Article

"Non-bank issued L/Cs are not inherently riskier..."

by Ali Polat

The issuer of an L/C can be defined either by what it is or what it is not. Calling an issuer a "non-bank" is an example of the latter; calling the issuer a "corporate" indicates what the issuer is. In any case, the matter can be ambiguous, since the definition of a "bank" or "corporate" may differ from one place to another.

Traditional L/C

The traditional L/C has long been used in international trade. In a simple L/C transaction, the applicant (buyer) gives its instruction to its bank (issuing bank) to issue an L/C in favour of the beneficiary (seller). In UCP 600, as in previous revisions, the applicant is not a party to the L/C, although it is the initiator of the whole process by its giving instruction to the issuing bank. The idea behind this is a reasonable one: the relation between the applicant and the issuing bank is one thing, and the responsibility of the issuing bank toward the beneficiary or confirming bank is another.

Upon shipment, the beneficiary presents the documents to the issuing bank, either directly or through another party, typically a confirming/nominated/advising bank. The issuing bank examines the documents to determine if they comply with the L/C requirements. If the documents comply, the issuing bank pays the beneficiary and delivers the documents to the applicant, and reimburses itself by withdrawing the funds from the applicant's account.

While the procedure means that the importer pays under the L/C if all of the terms and conditions have been met, it also means that the exporter must strictly obey the L/C terms and conditions to receive payment. Because the L/C process from issuance to payment is complicated, drafting an L/C consistent with the UCP and/or the ISBP is not a piece of cake. Without proper training and understanding, the operation may not succeed.

Non-bank (corporate) L/Cs

This brings us to the question of L/Cs issued by corporate/non-bank institutions. Among L/C practitioners, the subject has become more important, since financial deregulation has gradually lowered the barriers between different categories of business, financial organizations and instruments1.

Non-bank issued L/Cs are not inherently riskier than L/Cs issued by banks. It depends on the expectations of the parties and their financial circumstances (country risk, credit risk, etc.). There may be cases in which a non-bank can be more stable than a bank, particularly in the current economic climate. As long as the beneficiary is aware of the difference between a non-bank issued L/C and the traditional letter of credit, no problem will arise.

However, when applicant and the issuer are the same party, this does not accommodate traditional letter of credit logic, and that is not good for the beneficiary accustomed to the traditional L/C mechanism.

However, using a non-bank issued L/C, if not identified as such, can be risky for an unwary beneficiary who has been led to believe that the instrument was issued by a bank2. If there is fraud or an insolvency of the issuer, the beneficiary might seek to sue the advising bank that advised the non-bank L/C, the applicant and/or the issuing party. (This being said, it would be a rare case if a non-bank issuer became insolvent.)

Carlo de Ninni, a member of the ICC Banking Commission, claimed that it would have been simple to address the issue with a new article in the UCP stating that an issuing bank can be a non-bank. This would have been clearer, more logical and would not have affected the general focus of the new rules3.

ICC Opinions

The most detailed ICC view on non-bank issues can be found in the official Opinion of the ICC Banking Commission of 30 October 20024, which concluded that "It does not 'violate' the UCP for a non-bank to issue a credit subject to the UCP even though such issuance is not contemplated in the rules." Nonetheless, this still constitutes a problem for the exporters who cannot clearly distinguish a bankissued L/C from a non-bank one on a SWIFT message.

During the drafting process of the UCP 600, the UCP Drafting Group first used the word "party" rather than "bank" in describing issuers of L/Cs. On the strength of objections by ICC national committees, however, the term "bank" rather than "party" was retained. However, this does not necessarily mean that non-banks (i.e., a party that is not a bank) cannot issue L/Cs. In fact, this is a common practice used by large US companies with their Asian suppliers5.

Donald Smith6 claims that the main threats to traditional bank letters of credit are purchase order/open account trades and corporate L/Cs. It is possible for buyers to transmit their corporate L/Cs through an advising bank's system, so that a bank in the seller's country, receiving a SWIFT-formatted MT710 message might automatically generate an advice of an L/C addressed to the beneficiary and evidencing an issuing bank.

SWIFT and non-bank issued L/Cs

The question of non-bank-issued L/Cs and SWIFT Standards was considered at SWIFT's Trade Finance Maintenance Working Group meeting of 7 September 2004. At this meeting, the Working Group concluded that Category 7 messages may not be used to advise non-bank issued L/Cs7. Referring to ICC Opinion 470/ TA537rev of October 2002, and taking heed of the possibility of misleading the beneficiary by the use of standard L/C advising formats, SWIFT concluded that the Category 7 Standards cannot comply with the ICC Opinion and that therefore the standards cannot be used to cover non-bank issued L/Cs.

However, the Group reversed its earlier decision at the request of the US banking community, among others. As a business practice, non-bank letters of credits are used more widely in the US than in any other country. Therefore, such a decision made by SWIFT would have restricted US and other banks from providing a full range of trade services to their customers. The decision, it was claimed, would not only affect US banks, it would also restrict banks in other countries from enhancing their service offerings. As a temporary solution, a rule making clear that it is the responsibility of the sender of the MT710 and 720 messages to inform the receiving bank about the issuer's non-bank status was decided on8. Until it comes into effect, the sender should specify in free text form in field 52D, "Issuing Bank", when the issuer is a non-bank and should also mention the name and address of the non-bank issuer in field 47A, "Additional Conditions"9.

The SWIFT MT Standards of October 2007 describe the scope of MT 710 as one involving a message sent by an advising bank, which has received a documentary credit from the issuing bank or the non-bank issuer, to the bank advising the beneficiary or another advising bank. The message should be used to advise the Receiver about the terms and conditions of a documentary credit.

The Standards also indicate that:

- when an MT 710 exceeds the maximum input message length, additional information should be transmitted via up to three MT 711s;

- if a message is used to advise a non-bank issued documentary credit, field 50B must be used10;

- the advising bank must advise a documentary credit, including all of its details, in a way that is clear and unambiguous to the beneficiary.

Conclusion

In 1995, Howard Palmer, writing in International Trade Finance, said: "To the trade finance practitioner of the 1970s, today's trade financing has become a completely different industry."11 If that was true in 1995, it would be even more striking for trade finance practitioner of the 1970s to observe today's practices.

While non-bank issuance and such credits are proper in the US if not issued by the beneficiary of the L/C itself, this does not necessarily mean that all non-bank L/C issuers are equal, just as not all bank issuers are equal.

There is no basis in any law or practice that creates special rules favouring non-bank issuers and non-bank operations. There may be advantages and disadvantages of non-bank issued L/Cs for the parties. In any event, the issue needs more attention and discussion. The point is that the beneficiary who is not aware of what he has received runs the risk of being in possession of a strange instrument in which both the issuer and the applicant are the same party.

Ali Polat, PhD is in the Foreign Transactions Operation Department of Turkiye Finans Katilim Bankasi in Turkey. His e-mail is ali.polat@turkiyefinans.com.tr

* I would like to thank Kim Christensen for his review and valuable comments on the article. Any remaining errors are mine.

1. Michael Rowe, Letters of Credit 2nd editon, Euromoney Publication PLC, pp.63-64.

2. Documentary Credit World, September 2005, pp.3-4.

3. Carlo di Ninni, "Some real problems with the definition of 'bank'". The Insight Interview, DCInsight Vol. 12 No. 2 April-June 2006.

4. ICC, "When a non-bank issues a letter of credit" http://www.iccwbo.org/id525/index.html (12 August 2008).

5. R oger Kreitman, "UCP 600: The end in sight?" in October 2005, p. 7. (Letter of Credit Law Developments, Carter H. Klein, www.jenner.com).

6. Donald Smith, "Open Account Trade, Purchase Orders & The Future of Letters of Credit", http://focus.dcprofessional.com/.

7. "Non-bank-issued letters of credit and SWIFT standards" http://www.swift.com/index.cfm?item_id=43320.

8. "Non-bank-issued letters of credit accommodated by Swift" Posted 28 December 2004 http://www.swift.com/index.cfm?item_id=43491.

9. "Non-bank-issued letters of credit", Posted 17 May 2005 http://www.swift.com/index.cfm?item_id=57062.

10. Either field 52a "Issuing Bank" or field 50B "Non-Bank Issuer", but not both, must be present. Otherwise, this will cause error code C06.

11. Howard Palmer, International Trade Finance: A practitioner's Guide, Euromoney Publication PLC, 1995, p. 13.

"[Non-bank L/Cs:] what is the added value?"

by Donald Smith

The UCP 600 Drafting Group attempted to recognize that they were writing rules for a financial instrument, the letter of credit, rather than writing rules for bankers. After all, most nations' laws recognize the right of contract - a buyer and seller may choose to enter into a commercial agreement and to subject that agreement to any one of a number of sets of established rules or laws. The UCP 600 is the internationally recognized set of rules of letters of credit, and nothing in the rules prohibits an issuer that is not a bank from issuing a letter of credit and making it subject to the UCP 600.

Credits issued by parties other than banks do have somewhat interesting considerations for the beneficiary. For example, a credit issued by the buyer of the goods appears to add little, if any, value to the beneficiary. If the buyer is going to pay for the goods he has contracted to purchase, it is unclear to me how a letter of credit from the same party will enhance the beneficiary's decision regarding whether or not to ship. How "independent" can the credit be from the contract and the buyer's self-interest?

On the other hand, there are companies that are not banks that issue letters of credit for their clients. For example, some internationally renowned firms, primarily engaged in the movement of goods, are also known to issue letters of credit for their importing clients. Such a credit, subject to the UCP 600, may be truly independent of the underlying contract and provide a beneficiary with a true third-party undertaking to pay against complying documents. Such credits are routinely issued and made subject to the UCP 600.

In light of today's economic situation and the failure of even some highly regarded bank names, it is no wonder that beneficiaries are looking to receive a letter of credit from the most creditworthy issuer - and that issuer may not be a bank.

Were I a beneficiary of a credit issued by my trading partner, the buyer, I would have to ask myself: "What is the added value?" If such a credit were issued by a third party, not a bank, I would ask the same question.

Donald Smith is Vice President, Client Services at Norman Technologies in North Carolina (US) and Chair of the Banking Committee of the United States Council for International Business. The views herein are strictly his own. His e-mail is don.smith@normantech.com