Companies trading in the Middle East, Africa and Asia are increasingly facing collection problems concerning letters of credit (LCs), the longstanding core of trade finance. LCs are not providing the same assurance of payment as traders have historically expected due to foreign currency reserve shortages.
Letters of Credit and UCP 600
The Uniform Customs and Practice for Documentary Credits, abbreviated as the UCP, was first issued by the International Chamber of Commerce (ICC) in 1933. The UCP introduced documentary credit as a tool to finance international trade and its rules largely reflect accepted banking customs and practices around the world. The UCP has been amended several times and the sixth version, referred to as UCP 600, came into effect on 1 July 2007. It is widely stated that the UCP 600 is adopted for use by the banks of 175 countries. This can cause the misconception that UCP 600 is an international convention or treaty. This is not the case. The 39 articles of the UCP 600 rules must be incorporated into an agreement in order to apply as contractual conditions between the parties. The UCP was deliberately created so that disputes would be decided in local courts.
In the event that a bank fails to make payment under a letter of credit, the beneficiary of the letter of credit can first initiate a claim through the Documentary Instruments Dispute Resolution Expertise (DOCDEX) within the ICC. While not binding on the parties unless otherwise agreed, DOCDEX dispute resolution is cheap, with capped fees, and fair decisions made by a panel of three impartial experts, with the entire process usually lasting a few months.
If a resolution is not reached through a DOCDEX dispute resolution process, then a claimant normally has no choice but to sue in local courts in the home jurisdiction of the bank. Traders that have accepted letters of credit from banks in developing countries find themselves having to litigate in local courts in seeking to recover payment.
The new risk of Central Bank Insolvency and the decline of Forex Reserves
The typical cause of a letter of credit dispute is a discrepancy in the documents, but the combined effect of the Covid 19 pandemic, the global supply chain disruption, inflation in global prices for fuel and food, and other factors have combined to cause a significant depletion in foreign exchange reserves globally. There are increasingly banks in developing countries that are unable to remit foreign currency pursuant to a letter of credit either due to a lack of foreign currency or an order of the central bank.
In recent months, more and more countries are facing fiscal crisis and the inability to meet the necessary import payments. The widely reported instances are:
- Lebanon is in the fourth year of an ongoing financial crisis by which overseas remittances of foreign currency are rare and difficult.
- Sri Lanka has defaulted on its sovereign debt, and it is reported that foreign banks are refusing to confirm LCs issued by Sri Lankan banks, and oil suppliers are refusing LCs issued by Sri Lankan banks.
- The Central Bank of Nigeria is reported to have a backlog of US$2 billion of FX remittance requests that it is unable to honour due to the lack of foreign currency reserves.
- Nepal has seen a drop in its foreign currency reserves, and as a measure to pre-empt a financial crisis, introduced current account balance requirements for importers in December 2021, and banned the imports of many non-essential goods, including new automobiles, in April 2022.
- Pakistan is going through a severe economic crisis adversely impacted by the rise of commodity prices and depreciating currency.
- Kenya has seen a sharp drop in its forex reserves over the last year.
At the same point in time, in some countries the use of letters of credit has been rendered (de facto) mandatory in foreign trade transactions. The underlying rationale is to better control the outflux of foreign currency and implement AML regulations.
- In Libya any allocation of foreign currency for the importation of goods must be supported by a letter of credit approved by the Central Bank. This creates a significant bottleneck for Libyan importers.
- Egypt introduced a requirement in February 2022 that all imports must be settled through a letter of credit, with documentary collections no longer being permissible. This requirement was relaxed in May 2022 for the import of raw materials for industrial factories.
The Importance of a Confirmed Letter of Credit
The recent foreign remittance crisis has reminded the trade finance community of the importance of confirmed letters of credit. A confirmed letter of credit is a "back-to-back" letter of credit issued by the seller's bank on the assurance of the letter of credit issued by the buyer's bank. Given the additional cost, usually 0.5-2% of the letter of credit value, many traders have forgone confirmed letters of credit in recent years.
A confirmed letter of credit can only be done before the parties perform the transaction. The matter should be discussed upfront by the seller with its bank, as not every bank will confirm every letter of credit, as the confirmation passes on the risk of collection from the buyer's bank to the seller's bank.
Once a company is in a situation of having delivered goods without payment, and finds that a bank is unable to make payment due to local restrictions, the seller must immediately consider alternative solutions to payment.
- The first and most common method is to send a formal demand letter. This may force a discussion and negotiation that led to sellers securing a place in line for payment.
- If no resolution is forthcoming, then the next step is a DOCDEX dispute resolution process. This ICC expert review is not binding unless expressly agreed, but it can create a persuasive expert authority for a seller claiming payment.
- If no resolution is reached, a seller must then make a formal legal claim in local courts to collect payment.
Some sellers have also negotiated and accepted payment in kind, return of goods, or payment in local currency, which requires acceptance of taking on currency risk and opening a bank account in a local bank. This is not equivalent to collecting the funds under the letter of credit and may only be a solution only better than failure to collect payment under a letter of credit.
Originally Published 15 August 2022
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.