Article

by Jee Meng Chen

Back-to-back letters of credit (BTB L/Cs) involve the issuance of an import L/C against the receipt of a master export L/C. BTB L/Cs facilitate the work of the middleman (usually intermediaries/traders) in buying goods from the supplier and selling to the buyer without having the need to take physical delivery of the goods (Figure 1).

While the modus operandi and technical considerations of BTB L/Cs are well covered in conventional literature, the practicalities of the trading environment and its impact on the financing bank (in particular, the middleman's banker) are not. Indeed, what if the ultimate buyer in a BTB transaction does not take physical delivery but resells the goods instead? In essence, the ultimate buyer, as depicted in Figure 1, is another trading intermediary. And it is no longer a single-dimensional BTB L/C transaction; it becomes a double BTB L/C.

Illustration of double BTB

What exactly is a double BTB transaction? Perhaps, a hypothetical illustration would be useful:

Peter Yang, a Relationship Manager with S&D Bank, was very pleased. Having spent less than two months on the job, he secured his maiden deal. The proposed transaction looked like any conventional BTB deal - purchase of Type A Fertilizers from GS Co, a reputable producer in Indonesia and selling the same to SBL, an international company in the United States. In addition, the selling points of this transaction were:

- TCL's transactional performance had been satisfactory.

- Demand for Fertilizer Type A was strong with an increasing market price. Under pressure from supply shortages, SBL was unlikely to back out.

- Both GS Co and SBL were strong counterparties with good credentials.

Everything seemed fine until one week later Peter returned to office late in the evening after a long day of marketing calls. Before he could settle down, he couldn't help noticing a MT700 placed prominently on his desk, with a red-inked writing, "Urgent! What's happening? Discuss please!"

It did not take long for Peter to realize what the urgency was, as he scrutinized the export L/C from NA Bank. There were some contentious L/C clauses, but the instructions under field 46A were what caught his attention:

"Documents Required 46A: Ocean Bill of Lading covering: Full set of three originals and three non-negotiable copies of clean shipped on board bills of lading covering... made out to the Order of Bank 456, Karachi, Pakistan ... and notify 'The Real Buyer Incorporated'... ".

The proposed deal was totally out of context, as SBL was merely a trader along the chain. This was not the typical BTB transaction that Peter had envisaged. While Bank 456 was not a direct party to the transaction, the bills of lading were to be consigned to this third-party bank. Was this acceptable?

Peter was at a loss. Should he abort the deal? On the one hand, if he called off the deal, TCL could end up with financial losses, as TCL would have issued a performance bond to GS Co., in which case how should he explain this to the customer? But on the other hand, if he proceeded with the transaction, would the bank end up assuming more risk exposure than what was originally contemplated?

Analysis of double BTB

Figure 2 illustrates a double BTB L/C issuance scenario.

At times a double BTB transaction is unavoidable, because traders thrive on price differentials and exclusive contacts. It could have been that -

- SBL needed to buy a certain grade of commodity from GS Co., but had no access to the supplier. Consequently, the only way to proceed was for it to procure the goods via TCL, as TCL had a well-established relationship with GS Co.; or

- SBL was an authorized agent for the ultimate buyer.

Considerations and issues

While double BTB transactions are tenable, banks should be cognizant of the following considerations and issues:

L/C amendment & timing issue

Generally speaking, a double BTB transaction poses a big operational challenge for the middleman's bank (in this instance, S&D Bank). Trade finance and/or credit practitioners who are familiar with double BTB L/Cs will know that the master export L/C has to be amended in a majority of cases. To illustrate, NA Bank was likely to issue the L/C with the following conditions:

- Field 31D: Date and Place of Expiry (date) at our counters in New York Branch

- Field 41A: Available with ... By ... (BIC code) NA Bank, New York Branch, US By Negotiation But for obvious reasons, S&D Bank would require Field 31D to be amended so that the L/C would expire at its own counters, i.e., Malaysia, with Field 41A to be amended to "Any Bank".

L/C amendments are not uncommon. However, getting the requisite terms and conditions amended can take time, and the receipt of the amended export L/C will then be delayed. If the middleman's bank is prudent, it is unlikely to issue an import L/C to the ultimate supplier without having received the amended export L/C. This, however, creates a problem for the middleman, as the supplier will demand to see the import L/C before loading the cargo. A stressful situation can then ensue when the vessel is waiting at the port and incurring demurrage charges by the day.

Moreover, if the timing issue is not properly managed, the latest date of shipment and the dates of expiry of the import and export L/Cs will be undesirably close to one another. The dangers are very real. The ultimate supplier may present clean documents in the nick of time, but leave no timing buffer for the middleman to fulfil his export L/C negotiation. The financing bank could end up paying for the import leg while exposing itself to potential documentary discrepancies on the export leg.

Incoterms

Knowledge of Incoterms is important, and practitioners should not ignore them. For illustrative purposes, consider two scenarios, as follows: Scenaro 1:

There are three types of FOB contracts. The most common one in use is the "modern FOB", where the seller is required to load the said goods on a vessel nominated by the buyer at the agreed port. Under an FOB - FOB sale, the danger is that the middleman will not be in control of the vessel. And unless the middleman's bank is comfortable with the creditworthiness and market standing of the intermediary, the bank may not agree to finance an FOB type of transaction. In this instance, Peter's comfort, if any, rested on the creditability of SBL. Scenario 2:

In the event the identity of the ultimate buyer is not disclosed in the export L/C, it would be preferable if the middleman were to charter and control the vessel. Under an FOB - CFR transaction, the middleman charters the vessel. This offers the financing bank greater comfort, as the client has control over the discharge of goods. In addition, where necessary the financing bank can serve notice to the agent at the discharge port, assuming that the goods have reached the port of discharge earlier than the bills of lading.

Payment & bills of lading

As the case above illustrates, the interesting aspect of a double BTB in this case is that while S&D Bank presented documents to NA Bank under the export L/C, it appeared to lose control of the underlying goods, as the bills of lading were consigned to Bank 456, a thirdparty bank. What issues were there, if any, in such an arrangement?

(i) Notwithstanding that the bills of lading were consigned to a third-party bank, the payment risk resided with NA Bank.

(ii) The export L/C required the presentation of the full set of bills of lading consigned to "The Order of Bank 456". As much as S&D Bank might try, it was unlikely to succeed in requesting NA Bank to amend the L/C and to name the consignee as NA Bank instead of Bank 456. However, as long as the consignee is not the ultimate buyer, the risk remains acceptable. In the event Bank 456 released the bills of lading to the buyer, it could not reject payment on grounds of documentary discrepancies. Moreover, S&D Bank would retain the right of recourse to Bank 456, albeit NA Bank, for mis-delivery of cargo.

Conclusion

In this case, Peter Yang survived the ordeal, though at the cost of sleepless nights. The timing of the entire transaction was very tight. The movement of the vessel, the presentation of documents, etc., were closely monitored to ensure that the vessel delivered the fertilizer to the intended destination. Peter was lucky, in that the counterparties were reliable.

In hindsight, Peter should have exercised greater caution at the outset. The rule of thumb before committing to any transaction is to always obtain copies of the purchase and sale contracts. The sale contract, in particular, would offer hints as to whether the proposed transaction is a conventional BTB or a double BTB. If the counterparties involved are unknown to the bank, it would not be prudent to proceed with the transaction.

Jee Meng Chen is a freelance writer on general banking topics. His email is guanming_insight@hotmail.com.
This article is dedicated to the late Dr Ravi Mehta.