Companies operating in the Middle East, Africa and Asia are increasingly facing collection challenges regarding Letters of Credit (LC), the historical heart of trade finance. Letters of credit do not provide the same assurance of payment that traders have historically expected due to currency reserve shortages.
Letters of credit and UCP 600
The Uniform Customs and Practices for Documentary Credits, abbreviated as UCP, was first published by the International Chamber of Commerce (ICC) in 1933. The UCP introduced the documentary credit as a tool for financing 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, called UCP 600, came into effect on July 1, 2007. It is widely accepted that the UCP 600 is adopted for use by banks in 175 countries. This can lead to the misconception that UCP 600 is an international convention or treaty. This is not the case. The 39 articles of the UCP 600 regulation must be incorporated into an agreement to apply as contractual conditions between the parties. The UCP was deliberately created so that disputes would be decided by local courts.
If a bank fails to pay under a letter of credit, the beneficiary of the letter of credit can first submit a complaint through the expertise in the resolution of disputes relating to documentary instruments ( DOCDEX) within the ICC. Although not binding on the parties unless otherwise agreed, DOCDEX dispute resolution is inexpensive, with capped fees and fair decisions made by a panel of three impartial experts, with the entire process typically lasting a few month.
If a resolution is not reached through a DOCDEX dispute resolution process, a claimant normally has no choice but to file a lawsuit in the local courts of the originating jurisdiction. form the bank. Traders who have accepted letters of credit from banks in developing countries are finding themselves in local courts trying to recover their payment.
The new risk of central bank insolvency and the decline in foreign exchange 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, global supply chain disruption, global fuel price inflation and food, and other factors have combined to cause a significant depletion of foreign exchange reserves globally. There are more and more banks in developing countries that are unable to remit foreign currency under a letter of credit, either due to a lack of foreign currency or due to an order from the central bank.
In recent months, more and more countries are facing a budget crisis and the inability to meet the necessary import payments. The widely reported cases are:
- Lebanon is in the fourth year of an ongoing financial crisis whereby overseas remittances of foreign currency are scarce and difficult.
- Sri Lanka has defaulted on its sovereign debt, and foreign banks are reportedly refusing to confirm letters of credit issued by Sri Lankan banks, and oil suppliers are refusing letters of credit issued by Sri Lankan banks. lankans.
- The Central Bank of Nigeria is said to have a backlog of $2 billion in currency transfer requests which it is unable to honor due to lack of foreign currency reserves.
- Nepal has experienced a decline in its foreign exchange reserves and, as a precautionary measure for a financial crisis, introduced current account balance requirements for importers in December 2021 and banned the import of many non-domestic goods. essentials, including new cars, in April 2022.
- Pakistan is going through a serious economic crisis, negatively impacted by the rise in commodity prices and the depreciation of the currency.
- Kenya has seen a sharp decline in its foreign exchange reserves over the past year.
At the same time, in some countries the use of letters of credit was made (de facto) mandatory in foreign trade transactions. The underlying logic is to better control foreign currency outflows and implement AML regulations.
- In Libya, any allocation of foreign currency for the importation of goods must be justified 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 by letter of credit, with documentary collections no longer permitted. This requirement was relaxed in May 2022 for the import of raw materials for industrial plants.
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 “backed” 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, typically 0.5-2% of the value of the letter of credit, many merchants have moved away from confirmed letters of credit in recent years.
A confirmed letter of credit can only be made before the parties execute the transaction. The matter should be discussed beforehand by the seller with his bank, as not all banks will confirm every letter of credit, as confirmation transfers the risk of collection from the buyer’s bank to the seller’s bank.
Where a business is in a situation where it has delivered goods without payment and finds that a bank is unable to make payment due to local restrictions, the seller should immediately consider alternative solutions to payment .
- The first and most common method is to send an official demand letter. This can force a discussion and negotiation that led sellers to secure a place in line for payment.
- If no resolution is forthcoming, the next step is a DOCDEX dispute resolution process. This ICC expert opinion is not binding unless expressly agreed, but it may create persuasive expert authority for a seller claiming payment.
- If no resolution is found, then a seller must 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 accepting to take the risk of exchange and opening a bank account in a local bank. This is not the same as collecting the funds under the letter of credit and can only be a better solution than failing to collect payment under a letter of credit.