With the constant development of global trade, there is an ever increasing need to find the right way to finance these international transactions. For many years there have been a number of options available to international traders. Especially now, with the advent of modern technology, electronic funds transfer is always an option. However, many traders still opt for the safest measure of financing international transactions: the use of documentary credits. The use of these methods provides much legal protection against misuse, especially where the terms of the UCP500 are incorporated into the terms of the letter of credit, which provides a legal framework preventing any of the parties from obtaining a more superior position in the transaction than is warranted. However, within the context of documentary credits, there is still much choice available to a prospective international trader, due to the array of documentary credits available, each with their advantages and disadvantages. The scope of this brief is to examine and compare the legal and practical framework of two key types of documentary credit, namely transferable and back-to-back credits.
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This brief will examine these two types of documentary credits in the context of their respective legal frameworks. It will offer the conclusion that one is more legally supported than the other, and thus offers considerable more legal security when engaging in international transactions. The UCP500 plays a significant role in this determination, thus it will be this key piece of international law that will form the key basis of this brief's analysis. In addition to the legal background, each of the two documentary credits provides its own practical framework, which allows each one to become efficient in different situations. Thus, the practicality of using each of these credits in their own pet situations will also be considered in the comparison, as it is important to understand where it is best to use either a transferable or back-to-back documentary credit. Given that the scope of this brief has been established, it is now important to consider each of these two types of documentary credit in great detail, before considering their similarities and differences and then concluding as to which one of the two is more reliable in the greater context of international trade.
Back-to-Back Documentary Credits
In a different manner to their transferable counterpart, back-to-back documentary credits involve the issue of two consecutive credit facilities, whereby an existing letter of credit is used as collateral for the purposes of issuing the second letter of credit. Essentially, the procedure involves the first beneficiary (the seller of raw materials for manufacture, for example) having the initial credit (also called the “primary” or “head credit”)1 made out payable to him or her, and then using that letter of credit as security to the bank in order to create a new, second credit made payable to another party to avoid having to outlay his or her own funds. A back-to-back credit is also commonly known as a subsidiary, reciprocal, secondary or counter credit in some forms of international trade transactions. While the two credits are essentially interconnected with one another through collateral purposes, they are treated as separate and distinct credits, each with their own terms and conditions. The rationale behind back-to-back credits can best be demonstrated by Agasha Mugasha, an author on international trade law, who writes: The practice [of back-to-back documentary credits] developed to finance the sale of goods to the seller by the ultimate supplier where the seller does not want to disclose the identity of their supplier to the buyer, or where the original documentary credit cannot be transferred.
Therefore, according to Mugasha, back-to-back credits arose to fill a void that was left by transferable credits, particularly in circumstances where transferable credits were impractical, unreasonable or unsafe to use. Thus, another type of documentary credit had to develop which offered a more practical alternative to transferable credits. The concept of transferable credits will be dealt with in more detail in a subsequent section of this brief, however it is at this point important to understand the rationale behind the creation of back-to-back credits in order to also understand their practical uses and benefits.
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In order for a back-to-back credit to function effectively, it has been said that it needs to meet a number of substantive requirements. These requirements have been codified in the New Zealand jurisdiction, which symbolise their importance. These requirements, to be exercised by the bank issuing the back-to-back credit, include:
- The curtailment of the expiry date so as to enable the documents to be available for both transactions;
- The compatibility of documents under both credits;
- Adjustment of the value of the second credit to allow for a profit margin;
- The consideration of the exchange risk factor if the currencies change;
- Compatibility of the terms of the financial documents;
- Non-disclosure of the supplier's name to the ultimate buyer;
- The adequacy of insurance; and
- The second credit must have a clause that prohibits negotiations with any discrepancies of the above criteria.
Essentially, the bank issuing the back-to-back credit is under a significant amount of burden to ensure that the back-to-back credit complies with these requirements, in order to minimise the risk attributed to the issuing bank.
The risks associated with using back-to-back credits are quite significant. Firstly, if the seller (for example) fails to satisfy the documentary conditions (such as the doctrine of strict compliance of sale documents), then the issuer of the head credit will not pay, which leaves the issuer of the back-to-back credit in a position where they may be unable to draw funds from the security offered.8 Additionally, the parties to the head credit may agree between themselves to amend or cancel it, which means that any documents tendered under the back-to-back credit will not comply with it. This can be overcome by the bank issuing the back-to-back credit asking to confirm the credit, so that it now becomes a party to the credit. The dangers of using back-to-back credits were also highlighted in case law. One Australian case, in particular, shows the riskiness of such credits. The case of Commercial Banking Co of Sydney Ltd v Patrick Intermarine Acceptances Ltd (1978) 52 ALJR 404 (PC) that went to the Privy Council involves the issuance of two back-to-back letters of credit. A merchant bank (Patrick, herein referred to as “PIAL”) borrowed $1.5 million from the State Electricity Commission of Victoria (“SECV”). One credit secured the loan from PIAL to SECV (which was issued by CBC of Sydney) allowing SECV to draw upon Commercial Banking Co (“CBC”) for any unpaid loan amounts. The second credit secured a loan from PIAL to a company called First Leasing, which was the main purpose of the SECV loan. Therefore, PIAL was at the centre of two separate credit arrangements, assuming the roles of applicant of the head credit and beneficiary of the second credit. However, PIAL entered receivership prior to repaying the SECV loan. SECV attempted to draw its $1.5 million from the head credit with CBC, which it was permitted to do, and CBC attempted to declare a proprietary interest in Boston Bank's credit (the issuer of the second credit). However, the Privy Council rejected CBC's ability to claim against the second credit, as it was only permitted to do so in the event that First Leasing failed to repay, which was not the case. Therefore, CBC was effectively left with no method to recover its loss due to the bad security that was offered by PIAL; even though the security appeared to be very good at the time the credit was issued.
The evidence presented above indicates that the use of back-to-back credits provides significant risk to an issuing bank, where that bank is not also the issuing bank of the head credit. Thus, best practice appears to indicate that the same bank will ideally be the issuer of both the head credit and the back-to-back credit. Essentially, the use of a back-to-back credit does not, at least in the evidence presented, pose a significant risk to a buyer of goods, however the beneficiary of a back-to-back credit may be in an unwanted position in the event that the terms of head credit are not satisfied, and thus effectively breaking the links in the chain that flow on to the subsidiary credit.
Transferable Documentary Credits
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Essentially, a transferable credit is mainly used to enable the beneficiary to transfer whole or part of the credit to his supplier of goods or raw materials. This produces a ‘middleman' type relationship, where the beneficiary of the transferable credit is simultaneously owed money by a buyer, but himself owes money to a seller of goods. A practical example of such a documentary credit being used would be where a beneficiary (the ‘middleman') seeks to obtain raw materials from a supplier in order to manufacture them into goods, and then intends to sell these on to another party. So, the beneficiary would obtain the letter of credit from the buyer for the purchase of the manufactured goods, and may then transfer this documentary credit on to the provider of the raw materials in order to pay for the supply for the manufacturing process.
The process of transferring the documentary credits is relatively straightforward. Upon the original letter of credit being opened, the exchange of goods will take place between the initial beneficiary and the seller of the goods. Then, provided that the transferable credit complies with the relevant regulatory requirements, a transferring bank (can be the original bank or another) will debit the initial beneficiary's account and issue a new, fresh documentary credit payable to the second beneficiary. This transfer takes place pursuant to the tendering of invoices and documents relevant to the transferred credit, which then replace those that were used in the original credit. Obviously, the ideal situation for the initial beneficiary would be to have a new documentary credit issued that represents a lesser monetary value than the original credit, as any difference between the two credits represents profit.
Regulation of transferable credits takes prominent place in article 48 of the UCP500. The most relevant provisions of such regulations are as follows:
- A transferable credit is a credit under which the beneficiary (first beneficiary) may request the bank authorised to pay, incur a deferred payment undertaking, accept or negotiate (the ‘transferring bank'), or in the case of a freely negotiable credit, the bank specifically authorised in the credit as a transferring bank, to make the credit available in whole or in part to one or more other beneficiary(ies);
- A credit can be transferred only if it is expressly designated as ‘transferable' by the issuing bank. Terms such as ‘divisible', ‘fractionable', ‘assignable', and ‘transmissible' do not render the credit transferable. If such terms are used they shall be disregarded.
- The transferring bank shall be under no obligation to effect such transfer except to the extent and in the manner expressly consented to by such bank.
Based on these provisions, it is clear that a transferable credit is subject to stringent regulatory criteria in order to pass the relevant stages of acceptance and approval. It has to strictly comply with the rule of having it clearly marked as being ‘transferable', otherwise the transferring bank has the discretion (if not, the obligation) to decline the transfer. Paragraph (c) highlights the essentially contractual nature of this type of documentary credit between the bank and the beneficiary, with the bank not being obliged to transfer the letter of credit except as agreed to by the bank in the initial contract which opened the documentary credit. Perhaps the most important provision of article 48 of the UCP500 relating to transferable credits would be paragraph (h), which expressly states: The [transferable] Credit can be transferred only on the terms and conditions specified in the original Credit, with the exception of:
- the amount of Credit;
- any unit price stated therein;
- the expiry date;
- the last date for presentation of documents in accordance with Article 43;
- the period for shipment
In other words, the terms of the transferred documentary credit cannot be different to those of the original letter of credit, save for the specified exemptions in the UCP500. Additionally, these exemptions to the strict compliance rule must not be greater than the original credit. For example, if the original credit was for £15,000 then the transferred credit cannot be for £17,000. Thus, the credit can only be transferred on the terms and conditions of the original credit, subject to certain exceptions. This places restrictions on the practicality and reliability of transferable credits in certain circumstances, which this brief will now seek to discuss.
One main benefit of using a transferable credit is the fact that it allows the original beneficiary to trade in a manner that limits the outlay of his or her own funds, leaving much working capital free to address other business concerns. Additionally, the first beneficiary is able to avoid the “buyer and supplier from knowing each other's identity and from receiving knowledge of his profit margin”. This can represent an appealing situation for a trader to be in, as it does not tie down the capital of the business in international trade transactions, and also does not disclose the profit to either party, which effectively means that the trader is free to name his or her own price, rather than be guided by the demands of either party upon receipt of knowledge of the costs of goods and/or their manufacture. However, one must also consider the heavy burden of regulation that the use of such a documentary credit carries. For example, it is absolutely essential that the initial issuing bank expressly designates the credit as being ‘transferable' when it is first issued, otherwise such a transfer of beneficiaries will not be permitted to take place, as was previously discussed. Additionally, it must also comply with the other substantive and procedural issues that are raised by article 48 of the UCP500; otherwise the reliability of such a credit is questionable. One must consider whether the extra burden of regulation is worth the possible liberty available to a trader in determining their selling price relatively free from other extraneous influence.
Similarities and Differences
Based upon the legal and practical framework presented in the aforementioned sections of this brief, it is clear that some significant differences between the two letters of credit arise. This gives them their clear and separate nature from one another. First and foremost, it would appear that the sources of law for the two documentary credits differ considerably. While transferable credits are specifically provided for in article 48 of the UCP500, back-to-back credits are not. This essentially means that, where two parties have agreed to incorporate the UCP500 into the terms of the documentary credit, back-toback credits must rely on the broader principles of these provisions rather than being specifically catered for within the terms. In other words, transferable credits are significantly more regulated than back-to-back credits, making it significantly more difficult for a party to be taken advantage of due to the codified nature of the rules governing transferable credits.
The reliability of transferable credits was in significant doubt before the codification of its regulatory provisions in the UCP in the 1993 revision. The main reason for such a doubt to exist was the decision of the Privy Council in the case of Bank Negara Indonesia v Lariza (Singapore) Ltd  1 AC 583 (PC), where it was held that a bank had the discretion to refuse a transferable credit. This case relied upon the previous article 46(a) and (f) of the UCP 1973 revision, where the court held a literal interpretation of these sections to mean that while the beneficiary could issue instructions to transfer the credit, the bank had ultimate discretion whether or not to comply with such instructions. This has since been addressed in the current article 48(c) of the UCP500, which gives the seller-beneficiary the ability to request (but no express right to) a transfer, and empowers the bank to accept these instructions but does not obligate it to do so. However, it has also been contended that the bank can only refuse such a transfer where there are reasonable grounds for it to do so. The point to be made here is that the regulations for transferable credits are much clearer cut, whereas the use of back-to-back credits relies more so on the good faith of all parties concerned, and demands trust more so than protection at law.
Many banks are reluctant to issue back-to-back credits, due to the significant risks they represent for the bank in the event of the head credit failing, or documents not conforming. One example of this reluctance is shown on the website of UBS in Switzerland, who claim that transferable credits should always be chosen “in preference” to back-to-back credits, and will only issue a back-to-back credit if the ‘middleman' can guarantee proper processing of the documents, and is willing to assume all risks and costs associated with any documents that do not conform to the letter of credit, thus minimising any possible loss to the bank. In addition to UBS, the Bank of Valletta (“BOV”) also highlight the “complexity and sometimes problematic nature” of back-to-back credits, but do recognise its possible use as a valuable tool to the trader provided reasonable steps are taken to ensure its success. The reluctance that these popular European banks show towards back-to-back credits further enhances the notion that this type of credit should only be used in situations where the use of any other form of documentary credit is impractical or unavailable. Additionally, the courts have also illustrated key pitfalls of back-to-back credits and, while transferable credits are not watertight against any such situations, they do provide more security and more opportunity for recourse in the event of unforeseeable circumstances arising that can plunge the transaction into a state of disarray, mainly due to the heavier regulatory burden that they carry.
Predominantly, a transferable credit is used where the ‘middleman' is not in a position where he or she is able to open a documentary credit facility on their own account. The first beneficiary, therefore, is not required to have access to a credit facility in the same manner that would be required under a back-to-back credit, which could be said to make the process much more streamlined and efficient. It may also save the first beneficiary significant costs associated with maintaining a credit facility, though this would be difficult to comment on given the inaccessibility of banking charges at the time this brief was written.
While a back-to-back credit has its advantages, it would appear that the most reliable form of documentary credit out of the two would have to be a transferable credit. This is predominantly due to the more substantial regulation that a transferable credit carries under the UCP500 as opposed to its back-to-back counterpart. The presence of this regulation makes it significantly more difficult for one party to wield significantly more bargaining and trading power over another, making the international trading process much more fair and equitable to all parties concerned. While transferable credits were not as reliable prior to the 1993 revision of the UCP, the presence of these revised terms in the current version of the UCP500 places significant burden on the banks to ensure that they comply with one's request to transfer credit. It is acknowledged by this brief that the granting of such a transfer request is not an obligation imposed on the bank; however they are required to entertain a client's request for such a transfer to be made in accordance with UCP500 provisions. There is little from a legal perspective to support such an equitable relationship in a back-to-back credit arrangement. In fact, whatever little case law the does exist is geared more towards showing how back-to-back credits can present some pitfalls to banks that do not ensure they are adequately covered in the event of some unforeseen circumstances occurring.
Even the major European banks are leaning more towards using transferable credit rather than a back-to-back credit, due to the significant risk of loss that the bank can face in the event that (for example) there is a problem with the head credit, which thus invalidates the credit offered as security for the back-to-back credit. It is this chainlike constitution of back-to-back credits that makes that process generally unappealing for banks, unless the situation absolutely necessitates the use of such a documentary credit. Transferable credits also allow a trader to engage in trading activity with a limited outlay of his or her own working capital and, when coupled with the lack of a need to maintain a credit facility with the issuing bank, it makes for a far more appealing way of financing the international sale of goods, both in a legal and practical sense.