Documentary Credits – when they don’t pay up

The continuing liquidity crisis in the banking sector and the volatility experienced in the world’s commodity markets has produced a toxic mix of unpredictable prices and limited funds for some buyers to meet their payment obligations. More recently we have seen oil prices falling from their peak achieved earlier in the year while certain agricultural commodities have remained at record highs.

There have already been some financial casualties in the commodities trades as these market conditions bite and the strength of payment obligations in contracts will increasingly be tested. Many in the commodities trades and the trade finance sector have not lived through a similar credit crunch phase so now is a good time to focus on how we manage the stress points that creep into international sale of goods contracts and related finance instruments when markets move and credit lines are tight. In this first of four briefings we look at the practice of managing documentary credits when the issuing bank can’t or won’t pay.

A secure payment method ?

Documentary credits only provide a secure method of payment if they are issued or confirmed by a bank which is an acceptable credit risk itself and the beneficiary is in a position to present the documents that have been requested. If the issuing bank in an unconfirmed credit becomes insolvent or is unable to raise foreign currency to meet its obligations then the beneficiary will only be paid if it has had the foresight to obtain payment from the nominated bank on negotiation (or silent confirmation) of the credit documents without recourse or it is able to extract payment from the buyer direct. The presentation of compliant documents is largely something that is in its own hands, however, and if it does not possess the expertise to pre-check its documents before presentation then its bank will often make that service available – and it will come with the territory if the bank is itself financing the goods and relying on the proceeds of the credit to liquidate the trade finance loan.

Won’t pay?

Issuing banks are liable to pay once a presentation of documents is made which complies with the terms of the credit. In a stressed market however, the pressure on the bank (and the individual account officers) may be considerable. While the UCP 600 was revised in terms that the ICC Banking Commission hoped would eradicate unmeritorious discrepancies, there is sufficient room for discussion on a large number of issues to make the companion ISBP (International Standard Banking Practice) - which acts as a practical guide to examination and acceptability of documents presented under documentary credits – an indispensable resource for those presenting and checking documentary credits. In a tight corner, with an applicant whose creditworthiness now looks suspect and a cargo whose value has dropped significantly off the contract price payable through the credit, some issuing banks will be tempted to dig out some questionable discrepancies. Alternatively they might (depending on the jurisdiction) claim that they have been restrained from paying by a local court order or as a result of interference from the authorities. These are not common occurrences but it is important to appreciate the potential risk and how to react.

First steps

If a questionable discrepancy has been raised are we in time to solve the problem by getting another document or is time and the nature of the alleged discrepancy against us? If an original transport document is one of the documents then time normally runs out 21 days after the shipment date or the date of expiry of the credit whichever the earlier. Assuming that a fresh presentation is not an option and we take the view that the discrepancy is untenable, have the 5 banking days now allowed to the examining bank for the examination/acceptance or rejection of the documents yet expired? If not then let them expire. A quick smart answer to the discrepancy might make them pay up but on the other hand it might also make them review the documents again and spit out a new complaint. Once the 5 days are up the examining bank is stuck with the discrepancies it notified within the period. If they notify poor discrepancies during the 5 days period and miss a valid one that is their problem.

Weighing up the options? Sue for the credit sum or retire the documents?

If the credit called for original transport/title documents and these are lying unpaid and rejected at the counters of the issuing bank then the beneficiary or the nominated bank (if that bank now effectively owns the documents through negotiation) has an important decision to make which may well dictate how the dispute will be resolved. When an issuing bank fails without justification to honour its credit the presenter of the unpaid documents can either (1) sue the issuing bank for the full value of the drawing under the credit and leave the documents at the issuing bank’s counters or (2) collect the wrongly rejected documents and sell the goods they represent before claiming the shortfall between the net sale proceeds and the amount payable under the credit as “damages”.

The choice of action will be determined by a number of factors:

1. Where the goods are still afloat

If the sale is on CIF terms and the vessel has not discharged then on a practical level the seller (or its bank) will face a dilemma. If the issuing bank does not relent and take up the documents and pay (and the buyer refuses to accept the goods) then the cargo will remain undischarged and the seller will likely face a mounting demurrage detention bill. Depending on the nature of the cargo (is it perishable?), the credit position of the seller (is its bank getting nervous about liquidating the advance?), and the willingness of the shipowner to allow his ship to be used as floating storage (does he have another fixture lined up?) the cautious approach might well be to take back the documents and mitigate the potential loss by selling the cargo and claiming damages against the bank. There have been cases where the English court has heard discrepancy cases in record time while the cargo remains on board but the court process would have to be lightning fast, the cargo stable and the sum involved significant when compared to the mounting demurrage costs to warrant that course of action. The delay in getting to court might be considerable. If the issuing bank is unsure about its discrepancies this is the point where they are likely to review their decision since losing the claim would leave them having to pay for a cargo in perhaps four months time devalued through delay and demurrage.

2. Where the goods are discharged

In many trades the practice is to discharge against a Letter of Indemnity (LOI) before the documents have been presented. In that case the buyer will already have resolved one of the problematic areas ie the detention of the vessel. The CIF seller will no longer have the burden of demurrage costs round his neck. The continued non-payment will still concern him (and his bank) but if he is certain of his ground on the discrepancies he can now choose to commence a claim against the issuing bank. The cause of this sort of stand-off is often a dispute in the underlying contract. Documentary credits issued under UCP 600 deal with documents rather than goods or services so the entitlement to receive the full payment will be independent of the fact that the goods may be ruined or uncontractual. The parties to the sale contract will have to settle their differences in court and arbitration.

3. Where the applicant has a court order preventing the issuing bank from paying

Price swings and injunctions for alleged fraud used to go hand in hand in certain jurisdictions but happily are now less common. The almost global practice is now that a court will not injunct an issuing bank from paying unless it is shown evidence of fraud related to the goods or documents which is know to the presenter of the documents at the time of presentation. Changes brought in by UCP 600 mean that once the negotiating bank has paid in good faith (even on a deferred payment credit) there is no basis upon which an applicant can enlist the help of the court to prevent payment. The key consideration in the face of a local court injunction is therefore who is asking for payment? If the documents have been presented by the negotiating or confirming bank after they have paid or incurred a deferred payment undertaking then a court order against the beneficiary will be of no effect. If the presentation is made as agent for the beneficiary then the situation will need to be addressed. In either case, if the credit provided for negotiation in London then the court which will have jurisdiction to determine the dispute will be in London. If the issuing bank has a branch in the UK or has branches in jurisdictions which will recognise and enforce an English court judgment then it is open to the unpaid presenter of the documents to sue for the entire credit sum in London and ignore the local court order (subject to any local exposure it may have in that jurisdiction). Applying in foreign courts to discharge court orders can be a frustrating and costly business with mixed fortune. If you don’t have to travel to enforce your rights under the credit then don’t. It’s kinder on the environment too.

4. The case for negotiation/confirmation

A key consideration for a seller and its bank is the relative strength of position enjoyed by the bank seeking reimbursement as compared to the position of seller/beneficiary. The seller is entitled to treat the issuing bank’s obligation under the credit as independent of the underlying contract but in practice, if the applicant/buyer obtains a court order locally and the issuing bank has no overseas branches to speak of then enforcement could prove difficult. Recourse to the courts in the issuing bank’s country even when enforcing an English court judgment would very probably prove troublesome. The seller’s bank seeking reimbursement however will not be mired in the underlying contract dispute even if it is forced to go to the local court to discharge the injunction. The fees payable to the nominated bank for negotiation/confirmation can sometimes prove very worthwhile.

Checkpoints

  1. Ensure your credit is negotiable in London or a banking centre you are prepared to start proceedings in if a dispute arises. That’s the location where any dispute with the issuing bank will then be dealt with.
  2. Consider open or silent confirmation/negotiation with your bank. Their claim for reimbursement will generally carry more weight with the issuing bank – you will have been paid in the meantime.
  3. Risk manage your documentary presentation and logistics – if documents are going to be rejected you don’t want to find out as the ship waits at the discharge port if it can be avoided. Your options in terms of pursuing a claim will be reduced.
  4. If a discrepancy is raised unfairly – don’t panic. Think through the options and the timing of your response.
  5. Get your risk/legal department involved early – whichever side of the argument you are on. The choices made in the first few days will colour the outcome.