Monday, April 25, 2016

What’s draft got to do with it?[1]

Introduction
The bill of exchange (draft) has always been an integral part of documentary credits since inception. That situation could change in the near future. Voices opposed to this long partnership are getting stronger. Even though there is no official word about the next revision of the UCP, there is a rising demand for the next version to rid itself of its reliance on drafts. A sharp dividing line has developed between those who believe in the dictum “If it ain’t broke, don’t fix it”, and those who find drafts totally irrelevant – rather, more of a big nuisance – as far as documentary credits are concerned.

In two separate articles[3]  published earlier this year, experienced trade specialists Peter Sproston and Bob Ronai called on the LC community to “stop following the tradition of using drafts dating back to the 19th Century and eliminate drafts from the next revision of the rules.” In his blog post of February 2015, Kim Sindberg echoed similar sentiments, “…references to drafts and negotiation should be got rid of once and for all.”

Dependence on drafts
Documentary credits rely heavily on bills of exchange, both for their definition and for operation. Take Article 6(b) as a typical example. It states, “A credit must state whether it is available by sight payment, deferred payment, acceptance or negotiation.” Whether a bank may negotiate, accept (and pay on maturity), pay at sight or honour, pay with or without recourse, cannot be fully explained without a reference to drafts. For the definition of terms such as sight payment, acceptance or drawee one must refer to the laws framed for bills of exchange (draft). The UCP offers no definition for these terms in the context of letters of credit.
The UCP is thus shackled by the boundaries set by the laws related to drafts. Those who are not familiar with the laws related to bills of exchange would be hard put to understand:
  1. why a drawee bank cannot negotiate but only honour or pay;
  2. why “a credit must not be issued requiring a draft to be drawn on the applicant (article 6.c)”;
  3. how could a credit be simultaneously available ‘by negotiation’ with one bank and ‘by acceptance’ with another;
  4. if a drawee bank pays at sight, why such payment is without recourse; or
  5. why, once a nominated bank accepts a draft as the drawee, the acceptance is without recourse, and it irreversibly commits itself to pay on maturity.
For the layman, it would be equally difficult to understand why the definition of ‘negotiation’ in Article 2 UCP 600 had to pay obeisance to the BoE laws. The definition begins thus, “Negotiation means the purchase by the nominated bank of drafts (drawn on a bank other than the nominated bank)….etc.”. The UCP definition – or Section B10, ISBP 745 for that matter – failed to explain the significance of the words in brackets, viz., “drawn on…nominated bank”....
The ISBP grappled with drafts in its most recent revision and ended by tying itself up in knots. Instances are far too many to mention here, but one would come across ‘except drafts’ sprinkled all over this ICC document. Why so, is not explained. In fact, the ISBP devoted a whole chapter (Section B) to drafts alone. This is in spite of the fact that drafts are actually governed by legislations and enactments, which supersede any rule that the ICC may frame.

The problem with drafts
The bill of exchange, a negotiable instrument, was created to serve a specific purpose. The UCP was similarly formulated to guide the world of documentary credit operation. It should have been structured, ab initio, to stand on its own feet. There was no earthly reason for the UCP to piggyback on an instrument not under the control of the ICC, laws for which actually can override the ICC rules. The spirit of Article 4, viz., “[a] credit by its very nature is a separate instrument…” (emphasis mine) was thus totally negated.

By making the bill of exchange an integral part of the UCP, the ICC has practically forced a documentary credit practitioner to also master the applicable statutes governing bills of exchange (drafts). But the problem, very aptly summarised by DCW[4], has always been that, “LC bankers, business people, and lawyers commonly fail to grasp the requirements of a draft, or even what a draft is.” Therein lies the core of the problem.

An argument often put forth is that the inclusion of drafts in LC transactions offers the support of the statutes. If the LC mechanism fails, drafts could come to the rescue of the beneficiary in a court of law. Drafts, therefore, appear more like an insurance policy – useful only when disaster strikes. Theoretically, this is a fair proposition. In reality, however, to what extent this premise has proved its worth remains a matter of serious debate, including among the experts. For, the solution seems to lie elsewhere, in the law of contracts: If the LC fails to provide payment, the seller always has the right (or the option) to seek remedy directly against the buyer[5] through  a court of law for failure of performance under the sales contract.

In an article titled Ban the use of bills of exchange in UCP 700[6] Peter Sproston has put forward a compelling argument in favour of the separation. The essence of his arguments is as follows:
a)  A bill of exchange, drawn upon the issuing, confirming, or negotiating bank itself represents a payment obligation once it has been accepted by the issuing bank. It’s the evidence of a straightforward, unconditional obligation under the bill of exchange laws.
b)   Simultaneously, bank(s) is/are obliged to pay under LCs upon presentation of LC-compliant documents only, not otherwise. The LC foresees payment being triggered purely by presentation of compliant documents in accordance with the rules of the UCP.
Thus, on the one hand, under the applicable bills of exchange act, the issuing bank (as the drawee) - following the provisions of the Act - has a legal obligation to pay an accepted draft on its maturity. On the other hand, against that very same transaction, that same bank would have to comply with the rules of the UCP for taking a decision to pay (or refuse to pay), and if so agreed, when to pay. Same game, two referees? 

Where do we go from here?
The DCW’s lead commentary titled Drafts: In or out of UCP700?[7] observed, “Yet, there is another view (opposing the abolition of drafts - added): Can UCP re-drafting solve drafts? Not really, since LC terms requiring a draft will trump any UCP rule prohibiting drafts.” Well, I am not so sure. First and foremost, there is no point in “prohibiting drafts” from the UCP. Bridging the gaps would be difficult since mere patchwork will not work. Instead, the UCP and the ISBP should be re-drafted (no pun intended) from scratch. Kim Sindberg wrote in his blog post of February 2015 that he “would in fact welcome such initiative – of course given that it is a real revision. that means a real effort in taking the UCP out of the 18th century gaslight and into the twenty first century.” Unfortunately few, if any, have been a part of the solution.

If drafts are abolished
It will take a lot of lateral thinking and changes to the UCP to make it work. That’s for sure. Let us examine some of the issues that readily come to mind. The word ‘draft’ appears at eleven different places in UCP 600, and 48 times in ISBP 745. These articles and sub-articles have to be suitably re-phrased or replaced. ISBP 745 Section B would be deleted. S.W.I.F.T. message structures have to be redesigned to align the message formats with the new regimen.
Article 6.b offers four types of credit instruments. ‘Negotiation credit’ need not include a draft. Of the remaining three, credits ‘available by sight payment’ require a draft – for being presented to the drawee with a demand for payment[8]. As far as the beneficiary is concerned, the effects of a negotiation credit and credit available by sight payment are exactly the same. He gets money up front, immediately after the negotiation/honour of a complying presentation by a nominated bank.
Credits available by acceptance or by deferred payment are similar in terms of the time of payment to the beneficiary. The issuing bank will anyway pay only on the due date as per the terms of the credit (refer to sub-article 7.c UCP 600). Whether a non-confirming nominated bank would negotiate and pay up front to a beneficiary, is purely a credit decision of the nominated bank.
Thus, as far as the beneficiary is concerned, he could easily live with two types of credits in place of four – one that pays him upfront and another that pays after a lapse of a pre-defined, fixed period of time. We may, for now, refer to them as demand credits and time/usance credits respectively.
In the absence of drafts, presentation for acceptance and the basis for the calculation of maturity dates must undergo a sea change. The experts would have to put their heads together and come up with alternative structures and standardised wordings to replace ‘payable on demand’, acceptance, arriving at maturity dates and other related matters.

Honour
If drafts go, the definition of ‘honour’ (Article 2) would have to be modified. Presently, ‘honour’ is defined in the UCP thus:
  1. to pay at sight if the credit is available by sight payment.
  2. to incur a deferred payment undertaking and pay at maturity if the credit is available by deferred payment.
  3. to accept a bill of exchange (“draft”) drawn by the beneficiary and pay at maturity if the credit is available by acceptance.
I would avoid using the terms that we have grown used to, e.g. ‘at sight’, ‘acceptance’ etc. because these have their origin in, and are integral parts of, the bills of exchange statutes. Without a draft, terms such as ‘at sight’ or ‘sight payment’ would be meaningless. Paragraph ‘a’ of the above definition could, therefore, be modified to read as, ‘to pay on demand if the credit is available by payment on demand (or, it’s an ‘on demand LC’).
Same applies to ‘acceptance’, for no usance bill of exchange would exist in the UCP for the drawee to accept. However, if the term ‘maturity’ is to be retained, it must be clearly defined with suitable reference to its context. Else, ‘due date’ could replace it.
‘Deferred payment’ was never defined in the UCP. The general impression is that deferred payment equals ‘acceptance minus draft’ (I disagree, but that is not relevant to this discussion). In order to distinguish from credits that are not payable ‘on demand’ (not demand credits), terms such as ‘deferred payment credit’, ‘time credit’ or ‘usance credit’ could be used.
Of course, whatever expressions are finally selected must be clearly defined in the UCP. The text of the credit would also have to be revised and standardised accordingly.

Negotiation (Article 2), Purchase, Discount
The term ‘negotiation’ has a very long history of confusion and debate. The precise meaning and the utility of this term have been questioned ad nauseum, even by experts. The present definition under Article 2 is faulty in several respects[9]. Yet, in my opinion, this term need to remain in our rule books. Banks would need this term to distinguish between financing against LC bills and other modes of finance. Of course, the present definition needs to be completely revised and the glitches removed.

Why the change?
Personally, having worked for decades as a commercial banker, I can easily grasp the basics of the Negotiable Instruments Act, and have a good understanding about the working of drafts. Consequently, I am quite comfortable with having a draft as part of an LC. It’s been working well for over eighty years now, for better or for worse. But certain compelling arguments necessitate a serious re-think. Briefly, these are as follows:
a)    As an instrument for settlement of international trade, documentary credits should be a totally independent, stand-alone instrument, governed exclusively by its own set of rules. As of date this is not the case for reasons already explained.
b)     Many of those who deal with documentary credits find it very difficult to simultaneously grasp the nuances or the finer points of the statues applicable to bills of exchange.

Making the changes work
Abolition of drafts from documentary credit operations cannot be effective if our mindset does not change; if we do not get out from under the shadow of the laws for drafts that define or explain the standard terms that we have got accustomed to over the years. This would also mean strictly, consciously avoiding terminologies that have their genesis or roots in the BoE statutes; terminologies, the meanings of which, through continual usage we (and the UCP) have taken for granted, which are ingrained in our haemoglobin. Whatever the replacement terms introduced, these must be chosen with great care, fully and comprehensively defined. ICC should take the lead to create standardised texts for the new terms and expressions.
The biggest challenge would be the process of migration from what everyone has been used to for more than eight decades. The weaning process would be tortuous, the withdrawal symptoms painful. The unlearning and the relearning exercises is likely to be long and bumpy. Extensive training arrangements would have to be made to meet these challenges. But, whatever it takes, it is time to bite the bullet, time to take that long overdue big leap forward, time for documentary credit to the master of its own destiny.
*****




[1] First published in LCM-TSU, Jan-March 2016.
[2]The author is trainer, faculty and author of books and articles on international trade. Home page: http://www.rnbose.com.
[3] Drafts: In or out of UCP 700? Documentary Credit World, Page 1, Vol.19, Number 1, issue of January 2015
[4] Drafts: in or out of ucp700? Documentary Credit World, Page 1, Vol.19, No 1, January 2015
[5] Refer to Newman Industries Ltd v Indo-British Industries, [1956] 2 Lloyd’s rep 219; see also W.J. Alan & Co Ltd v El Nasr Export and Import Co [1972] 2 Q.B. 189, 209-212, 221. (Peter Sproston, DCW, Jan ‘15)
[6] Documentary Credit World, Page 20, Vol.19, No 1, January 2015,
[7] Documentary Credit World, Page 1, Vol.19, No 1, January 2015.
[8] Bills of Exchange Act, UK, Section 45(2): Where the bill is payable on demand, then, subject to the provisions of this Act, presentment must be made within a reasonable time after its issue in order to render the drawer liable, and within a reasonable time after its indorsement, in order to render the indorser liable.
[9] See Negotiation and the law of contracts, Rupnarayan Bose, DC Insight, Vol. 16, No. 2, April-June 2010; and Re-defining Negotiation, Rupnarayan Bose, LC Monitor-Trade Services Update, Vol. 11, Issue 4, July–August 2009.

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