Drafts/Bills of Exchange In LC transactions

By Kim Sindberg

Usage of drafts under documentary credits: is there a real need?

T he International Chamber of Commerce (ICC)held its technical meeting in Tbilisi,Georgia, in October,and a segment of the meeting was called "Documentary Credit Practices:Controversy & Guidance". One of the topics discussed during this segment was "usage of drafts under documentary credits: is there a real need?"

In addition to that discussion, the ICC is working on a document titled"Drafts under Documentary Credits Guidance Paper." That document has been circulated for comments by the ICC National Committees, and the deadline was set for November 23,2018.

The purpose of this article is to present some of the comments made during the abovementioned discussion, as well the recommendations in the ICC Guidance paper.

But first; a historical overview of the usage of these drafts in documentary credits:

There is no doubt that many letters of credit (LC) experts would happily get rid of drafts in documentary credits.Frankly, when you look at the history of the Uniform Customs Practice (UCP),this is not an easy task. The "draft" has had its place in the UCP since the very first version; i.e. UCP 82. In that version the "draft" is even entangled with the obligation of the issuing bank. Article 9 opens as follows:

"When an irrevocable credit is opened in the form of a Commercial Letter of Credit, the Letter of Credit itself must include notification of the opening of an irrevocable credit and constitute the definite engagement by the issuing Bank towards the beneficiary and holder in good faith to honour all drafts issued by virtue of and in conformity with the clauses and conditions contained in the document.This document may be transmitted and/or notified by another Bank without engagement for the latter." [emphasis added].

This provision assumes that a draft is part of the presentation. This is also the case, for the next version of the UCP; i.e.the UCP 151. UCP 151 makes various references to drafts, especially article 5,which opens as follows:

"Irrevocable credits are definite undertakings by an issuing Bank and constitute the engagement of that Bank to the beneficiary or as the case may be,to the beneficiary and bona fide holders of drafts drawn thereunder that the provisions for payment, acceptance or negotiation contained in the credit, will be duly fulfilled provided that the documents or as the case may be, the documents and the drafts drawn thereunder comply with the terms and conditions of the credit."[emphasis added].

A similar provision is also in the following version of the UCP, namely the UCP 222. The opening of article 3 reads as follows:

"An irrevocable credit is a definite undertaking on the part of an issuing bank and constitutes the engagement of that bank to the beneficiary or, as the case may be, to the beneficiary and bona fide holders of drafts drawn and/or documents presented thereunder, that the provisions for payment, acceptance or negotiation contained in the credit will be duly fulfilled,provided that all the terms and conditions of the credit are complied with." [Emphasis added].

This signifies a major change, in that it takes into the equation the "documents presented" as an alternative to "drafts drawn". In effect this means that a presentation can be made without drafts. Or rather, the presentation of a draft is not mandatory.

In the next version of the UCP; i.e.UCP 290, again there is a change in the approach to the draft. Still the draft is linked to the undertaking of the issuing bank. However, the role of the draft clearly has been "downplayed." Here is a quote from article 3:

"An irrevocable credit constitutes a definite undertaking of the issuing bank, provided that the terms and conditions of the credit are complied with [...] to pay, or that payment will be made, if the credit provides for payment, whether against a draft or not" [Emphasis added].

In addition to the above, the rules take into account the draft in the definition of the documentary credit:

"For the purposes of such provisions,definitions and articles the expressions'documentary credit(s)' and 'credit(s)'used therein mean any arrangement,however named or described,

whereby a bank (the issuing bank),acting at the request and in accordance with the instructions of a customer (the applicant for the credit),

i. is to make payment to or to the order of a third party (the beneficiary), or is to pay, accept or negotiate bills of exchange(drafts) drawn by the beneficiary, or

ii. authorizes such payments to be made or such drafts to be paid, accepted or negotiated by another bank, against stipulated documents, provided that the terms and conditions of the credit are complied with." [emphasis added].

As was the case in UCP 222 the provisions in UCP 290 introduce drafts as an alternative to "make payment".This means it is not mandatory to use the draft - it is only a possible alternative.

UCP 400 seems to balance drafts more or less the same way as its predecessor.It is mentioned as an alternative and mentioned in the definition of a documentary credit and in the undertaking of the issuing bank, linked to the availability of the documentary credit. Limited to the situations where the documentary credit is available by acceptance or negotiation, the latter is balanced as follows in article 10(a)(iv):

"[...] if the credit provides for negotiation - to pay without recourse to drawers and/or bona fide holders,draft(s) drawn by the beneficiary, at sight or at a tenor, on the applicant for the credit or any other drawee stipulated in the credit other than the issuing bank itself, or to provide for negotiation by another bank and to pay, as above, if such negotiation is not effected." [emphasis added].

UCP 500 included similar provisions as UCP 400, with minor drafting changes.The major change, in respect of drafts,was to clearly state the obligation of the confirming bank in addition to that of the issuing bank.

Additionally, when the UCP 500 came into force it was accompanied with the publication "Standard Documentary Credit Forms for the UCP 500." This offered examples of standard application forms for documentary credits. In respect to drafts, the Guidance Notes stated:

· A sight payment credit may require presentation of documents without any drafts. The 'box' calling for a draft should only be X-marked if the applicant's instructions stipulate a draft.(An additional comment was made that, at times, because of stamp duties,it is necessary in certain countries to issue credits available by sight payment without calling for drafts.)

· A deferred payment credit will call for documents to be presented but not for any drafts.

· If the credit is to be available by acceptance, the applicant should call for drafts.

· A credit may authorize another bank to negotiate with or without the credit calling for drafts. In a negotiation credit, the 'box' calling for a draft should only be X-marked if the applicant's instructions stipulate a draft.

· For freely negotiable credits, if drafts are to be required, the drafts may be stipulated to be drawn on the issuing bank or, if the credit is to be confirmed,on the confirming bank.

· The beneficiary's draft 'box' must be X-marked if either of the following'boxes' has been X-marked: 'available by acceptance' or 'available by negotiation(with drafts)'.

The above clearly supports the path from the previous versions of UCP where the draft is not mandatory - but rather an alternative that can be required when actually needed.

The UCP version in force today - the UCP 600 - makes clear that nominated banks are authorized to accept or incur a deferred payment undertaking and that the nominated bank is authorized to prepay or purchase such a deferred payment undertaking.

The conclusion of the above is that the UCP rules have evolved over the years,and the draft is no longer a mandatory requirement apart from documentary credits available by acceptance. In addition to that, UCP 600 even allows financing via prepayment of a deferred payment undertaking - i.e. financing not based on a draft/bill of exchange.

The Tbilisi Notes

As indicated in the introduction, the usage of drafts under documentary credits was discussed during the ICC technical meeting in Tbilisi in October.Here is an overview of some of the comments and arguments made:

· More often than not the requirement for a draft in a documentary credit is triggered by the policy of the issuing bank. At the meeting one bank reported that it had removed the draft from the documentary credits issued by them.This had created no reactions.

· There are some situations where a draft is necessary - when the documentary credit is available by "acceptance" for example. This is defined as follows: "[...] to accept a bill of exchange ("draft") drawn by the beneficiary and pay at maturity if the credit is available by acceptance" (UCP 600 article 2, definition of "honor".)

· The draft/bill of exchange is covered by Section B (drafts and calculation of maturity date) in International Standard Banking Practice 745. Paragraph B1 (b) sets the standard for examining a draft, which is different than the standard that applies to the rest of the presented documents. This one reads:

"Banks only examine a draft to the extent described in paragraphs B2-B17."

· There are many examples where the data in the draft is used to refuse a presentation under a documentary credit.

· There are even examples where more presentations are refused than necessary, where multiple sets of presentations - covered by one draft- were made. In such case it is in fact one presentation. Since all presentations are covered by (only) one draft, there is no middle ground: The bank must refuse all presentations - or accept all the presentations.

·In respect of the two bullet points above it seems wrong and unfair to refuse a presentation under a documentary credit, when the draft is not added to the credit based on an instruction from the applicant - but is based on the internal policy of the issuing bank.

Drafts under Documentary Credits Guidance

As mentioned in the introduction the ICC is working on a document titled "Drafts under Documentary Credits Guidance Paper," which has been circulated for comments by the ICC National Committees. The document in its current form offers a very thorough and sober analysis of drafts in documentary credits. On that basis the recommendations seem well thought-through and hereby recommend the following:

Here is an overview:

"Ordinarily, a UCP 600 documentary credit need not require a draft be presented together with the stipulated documents. Accordingly:

1. It is recommended that the[longstanding] habit of requiring a draft for a documentary credit available at sight be curtailed, particularly sight drafts drawn on an issuing bank,confirming bank, or a bank nominated to pay.

2. UCP 600 article 2 allows for negotiation to occur under a documentary credit available by negotiation with or without a presentation of a draft. It is recommended that the habit of requiring a sight draft for a documentary credit available by negotiation be reviewed and that negotiating banks be encouraged to rely, not on negotiable instruments' law,but instead on specific agreements with beneficiaries evidencing negotiation and their respective recourse and other rights and remedies.

3. UCP 600 article 12 (b) supports the prepayment of a deferred payment undertaking. As such, it is recommended that banks issue usance documentary credits available by deferred payment as an alternative to availability by acceptance of a draft, unless there is specific commercial, regulatory or legal reason to create a bankers' acceptance.

4. All banks should review their UCP 600 documentary credit forms,whether in paper format and/or online,to indicate that a draft is not a standard requirement of the issuing bank and to indicate their requirements for a nonnegotiable form of demand."

Conclusion

Fair to say, the above paints a very distinct picture about the draft. It is an instrument that - in one form or another - has been part of the documentary credit for at least 85 years.It represents a practice that is difficult to change, regardless of the facts and arguments that would support removing drafts from documentary credits.

It is apparent, however, that the ICC document "Drafts under Documentary Credits Guidance Paper" is the strongest and most convincing attempt to make changes to date. Let this article be my voice in supporting the ICC in only calling for a draft when there is a commercial or UCP 600 reason to do so.

The author is technical advisor to the ICC Banking Commission