An analysis of key changes in UCP 600 compared to UCP 500 and Recommendations for better application

  Introduction Relevant of the study It is generally accepted that international trade transactions naturally carry more risks than domestic ones due to differences in practice, culture, business processes, laws and regulations. It is, therefore, important for traders to ensure that goods are dispatched and payment is made complying with the contract provisions. One effective solution for traders dealing with these risks has been documentary credit (D/C) or letter of credit (L/C). Despite of its complexity in compliance and high cost, L/C still enjoys popularity due to its safety with banks’ participation. It has been described as “the life blood of international commerce” (D’Arcy, Murray & Cleave 2000, p. 166) and the importance of L/C in trade transactions is evidenced by its global acceptance, with an estimated usage in excess of 1 trillion USD per annum (SITPRO Ltd, 2003). For more than 70 years, the International Chamber of Commerce ICC has formulated the so-called UCP-The Uniform Customs and Practice for Documentary Credits. The first attempt to codify letter of credit practice started in 1929 when ICC introduced its “Uniform Regulations and Commercial Documentary Credits”. Although the failure to gain wide acceptance, these rules provided a foundation for further developments. Then, in 1933, ICC issued “The Uniform Customs and Practice for Commercial Documentary Credits” and this set of rules received formal acceptance in more than 40 countries all over the world. It is, however, not until the issue of UCP in 1962, that global acceptance took place. Since then the rules has been regularly updated in 1974, 1983 (UCP 400), 1993 (UCP 500) and now we have the sixth Revision-UCP 600 which came into effect in July 2007. From the fact that the old revision-UCP 500 has reached a ten year cycle of usage and during its lifetime, it was proved to be more and more outdated, over-complicated and ambiguous which led to series of queries, commercial disputes, unjustified discrepancies leading to documentary rejections. Indeed, under ICC’s estimate, there is up to a 70% documentary non-compliance rate in letter of credit transactions (ICC Thailand, 2002). The new 2007 Revision, therefore, should be made to improve its certainty and clarity, reduce discrepancy problem and facilitate international trade activities using L/C product. Aims of the study This study, “An analysis of key changes in UCP 600 compared to UCP 500 and Recommendations for better application”, aims to consider the differences from UCP 500 to UCP 600. The research questions posed in this study are: “Where the rules have been amended?” and “Which results in a potential changes in practice?”. Basing on the findings, this study will draw recommendations for parties involved in L/C transaction in applying the new revision UCP 600 before reaching the conclusion. Research methodology The thesis relies on relevant literature, associated rules, articles, available statistics and employs method of comparison, analysis, arguments and synthesis. Data for the study was collected from various sources including reference books, magazines, articles, reports, new letters and the Internet. Object and scope of the study Objects of the thesis are the two recent versions: UCP 500_1993 Revision and UCP 600 having commencement date of 1 July 2007. To have an in-depth understanding and appropriate application, associated rules that may have impact on these two revisions have been used as reference documents. Structure of the study To achieve the above objectives, the study is divided into 3 chapters Chapter I: “Literature review”, provides an in-depth background that covers all theoretical issues relevant to UCP set of rules and documentary letter of credit. Chapter II: “Key changes under UCP 600 in comparison to UCP 500”, points out structural changes as well as key changes in UCP 600 in comparison with UCP 500. An evaluation of improvements and remaining problems is also discussed in this chapter. Chapter III: “Recommendations for better UCP 600 application”, based on the findings, the chapter will put an end to the study with recommendations for main parties involved in letter of credit transaction to suggest the best way in applying the new UCP 600. Chapter I Literature review What is UCP? The Uniform Customs and Practice for Documentary Credits (UCP) is a set of rules on the issuance and use of letters of credit. The UCP is utilised by bankers and commercial parties in more than 175 countries. About 11-15% of international trade utilises letters of credit, totalling over a trillion dollars (US) each year (SITPRO Ltd, 2003). Historically, the commercial parties, particularly banks, have developed the techniques and methods for handling letters of credit in international trade finance. This practice has been standardized by the International Chamber of Commerce - ICC by publishing the UCP in 1933 and subsequently updating it throughout the years. Today, they have achieved almost universal acceptance by practitioners in the countries worldwide. It is important to note that The Uniforms and Practice for Documentary Credits (UCP) is not law. It is private set of rules, which affects all the stakeholders involved in letter of credit transactions if they choose to apply it. Stakeholders here refer to banks and other institutions that issue, confirm or otherwise process L/Cs; buyers who cause L/Cs to be issued; seller who look to L/Cs for payment; and service providers such as forwarders, carriers, customs brokers who provide or use the documents that the credits stipulate. Therefore, UCP is not a legal regime automatically applicable to all letters of credit. It is just a voluntary self-regulatory rule system standardized by ICC when it is expressly incorporated into the letter of credit. Beside UCP, ICC Banking Commission also provides some other supplementary publications specifying in more details the relationship between the banks themselves, i.e. the rights and obligations of Advising, Confirming, Issuing and Nominated banks. The latest up-to-date ones are ISBP 681 (International Standard banking Practice), eUCP 1.1 2007 (Supplementary to the Uniform Customs and Practices for Documentary Credits, for Electronic Presentation), “Commentary on UCP 600”, ICC Banking Opinions and many guide books for Documentary Operation as well. 1.1.1 The born of UCP 500 The considerable increase in litigation under documentary credits and the fact that up to 50% of documents are rejected when first presented to Banks led to ICC’s authorization of the revision in November 1989 of UCP Publication No. 400 published in 1983. International judicial decisions and technological innovations were considered origins and foundation for the content of new revision. The stated aim of this revision was to address developments in the banking, transport and insurance industries. It also sought to improve the drafting of the UCP 400 in order to facilitate consistent application and interpretation of UCP rules. A Working Group (WG) including international banking experts, legal professors and banking lawyers was formed to draft the proposed revision. After 4 years, with the tireless effort of WB, the final draft –UCP 500, 1993 Revision – was reached and came into effect since January 1st 1994. In comparison with the earlier revision UCP 400, UCP 500 is more concise and updated with 49 articles. It was divided into seven sections, which were lettered from A to G and headed in turn: General Provisions and Definitions; Form and Notification of Credits; Liabilities and Responsibilities; Documents; Miscellaneous Provisions, Transferable Credit and finally Assignment of Proceeds. After ten year of usage, UCP 500 has revealed lots of weaknesses due to the advance in fields of global logistics and technologies which needed to be incorporated in L/Cs. In addition, there was a high proportion of documentary rejection under UCP 500. Seventy percent documentary discrepancy in letter of credit transaction is the statistic collected by ICC Thailand in 2002. This fact together with the increasing demand in international trade transaction has forced ICC to start a new revision process. 1.1.2. The born of UCP 600 The latest revision process started in 2003. A drafting group comprising nine people together with a consulting group with forty-one members from more than 25 countries were formed to develop proposed revisions for the ICC national committees worldwide. In fact, it cannot be denied that no draft will satisfy everyone, thus the drafting committee gave everyone an opportunity to express their own view by making comments. After all the suggestions had been considered, no matter how they are minor or small, decision on the new draft is taken by a voting system and the final text of UCP 600 was reached. The new revision replacing the UCP 600 was approved by the Banking Commission of the ICC at its meeting in Paris on 25 October 2006 and had a commencement date of 1 July 2007. It is the fruit of more than three years of work by the ICC's Commission on Banking Technique and Practice. The main objective of the revision was to reduce documentary rejection by ensuring transparence and clarity, limit potential disputes, seek to eliminate poor presentation by beneficiaries and provide a clearer understanding of principles in UCP. What is Documentary Credit? Documentary credit (D/C) or Letters of Credit (L/C) has been a milestone of international trade since the early 1900s. They continue to play a critical role in world trade today. For any company entering the international market, letters of credit are a payment mechanism, which help eliminate certain risks. A letter of credit is a document issued mostly by a financial institution which usually provides an irrevocable payment undertaking (it can also be revocable, confirmed, unconfirmed, transferable or others e.g. back to back, revolving but is most commonly irrevocable/confirmed) to a beneficiary against complying documents as stated in the letter of credit. Letter of credit is abbreviated as an LC or L/C, and often is referred to as a documentary credit, abbreviated as DC or D/C, documentary letter of credit, or simply as credit (as in the UCP 500 and UCP 600). Once the beneficiary or a presenting bank acting on its behalf, makes a presentation to the issuing bank or confirming bank, if any, within the expiry date of the LC, comprising documents complying with the terms and conditions of the LC, the applicable UCP and international standard banking practice, the issuing bank or confirming bank, if any, is obliged to honour irrespective of any instructions from the applicant to the contrary. In other words, the obligation to honour (usually payment) is shifted from the applicant to the issuing bank or confirming bank, if any. Non-banks can also issue letters of credit however parties must balance potential risks. Source: the free encyclopedia Wikipedia Letter of credit is also defined by TD bank financial group as “a written instrument issued by a bank at the request of its customers, the Importer (Buyer), whereby the bank promises to pay the Exporter (Beneficiary) for goods or services provided that the Exporter presents all documents called for, exactly as stipulated in the letter of credit, and meet all other terms and conditions set out in the letter of credit. A letter of credit is also commonly referred to as a Documentary Credit or Commercial Credit.” In principle, letters of credit are commonly used to reduce credit risk to sellers in both domestic and international sales arrangements. It is issued to substitute the bank's credit worthiness for that of the customer. Basically, if you are an importer, you don't want to send the money before you get the goods. On the contrary, the exporter does not want to send the goods to you, unless they get their money. Therefore, an LC is a statement of issuing bank, which tells that the buyer has the money, they gave the money to issuing bank, once the goods arrive safely at the destination, and is confirmed to be what it is supposed to be, this bank will give the money to the vendor. Usually, banks play the role of the 3rd party since they are institutions recognized to be trustworthy for this sort of thing, and they sometimes also obliged to convert the currency as well – one of bank’s main functions. The bank will also charge a fee for the service and this is just one of the ways banks make money in the field of international business. However, traders should bear in mind that L/C is an independent agreement separated from original sales contract. All parties in letter of credit transaction deal with documents, not with goods which the documents refer. Thus, the Seller gets paid, not after the Buyer has inspected the goods and approved them, but when the Seller presents certain documents (typically a bill of lading evidencing shipment of the goods, an insurance policy for the goods, commercial invoice, etc.) to his bank. The bank does not verify that the documents presented are true, but only whether they “on their face” appear to be consistent with each other and comply with the terms of the credit. After examination, the bank will pay the Seller. 1.2.1. Classification There are three basic ways to classify letters of credit including classification by method of payment; by the manner in which the credit is issued and by other specific features of the credit. Each type of credit has advantages and disadvantages for the buyer and for the seller. Charges for each type will also vary. However, the more the banks assume risk by guaranteeing payment, the more they will charge for providing the service. Classification by reference to method of payment Letter of credit may be by “sight” payment, by “deferred” payment, by “acceptance” or by “negotiation”. All the credits must clearly state whether they available by sight payment, deferred payment, by acceptance or by negotiation. A “sight” credit is one in which an issuing bank authorizes a seller of goods to present documents for payment, without a bill of exchange or with a bill of exchange drawn on it payable at sight, to the bank issuing the credit or its correspondent and undertakes to pay the seller, or reimburse its correspondent upon the correspondent paying the seller, against the documents presented. A “deferred payment” credit or ussance credit follows the normal form as to payment against documents, except that the paying bank is not called upon to pay until some specific later date. The paying bank is, however, required to pass the documents to its principal and may find itself under promise to pay in the future, having lost the security of the documents. Moreover a confirming bank that makes payment to the beneficiary before the deferred payment date without obtaining the authority of the issuing bank does so as its peril. If , before the date for payment, it is proved that the documents have been presented fraudulently the confirming bank cannot recover a indemnity from the issuing bank and must pursue a claim against the beneficiary or another fraudulent party. An “acceptance” credit is one which a bank authorizes a seller of goods to draw a bill of exchange on it or its correspondent in the country of the seller, and undertakes either to the seller or an intermediary bank to accept and pay at maturity a bill drawn o it or to pay a bill which has not been accepted by the bank on which it is drawn. It is possible to stipulate in a credit that the issuing bank will pay a bill of exchange drawn on the buyer in the event of non-acceptance by the buyer, but this is discouraged by the UCP, which states that a credit should not be issued available by bills of exchange drawn on the applicant (buyer). A “negotiation” credit is, strictly speaking, one that authorizes the beneficiary to draw on the issuing bank and to negotiate the draft with the intermediary bank advising the credit or with his own or some other banks. The issuing bank’s obligation is to pay without recourse to the drawer. The benefit of a negotiation credit is that the seller ca discount the bills of exchange prior to the maturity date. Classification by reference to the manner of which the credit is issued Documentary letters of credit can be either Revocable or Irrevocable, although the former is extremely rare. Irrevocable letters of credit can be Confirmed or Not Confirmed. Documentary Revocable credit may be modified or even canceled by the buyer without the agreement of all the parties. Therefore, they are generally unacceptable to the seller. The issuing bank gives a binding undertaking t the beneficiary provided all terms and conditions are fulfilled. Under UCP 600 all letter of credit are irrevocable. Documentary Irrevocable letter of credit is the most common form of credit used in international trade. Irrevocable credits may not be modified or canceled by the buyer. The buyer's issuing bank must follow through with payment to the seller so long as the seller complies with the conditions listed in the letter of credit. Changes in the credit must be approved by both the buyer and the seller. If the documentary letter of credit does not mention whether it is revocable or irrevocable, it automatically defaults to irrevocable. There are two forms of irrevocable credits: Unconfirmed credit (the irrevocable credit not confirmed by the advising bank) and Confirmed credit (the irrevocable confirmed credit). (In an unconfirmed credit, the buyer's bank issuing the credit is the only party responsible for payment to the seller. The seller's advising bank pays only after receiving payment from the issuing bank. The seller's advising bank merely acts on behalf of the issuing bank and, therefore, incurs no risk. (In a confirmed credit, the advising bank adds its guarantee to pay the seller to that of the buyer's issuing bank. Once the advising bank reviews and confirms that all documentary requirements are met, it will pay the seller. The advising bank will then look to the issuing bank for payment. Confirmed Irrevocable letters of credit are used when trading in a high-risk area where war or social, political, or financial instability are real threats. Also common when the seller is unfamiliar with the bank issuing the letter of credit or when the seller needs to use the confirmed letter of credit to obtain financing its bank to fill the order. A confirmed credit is more expensive because the bank has added liability. Classification by reference to other specific features of credit Standby letter of Credit This credit is a payment or performance guarantee used primarily in the United States. They are often called non-performing letters of credit because they are only used as a backup should the buyer fail to pay as agreed. Thus, a stand-by letter of credit allows the customer to establish a link with the seller by showing that it can fulfill its payment commitments. Standby letters of credit are commonly used to assure the refund of advance payments; support the obligation of a successful-bidder to accept a contract and to perform under the terms of the contract; back up bonds issued by insurance companies; and stand behind a monetary obligation under a promissory note or another like commitment (rental payments, etc.). The beneficiary to a standby letter of credit can cash it on demand. Stand-by letters of credit are generally less complicated and involve far less documentation requirements than irrevocable letters of credit. If the seller performs his other obligation, there will be no need for the buyer to draw against the standby letter of credit, which supports the obligation. Back-to-Back letter of Credit Back-to-back L/C is a type of L/C issued in case of intermediary trade. W