Wednesday, November 04, 2015

What is ‘negotiation’, and why it must stay in the UCP

Introduction
There is no formal announcement from the International Chamber of Commerce (ICC) as of date, no preparatory move, no action at all on this front. No matter. The brainstorming has begun in right earnest! Intensive discussions are taking place on what changes are desirable in the next version of the Uniform Customs and Practice for Documentary Credits (UCP), an ICC publication that lays down the rules for the operation of documentary letters of credit (LC). This article examines only a few of the proposals that have been put forward in recent times.

The proposals
The suggestions are to:
a)     delete all references to drafts from the UCP
b)    merge the UCP with ISBP
c)     make the ISBP and the ICC Banking Commission Opinions available through the electronic medium to all (if it must be so, at an affordable price)
d)    purge ‘negotiation’ from the UCP and the ISBP.

Drafts
The angst against drafts is understandable. It emanates primarily from the fact that only a handful of people around the world seem to understand what a draft (a bill of exchange, a negotiable instrument) is all about. Well, I agree that the UCP and the draft should head for a divorce, but for the lack of understanding. The reason is because drafts follow a different drummer. Drafts are statutorily governed, by the Negotiable Instruments Act or the Bills of Exchange Act, howsoever called in the country concerned. The ICC has no control over the rules for drafts. This tiny fact of life goes against the very spirit of a letter of credit, which is structured as a completely independent, stand-alone instrument of payment, governed exclusively by the provisions of the UCP.

The transition is not going to be smooth. Some divorces are messy. This one could be too. It would be tricky and painful, to say the least. Re-drafting of the UCP, unlearning and relearning by the trade professionals, would surely be a tough ask. And we are not done yet! Add to this the call to rid the UCP of negotiation, and what could we have on our plate?

Proposal to merge ISBP with the UCP
A suggestion being discussed is to merge the UCP and ISBP into a single rule book. It does not appear to be a good idea. The steel-frame that defines the rules of the game for LCs ought to remain as it is at present. The sanctity of the UCP rules should not be diluted. The explanations, clarifications, illustrations or ICC Opinions are not ‘rules’ by any stretch of our imagination. These should continue to be separately available, as they are now, flexible enough to be open to changes as required.

Get rid of negotiation?
“Get rid of negotiation” is not a new call to action. ‘Negotiation’ remains a riddle wrapped in a mystery inside an enigma ever since it first appeared in the UCP. It seems to have defied understanding, or attempts at arriving at a definition acceptable to all. Yet, it survives to exist in the UCP to this day. This article takes up the cudgel on behalf of the much debated and berated term, and explains why it must continue to remain in the UCP. To fully understand the reasons, one needs to refer to the concepts that govern the laws of contract, more specifically the inter-se relationship between the agent and the principal. A bit or risk management issues thrown in may cause no harm either!

Letter of credit and contracts
In two articles[1] of mine I had pointed out that the UCP very clearly reflected the provisions of the laws of contract. Particular attention is invited here to the following aspects:
  1. Offer: An explicit commitment in writing of the issuing bank to honour a presentation if it complies with the terms of the credit.
  2. Acceptance: Of the proposal – by way of specific performance of the terms of the LC, namely, a complying presentation.
  3. Silence is not acceptance: “A statement made by or other conduct of the offeree (the one to whom an offer is made) indicating assent to an offer is an acceptance. Silence or inactivity does not in itself amount to acceptance.” (Article 18(1) of the UNCISG)
Article 7 of the UCP defines the undertakings of the issuing bank. Note that the UCP does not require the beneficiary to communicate, explicitly or implicitly, acceptance of the terms of the contract (the LC). The beneficiary’s performance – a complying presentation – is sufficient indication to the offeror, viz., the issuing bank, the fact of the beneficiary’s acceptance of the offer. The very act of a complying presentation binds the issuing bank (sub-article 15.a) to its promise under its own contract (the LC) to the beneficiary to pay the agreed consideration.

If there is no ‘acceptance’ of the offer by the offeree (the beneficiary of a credit) by way of specific performance (a complying presentation), the issuing bank has no obligation to pay either (sub-article 16.a).
Incidentally, sub-article 10(b) of UCP 600 is another example of the same principle. This sub-article provides that the beneficiary should either “give notification of acceptance or rejection of amendment.” Where it does neither, it can still indicate acceptance of an amendment by making a presentation that complies with the not yet accepted amendment. The acceptance of the offer is thus through action, if not through so many words. The issuing bank will still be bound by its commitment to the offeree, the beneficiary.

The principal and the agent
Chapter X of The Indian Contract Act 1872 deals with ‘Agency’. Our interest is limited to the following provisions (summarised):
  1. The authority of an agent may be expressed or implied.
  2. No consideration is necessary to create an agency.
  3. No one can be forced into entering into a contract of agency.
  4. An agent who acts within the scope of authority conferred by his or her principal binds the principal in the obligations the agent creates against third parties.
The nominated bank
We know that the offeree cannot be compelled to accept an offer, i.e. perform under a credit. A non-confirming nominated bank too occupies a similar status in the UCP. Even if nominated by the issuing bank, it is under no obligation to negotiate or to honour even if a presentation complies (sub-article 9.a). The non-confirming nominated bank need not comply with the provisions of article 16 of the UCP either.
Section 8 of the Indian Contract Act reflects UNCISG while it states,

“Performance of the conditions of a proposal, or the acceptance of any consideration for a reciprocal promise which may be offered with a proposal, is an acceptance of the proposal.”

Thus, if the beneficiary performs as per the LC terms, the issuing bank is obligated to meet its commitment as per its undertaking in the credit. Similarly, if the nominated bank negotiates a complying presentation, it earns the right to be reimbursed by the issuing bank (sub-article 7.c).

Purchasing or discounting bills for collection
A significant part of the business activity of commercial banks comprises advancing against domestic or export bills outward. Banks advance money against bills sent on ‘collection basis’ (refer to URC 522) by purchasing DP bills, discounting DA bills or permitting overdrafts against the underlying goods in transit. To advance against these bills (post-shipment finance) is a credit decision of the lending bank. The decision to advance money is based on various parameters, of which risk management is a very important criterion. Granting advance is an arrangement wholly between the drawer (seller) and his bank. No other party is involved in this decision, or in the risk management exercise, of the lending bank.

Defining negotiation
The risk analysis scenario changes significantly when documentary credits enter the picture. The issue to lend or not to lend now has a third element to consider, namely, an undertaking of another bank through a letter of credit. It brings to the table the commitment of the issuing bank which “undertakes to reimburse a nominated bank that has honoured or negotiated a complying presentation and forwarded the documents to the issuing bank (sub-article 7.c UCP 600)”. It’s no more bipartite, but a tripartite arrangement now.
Keeping in mind what we have discussed about the laws of contract, let us view the issuing bank as the principal and the bank that acts under its nomination as the agent. Irrespective of its commitment to the beneficiary (as per the terms of the credit), the issuing bank is simultaneously bound by its commitment to its agent – the nominated-cum-negotiating bank. The remaining part of sub-article 7(c) beautifully captures this essence, thus:

“Reimbursement for the amount of a complying presentation under a credit available by acceptance or deferred payment is due at maturity, whether or not the nominated bank prepaid or purchased before maturity. An issuing bank’s undertaking to reimburse a nominated bank is independent of the issuing bank’s undertaking to the beneficiary.”

The laws of contract by another name? You bet!

Viewed in this light, the meaning and the implication of the term ‘negotiation’ becomes abundantly clear. It is also apparent why negotiation (a tripartite arrangement) cannot be equated with discount or purchase (a bipartite issue); why one cannot be jettisoned in favour of another.

Negotiation and risk management
Documentary credits occupy a special place in the world of international trade. The major advantage of a letter of credit is that owing to its very nature it helps to reduce several risks inherent in international trade of goods and services. Consequently, the beneficiary of an LC is deemed a better credit risk than one without it. In terms of risk exposure, the availability of an LC makes the transaction less risky for the lending bank (and hopefully one day, for the CAR). For reasons of lesser risk exposure, an exporter pays a reduced premium to obtain export risk insurance cover.

Almost every country around the world is keen to develop its volume of external trade through export. Documentary credits are a major facilitator in this direction. Without the benefits of negotiation, a major incentive for procuring LCs by the exporter would surely disappear. LC bills will look more like collection bills, with added problems of higher charges and complicated compliance issues thrown in for good measure.

As an instrument for the settlement of international trade, documentary credit is already under threat from several quarters. If negotiation is removed from the UCP, the demise of the most preferred and reliable instrument for settlement of cross-border trade will simply be accelerated. Will that help in the development of international trade? Hardly, in my opinion!

UCP sans ‘negotiation’: a few afterthoughts
A documentary credit world without ‘negotiation’ does not appear to be very encouraging, to say the least. If one indulges in a speculation spree, possible consequences could be as follows:
  1. Lending by the nominated bank against export bills under LCs will not receive the protection of the UCP any longer.
  2. Without the benefit of negotiation, the seller’s bank will be more reluctant than before to lend by way of post-shipment credit.
  3. The term ‘complying presentation’ may be relevant to none barring the issuing bank.
  4. Would there be any need for a bank to be nominated?
  5. Several articles, including article 38 on transferable credits, would have to be re-written or modified to remove all references to nominated banks, negotiation and everything related to these.
  6. Would the exporter’s bank, or the nominated bank (if any), have any incentive or compelling reason to examine the documents presented for compliance?
  7. If drafts go, terms such as at sight, acceptance, acceptance credits or sight payment would have to be removed from the UCP; the affected articles must then be completely revised. Reliance on the bills of exchange laws for definitions of these terms must be carefully, meticulously, and consciously avoided. Hence article 2 would also have to be expanded.
  8. No negotiation means no reimbursement. Would we need article 13 or the URR?
  9. The entire UCP will be reduced in size, to barely a few brief articles. For example, article 7 will retain only sub-article 7(b). Articles 14 and 16 will be of interest only to the issuing bank. Article 15 could be deleted. The impact will affect the ISBP is a similar fashion.
  10. What about Article 8 on confirming bank undertaking? What would be the responsibilities of a confirming bank anyway? Will it be negotiating without recourse, or honouring a complying presentation? Will sub-article 8(b) mean anything to anybody any more in the documentary credit world?
  11. The sale of the ICC publications like the UCP, the ISBP or the ICC Opinions could plummet, since their demand may shrink, or be confined to the issuing banks alone.
  12. And finally, would the time, the effort, the resultant confusion and the cost of the entire exercise be really worth it?
It goes without saying that I would be happy if I am proved wrong on all counts.

“Off with his head”, said the Queen
A curious approach is evident in some quarters for solving problems that defy their understanding. Whether it’s Queen Margaret (Henry VI Part III, Shakespeare) or the Queen (in Alice's Adventures in Wonderland by Lewis Carroll), finding solutions to any problem was to simply declare, “Off with his head”! Now we hear something similar, thus, “I don’t know what this thing called draft is, so let’s chop it off from the UCP.” Or, “I don’t have any idea what negotiation means. Why not remove it altogether from the UCP?” Voila, problem solved!

Conclusion
Change for the better is always welcome. But we must be capable of managing that change. Eight years on, many trade professionals are yet to fully wrap their heads around the UCP provisions. Huge deficiencies already exist in terms of skill levels and in the dissemination of information at all levels across the industry. The knowledge and information gaps may be too wide to bridge easily or smoothly. Unless handled well, any drastic change could be counter-productive. The ICC, unfortunately, does not appear to play a leading role in actively addressing or resolving these deficiencies, at least not in India. A couple of elite conferences in a year do not help. Owing to the implications, suggestions for changes in the next UCP should, therefore, be thought through with great care. Recall the (supposedly) Chinese curse, “Be careful about what you wish for; you might receive it!”
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[1] Some random thoughts on the UCP, LC Monitor-Trade Services Update, Special Edition, January 2011 and Negotiation and the law of contracts, DC Insight, Vol. 16, No. 2, April-June 2010.

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