Thursday, April 25, 2013

Redefining 'negotiation'

The term ‘negotiation’ has defied definition since its inception. As far back as the early 1980s people have been asking what negotiation was supposed to mean. Integral to the meaning of negotiation is the issue about recourse payment. The confusion about correct interpretation and application of the term ‘negotiation’ is not confined to laymen like me, but has troubled some of the experts in the business.
Ole Malmqvist, a member of the UCP Drafting Group for UCP 600 says, 
.... there has been an extended discussion about the word negotiation, which nobody can define and which only a few want to get rid of.... I'm still looking for someone who can explain to me the difference between payment and negotiation .... so far no one has been able to come up with a definition, not one I have seen, at any rate, so I doubt that anyone will be able to come up with a definition now .... I suggested that we get rid of the word negotiation.... The word ‘negotiation’ is a problem.... In short, I think we should get rid of the word ‘negotiation’ because we cannot define it and because we don't need the concept….
“Every L/C expert knows exactly what negotiation is/means. But ask any three of them for their interpretation and be prepared to receive three different answers! (Yet another reason to get rid of the term ‘negotiation’!) No one has been able to come up with a definition that everyone can agree on,…..”.(DC Insight)
Reinhard Längerich commented[i]
“I am convinced that by removing the term 'negotiation' and 'the right of recourse against the beneficiary' [from UCP], we would make the letter of credit a more reliable instrument.”
Robert M. Rosenblith, Esq. says[ii]
“Essentially, it was (and still is) my opinion that unless a bank ‘negotiates’ without recourse, it is merely a collecting bank. …..Negotiation is intended to confer a benefit on the beneficiary by affording it a final payment, the same type of payment an issuer makes. Any payment that can be recovered (absent for fraud) is not a final payment.”
Negotiation: A flawed definition
“Negotiation” is defined in Article 2 of UCP 600 as follows:
“Negotiation means the purchase by the nominated bank of drafts (drawn on a bank other than the nominated bank) and/or documents under a complying presentation, by advancing or agreeing to advance funds to the beneficiary on or before the banking day on which reimbursement is due to the nominated bank.”
As if the confusion about the meaning of the term, since it was created, was not enough, now we have serious problems with the definition itself. The definition appears to have serious flaws, for reasons stated below:
(1) “Negotiation means the purchase….of drafts (drawn on a bank other than the nominated bank)…and/or documents …etc.” I believe that ‘negotiation’ and ‘purchase’ have different implications, hence cannot be interchanged. The term ‘negotiation’ implies advancing funds under some sort of mandate or authorisation (e.g. a letter of credit) from a third party. The term ‘purchase’ is used where a mandate or authorisation is absent in a transaction (e.g. purchase of collection bills under URC 522).
(2) “Negotiation means the purchase….of…by advancing or agreeing to advance…”: Nowhere in the banking industry an agreement to advance is equated with the release of an advance facility, the creation of a liability. An act of ‘purchase’ is by no means the same as merely ‘agreeing to advance funds’. The ‘agreement to advance’ is the culmination of a formal process leading up to, but not the same as, the actual release of an advance. The former includes application, appraisal, approval, sanction letter (communicating type and ceiling amounts of facilities approved, terms and conditions), execution of documents, creation of securities, legal formalities and so forth.
The communication of sanction (say, to the beneficiary) is the act of formally “agreeing to advance funds to the beneficiary”, or of non-fund (i.e. fee based) facilities. This facility may include an LC limit, negotiation (if under LC) or purchase (if not under LC) of export bills – depending on what the borrower wants and the lending bank approves. However, everything said and done, it is no more than an agreement. It is not the same as an actual risk exposure by the lending institution.
It must be appreciated that an exporter’s cash flow problem cannot be solved by a mere ‘promise to pay’. ‘Agreeing to advance funds on a future date’ does not help the exporter receive money against export bills, funds to pay salaries or cash to his suppliers.
T O Lee’s says[iii], “Some beneficiaries in the US ask the nominated banks to issue a written undertaking to agree to negotiate when it is needed by the beneficiary at a future time if the documents comply. This is done to prepare a ‘finance umbrella’ whereby funds can be used to purchase raw materials or buy goods from other parties, etc. That letter to undertake to negotiate in case of need is sort of an ‘agreement to advance fund.”
I am in complete agreement with him. Banks do not encourage ad-hoc request for financial facilities. A formal process as described above is the general practice. The letter of approval or sanction (as referred by T O Lee) issued by a bank to a prospective borrower is not only an undertaking “to negotiate in case of need”, is not only a “sort of an ‘agreement to advance fund’”, but is a formal communication of an arrangement (being in place) to release the funds/facilities as and when requested by the borrower.
To reiterate, till an advance is actually released by a bank and availed of by a borrower, until and unless an actual (fund based or fee based) liability is created, there is no advance (outstanding) in the books of a lender. When drafts or documents are purchased, that is an act of advancing by a bank. When an advance is given, money moves – from the lender to the borrower; an actual, tangible, specific, determinable, quantifiable liability is created. Where an LC is issued a clear liability, a risk exposure, comes into being. Capital adequacy requirements come into play. Hence, ‘purchase’ by the nominated bank can never be equated with a bank merely ‘agreeing to advance funds’. Where there is nothing but a mere “agreement to advance funds”, there is no risk exposure, the issue of recourse or non-recourse negotiation does not arise, there is no issue about paying back; Basel norms are not applicable. For similar reasons, I beg to differ with the observations of Glenn Ransier[iv] (“…so I agree, in writing, …etc.”) on negotiation.
If we accept the definition of ‘negotiation’ in Article 2, if we equate advancing funds with an ‘agreement to advance’, can a confirming bank (for example) – by simply agreeing to advance funds (at a future date) – said to have ‘negotiated’? Can we apply the term ‘without recourse’ to such ‘negotiation’ (agreement to advance)? Obviously not; but then the issue is, why not!
For reasons just stated, a mere agreement to advance, under no circumstances can be equated with an (outstanding) advance. The two are different things altogether. Therefore, I am unable to agree with Sheilar’s comment[v] that “…‘agreeing to advance funds’ should be deemed as another form of ‘purchase’.” A transaction that stops only at the stage of an agreement (to advance), short of the actual lending of funds, cannot be construed as ‘negotiation’ – whatever the circumstances.
(3)  “…on or before the banking day on which reimbursement is due to the nominated bank”:
I agree with comments[vi] by WangXuehui (Ofei) on this issue. Where the value date for both the receipt and the release is the same, a bank’s books will never show a liability or advance outstanding in its books. Where the negotiating bank “effects payment after receiving issuing bank’s cover” it is not advancing funds to the beneficiary; in reality paying out money that is actually the beneficiary’s own. Sheilar’s assumption[vii] that “that bank is still a negotiating bank provided that it has actually paid the beneficiary with its own funds”, therefore, appears misplaced. The transaction is absolutely no different from paying a drawer on the realisation of the proceeds of a documentary collection. Such a bank is not out of pocket, takes no risk, has no exposure, creates no ‘position’. The beneficiary has no liability or obligation towards the bank.
More confusion about ‘negotiation’
The UCP provisions on examination and forwarding of documents are as follows:
(a)“Negotiation means the giving of value for draft(s) and/or document(s) by the bank authorised to negotiate. Mere examination of the documents without giving value (emphasis mine) does not constitute a negotiation.” (UCP 500, sub-article 10.b.ii).
Has this principle undergone a change in UCP 600? What should be defined as ‘giving value’?
(b) UCP 600, sub-article 12(c), states: “Receipt or examination and forwarding of documents by a nominated bank that is not a confirming bank does not …. constitute honour or negotiation.”
(c)  And now our favourite definition (Article 2 of UCP 600): “Negotiation means the purchase by the nominated bank of drafts (drawn on a bank other than the nominated bank) and/or documents under a complying presentation, by advancing or agreeing to advance funds to the beneficiary…etc.”
Does this “agreeing to advance funds to the beneficiary” come with any obligation or commitment on the part of the ‘negotiating’ bank? Are they really worth anything? For indications, refer to FAQ on UCP 600 by Gary Colleyer:
Question no. 2.15: “What are the consequences, if any, when a nominated bank negotiates documents and agrees to advance funds to a beneficiary but fails to do so on or before the banking day reimbursement is due to the nominated bank?”
Suggested answer: “A nominated banks give no undertaking to negotiate, unless they have confirmed the credit or communicated their agreement to act, on a without recourse basis – in accordance with sub-article 12(a). The fact that a nominated bank agreed to advance funds on a future date (i.e., on or prior to the date reimbursement was due) does not bind that bank to acting accordingly on the date the advance was expected or due (emphasis added).”
Clearly, such agreements or promises to advance funds, if they do not bind the bank and can be rescinded at will, are meaningless and should have no value. It would be foolhardy for a beneficiary to rely on such ‘promises’ to plan his cash-flow or his expenditure.
Yet, this nebulous ‘agreement’ makes all the difference to our definition of what ‘negotiation’ is. It is strange logic that a revocable promise or agreement to provide value (extent of exposure still indeterminate) on any future (but indeterminate) date earns itself the definition of ‘negotiation’ (Article 2). Whereas, sending the very same documents ‘on approval basis’, or for acceptance by the issuing bank (well before fund is provided to the beneficiary), does not. Note that in both instances the nominated bank does not transfer funds to the beneficiary, creates no liability. Yet, what distinguishes the two is a mere agreement without any binding commitment.
Oh, what a tangled web we weave…!
Let us examine another related issue, as follows:
1. Let us imagine a situation where a bank “agrees to advance funds” and forwards documents as required by Article 15. Later, prior to the date when reimbursement is due, it rescinds the agreement. Is it still a ‘negotiation’ in the eyes of the UCP?
2.  According to Ofei[viii], “In China, many banks forward the documents to the issuing bank after examination of documents and credit the funds to the beneficiary’s account after they receive cover from the issuing bank.”
Should the foregoing be defined as ‘negotiation’ under the UCP? Not so, if we go by sub-article 12(c). Would an ‘agreement’ between the bank and the beneficiary make any difference; in what way does it matter to the issuing bank, anyway? However, if there is no negotiation (under sub-article 12.c), where does it place the issuing bank vis-à-vis the LC and the UCP?
3.  Allow me to refer to question no. 2.11 (FAQ on UCP 600 by Gary Colleyer): “An issuing bank accepts a complying presentation and communicates the maturity date to the nominated bank, post which the nominated bank negotiates. Is this covered under the current definition of negotiation?”
Suggested answer: “Article 2 refers to negotiation being the purchase of drafts and/or documents under a complying presentation. Sub-article 12(c) states that the receipt or examination and forwarding of documents by a nominated bank do not constitute negotiation. If, at the time of presentation, a nominated bank is not willing to act on its nomination, which in this case is to negotiate a complying presentation, then they should request the issuing bank in their covering schedule to authorise their negotiating on receipt of an advice from the issuing bank that documents have been accepted by them.”
[So, must we now introduce a new element, an authorisation from the issuing bank, to justify the delayed release of funds as negotiation under the UCP?.]
“…The definition of the term “Negotiation” suggests that it is to be made (whether in the case of an advance of funds or an agreement to advance funds) against the draft and/or documents…. As one cannot “purchase” a draft/documents which have already been sent to the issuing bank or have already been received by said bank or the applicant (emphasis added).” (Pavel Andrle, international trade finance consultant and trainer and Secretary of the Banking Commission of ICC Czech Republic)[ix].
In reality, banks do advance funds by passing entries after drafts/documents have been already been sent by them and are no longer in their physical possession. Although not clearly defined by the UCP, such practices are not against the banking laws of most countries. The real issue, however is, can these (deferred) transactions be termed as negotiation? Article 15 (especially sub-article 15.c) does not say so.
Why an LC?
Primarily, an LC serves two distinct purposes. The first concerns the beneficiary’s performance under the credit, coupled with his aim to secure payment against certain risks; the issue is between the beneficiary and the issuing bank. The other, is to facilitate financing. This latter is a business decision, an arrangement exclusively between the beneficiary and the nominated (financing) bank.
With regard to the first, it is hardly of any concern to the issuing bank whether the nominated bank has negotiated or has agreed to advance funds. Whether banks agree to “advance funds to the beneficiary [on or] before the banking day on which reimbursement is due to the nominated bank”, negotiates, advances, purchases, provides a ‘finance umbrella’, gives overdrafts against export bills, pre-pays (sub-article 12.b), really makes no difference to the issuing bank or to the utilisation of a documentary credit. Its obligations under Article 7 – especially under sub-article 7(b) – continue. Frankly, the issuing bank is entitled to insert in the credit any stipulation that is within its authority. But matters on financing (barring Red Clause credits) are surely not one of them!
It should be the “beneficiary’s choice to obtain financing only on some determined future date due to their own practical reasons such as a liquidity arrangement and their own budget of funding cost (Sheilar[x])”. As Donald Kurtz[xi] says, “It is their business decision when, if, and how to purchase the drawing. …Is it the beneficiary who is asking his banker to purchase the drawing? That’s between him and his banker, including the w/ or w/o recourse issue”.
Regarding payment with or without recourse, this too is a matter between the nominated or confirming bank and the beneficiary. Adding confirmation, a nominated bank’s ‘obligations’ under sub-article 12.a etc. do not change the issuing bank’s obligations to the beneficiary under a documentary credit.
Hence, as Kurtz succinctly puts it[xii], “I am wondering what the problem is, and who it is that has the problem. It seems that the process is working fine.”
The problem is possibly with the ‘wordsmiths’ and of course, the UCP itself. Nguyen Huu Duc (Vietnam) suggests[xiii] that the expression ‘…on or before the banking day on which reimbursement is due to the nominated bank’ was added to UCP 600 Final Text September 2006, which was adopted by the ICC Banking Commission at their meeting in October 2006. I have a sneaky suspicion that last minute addition of the expression “…on or before the banking day on which reimbursement is due to the nominated bank” was to accommodate a situation where a beneficiary makes a complying presentation for negotiation, wants to take advantage of the LC and the UCP provisions, but requires (or asks for) no funds (call it a ‘non-funded’ negotiation, if you will).
Since the transaction is exactly as defined in sub-article 12(c), how is one to distinguish ‘mere examination and forwarding of documents’ (refer to comments of Ofei and T O Lee cited earlier) from ‘negotiation’?
Re-defining ‘Negotiation’
Combining the multifarious financing function of a documentary credit with its use purely as a payment mechanism in international trade into a neat little box called ‘negotiation’ – and drafting of the articles of the UCP to reflect that approach – is proving to be a nightmare for all concerned. As the foregoing analysis shows, the time has come to clearly distinguish between the utilisation of a documentary credit under the UCP by a beneficiary from its financing function. Accordingly, I suggest the following:
¨   Let the term ‘negotiation’ continue in the lexicon of the UCP. (It has been there for far too long; more than 70% of the LCs issued globally are negotiation credits; may cause a serious withdrawal symptoms or hangover if dumped.) But, it should only define a complying presentation to a nominated bank under a documentary credit – irrespective of whether that bank finances against the documents presented, merely makes a promise, sends documents on approval basis or for acceptance (pending subsequent advancing of funds to the beneficiary), pre-pays etc. Every aspect of financing should be left to the borrower and the lender, to be determined by their respective countries’ laws, norms, procedures and practices.
¨   The magic word ‘negotiated’ or ‘negotiation’ must find a place on the forwarding letter (covering schedule) of the nominated bank, which must indicate thereon that the documents have been negotiated under a particular credit number of the issuing bank.
Suggested revised definition of ‘negotiation’:
Negotiation means the complying presentation of documents – with or without being accompanied by drafts (drawn on a bank other than the nominated bank) – to a nominated bank, and the latter’s declaration on its forwarding letter that it has negotiated against a particular documentary credit of the issuing bank.
¨   Where a confirming bank negotiates, sub-article 8(a)(ii) – among others – should continue to apply. For the banks that have not confirmed a credit, the matter of recourse payment or payment under reserve should be left exclusively to the nominated bank and the beneficiary. (Every bank that lends to its borrower-clients, including to the beneficiary of a credit, anyway legally binds the borrower against possible default in repayment, non-payment or non-realisation of advances granted to it.)
¨    The term ‘reimbursement’ is supposed to be used only by a bank that is already out of funds (having made an advance). An option is to use the term under all circumstances where a claim is made under an LC. The alternate is for the negotiating bank to ‘claim reimbursement’ (if it is out of funds prior to its claim), or ‘claim realisation/payment’ (where it is not out of funds).
¨    Through a suitable worded article, the UCP may clarify that its provisions do not stand in the way of financing arrangements between institutions (including banks) and prospective borrowers, whether against LCs or drafts/shipping documents. This reiteration may help avoid inconvenience to the parties in a documentary credit transaction and legal issues.
Advantages from the revised definition
I expect that, following the revised definition of the term ‘negotiation’, the following issues should stand resolved:
  1.  Definition of ‘negotiation’ in Article 2: A nominated bank honours or pays without recourse against drafts/documents drawn on it – unless it pays under reserve. The UCP is silent on this aspect.
  2.        Definition of ‘negotiation’ in Article 2: Here, negotiation is equated with purchase. In reality, it is not so.
  3.        Definition of ‘negotiation’ in Article 2: The fact that ‘agreeing to advance funds’ has been equated with an outstanding advance.
  4. .      Definition of ‘negotiation’ in Article 2: The assertion that ‘agreeing to advance funds to the beneficiary on … the banking day on which reimbursement is due’ is an advance.
  5.        Whether advancing of funds – well after the documents have been despatched, or after the issuing banks approves of or accepts the documents presented – before the value date of reimbursement can be termed as ‘negotiation’ within the meaning of the UCP.
  6.        Sub-article 12(a): A confusing, if not meaningless, reference to ‘obligation’ of “the nominated bank to honour or negotiate, (where it has) expressly agreed to (do so) and communicated (accordingly) to the beneficiary”. Further, the ‘obligation’ is not the same as that of a confirming bank, though a general reading of the sub-article points to an erroneous conclusion. The ‘express agreement’ is purely an arrangement between the negotiating bank and the beneficiary; it has nothing to do with the utilisation of a credit. This sub-article should be deleted.
  7. .      Sub-article 12(b): Advancing of funds to a borrower/beneficiary in any manner whatsoever, is not something that the issuing bank or the applicant should be concerned with. Additionally, this sub-article, if retained in its present form, could have serious implications – as pointed out by Sheilar T. Shaffer[xiv]. The revised definition of ‘negotiation’ should resolve the anomalous situation.
  8.        Sub-article 12(c): The interpretation of mere “receipt or examination and forwarding of documents by a nominated bank…” and the resultant confusion and contradictions with other provisions of the UCP would no longer exist.
  9.        Para 2 of Article 35: The section “If a nominated bank determines that a presentation is complying and forwards the documents to the issuing bank or confirming bank, whether or not the nominated bank] has honoured or negotiated,…” can be simplified further.
  10. In the whole of the UCP, payment ‘without recourse’ finds mention only against sub-article 8(a)(ii). Yet, the issue is closely linked with expressions such as honour, (to) pay, obligation, express agreement, drafts drawn on the nominated bank, and so on. Strangely, nowhere does the UCP provide clarity or guidance on ‘recourse’ payment in the context of the aforementioned expressions. The issues, therefore, continue to remain as confusing as ever.

Selected articles of the UCP would have to be revised to reflect the changes on the lines suggested.

[i] DCInsight, April-June 2004.
[ii] LC Monitor-Trade Services Update, Volume 11, Issue 2, March–April 2009.
[v] Ibid.
[vi] Ibid.
[vii] Ibid.
[viii] Ibid.
[ix] DCInsight, Vol 15, No 3, July-September 2009.
[x] LC Monitor-Trade Services Update, Volume 11, Issue 2, March - April 2009.
[xi] Another comment on ‘Negotiation, Trade Services Update Volume 12, Issue 3, May – June 2009.
[xii] Ibid.
[xiii] LCM-Trade Services Update, Volume 11, Issue 2, March - April 2009.
[xiv] DCInsight, Vol 15 No 3, July-September 2009.

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