of red clause letters of credit is to provide the exporter with certain funds prior to the shipment of cargo. The reason for that is to allow the exporter financing production of the goods (e.g. purchase of raw materials). Such LCs functions as a kind of advance payment on demand. It can usually be realised against a simple receipt or a statement from the beneficiary agreeing to return the funds in the event of non-shipment. However, most of such LCs require the advance payment to be made against the presentation of an payment guarantee156. The importer's issuing bank may advance some or all of the funds. The importer, in principle, extends financing to the exporter and bears the risk for all advanced credits.

Green clause Letter of Credit Such letters of credit contain a clause whereby a portion of the proceeds is held back for a period of time specified in the LC terms. The purpose of this is to cover a warranty period. Payment of the detained portion may be effected against a document issued by the importer confirming that the subject goods have performed correctly.

Revolving Letter of Credit With a revolving letter of credit, the issuing bank restores the credit to its original amount once it has been used or drawn down157. Usually, these arrangements limit the number of times the importer may draw down its line over a predetermined period.

Transferable Letter of Credit This type of credit allows the exporter to transfer all or part of the proceeds of the original letter of credit to a second beneficiary, usually the ultimate supplier of the goods. The letter of credit must clearly state that it is transferable to be considered as such. This is a common financing tactic for middlemen and is most popular in East Asia. This arrangement is particularly beneficial for the exporter who acts as an intermediary. He can use the LC issued by his customer to satisfy the obligations toward his supplier. In that case, the amount of transferred LC will be slightly lower than the amount of LC received from the issuing bank
156 157

Trade Yorkshire web-site; http://www.tradeyorkshire.com/resources/finance_bank_docs.htm Credit Research Foundation, op. cit.

69 / 97

(usually less the intermediary exporter commission). Owing to this the exporter bears no financial burden158 and risk of financing the purchase.

Back-to-Back Letter of Credit The purpose of a back-to-back LC is the same as the transferable LC. It is a new letter of credit opened based on an already existing LC which is non-transferable, meaning it is not allowed to transfer it to any third parties. In this case the existing LC acts as collateral for the new back-to-back LC.

158

except certain bank fees.

70 / 97

8. SWOT ANALYSIS The SWOT analysis presented below lists main features of documentary credits used to settle payments between parties located in two different countries.

STRENGTHS
a) low commercial risk b) immediate payment upon presentation of documents c) independence on the underlying contract (autonomy) d) requirement of strict compliance of documents e) quick communication due to the use of SWIFT f) flexibility of payments g) flexibility of deliveries h) acceptance on collection basis a) high cost

WEAKNESSES
b) time consuming and complicated use

OPPORTUNITIES
a) electronic application for LCs b) electronic LCs c) new legal developments: UCP600 revision

THREATS
a) fraud of documents b) limited liability of banks c) problems with import clearance of goods d) submission of discrepant documents e) ambiguity in letter of credit instructions

71 / 97

STRENGTHS Because of its related nature, a letter of credit holds many features similar to documentary collections. These are: existence of a trusted intermediary, uniform rules worldwide, flexibility due to variety of types available, and existence of a draft which nature is similar to that of a documentary collection. Therefore, I do not consider this necessary to describe them once more. On the other hand, however, documentary credits have many advantages, which distinguish them from collections. Below the most important of them are briefly described.

Low commercial risk The main advantage of documentary credits is that the beneficiary does not need to face the threat of the importers insolvency. This is because the payment is guaranteed by a bank usually a trusted institution with very good financial standing159. As a result, in case the importer establishes a letter of credit, the beneficiary, if submitting conforming documents, may be virtually 100% sure that he will receive the LC proceeds. This certainty may be additionally increased if the parties agree to resort to a confirmed letter of credit.

Immediate payment upon presentation of documents In case of sight documentary credits, the beneficiary is entitled to receive the proceeds immediately after the conforming documents have been submitted to the advising bank160. According to article 13b of UCP500, banks are obliged to examine the documents submitted within reasonable time, not exceeding 7 banking days. This means that the bank must inform the beneficiary within this period on his acceptance or rejection of documents tendered. Subsequently, if the documents are found conforming, the issuing bank161 should credit the beneficiary accounts within following few days. In case of an unconfirmed documentary credit, the advising bank needs to await the issuing bank transfer or undertaking to pay162. Only then, the advising bank credits the beneficiary account. Usually, however, the money is transferred within 1 week after the submission of documents. This is a very short period, especially since it is valid also in case the paying bank and the beneficiary are located in other parts of the world. Therefore, it is very convenient for beneficiary as he may calculate the time, within which he receives the LC proceeds in his account.
159 160

Export911 web-site, op. cit. Schmitthoff, op. cit. 161 In case of a confirmed letter of credit, the advising bank (and in the same time the confirming bank). 162 Schmitthoff, op. cit.

72 / 97

Independence on the underlying contract (autonomy) As has already been mentioned in the chapter, one of the basic principles of a letter of credit is its abstractive nature. This means that the letter of credit obligation is separated from any underlying contract or agreement from which it stems. It provides the exporter (beneficiary) with a great deal of security, as the buyer, in case he is fraudulent, may not allege breach of contractual terms or use any legal tricks to prove contract infringement in order to prevent the bank from fulfilling its credit obligations163. The only case whereby a bank may refuse the pay the LC proceeds despite conforming documents is the so called fraud exception164. The point of the exception is that the bank can either avoid payment, or can be prevented from making payment, if at the time of the presentation of the documentation stipulated in the letter of credit; the beneficiary has misrepresented a fact, which would otherwise have entitled the bank to avoid making payment on the credit165. The fraud exception may be utilised by both the bank as a defence to avoid claims for payment, or by any other party as an injunction to prevent the bank from making payment under a documentary credit. The usual requirement is that the beneficiarys fraudulent conduct must be clearly established, and that the bank must have knowledge of this fraud before making payment on the credit166.

Requirement of strict compliance of documents Another important feature of a letter of credit transaction is that the banks examining documents submitted are obliged to carefully check their content in order to determine whether or not they are in strict compliance with LC instructions. This helps preventing frauds or any other unfair behaviour from the beneficiary side and hence secures the importer interests. This is particularly important in case of transport documents, as the conformity of all data imposed on them is of crucial importance to determine that the exporter has complied with the terms of the contract and the LC.

163 164

Hinkelman (2003) Schmitthoff, op. cit. 165 ibidem. 166 Coutsoudis, Basil; Letters of Credit and the Fraud Exception: A Comparative Analysis of the Laws of the United States of America, England, and South Africa , www.law-online.co.za/IntTradeLaw/letcredit.htm

73 / 97

Quick communication due to the use of SWIFT At present, letters of credit may be established, amended and cancelled in two ways. The first way is by airmail, which involves sending hard copies by mail or by courier. It is quite time consuming and involves risk of them being lost and stolen in transit. The second manner, which is ever more popular nowadays, involves electronic communication by means of SWIFT system167 messages. The following SWIFT messages may be sent from the presenting bank to the remitting bank168: MT 700: Issue of a Documentary Credit MT 705: Pre-Advice of a Documentary Credit MT 707: Amendment to a Documentary Credit MT 710: Advice of a Third Bank's Documentary Credit MT 720: Transfer of a Documentary Credit MT 730: Acknowledgement MT 732: Advice of Discharge MT 734: Advice of Refusal MT 740: Authorisation to Reimburse MT 742: Reimbursement Claim MT 747: Amendment to an Authorisation to Reimburse MT 750: Advice of Discrepancy MT 752: Authorisation to Pay, Accept or Negotiate MT 754: Advice of Payment/Acceptance/Negotiation MT 756: Advice of Reimbursement or Payment MT 790: Advice of Charges, Interest, and Other Adjustments MT 791: Request for Payment of Charges, Interest, and Other Expenses MT 792: Request for Cancellation Receipt of such a SWIFT message is considered an official and legally binding confirmation of the LC establishment or amendment, and the beneficiary is immediately informed by the advising bank of the fact. The use of SWIFT greatly speeds up the whole process of information exchange between the parties to the documentary credit and significantly reduces the risk of fraud.

167 168

the SWIFT system has been already described in Chapter II of the thesis. AnSys web-site, op.cit.

74 / 97

Flexibility of payments Since letters of credit provide high level of payment security, they may sometimes be also used as a cash equivalent169. Therefore, the beneficiary (exporter) may use LC issued in his favour in further transactions for instance to finance purchase of the goods which he sells under this same letter of credit. Three options are available: transferable letter of credit, backto-back letter of credit, or assignment of proceeds. With regard to the first one, a portion or entire LC amount can be transferred to another person or company only providing the LC clearly states that it is transferable. Upon receipt of relevant application from the beneficiary, the advising bank will then transfer the credit or its portion to a third party (transferee). Wing to that, the exporter may realise the whole transaction without virtually investing any of his money. In case the LC is not transferable the beneficiary may alternatively use the so-called back-to-back letter of credit170. The essence of such LCs is that the beneficiary uses the nontransferable LC issued in his favour by his customer (importer) as collateral for the advising bank to issue a new, back-to-back LC, in favour of his supplier. Such a transaction may be realised without the importers awareness and hence secures the exporter commercial secret of the source of his supplies and precludes direct communication between the importer and the supplier. Lastly, in case the exporter (beneficiary) wishes to transfer only a smaller portion of the LC proceeds to a third party (usually an agent who assisted in the transaction between the exporter and the importer), he may assign all or part of the proceeds under that credit to that third party (the assignee). However, unlike a transferable letter of credit or back-to-back letter of credit, the beneficiary maintains sole rights to the credit and is solely responsible for complying with its terms171. For the assignee, an assignment of proceeds only means that the paying bank, once he receives conforming documents from the main beneficiary, will transfer some portion of the LC amount to that assignee, as per the assignment proceeds. The assignee is dependent upon the beneficiary for compliance, and thus this arrangement is riskier than a transferred or a back-to-back credit. Before agreeing to an assignment of proceeds arrangement, the assignee should carefully review the original letter of credit. Given the above possibilities, it has to be said that LCs are a very flexible payment instrument for exporters. A knowledgeable trader is able to use LCs as an instrument allowing them to finance a complicated transaction without investing his own money and without bearing virtually any commercial risk.

169 170

Credit Research Foundation web-site, op.cit which was already described in this chapter. 171 Credit Research Foundation web-site, op.cit

75 / 97

Flexibility of deliveries If LC instructions so allow, the beneficiary may deliver goods in several batches. After shipment of each batch is accomplished, he collects required documents together with a transport document and submits them to the advising bank. If the documents are found conforming, the exporter receives proceed equal to the value of the goods delivered, which is stated on the invoice. This gives the exporter more flexibility as he does not have to wait until the full quantity of goods is ready for shipment172 and may immediately receive proceeds for the goods shipped. This option provides more flexibility also to the importer in case he is not able to pay the full LC amount by once. In general, partial shipments allow both the export and the importer to maintain better financial liquidity as neither of them needs to invest full transaction volume at the beginning. On the other had, it must be had in mind, that each submission of documents to the bank is a service for which the parties will be charged. This means that the total cost of such a deal is higher for both the exporter and the importer. Furthermore, if the letter of credit instructions so permit, the exporter may ship cargo which quantity is not exactly similar to the quantity indicated in the LC. This is very important in case of bulky goods, such as liquid chemicals, commodities or other raw materials, whereby it is hardly possible to load the exact quantity of the cargo and hence there is always a small difference between the loaded quantity and the LC instructions. In such the case, after submitting commercial documents to the bank, despite them indicating different quantity of the goods, the bank must nevertheless accept the documents and pay the proceeds. The tolerance usually amounts to +/-5%.

Acceptance on collection basis In case the documents tendered to the bank are deemed discrepant, the exporter has two options: to correct the documents or to submit them to the importer on collection basis. The former option is not always possible particularly in case of certain types of transport documents, which are issued by the vessel captain. In that case if the vessel has already left the port, it is not possible, or at least extremely difficult, to get amended copy of the document. Additionally, when submitting document to the bank once again, the exporter needs to once more bear the costs of bank service. Therefore, the latter option may sometimes be a better alternative, especially if relations between the exporter and the importer are

172

this is especially important in case of big quantities of products with long production lead time.

76 / 97

relatively good. In such the case, the exporter may ask the bank to present the documents directly to the importer. If the importer accepts the documents, in spite of discrepancies, the bank will be able to pay the proceeds. Such an operation is similar to documentary collection. It must be noted, however, that in such a case the acceptance or refusal of the documents is totally up to the importer.

WEAKNESSES High cost Documentary credits are definitely the most expensive payment instrument of these already described in the thesis. It is more expensive than a documentary collection and far more expensive than a SWIFT transfer. Usually the total cost of LC amounts to 1-8% of LC value173. It has to be noted, additionally, that similar commission needs to be paid by both sides, which doubles the overall cost of the transaction. Additional fees for amendments, draft protests, tracers, endorsement of documents of title, or assignment of proceeds may apply. Furthermore, contrary to a documentary collection, in the case of an LC, the payment is guaranteed by the bank. Depending on agreement between the importer (applicant) and its bank, the latter will usually require the full or at least partial advance payment from the applicant to make sure it will be reimbursed for the payment made under LC. Usually, banks require applicant to deposit the LC amount on a separate account in the bank that serves as collateral in the case of the applicant insolvency or unwillingness to pay. Also, with regard to the exporter, pursuant to article 34 of UCP500, in the case of LC based on CIF deliveries, the goods need to be insured for the sum amounting to 110% of their invoice CIF value. This creates additional financial burden for the exporter.

Time consuming and complicated use Because LCs usually require much more documents than a documentary collection, the time required for their preparation is accordingly longer. The doctrine of strict compliance forces the importer to attach a great deal of attention when preparing the documents. Even the smallest mistake or a literal error may serve as a ground for document rejection by the bank. As a result, preparing LC documents is a very time consuming activity which requires the beneficiary employees to be very cautious and accurate. Similarly for the importer (applicant) it is a quite time consuming operation to prepare relevant LC application. It needs to state

173

Andy Gary, Letters of credit, week of May 29, 2006 Fairfielx County Business Journal

77 / 97

precisely all the terms of the credit and must be in conformity with the underlying contract from which it stems. Consequently, it is quite frequent that many traders do not agree to employ letters of credit, not because of their high cost, but mainly because of long time needed to tackle all formalities.

OPPORTUNITIES Electronic application for LCs An electronic version of application for documentary credits becomes more and more common among banks and traders. The way it works is that the applicants (importers) receive and install special software in their computers. The software enables them to fill out an application and send it via Internet to the bank processing centre. Upon receipt, the applications are processed in the same way as traditional paper-based applications. Concerns may be raised here about security of such a manner of communication. Fortunately, the applications are secured using a special protocol and password system, which virtually precludes the information from leaking to unauthorised persons. The main advantage of such electronic applications is that they enable a repeat letter of credit applicant faster turnaround and in the same time they drastically cut paperwork for the bank174. Such electronic applications are not yet very popular. However, since they considerably reduce costs for both the banks and the applicant, their popularity is increasing very quickly. It is therefore recommendable for traders to check with their banks whether already and, if not yet, when their banks will introduce such software to their customers. Electronic LCs Nowadays, e-commerce accounts for ever bigger share of international commercial turnover. However, web sites which offer the possibility of purchasing products via Internet allow customers to pay chiefly by credit cards or bank transfers. These modes of payments are sufficient for purchases of low dollar value. In case, however, a customer wants to buy for instance machinery or long lead time manufactured products, most company web sites only offer advance payment facility or open terms as viable options. Letters of credit are not popular as an e-commerce payment instrument at all. This is because they are inherently complex and require coordination of banks, freight forwarders, custom agents, shipping schedules, government agencies, and coherent documentation. Preparation of each such document is labour intensive and generates difficulties that would be difficult for software to
174

Hinkelman (2003)

78 / 97

solve. Nevertheless, first attempts have been made recently to introduce an E-letter of credit. The settlement process of such a letter of credit consists of five stages175. The first step is for an importer to generate a purchase order with the selling company. The order is filled-in online and includes all the details necessary to realize an international trade deal supported by an LC (such as Incoterms, available documents, port of loading and discharge, etc.). Secondly, the order is accepted and a proforma invoice is issued by the exporter. It includes all the details of the order such as banking fees, transport and insurance charges. The proforma invoice becomes the base value of the LC. Thirdly, the proforma invoice is sent to the importer with the detailed letter of credit instructions. Fourthly, the exporter, if necessary amends the letter of credit after it is issued. Lastly, the LC is sent to specialized company for management and processing. To regulate the issue of electronic letters of credit, a eUCP was introduced. It has been in force since 1 April 2002 and it is applied as a supplement to UCP500. It does not contain provisions for issuance of an LC, but only for its presentation. An LC document may be only electronic or mixed with paper based documents. The eUCP applies as a supplement to the UCP where the credit indicates that it is subject to eUCP. In the case of eUCP, the following definitions apply: appears on its face shall apply to examination, document shall include an electronic record, place for presentation means an electronic address, sign shall include an electronic signature, superimposed, notation or stamped means data whose character is apparent in an electronic record176. The eUCP has not yet gained popularity among traders and its use has been minimal. A new version of eUCP is to come in force from July 2007 which coincides with the introduction of new version of standard UCP, meaning UCP600. It is to be slightly amended to integrate more with UCP600. However, because of low popularity of eUCP, it has not been fully incorporated into UCP600 and will still remain as its supplement only177. Despite still underdeveloped legal framework, an electronic LC has many benefits over traditional, paper-based documentary credits. The most important of them include:

175

Dunlop, John. W.; How to Put Letter of Credit Transactions into E-commerce, Trade Editorial 5, www.avgtsg.com 176 AVG Trade Group web-site; www.avgtsg.com 177 Wikipedia web-site; http://en.wikipedia.org/wiki/Uniform_Customs_and_Practice_for_Documentary_Credits

79 / 97

Documentary credit feature: Payment time from shipment Total cost of negotiation178 Discrepant presentations Document preparation export LC Document examination
Source: AVG Trade Group investigation179

UCP 24 days USD750 80% 6 hours 2.0+ hours

eUCP 5 days USD35 15% 1 hour 0.5+ hours

New legal developments: UCP600 revision The UCP was first published in 1933 by the International Chamber of Commerce (ICC). Subsequent revisions were issued in 1951, 1962, 1974 and 1983. The document is revised periodically to ensure that it continues to reflect the custom and practice of the users. Current revision, the UCP500, even though it has been applied worldwide since 1993, still contains many ambiguities that cause confusion among banks and traders, sometimes creating legal conflicts. In order to decrease the risk, a new revision of UCP, the UCP600, has been prepared. Among the many important changes to UCP500 are the inclusion of a new article of definitions, introduction of a 5-day time for banks to examine LC documents, clarity on the discrepancies in beneficiary addresses and responsibilities of a confirming bank, a new focus and clarity on the act of negotiation, as well as a complete review of the transport articles180. The new rules will be named UCP600. The UCP600 will have an effective date of 1 July 2007. It is anticipated that the new revision will greatly increase legal clarity and certainty among letter of credit user worldwide. Owing to this, the popularity of LCs may increase even more.

THREATS Fraud of documents The increasing volumes of international trade and the popularity of export finance instruments have also some negative consequences. Namely, the ever growing number of export finance frauds committed on both exporters and importers sides. The volumes of frauds increase constantly at an alarmingly high rate and new manners of fraud are invented every year. It is estimated that only a very insignificant share of the frauds is discovered and reported by
178 179

for transactions volumes higher than US$ 250,000 AVG Trade Group web-site; op. cit. 180 Association of Executives in Finance, Credit & International Business; Conference: UCP 600: New Rules for Letters of Credit, September, 29, 2006

80 / 97

bankers, as they are not willing to expose them for fear of bad publicity181. The exact volumes of frauds worldwide are still unknown. However, some idea about the most likely enormous amounts of money earned by fraudsters can be had when we realize that in a recent letter of credit fraud case, biggest international blue chip banks lost over USD 500 million182. Under a letter of credit based transaction, the payment is released by a bank when it determines that the documents submitted by the beneficiary (especially the transport document) are genuine and in conformity with the letter of credit instructions. However, it is highly possible that the documents submitted by the beneficiary may be forged or in any other way falsified. Banks, despite experience in such the verification, may not always be able to distinguish whether the documents are genuine. The fraud usually concerns transport documents. This is because usually these are the only documents which are issued not by the beneficiary and serve as evidence that the cargo has been factually loaded onboard a vessel, a truck or a plane. As a result, the beneficiaries often simply forge the document as a whole or amend certain clauses on them such as quantity, type of goods, etc. To make things worse, sometimes a beneficiary acts in collusion with his freight forwarder and an original transport document is issued. In such the case, the bank has virtually no chance to discover a fraud. In order to reduce the risk of becoming a victim of such a fraud, traders should attach great care when selecting business partners. At the very beginning, meaning in the letter credit assessment and approval process, the exporter should carefully screen the importer business. This should include checking the nature and history of his business, including any recent change in the ownership and management of the company, major trading partners and its trading pattern. Possible credit lines should be approved by the exporter bearing in mind, among others, the business need of the importer, the value of underlying collateral and proven track record of repayment. Any requests for considerable increase in credit facilities within a short period of time should be carefully examined. Also, drastic increase in L/C outstanding balances should be closely monitored183. As regards banks, they should also very carefully monitor each transaction. When handling the L/C documentation, negotiating banks should ensure that L/Cs have been authenticated by the advising bank. Where necessary, they should confirm the authenticity of the L/C with the issuing bank. Banks should also review carefully the terms of L/Cs and any subsequent amendments thereof, and where necessary, follow up with the issuing bank. For L/Cs of substantial amount or in case of doubt, shipping documents
T.O. Lee Consultants Ltd web-site; http://www.tolee.com/html/col426.htm The famous Solos case. More information on http://www.guardian.co.uk/Archive/Article/0,4273,3923239,00.html 183 Hong Kong SAR Information Centre; http://www.info.gov.hk/hkma/eng/guide/circu_date/circu_190799b.htm
182 181

81 / 97

should be authenticated before negotiation. These steps could help ensure the authenticity of L/Cs and the shipping documents. It has to be noted, however, that there is no 100% secure protection against frauds and scams. Therefore, the risk of fraud is inherent to each LC based transaction.

Limited liability of banks One of the potential threats that parties to an LC transaction need to face is the limited liability of banks under the UCP500 terms. Pursuant to the document, banks assume no liability or responsibility for the form, sufficiency, accuracy, genuineness, falsification or legal effect of documents, or conditions stipulated in the documents184. Neither are the banks responsible for the description, quantity, weight, quality, condition, packing, delivery, value or existence of the goods represented by the documents, nor for the good faith or acts of the consignors, the carriers, the forwarders, the consignees or the insurers of the goods. Furthermore, banks assume no liability for the consequences arising out of delay or loss in transit of messages, letters or documents pertaining to the LC transaction185. In case it is not possible so that the issuing bank contact the presenting bank directly because they are not corresponding banks and hence an intermediary bank or banks are required, banks utilizing the services of another bank or other banks for the purpose of giving effect to the instructions of the applicant do so for the account and at the risk of such an applicant. Banks assume no liability or responsibility should the instructions they transmit not be carried out, even if they have themselves taken the initiative in the choice of such other bank186. It must be emphasized that such the situation, whereby banks find themselves in privileged position over the other parties to the LC transaction, is not favourable for the exporter or the importer. As a result, in case some unexpected problems occur, the banks are virtually always able to disclaim any responsibility basing on the UCP500 provisions. Therefore, the parties (whether importer or exporter) will need to bear all the burdens and risks by themselves.

Problems with import clearance of goods It should be also mentioned that both the exporter and the importer need to be very careful when agreeing terms of the letter of credit, including the documents which need to be submitted under that LC. They must take into account the legal requirements for clearance in

184 185

Article 15 of UCP500 Article 16 of UCP500. 186 Article 18 of UCP500.

82 / 97

the importers country. In case the letter of credit does not contain all such documents, the importer may be unwilling to clear the goods in import and hence access to them. For the importer, this is a serious threat as he finds himself in the position whereby he has no goods and he has already paid the money to the bank or obliged himself to do so. Similarly, for the exporter the situation may be dangerous, as well. This is because the exporter maintains ownership of the goods until he gets payment for them. As an owner, he is also responsible for storage charges. In case the importer is unable to clear the goods, the cargo is detained in a custom warehouse. If the storage time exceeds certain number of days, the exporter may be forced to bear additional costs of the warehouse. The situation is even worse in case the goods are of perishable nature. If this is the case, a prolonged import clearance may render the goods completely useless causing the importer to loose considerable amount of money.

Submission of discrepant documents Another threat that parties to LC transaction need to face is the submission of discrepant documents to the bank and, consequently, their rejection. As has already been mentioned in this chapter, one of the fundamental rules governing LC transaction is the so called doctrine of strict compliance. This means that the documents submitted to the bank need to be prepared exactly in conformity to the LC instructions. Any minor difference (even a literal error or lack of space or coma) may serve as a ground for the bank to reject the documents. Actually, in practice such situations happen quite often. The table on page 85 presents a list of discrepancies resulting in letter of credits documents rejection. As it can be seen, some of the most common discrepancies are those which are the simplest to correct and where the correction can be made by the beneficiary himself. These are discrepancies such as inconsistent data within the documents submitted or late presentation of submitted documents; late shipment and, what is quite surprising, absence of certain documents required under the letter of credit terms. The submission of discrepant documents may have various consequences: need to amend the documents, delayed payment, non-payment, need to apply for acceptance on collection basis. In any case, the discrepancy means certain financial losses to the beneficiary. In the worst case, the beneficiary may lose the chance of being paid (for instance if the letter of credit expires). A survey187 estimates that in 2000 United Kingdom exporters lost 113 million through non-compliant documents being presented under letters of

187

Ninth Survey of International Services, op. cit.

83 / 97

credit. This is merely the amount that can be measured and does not include other factors such as lost opportunity and cash flow problems. Thus it is of paramount importance for exporters to be very careful and accurate when preparing and submitting documents under letters of credit and hence to minimise the opportunity for importers to reject or delay payment. Once the discrepancies occur and the beneficiary is forced to request documents acceptance of collection basis, importers can use this situation to reject or delay payment and to negotiate a discount, thus leaving the exporter at their mercy188.

Source: Ninth Survey of International Services Provided to Exporters, commissioned the Institute of Exporters189.

188
189

OCBC Bank (Malaysia) Bhd; New Straits Times-Management Times; Copyright 2001. http://www.sitpro.org.uk/reports/lettcredr/lettcredr.pdf

84 / 97

Ambiguity in letter of credit instructions The likelihood of submitting discrepant documents is additionally increased in case the beneficiary receives an LC which includes ambiguous or unfavourable instructions. Some letters of credits, unfortunately, are issued with problems designed in. This stems from many reasons: lack of clear agreement with the importer as to the instruction of the LC, importers deliberate actions, or adding additional clauses by the issuing bank that render the LC ambiguous (or even typist mistakes, imagination, etc)190. The result may be that the LC may contain unfavourable or ambiguous terms. In the worst case, the LC may be completely unworkable. Ambiguous LC conditions usually are caused by the fact that some expression may be subjective in nature and hence unclear. For instance, original invoice in triplicate could possibly mean three originals, one original and two copies, or one original and three copies191. Unfavourable terms usually relate to documents or its form which are required under the LC. This may be, among others, legalizations from embassies, certificates of origin by individual item in the assemble, applicant signatures required, specific ship routing, unrealistic shipping and presentation dates, excessive price details, conflicting additional conditions, unavailable documents, ambiguous requirements, and references to unknown or undefined agreements. A distinction must be stressed between the unworkable and the unfavourable terms. A letter of credit can be unfavourable and still be able to able to be complied with. Unworkable conditions can be categorized into broad areas, such as: performance conditions, document requirements, additional conditions, and ambiguities192. Unworkable conditions are frequently country specific, and must be tolerated by the beneficiary if he intends to continue trading with that country. Unworkable performance conditions are usually the latest shipping date, expiry date, or presentation period. They stem from the importer unwillingness to freeze his LC collateral with the issuing bank any longer than it is indispensable. Therefore, he often only allows the beneficiary minimum time to ship the goods and present documents before the LC expires. As regards unworkable document requirements, these are documents that the beneficiary is unable to issue or procure upon shipment of cargo. The most popular example includes documents that the beneficiary must get from the importer after shipment and delivery, such as an inspection certificate signed by the importer that is required to be included in the documents submitted to the bank. Unworkable additional conditions, in turn, are requirements that cannot simply be complied
190

Dunlop, John W.; How Letter of Credit Discrepancies can be Eliminated , Trade Editorial 2; www.avgtsg.com/References/Trade%20Editoral02%20-%20Discrepancies.pdf 191 ibidem. 192 ibidem.

85 / 97

with in any way. Unworkable ambiguities are usually two opposite requirements in the same LC. To give an example, the Incoterms may be FOB in one line of LC instructions, while in other line freight prepaid to destination may be required. The LC may also contain language that is vague or not understandable such as, an original copy, or certified fax193. According to John W. Dunlop, many such ambiguous instructions are issued deliberately by the banks. This is because the amount of fees and interest foreign banks can collect on trade finance transactions is directly proportional to the confusion and complexity of the LC issued. There simply is an opposite incentive to do it correctly. Exporters contribute to the problem by accepting unworkable credits because they prefer to take the risk than negotiate the terms with importers and face the threat of loosing the contract. Once the beneficiary receives the LC issuing notification, the advising bank cover letter usually includes the following statement: "If you are unable to strictly comply with its terms, please communicate directly with the Applicant to have the Credit amended". In case the credit instructions are unworkable, unfavourable or inconsistent with the original agreement between the exporter (beneficiary) and the importer (applicant), the former should inform the bank that he rejects the LC and ask the applicant to make relevant amendments to the LC. According to the UCP500, in case the beneficiary does not inform the bank within 5 banking days on the acceptance or rejection of the LC, it is understood that the LC has been accepted by the beneficiary. It should be emphasised that banks are obliged to pay the LC proceeds only in case the documents submitted by the beneficiary are found conforming. If this is not the case, than the beneficiary finds himself totally at the mercy of the bank or the importer as regards the payment. In such the case the LC no longer fulfils its basic role as a payment guarantee and is worth no more than an ordinary documentary collection. Therefore, it is of paramount importance for the beneficiary to carefully check if he can comply with LC terms and submit fully conforming documents.

9. SUMMARY Nowadays, letters of credit are one of the most popular settlement instruments in international trade. In order to assess their usefulness and compare against the previously described means of payment, the following most important factors should be assessed: transaction cost, preparation time, execution time, risk of fraud, and commercial risk.

193

ibidem.

86 / 97

Letter of credit is definitely the most expensive payment instrument. It is costly for both importer (applicant) and the exporter (beneficiary). The former pays the issuance fee to his bank (issuing bank) while the latter needs to cover the document examination fee charged by the advising bank. Depending on the credit type, fees like confirmation fee or amendment fees need to be paid by the parties. Another very significant financial burden for the issuer (importer) is the need to freeze funds amounting usually to 100% of the LC value that serve as collateral of applicant obligation to reimburse bank194. Consequently, LCs are the most financially burdensome payment instruments, particularly for importers. Thus, if commercial risk is not too high, the parties should opt for alternative types of settlements. So is the preparation time. LC is definitely the most time consuming payment instrument both for the importer and the exporter. The former needs to prepare a complicated application form, which unfortunately is still predominantly paper based. He needs to take a great care not to make any literal mistake which would render the application incorrect, incoherent or discrepant with the underlying contract. In the last case, the LC may be simply rejected by the beneficiary, which may force the issuer to bear additional cost of amendments. The beneficiary, in turn, needs to devote even more time to tackle LC formalities. Firstly, he needs to verify the LC issuance advice received from his bank for discrepancies. Afterwards, he needs to prepare lots of commercial documents in several copies, including agreeing upon the exact wording of negotiable transport document with his freight forwarder. In view of the above, many traders as a part of their policy do not accept letters of credit. The execution time, in practice, depends on the time within which the advising/confirming bank examines the documents, which may vary from two up to seven labour days. Subsequently, 3-4 additional working days need to be added, until the issuing bank receives relevant message and transfer the funds to the advising bank. Therefore, as regards execution time, LC is quite an attractive payment instrument. As regards the risk of fraud, in case of LC, similarly to documentary collections, it is very low. This is because nowadays most of LCs are issued in electronic form and exist only within SWIFT network. Therefore, it is virtually impossible to fraud them. As for the commercial risk, since this is a bank and not an importer, which is responsible for satisfying exporter for the goods/services delivered, LCs are definitely the most secure means of international payments. The principle of autonomy of LC obligation on the underlying contract and the doctrine of strict compliance additionally increase the security, making it

194

however sometimes it is possible to negotiate a partial collateral with bank even in case of sight LCs.

87 / 97

very difficult to block payment under an irrevocable LC even under litigation. Nevertheless, it must be mentioned that LC are not fully fraud proof. It may happen that LC is issued by a non-existing bank or a bank with poor financial standing which reduces the chances of receiving money. Also, LCs provide the unconditional obligation of bank to pay the proceeds only in case the documents tendered to the bank are fully in conformity with the LC terms. Otherwise, the documents are submitted on a collection basis and it is entirely up to the importer whether he accepts them, rejects, or demands more favourable conditions before accepting them. Additionally, it must be noted that LC does not protect the importer against fraudulent action of exporter. If the latter acts in collusion with his freight forwarder, as a consequence of which transport documents are forged, LC provides virtually no security to the importer. There is of course no 100% secure payment instrument. Nevertheless, LCs provide the best commercial security against exporter or importer unfair practices or bankruptcy. It is therefore recommendable in case the parties do not give much trust to each other.

88 / 97

FINAL ASSESSMENT AND CONCLUSIONS


In order to summarise my observation from the preceding pages of this thesis, I have decided to create a table assessing attractiveness of each of the four payment instruments described above. The factors being assessed are the same as those described in summaries to each chapter of the thesis, meaning: transaction cost, preparation time, execution time, fraud risk, and commercial risk. Each factor has been graded from 1 to 10. Since all the factor represent either time or risk (so the lower the better), grade 10 means longest time or highest risk, meaning the least attractive conditions. If grade 1 (or 0 in some cases) is received it means the shortest time or lower risk, which is the most attractive evaluation. It has to be noted, moreover, that the assessment is usually different (opposite) for exporter and importer due to their opposite positions in a transaction. Therefore, I have decided to grade attractiveness of the payment instrument in question separately for the exporter and the importer. Below the basic assumptions of the evaluation are listed.

General assumption of the evaluation: Amount transferred: USD 250,000.Exporter (beneficiary) located within the EU Importer (payer) located outside of the EU (non-European)

Additional assumptions for bank transfers: Cost option share (the most common) Mode of payment: prepayment Priority: normal

Additional assumptions for cheques: Legal base: issued under Geneva Convention Type: personal cheque (not a bankers cheque) Mode of payment: prepayment, cheque post-dated

Additional assumptions for documentary collections: Collection terms: D/A

89 / 97

Additional assumptions for letters of credit: LC terms: payment at sight LC type: irrevocable, unconfirmed

Evaluation of attractiveness of payment instruments:


Party Cost Preparation time Execution time Fraud risk Commercial risk

BANK TRANSFERS

Exporter Importer Exporter

2 3 5 2 7 7 8 10

0 2 4 0 10 2 8 4 6 10 6 8

2 2 9 6 4 2 2 3

0 10 6 8 4 3 1 2

CHEQUES

Importer
DOCUMENTARY COLLECTIONS

Exporter Importer Exporter Importer

DOCUMENTARY CREDITS

The evaluation presented above is based on data both objective and subjective collected in the course of preparation of the thesis, my interviews with experienced international traders and financial officers, as well as my own knowledge. In case of bank transfers it may be noticed that they are a very quick and cheap payment instrument, both for importers and exporters. However, in the same time they are a high risk means of payment. In case of prepayment the risk is born by importer, while in case of open account sales, this is the exporter who has to face the threat of payer default. Therefore, bank transfers are recommended only in case both parties know each other very well and there is a considerable trust between them. Otherwise, using bank transfers creates unjustified difference in the level of risk between importer and exporter. With regard to cheques, they are both costly (for the importer to collect) and time consuming instrument. Additionally, cheques provide a very limited level of commercial security for both parties, which is made even worse because of threat of fraud. Therefore, cheques in the traditional paper based form are not recommended payment instrument in international trade.

90 / 97

Documentary collection may serve as an interesting option for partners that do not yet have a close relation and are reluctant to resort to bank transfers because of inherent high risk. In the same time, the importer does not want to agree to a letter of credit because of high cost and the need to freeze considerable amounts of money with his bank. Documentary collections provide much higher security than bank transfers due to existence of a draft and a bank as an intermediary. In the same time, they are not as costly as letters of credit. Therefore documentary collections are recommendable for middle size transaction between parties that give themselves limited (say medium) trust. Finally, letters of credit are recommendable in two cases. Firstly if the transaction is made between parties that do not know each other very well and cannot afford to give trust to each other, particularly in high risk regions of the world. In such a case, regardless of transaction amount, letters of credit should be used. The second type of business circumstances is when the transaction volume is considerable and the exporter may not allow not having a full guarantee of payment of the amount due. This may be not only the question of trust, but also solvency of the importer. To summarise my observations in the following page you can find a table indicating recommendable payment instrument in dependence on the commercial risk and the transaction amount. It should be observed that cheques are not shown there. This is because I do not find them an efficient means of payment under wholesale international trade transactions. The table is, obviously, only a simplification as it is impossible to show the complexity of an international trade transaction in a 2-dimensional table. It may give, however, a good idea on the attractiveness of each payment instrument depending on the change of nature of international trade transaction.

91 / 97

ATTRACTIVENESS OF PAYMENT INSTRUMENTS IN RELATION TO COMMERCIAL RISK AND TRANSACTION AMOUNT

Risk
HIGH HI

MEDIUM

LOW

LOW

MEDIUM

HIGH

VERY HIGH

Amount

BANK TRANSFER

DOCUMENTARY COLLECTIONS DOCUMENTARY CREDITS

92 / 97

LITERATURE:

BOOKS: 1. Axtell, Roger E.: The dos and taboos of international trade : a small business primer, revised 6th edition, New York : Wiley, 1994 2. Caves, Richard E.: World trade and payments, 9th Edition, Addison-Wesley, 2004 3. Coutsoudis, Basil; Letters of Credit and the Fraud Exception: A Comparative Analysis of the Laws of the United States of America, England, and South Africa http://www.law-online.co.za/IntTradeLaw/letcredit.htm#_ftn2 4. Heropolitaska, Izabela: Jak rozpozna prawidowy czek zagraniczny poradnik praktyczny, Twigger SA, Warsaw, 2003 5. Heropolitaska, Izabela: Prawo czekowe polskie, zagraniczne biblioteka bankowca, Twigger SA, Warsaw, 1997 6. Hinkelman, Edward G. A Short Course in International Payments. Novato, CA, USA: World Trade Press, 2003. 7. Mann, Ronald. J: The role of letters of credit in payment transactions, 2000. 8. Marciniak-Neider, Danuta Heropolitaska: Rozliczenia w handlu zagranicznym, PWE, Warsaw, 2002. 9. Muntingh, JA: The Fraud Exception in the Context of Documentary Credits: A Comparative Study of the Remedies in Various Jurisdictions LL.M dissertation, Stellenbosch University (1997). 10. Rooy, Frans P. de: Documentary credits, Deventer, The Netherlands ; Antwerp ; Boston : Kluwer, c1984 11. Schmitthoff, Clive M.; DArcy, Leo; Murray, Carole; Cleave, Barbara: Schmitthoffs Export Trade The Law and Practice of International Trade, Tenth Edition, London 12. Smith, Alan: International trade and payments in the former Soviet/CMEA area : reorientation or reintegration, London : Royal Institute of International Affairs, 1994 13. Todd, Paul: Bills of lading and bankers' documentary credits, London : Lloyds of London Press, 1990 14. United States General Accounting Office: Perspectives on trade and international payments : report to the Congress / by the Comptroller General of the United States, Washington : U.S. General Accounting Office, 1979 15. Wilson, Effingham: A practical treatise on banking, 2nd ed, 1828, London. 93 / 97

PAPERS (ACADEMIC AND BUSINESS): 1. AVG Trade Group: How to Put Letter of Credit Transactions into E-commerce; Trade Editorial 5 2. Bills of Exchange Act 1882, United Kingdom. 3. Commonwealth Bank of Australia, International Trade Products: Exporters Handbook - Foreign Exchange and Currency Risk Management, 7th edition, Sydney, 2005. 4. Commonwealth Bank of Australia, International Trade Products: TradeGuide, 7th edition, Sydney, 2005. 5. Documentary Credit World, Volume 5, Number 6, June 2001. 6. Documentary Credit World, Volume 8, Number 10, November/December 2004. 7. Edward J. Potter, President, PSI Fraud Solutions: Customer Authentication: The Evolution of Signature Verification in Financial Institutions; Journal of Economic Crime Management Summer 2002, Volume 1, Issue 1 8. Explanatory Note by the UNCITRAL Secretariat on the Model Law on International Credit Transfers, 1992; http://www.jus.uio.no/lm/un.credit.transfers.model.law.1992/doc.html#151. 9. Financial Transactions and Report Analysis Centre of Canada (FINTRAC), S.W.I.F.T. format EFT Transactions Batch Reporting Instructions and Specification Version 1.8, for development purposes May 28, 2002 10. Gregor C. Heinrich [CPSS Secretariat]: International initiatives towards

harmonisation in the field of funds transfers, payments, payment systems, and securities settlements; Annotated Bibliography, Basel, February 2001 11. Ian Woods, Australian Bankers Association: Fraud and the Australian Banking Industry; Melbourne, 1998. 12. John Davies: C24 White Paper: just how hard can it be to parse a SWIFT message? The beginners guide to parsing SWIFT messages; Ref: 11/1/2005 13. LC Monitor, Volume 6, Issue 4, July/August 2004 14. Model Law on International Credit Transfers, UNCITRAL, 1992; http://www.uncitral.org/uncitral/en/uncitral_texts/payments/1992Model_credit_transfe rs.html 15. SITPRO Briefings Financial: Methods of Payment in International Trade, SITPRO, London, 2002. 94 / 97

16. SITPRO Ltd: Report on the Use of Export Letters Of Credit 2001/2002, London 17. SWIFT: Exceptions and Investigations: The need for a SWIFTNet solution, Business Case Report, 2003 18. The Geneva Convention of 19 March 1931, providing for a Uniform Law for Cheques 19. Uniform Commercial Code (UCC), United States of America, 1952 with subsequent revisions.. 20. Uniform Customs and Practice for Documentary Credits; ICC Publication No. 500 Effective January 1, 1994 21. Uniform Rules for Collections No. 522, 1995 Revision in force as of January 1, 1996, Leaflet Version, ICC No.522LF. 22. Zambakhidze, Tamar: Documentary Credit An Advantageous Form of International Payment; Georgian Law Review, 5/2002-1

WWW: 1. http://austlii.edu.au/~alan/true-owner.html 2. http://en.wikipedia.org/wiki/Cheque 3. http://europa.eu.int/comm/internal_market/payments/fraud/index_en.htm 4. http://europa.eu.int/youreurope/nav/en/citizens/guides/iban/en.html 5. http://news.bbc.co.uk/1/hi/business/2151881.stm 6. http://news.bbc.co.uk/1/hi/magazine/3242776.stm 7. http://news.bbc.co.uk/1/hi/programmes/moneybox/4233002.stm 8. http://tf.nordea.dk/index.asp?pid=820 9. http://www.acfe.com/fraud/samples.asp?Source=FIN_2005_11_30

10. http://www.acfe.com/fraud/view.asp?ArticleID=463 11. http://www.anasys.com/swifthandbook/swift.html?fmt103.html 12. http://www.anasys.com/swifthandbook/swift.html?fmt103.html 13. http://www.anasys.com/swifthandbook/swift.html?fmt103.html 14. http://www.apacs.org.uk/payments_industry/payment_fraud_2.html 15. http://www.bba.org.uk/bba/jsp/polopoly.jsp?d=263&a=367 16. http://www.bba.org.uk/bba/jsp/polopoly.jsp?d=263&a=5603 17. http://www.c24.biz/library_swift.htm 18. http://www.ckfraud.org/ckfraud.html 19. http://www.consumeraffairs.govt.nz/consumerinfo/banking.html 20. http://www.crfonline.org/orc/cro/cro-9-2.html 95 / 97

21. http://www.europa.eu.int/comm/internal_market/payments/index_en.htm 22. http://www.export61.com/services.asp?code=S 23. http://www.export911.com/e911/export/docColle.htm#docCollection 24. http://www.export911.com/e911/export/export.htm 25. http://www.export911.com/e911/export/export.htm 26. http://www.exporter.pl/zarzadzanie/eksport/4platnosci.html#dc 27. http://www.fintrac.gc.ca/ 28. http://www.firsttradenet.com/its/glossary/index.jsp?area2=gloss&letter=C 29. http://www.fraudinvestigator.co.za/cheque_fraud_-_faq.htm 30. http://www.icc-cr.cz/poradna/c2.html?type=1 31. http://www.iiblp.org/dcw.asp 32. http://www.inc.com/magazine/19960301/1584.html 33. http://www.insolvencyhelpline.co.uk/ltd-companies/bad_cheques.htm 34. http://www.intrustbank.com/Business/International/HowTo002.aspx 35. http://www.intrustbank.com/Business/International/HowTo012.aspx#13 36. http://www.intrustbank.com/Business/International/HowTo021.aspx 37. http://www.iss.co.za/pubs/ASR/6No2/Camerer.html 38. http://www.jus.uio.no/lm/private.international.commercial.law/payment.mechanisms.a nd.guarantees 39. http://www.jus.uio.no/lm/private.international.commercial.law/payment.mechanisms. and.guarantees 40. http://www.jus.uio.no/lm/un.bills.of.exchange.and.promissory.notes.convention.1988/ doc.html#235 41. http://www.jus.uio.no/lm/un.bills.of.exchange.and.promissory.notes.convention.1988/ doc.html#235 42. http://www.kb.cz/en/seg/seg4/products/documentary_collection.shtml 43. http://www.lawsure.co.za/htdocs/4_Newsletter/archive.php?view_archive&file=2003_ 06_25_Ownership_of_a_Not_Transferrable_Cheque.txt 44. http://www.mantissa.co.uk/support/nextucp3a.htm 45. http://www.nordea.lt/en/cs.prices.prekybos.phtml 46. http://www.ppl.nl/ 47. http://www.remburskonsulenten.com/Outward_LC.html 48. http://www.richardbacon.org.uk/speeches/Michael_Hart_case.htm 49. http://www.sitpro.org.uk/reports/lettcredr/lettcredrap3.html 96 / 97

50. http://www.swift.com/index.cfm?item_id=2941#_What_are_the 51. http://www.swift.com/index.cfm?item_id=3184 52. http://www.thehindubusinessline.com/bline/mentor/2004/01/19/stories/200401190017 1000.htm 53. http://www.thelivingweb.net/identity_theft//directory/letter-of-credit-fraud.html 54. http://www.tolee.com/col.html#ucp500group 55. http://www.tradeport.org/how_to_import/import_finance.html 56. http://www.tradeport.org/how_to_import/import_finance.html 57. http://www.tradeport.org/how_to_import/import_finance.html 58. http://www.ubs.com/1/e/ubs_ch/bb_ch/finance/trade_exportfinance/documentar_inkas so/grundsaetzliches.html#_vorundnachteile 59. http://www.ubs.com/1/e/ubs_ch/bb_ch/finance/trade_exportfinance/documentar_inkas so/inkassoarten.html#_verpflichtungsschreiben 60. http://www.ubs.com/1/e/ubs_ch/bb_ch/finance/trade_exportfinance/documentar_inkas so/grundsaetzliches.html 61. http://www.weksel.pl/przyklady_czekow.html 62. http://www.worldtraderef.com/WTR_site/documentary_collections.html

97 / 97

Vous aimerez peut-être aussi