A letter of credit (LC) is a
bank instrument that is issued to protect the beneficiary in a
transaction. It is not a contract
although there are usually contractual undertakings that underlie the credit. (It is important to reserve in your mind
that the contract on which the credit is based cannot be referenced in the
credit itself and cannot be a decisive factor when the credit is presented for
payment. This is “The Independence Rule” which will be discussed later.)
Technically a letter of credit is not a guarantee although it does, in
fact, guarantee payment of an obligation to a beneficiary.
There are laws and rules that govern letters
of credit. The Uniform Commercial Code
(UCC) Article 5 covers letters of credit and is law. The Uniform Customs and Practice (UCP), which is
distributed by the International Chamber of Commerce (ICC), has a series of
publications that are the accepted rules
for credits. The ICC/UCP500 and the
ISP98 are their two most current publications for letters of credit. The ICC/UCP500 is entitled, ICC Uniform Customs and Practice for
Documentary Credits and has been in force as of January 1, 1994. The ISP98 is called the International Standby Practices ISP98
reflects generally accepted practice, custom and usage of standby letters of credit and has been in force since
January 1, 1999.There are three basic parts to a letter of credit transaction.
Applicant – The applicant is also known as the account party or customer. He
requests from the issuer the credit he wants for his beneficiary. He pays the
issuer for the credit with cash or collateral so as to secure the issuer the
funds necessary for the reimbursement obligation to the beneficiary.
Beneficiary – The beneficiary is the party that will be identified in the credit as
the entity entitled to draw or demand payment under the letter of credit.
Advising Bank – The role of the advising bank is to notify the beneficiary that a
credit has been issued by another bank. It assumes no responsibility other than
notifying the beneficiary. However, its
obligation is limited to accurately advising the terms of the credit that has
been issued. In this capacity it is
only playing “post office”. (UCP500 Article 7).
Confirming Bank – The responsibility of the confirming bank is that it becomes directly
obligated on the credit and now assumes the rights and obligations of the
issuer. (UCP500 Article 9, a, b, c, d). Typically the confirming bank’s role is
one for geographic convenience, i.e., a bank located close to the
beneficiary. However, it can also be a
well-known bank, that will assume the responsibility for a lesser known bank by
confirming their credit, therefore, rendering the credit more acceptable to the
beneficiary.
Independence Rule – This principle of independence clearly states that the obligation of
the paying bank is in reading the text of the credit which is wholly
independent from sales or other contracts on which the credit may be based. The
issuing bank is not required to evaluate if the beneficiary has performed under
the underlying contract or if it is contractually entitled to payment. The
issuer is only obligated to pay upon presentation of documents that conform to
the requirements of the letter of credit. (UCP500 Article 3, a, b, Article 4).
Strict Compliance Rule – The beneficiary must make presentment in strict compliance with the
terms, conditions and procedures of the credit. Further to this, since the adherence of the requirements must be
strictly applied to the beneficiary, the beneficiary must know precisely and
unequivocally what those requirements are. Although the Independence Rule above, is “rule” the Strict Compliance Rule is considered “law” since this
standard has been applied and followed by a majority of federal jurisdictions
and state courts.
Transferable Credit – A transferable credit is a credit under which the first beneficiary
requests the paying bank to make the credit available in whole or in part to
one or more beneficiaries. A credit can
be transferred only if the text clearly states that it is transferable.
(UCP500, Article 48, a-j; ISP98, Rule 6.0-6.05).
Every letter of credit must address the
following:
Terms: Dollar amount to be paid for the
transaction by the applicant to the beneficiary in accordance with the
specifications listed in the letter of credit within the period of validity and
date of expiration.
Conditions: Beneficiary must satisfy the
terms above in order to qualify and to be able to draw the proceeds on the
credit.
Procedures: Applicant opens the letter of
credit with the issuing bank. Issuing
bank advises beneficiary that the credit is available to his account.
Particulars of underlying contract must be clearly stated in credit (although
contract itself is not cited nor will it be evaluated when credit is presented
to bank for payment – “Independence Rule”.
QUANTIFIERS
Every letter of credit, as
with all contracts, must address the following quantifiers.
Who – The parties involved with the transaction (applicant, beneficiary,
issuing bank, confirming bank).
What - Type or name of transaction
(commodities, supplies, services, funding).
Why – Needs on both ends of transaction (buyer, seller, lender, borrower).
Where – Banks involved (where credit is to be opened, confirming bank, paying
bank, jurisdiction of applicant and
beneficiary).
When – Time frames (date credit is issued, periods of validity and
expiration, ETD for shipment or release of funds, ETA for shipment or draw of
funds, partial or full shipments allowed).
How Much – Amount of transaction, if partial draws allowed
THERE ARE TWO CATEGORIES OF
LETTERS OF CREDIT USED TODAY
1 Documentary Letter of Credit (DLC or L/C)
2 Standby Letter of Credit (SBLC or SLC)
The Documentary Letter of Credit
is conditioned on performance
by the supplier, whose acceptable and satisfactory performance makes him the
beneficiary of the credit.
The Standby Letter of
Credit is conditioned on default or non-performance by the
account party or applicant who opened the standby letter of credit.
Now consider this:
A documentary letter of credit is issued with the expectation that it would be drawn on by the
beneficiary.
A standby letter of credit is issued with the expectation that it will not be drawn on by the
beneficiary.
Although there is misuse and manipulation of documentary letters of
credit by crafty businessmen, this article will deal only with standby letters
of credit, the instrument which fraudsters use to dupe the uninformed and
inexperienced investor.
Standby letters of credit are sometimes referred to as “sui generis” (of their own kind, or “beasts
unto themselves”). They are flexible and their versatility is virtually
limitless.
The premise or the essence of a standby letter of credit is that the
issuer will “stand by” to perform in the event of the account party’s non-performance or default.
One distinguishing characteristic with standby letters of credit is that
documentation of non-performance or
default is required for the beneficiary to obtain payment. This
documentation must be precise and strict adherence to the language of the
credit and satisfying whatever is
called for in the credit indicating non-performance by the issuer. This could include, submitting drafts and
perhaps a statement indicating that the account party has defaulted in
accordance with the text of the credit. (Strict
Compliance Rule).
Standby letters of credit are a type of IOU. More closely related to a co-signer on a loan. That is to say, if
you default or don’t perform in accordance with your agreement with the lender,
the ”co-signer” is responsible for you and your debt and pays on your
behalf. In reality, he is standing by
for you.
Following are some examples of its flexibility. Always keep in mind non-performance
or default.
Example One
A contract requires goods of a certain quality to be delivered. Some or
all of the goods are subquality or substandard. A standby letter of credit, either separately as a companion
credit or as the primary credit, could provide funds for replacing substandard
goods independent of the contract requirements in the event there is a
compromise in the quality of the produce.
Example Two
As a performance guarantee.
Suppose a contract requires performance by a certain date and the
completion is late. The primary
contractor could require a series or standby letters of credit from
subcontractors to help pay delay penalties under the master contract.
Example Three
Goods are to be delivered to a specific location on a certain date and
they are delivered to the wrong place.
Payment under a standby letter of credit could provide funds for
transportation costs to the specified location.
Example Four
Perishable foods arrive late (fruits and vegetables). A standby letter of
credit could enable the beneficiary to replace those items that rotted.
Example Five
Party A promises to repay Party B $10,000 for a loan by a certain
date. That certain date arrives and
Party A defaults, he does not perform.
Party B, the beneficiary takes the letter of credit to the bank with the
required documents, statements, evidence and the attached draft and receives
the funds due to him which the bank was standing by to make good for Party A in
the event of his default.
Now here is where
fraudsters use this same standby letter of credit and prey upon the uninformed
investor.
Following is a descriptive example of a standby letter of credit being
issued as a form of guarantee for payment to a beneficiary due to
non-performance or default by the applicant.
A standby letter of credit is issued by ABC’s bank to XYZ as
beneficiary. The standby letter of
credit states that on December 10, 1999, ABC is to remit to XYZ $100,000. In
the event ABC does not honor the text of responsibility as indicated in the
credit, XYZ is to submit the credit and what ever evidence or documentation is
required as per the language of the credit to the bank for payment.
Now two important factors come into play. One, XYZ could not
submit the credit to the bank for payment before the due date, and if ABC paid
XYZ prior to the due date then the credit would have no surrender value. That means that the credit only has value,
in this instance, upon default by ABC, the applicant.
Consider this, how would someone (the beneficiary) be able to discount a
credit to a third party if, first of all, the credit would have absolutely no
value prior to the due date, and, secondly, if the applicant (ABC) met his
obligation and paid the beneficiary (XYZ) prior to the due date (expiration),
the credit could never be called and, therefore, with no surrender value.
Secondly, the credit must state that the credit is transferable partially or in
its entirety and, as stated in the ISP98, (Rule 6.02 a,b) “A standby is
not transferable unless it so states”... and “may not be transferred
unless the issuer (including the confirmer) or another person specifically
nominated in the standby agrees to and effects the transfer requested by the
beneficiary”. The UCP500 (Article 48
a-j) also states, “A credit can be
transferred only if it is expressly designated as transferable by the issuing
bank.”
Now let’s assume that the credit could be transferred and it was sold at
a discount to a third party. But, unbeknown to the third party the original
beneficiary (XYZ) received his $100,000 payment from the applicant. The credit,
although having been transferred, cannot be presented for payment because it
was only valid in the event of default. The applicant honored his obligation
and although the credit was discounted the transferee now has a worthless
document. Such a scenario could in fact
become a reality and oftentimes it is one of the schemes and scams of
fraudsters.
Fraudsters also create schemes whereby they represent to have standby
letters of credit from lesser-known banks. In reality these credits are usually
worthless since the rating of the banks issuing them are unknown or that a
prominent bank will not confirm their credit.
If they did have a standby letter of credit (already issued) your first
step is to see if the credit was key tested and if yes, does the text state
that mail copy is to follow. It is not
customary for individuals, outside banks or financial institutions, to have a
hard copy of a credit unless it is stated that such copy is to follow or to be
made available to the beneficiary. So if a statement does not appear at the bottom of an electronically transmitted
credit indicating that a copy is to be mailed and a credit in hard copy is
presented to you, you must consider withdrawing from that transaction without
further delay.
If a statement indicating that a hard copy will follow and such copy is
presented to you, then here is a series of questions you should raise:
First, to whom is the credit issued (the beneficiary)?
Second, why is it being issued and for what reason?
Third, if credits are not issued in “blank” so to write how can this be
genuine or valid?
Fourth, is it transferable, and if yes, to whom is it transferable? Just asking
those simple questions should help you pave a path leading in the opposite direction
from the fraudster, in almost every instance.
There are other times when fraudsters will produce an electronically
transmitted credit which contain a provision for authorized signatures of bank
officers to appear at the bottom of the credit. It is highly unlikely that a
reputable bank would issue a document with this kind of error.
If you receive an investment proposal that offers standby letters of
credit at discount and you are not sufficiently convinced that after reading
the above that most if not all discounted standby letters of credit are
questionable, STOP! It is strongly recommended that you check with Thompson
Financial Bankwatch at www.bankwatch.com
or 708 933 8069 or 800 321 3373 where hundreds of banks are listed and rated.
With the information you obtain from Bankwatch, you can always ask the issuing
bank to confirm the validity of the credit. A simple step easily taken.
You could also visit the website of International Chamber of Commerce at www.iccwbo.org or 212 206 1150 or the US
Consulate for International Business 212 354 4839/354 4480 or London 44 171 823
2811 or ICC Commercial Crime Services, London 44 181 591 3000.
Not all banking instruments, and especially standby letters of credit,
have any marketable value. It is with this fact, “marketable value” that frauds
are perpetrated, perpetuated and the uninformed and unsuspecting investor is
victimized. Usually they are told that they have bought an irrevocable
negotiable instrument when in fact, the only irrevocable element is that they
cannot recall their investment funds from the fraudster.
Here is a mental check-off
list that will help you to identify basic flaws in a standby letter of credit:
Ø
Misspellings
Ø
Missing dates of issue and
expiration (maturity)
Ø
Incorrect naming of ICC
publication numbers
Ø
Citing ICC publication numbers
that are obsolete (ICC400 has been replaced by the ICC500 and ISP98, or even
more commonly, the citing of the ICC600, which does not exist)
Ø
Reference to ICC
Non-Disclosure/Non-Circumvention (ND/NC) agreements, while the ICC has never
issued such ND/NC agreements (refer to ICC 460/434 Statement of Policy articles
which refutes the existence of such agreements).
Ø
Being unfamiliar with the name of
the bank issuing the instrument and cannot confirm a satisfactory rating
through Thompson or another source
Ø
Lesser known bank’s instrument is
not confirmed by well known correspondent bank
Ø
Use of general terms and
conditions when specifics will be required to encash the instrument
Ø
Lack of transferability clauses in
letter of credit document
Ø
Looking carefully for illogical
statements, for example, requesting the signatures of bank officers on an
electronically issued instrument
If the basics are flawed and fundamentals are questionable, remember that
if the premise is fallacious then no matter how much you manipulate it, the
conclusion will most likely be fallacious, too.
Robert Alden wrote, “There is not
enough darkness in the all the world to put out the light of even one small
candle”. To which we add, there is
not enough light in all the world to illuminate and authenticate that which is
obscured in a bogus bank instrument.