Letters Of Credit: What’s The Difference Between One Inch And One Foot?

Letter Of Credit, Invoice, Discrepancy

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LETTERS OF CREDIT: STRICT COMPLIANCE

Banks are often accused of being nit-picky and overzealous when they examine documents against a letter of credit. It seems they want every “t” crossed and every “i” dotted. Would you believe one exporter did not get paid because of a simple apostrophe?

The United States remains one of the few countries that employs the imperial measurement system. As if that doesn’t generate enough confusion, it becomes even worse when Americans use abbreviations, which make no logical sense to the rest of the world.

HOW BIG WAS THAT T.V.?

The merchandise description in one letter of credit stated, “Shipment of TV sets with 24” screens.” The description on the invoice presented stated, “Shipment of TV sets with 24’ screens,” and the bank rejected the documents because of this discrepancy. In the United States an apostrophe and quotation marks have different meanings when used to signify a unit of measure. An apostrophe designates feet. Quotation marks designate inches.

In an earlier blog, we related the story of Holstein cows, 24 months pregnant. The use of a dash makes a significant difference between 24 months and 2-4 months.

IMPLICATIONS OF "DISCREPANCIES"

Is a bank too nick-picky to note these discrepancies? Probably not, because of the implications. The burden of accuracy falls on the preparer of the documents. Before they are sent to the bank for examination, the preparer must understand and follow the requirements of the letter of credit as well as the rules stipulated in the UCP 600.

Revolving Letter Of Credit: Ladies Italian Unfashionable Dresses

Revolving Letters Of Credit, Tenor, Draft, Discount Charges, Applicant, Bankers’ Acceptance, Self-Liquidating

REVOLVING LETTER OF CREDIT

An importer requested a bank to issue a letter of credit for ladies fashion dresses from Italy. When the importer completed the application for the letter of credit, he indicated the tenor of the drafts at 180 days sight with discount charges for the applicant. Additionally, the letter of credit was issued as a revolving letter of credit with the balance reinstated on the first day of each month until the letter of credit expired six months later. This allowed the beneficiary to make shipments each month equal to the amount of the letter of credit.

BANKERS' ACCEPTANCES INCREASED THE RISK

This arrangement permitted the bank to make payment to the supplier in Italy upon receipt of the required shipping documents. The bank would then delay payment to the buyer for 180 days and the buyer agreed to pay for the cost of interest during the 180 days period. Initially, everything went as planned. The bank received documents and found them in compliance with the terms of letter of credit. They remitted the payment to Italy, created a “Banker's Acceptance” for 180 days, and charged the cost of financing to the buyer. The bank released the documents so the buyer could clear the goods through customs, sell the dresses and collect the money before the due date of the draft.

WHERE IS THE PAYMENT?

The bank waited for the clock to wind down to the payment date, 180 days later. And wait they did. On the 180th day, when the bank requested payment from the buyer, they learned the buyer could not pay. The buyer informed the bank that he was preparing to file for bankruptcy and the unsold dresses were in a warehouse. Since the bank had a lien on the assets of the company, the bank’s lending officer began arrangements to seize them. Unfortunately, the only assets available were the ladies fashion dresses, now 180 days old and no longer in season. The bank’s loss increased exponentially because by the time they realized they had a problem with the shipment made in the first month, they had already obligated themselves for shipments made the subsequent five months.

HOW REAL IS "SELF-LIQUIDATING?"

The bank ultimately sold the dresses. The recovery of funds amounted to less than 50% of the bank’s loan and they took a loss for the balance of the unpaid loan. While letters of credit seem self-liquidating and self-securing because of the underlying transactions, banks need to cautiously ascertain the value of goods and determine if they can be readily liquidated, or face the resulting consequences as illustrated in this lesson. Once it becomes known that a bank has distressed merchandise, the value of the merchandise drops significantly. Bankers, who do not have expertise in selling merchandise, eagerly find a buyer as quickly as possible even if it results in a loss. This lesson illustrates why banks should be very cautious when issuing letters of credit; It carries the same risk as when a customer applies for a loan. Usually banks prefer not to rely on the underlying transaction as collateral. They typically will want some other collateral as well and often will require the applicant to secure the letter of credit with cash in an account at the bank.

Letter Of Credit: Shipment Of One Cow (Partial Shipments Prohibited)

As we have discussed in various other blogs, letters of credit contain precise requirements that the beneficiary must meet in order to receive payment. The letter of credit must also state the specific documents needed to meet the requirements. Then, other conditions may exist such as whether partial shipments are allowed or not. If allowed, the beneficiary may make a partial shipment, present documents and get paid for the value of the goods shipped. Later he may make another shipment, present documents and receive payment, etc.

One beneficiary enjoys telling the story of the letter of credit he received for the shipment of “one live cow.” The letter of credit contained the condition that partial shipments were not allowed.

He thought this condition rather humorous since a partial shipment would be, well, utterly impossible!

Letter of Credit: History of the Red Clause

Red Clause, Letter Of Credit, Beneficiary, Draft, Applicant

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RED CLAUSE RESULTED IN $70,000 SAVINGS ANNUALLY

A US company importing mosaic ceramic tile sent an annual payment on January 1st to their Italian supplier for the entire year’s purchases. The supplier always performed and presented no obvious risk of nonperformance.

When the US company learned of the red clause letter of credit, they realized it could save them money. Issuing a red clause letter of credit to the supplier would enable them to borrow money from their own bank and pay interest instead of using the importer’s money interest free. After issuing a letter of credit with the red clause, they estimated that they saved $70,000 the first year.

WHY IS IT CALLED "RED CLAUSE?"

A red clause letter of credit, originally so called because of a clause printed in red ink on the face of the letter of credit, permits the beneficiary to obtain advance funds from the letter of credit with the intent to repay the funds at the time he presents documents for payment. The red clause typically restricts the advance to a certain percentage of the letter of credit, say 30%. When the beneficiary presents documents for payment, the bank uses 30% to repay the loan and the beneficiary receives the remaining 70%.

ORIGINS OF THE RED CLAUSE

Several versions of the history of the red clause letter of credit have circulated. Jim Harrington believed it began in the Philippine Islands. The Philippines established home-based businesses to produce lace tablecloths. Eager buyers filled a demand of a ready market in the United States. Buying agents would call on home-based businesses throughout the Philippine Islands agreeing with each to order a certain quantity of tablecloths.

The agents discovered they could get better prices by paying for a portion of the goods in advance because the households needed money for living expenses and also to purchase needles and thread to make the tablecloths. The red clause allowed the agent to borrow from the Philippine bank, pay the households and then store the tablecloths until he had enough to make a shipment and draw a draft against the LC. The proceeds of the draft paid off the borrowed money.

The applicant of the letter of credit should understand the risk: The beneficiary could get the advance and disappear with the money. In that case, the bank which made the advance has recourse to the applicant. As in any other transaction, a high level of trust reduces the risk.

Because of the risk, buyers rarely use red clause letters of credit. However, buyers such as the mosaic tile importer, who have to pay cash up-front, may consider the red clause letter of credit as a viable alternative.

In one of his workshops, Jim Harrington stated that he wanted to put to rest a myth. With a twinkle in his eye, he explained that the red clause has nothing to do with lobsters whose claws turn red when placed in boiling water.

Letter of Credit Non-payment Resulted in Paper Slippers Becoming a Tax Deduction

Letter Of Credit, Beneficiary, Applicant

LETTER OF CREDIT ISSUED FOR THE PAYMENT

A New York bank issued a letter of credit for the importation of paper slippers used in medical clinics and hospitals. The patients donned the disposable slippers as they strolled through sanitary areas of the hospital. The merchandise description on the letter of credit read as follows: “paper slippers with soles double-stitched.”

"DISCREPANCIES" IN THE DOCUMENTS

The documents presented by the beneficiary did not properly indicate double-stitched soles. The issuing bank inadvertently overlooked this requirement and honored the beneficiary’s request for payment.

When the applicant received the slippers and inspected the incorrect documents, he rejected them, demanding that the issuing bank refund their money. Since the bank had already paid the beneficiary, the bank became the unwilling owner of single-stitched paper slippers with little hope of selling them to recover their loss.

DONATE THE SLIPPERS

An official at the bank ingeniously suggested they donate the slippers to a Veterans Administration hospital and capture a tax deduction. The savings resulting from the tax deduction nearly compensated the bank for its loss.

Another lesson learned, thanks to Jim Harrington.

Counter Trade: Let’s Swap Lunches

Counter Trade, Barter

COUNTER TRADE SIMPLIFIED

Remember grade school days, when another student’s lunch looked better than yours, so you swapped?

It still happens today in international trade.

I have read estimates stating that as much as 5% to 20% of world trade falls into the category of counter trade, although the exact numbers are hard to verify. What exactly constitutes counter trade?

While several forms of counter trade exist, in its most basic form it is exchanging goods for goods, commonly called bartering. Likely, one or both parties do not have access to the other party's currency. When both parties have merchandise the other wants to use or to sell, they may mutually agree upon an exchange of goods.

COUNTER TRADE: UNINTENDED CONSEQUENCES

After the exchange, both parties should have the ability to use or sell the goods acquired. If they don't, they may find some unexpected consequences. A popular story involves an aircraft manufacturer. They received an order from a country that did not share their currency but offered to exchange canned ham for the aircraft. The seller agreed.

When the canned ham arrived at the port of importation, U.S. customs officials would not approve the ham for sale in the country. The manufacturer of the aircraft negotiated with the customs agency to release the goods with the condition that they would not sell the goods. Responsibility for determining the final use for the large quantity of canned ham fell to the staff in the company's cafeteria.

COUNTER TRADE: COMPLICATED

Counter trade becomes complicated when more than two parties and more than two countries are involved. A hypothetical example of a three-way trade would be one involving a shipment of oil from Venezuela. The purchaser in Germany offers to pay for the oil with medical equipment. The Venezuelan oil producer does not need medical equipment, so they find a distributor in the United States who takes the medical equipment and pays for it with automobiles, which the party in Venezuela can use. The shipment of oil goes to the party in Germany who sends medical equipment to the party in the United States who sends automobiles to the party in Venezuela and everyone lives happily ever after. Obviously, such a transaction has complications and has potential for things to go wrong.