THE ROLE OF LETTERS OF CREDIT IN INTERNATIONAL BUSINESSES - Essay Example

?THE ROLE OF LETTERS OF CREDIT IN INTERNATIONAL BUSINESSES Outline Introduction Letters of Credit as the Lifeline in International Business Historical Background of Letters of Credit Alternatives to Letters of Credit Advantages of Letters of Credit Disadvantages of Letters of Credit Conclusion References Introduction A letter of credit or document of credit is a popular facility for the financing of international trade (Gillies & Moens, 2000 p387). It is an undertaking by a bank issued at the request of a customer (usually the buyer of goods in a foreign country) to pay a supplier in a foreign country a specified amount of money, provided the supplier submits certain documents (Craig, 1999). The salient features of a letter of credit are as follows: 1. A payment undertaking given by a bank (issuing bank) 2. It is issued on behalf of a buyer (applicant) 3. The undertaking is to pay the seller (beneficiary) a given amount of money. 4. The payment is on condition that the seller (beneficiary) submits some specified documents to the bank. 5. The seller (beneficiary) should claim the money from the bank within the time limit stipulated in the agreement. 6. The documents submitted should conform to the terms and conditions defined in the undertaking. 7. Documents should be presented at a specified date (Muralidharan, 2005 p66) Gillies & Moen (2000) go further to state that letters of credits are autonomous. They are payment instruments that are separate from the contract of sale between the applicant and the beneficiary. This therefore means that there is no link between the terms or discharge of the fundamental contract at hand and the cashing of the letter of credit. In other words, the banks do not concern themselves with the contract terms or its status whenever it comes to payments for the loan. Hence a bank cannot reject the payment of a letter of credit on any of these four grounds: 1. To serve the applicant’s interest 2. To serve the bank’s own interest 3. After express waiver of a particular discrepancy 4. Without giving the beneficiary some time to correct a minor discrepancy (Seyoum, 2009 p207). Rejection can only be made on one of two grounds (Stevens, 1987 p95). First of all, when the credit expires or there is a lapse of time on the part of the beneficiary. Secondly, when there is the case of clear-cut fraud or forgery on the part of the buyer (Seyoum, 2009). Thus the letter of credit acts as some form of international collateral for international business transactions unless these two fundamental breeches occur (Craig, 1999 p360). In Wood Hall Ltd V Pipeline Authority [1979] 141 CLR 443 457 the landmark ruling by the Judge was “The Letter of Credit ... is as good as cash in the eyes of those whom it is issued and that is essentially its function” (Dixon, 2004 p392). This paper therefore examines the use of letters of credit in international business. It begins by critically assessing whether or not it is the cornerstone of international business around the globe. It goes further to examine the evolution of the concept and use of letters of credit in modern business. The assessment of alternatives to letters of credit follows. The paper ends by critically examining the advantages and disadvantages of letters of credits in international business. Letters of Credit as the Lifeline in International Business In a landmark ruling, Lord Justice Kerr stated that Letters of credit are the “lifeblood to international commerce” (Harbottle (Mercantile) Ltd V National Westminster Bank Ltd [1978] QB 14 6 155). In this ruling, he emphasises the importance of the use of letters of credit in international business. This is reemphasised by Lord Justice Griffith two years later in the case of Power Garber International Ltd V National Bank of Kuwait SAK [1981] 2 Lloyd Rp. Once again, the Judge stated that letters of credit are important and need to be honoured and preserved to enhance international trade (Schmitthoff, 1988). Basically, the use of letters of credit is very important because it enables businesses to move about freely in other nations and communities with a collateral that is as good as cash. This therefore presents a positive insight into business across borders and enhances positive business traits and builds partnerships across borders. Also, there have been attempts by the international community to unify the system for the use of letters of credit using the Uniform Customs & Practices for Documentary Credits in 175 states across the world (Schmitthoff, 1988 p573). These nations have Central Banks that monitor and control the issue and cashing of letters of credits. However, in spite of the assurances that letters of credit give, it has “a failure rate of 50%” (Schmitthoff, 1988). This therefore implies that one out of every two transactions based on letters of credits fail around the globe. This is a piece of alarming statistics that makes it wiser to consider the use of alternative methods of transacting business international or at least a high level of professional scepticism in the field of international payments for business owners. The most popular cause of failure in the use of letters of credit is the disappearance of importers (Practicing Law Institute, 2003). This is because in most cases, when the goods are supplied and the importer leaves the country of the supplier, it is difficult to track him down. International conmen and criminals end up exploring this loophole by presenting fraudulent documents that tend to mislead suppliers to carry out their goal of stealing from unsuspecting international businesses. This therefore leaves a serious vacuum in the importance and central role of letters of credit in international business. Thus, over the past 30 years that the landmark rulings were made, alternative methods and forms of international business payments and systems have been developed to avoid he loopholes and poison pills that letters of credits present. Historical Background of Letters of Credit There is evidence that the use of systems similar to letters of credit were used in Ancient Egypt, Ancient Greece and Rome (Mugasha, 2005). However, it became pronounced in its usage over the past millennium and this has been transposed into our own time. In the 13th Century, King John of England sent letters through traders to the various emissaries in Italy instructing them to pay for the costs incurred by the traders, who were sent there in his name (Dolan, 1991 p3). In medieval times, there was a challenge about how to categorise merchants in law and this was one of the catalysts of the development of international commercial aw. However, Lord Mansfield stated in a land mark case that The Law of Merchants and the law of the Land are the same (Todd, 1973). In this vein, Lord Mansfield laid the legal foundation for the creation of uniform laws and systems that would enable merchants to trade in faraway lands without having to face so many restrictions that came with movement from nation to nation (Finkelstein, 1930). Finkelstein goes further to state that British Colonial trading companies therefore came up with new systems and methods that enabled British merchants to trade in the various colonies with arrangements like letters of credit. This helped these businesses to move from place-to-place utilising British banks to make their businesses much easier and more convenient. At the other side of the Atlantic, the panic attacks of traders in 1873 in some states of the US caused the need for businessmen to travel around the globe with some kind of legal tender but not money because businessmen were targets for robbers (Markham, 2002 p291). The banks therefore resorted to the use of the letter of credit system. This made it popular and enabled people from different parts of the United States and even outside the US to come over and do business without having to carry huge sums of money that would attract thieves and robbers. With time, the nations around the world began using letters of credit to enhance business across borders. In most nations of the British Commonwealth, the use of letters f credit became popular and known after the Second World War. The Paris Agreement of 1924 attempted to harmonise the use of letters of credits across the globe (Schmitthoff, 1988 p573). This attempt began an era where banks and other financial institutions supervised payments using these letters of credit. By the year 2002, the International Chamber of Commerce attempted to harmonise the use of letters of credit (Mugasha, 2005). This arrangement sought to bridge the international diversity and lapses in the conflict that came with the use of letters of credit across borders. However, in spite of the evolution and attempts to harmonise the systems of letters of credits across the globe, there is a major pointers that each business involved in the use of letters of credit need to be aware of (Yates, 2007 p131). Basically, a supplier entering a letter of credit arrangement needs to investigate the financial credibility of the bank and buyer. Usually, in practice the paying bank to request the issuing bank to confirm the credibility of the transaction at hand (Seyoum, 2009). If the foreign bank agrees to honour payment, then the bank in question would also honour payment. If not, the transaction is usually investigated and if it is found to be fraudulent, the transaction is cancelled altogether. Thus, it is worthy to note that although the letters of credit system has come a long way, there are several lapses and loopholes that make it difficult for it to achieve its objectives and eschew fraud. Due to this, most individuals and businesses are moving on to use alternative methods and systems of paying money in overseas transactions. Alternatives to Letters of Credit “Cash management in international business is shifting to electronic fund transfers (EFT) which involves the use of computers to initiate and complete bank to bank or account to account transactions” (Lee et al, 2008 p368). This therefore implies that most public and large organisations are more interested in the use of electronic money transfer systems rather than letters of credit. With the current trend of globalisation and the increases in technology, people can easily complete bank transactions using computers and various internet connections and systems. This works because the harmonisation of international trade and activities as well as the gradual disappearance of international borders guarantees that the use of electronic systems presents better and quicker options and transactions. For bank-to-bank transactions, there are several options that are popularly known as GIRO transactions (Ellinger, 1986). They include bankers draft, mail transfer, telegraphic transfers, in-house electronic transfers and SWIFT Transfers. Bankers draft can be used in situations where a business seeks to remit money to another business overseas but is not so sure of who the payee will be (Iwahara, 2003 p290). This way, any time the business completes a good transaction, it would be able to present the bankers draft to the business it contracted with. This system has a superiority over the letters of credit systems whereby the business is bound to pay for a transaction even where it is not satisfied with the service it received. There is are also other forms of electronic transfers like the mail transfers, telegraphic transfers, in-house electronic transfers and SWIFT which allows a business to pay its partners overseas in a matter of hours after completing a contract. These systems are quick, fast and reliable and do not really require too much effort or in some cases, travel to the other party’s country as bearers of letters of credits might need to do. Iwahara (2003) also identifies another method of transaction money overseas where a business uses a travellers’ cheque. This virtually gives a manager who travels overseas to transact a business a cheque, which can be used to pay for his transactions. It reduces the bulk of money that can be carried around and again it is flexible, in that it can only be given as and when a transaction is satisfactorily complete. These days, there are more modern technologies and systems that can be used to transfer electronic funds much quicker, easier and more conveniently. Popular methods that can be used aside bank account transactions and systems are electronic currencies. Electronic currency systems like Paypal and Moneybookers can enable businesses to transfer huge sums of money between accounts from different locations around the world. These companies operate almost independent money transfer systems that enable any two parties to log on and deposit money and also transfer money. This does not go without saying that organisations and individuals can make use of credit cards that can enable them to send money over long distances without having to use letters of credit. These electronic forms of money transfer across borders are fast, convenient, confidential and reliable. However, the current anti-money laundering systems place restrictions on many businesses in their use of electronic fund transfers. In the UK, the Proceeds from Crime Act (2002) places additional responsibilities on people who use electronic transfers for funds to make extra disclosures (Hopton, 2009). This makes it a bit inconvenient for the business sector to rely solely on electronic funds transfer. However, Johnson (2008) points out that in spite of the many attempts by authorities to restrict the use of electronic funds transfers, there are still many options and opportunities for the use of electronic means to send money abroad. Advantages of Letters of Credit The first advantage of the use of letters of credit lies in the fact that it is a popular system of transferring money amongst business associates (Kravitt, 1997). This effectively means that many other business professionals who handle very huge amounts of money rely on the letters of credit systems. Hence, there is a prestige attached to it. Furthermore, it is a highly trusted system by many people in the world and this makes it the automatic choice and preferences of most people in international business circles. In the UK, there is a developed jurisprudence for the use of letters of credit because it has been used in Britain and its dependencies for over seven hundred years now. This therefore gives an individual some kind of assurance that the law can always intervene when there are challenges in a the operation of the letter of credit. Secondly, letters of credits give clear assurance that the money of a given business transaction will be received quickly (Kim & Kim, 2006 p323). This is because once a contract is signed and an international buyer gives a local seller the letter of credit, the local seller can always go to a local bank and get the money paid as soon as possible. This is because by the legal nature of letters of credit, a supplier gets the legal rights to his proceeds the moment he gets the letter of credit and can produce the documents required by the letter. This therefore means that the letters of credit bring fast, quick and convenient funds to people selling goods to international business partners and associates. There are many complications in international trade. There are national cross-border restrictions, legal requirements, bilateral and multilateral restrictions as well as local restrictions placed by Central Banks. With a letter of credit though, a business gets to avoid most of the effects of these restrictions and get to the point to honour the business requirements at hand (Dewey & Shugrue, 1980). In other words, the use of letters of credit guarantees that a given transaction will safely occur irrespective of the local or international pressures between the two parties. The use of letters of credit therefore bridges the gap between nations and makes international commerce much easier, convenient and adds up to the seriousness of international commerce. The use of letters of credit helps to build trust between two parties operating from different nations across the globe (Shim & Siegel, 2008 p248). There is a lot of paranoia and suspicion in international business. Once a person is to do business in a foreign country, there are many concerns and doubts that comes up in his mind. However, with the use of letters of credit, one is not obliged to pay cash upfront until the buyer is satisfied with the goods and services received. This therefore means that a foreign trader can always get the upper hand in a transaction involving the use of letters of credit. Thus it is a good source of protection against exploitation in a foreign land. Also, letters of credits are internationally recognised. It is based on international law and hence there are many countries that treat it as a medium of exchange in international business (Finkelman, 2005). This therefore means that letters of credit can be trusted means and methods for international trade and this makes the holder get some level of credibility, prestige and acceptance in nations he operates in. Disadvantages of Letters of Credit First of all, Bhalla (2003) identifies that there are high fees that are charged for letters of credit. This therefore implies that if a person goes in for a letter of credit, he risks getting charged too much money that will reduce his earnings. This can make the person’s finances fall below the borrowing line and hence cause the letter of credit to be rejected by the other party. There are high administrative costs in trying to arrange another agreement that will compensate for the loss that occurred. Secondly, importers can disappear after they present a letter of credit (Practicing Law Institute, 2003). This is because banks are required to reject a letter of credit if it is fraudulent. This implies that a malicious importer can easily forge a letter of credit and use it to defraud many international businesses. Due to the large scope of possibilities available to such fraudsters, it will be very difficult to control them when they start operating in different parts of the world. It is therefore a major risk on the part of suppliers when they decide to accept payments in the form of letters of credit. Since letters of credit are autonomous, there is a major difficulty on the part of buyers (Gruwer, 1981 p49). This is because the agreement is effectively distinct from the letter of credit. This therefore means that as a buyer, if you are not satisfied with the quality of goods or services you are receiving, you are still bound to pay without any recourse because the letter of credit makes it a must to pay for them. It can therefore be said that the letter of credit limits the concept of caveat emptor because the buyer has a limited scope to examine and take a decision once an agreement is in place. When contrast with a normal cash contract, it can be said that the buyer can have recourse to some action or control if the seller provides goods or services he is not happy with. However, in this scenario, it is very difficult to say that a buyer will have the same rights because he is bound to pay for the goods once he presents the letter of credit to the seller. In cases where letters of credits fail, there is very little a supplier can do (Genzbergen, 2003). This is because a breach in such an agreement means that the supplier will have to take action in a foreign land or at best against a foreign buyer. In this case, if the buyer does not co-operate, it will be very difficult for any action to be taken because the agreement is over two different jurisdictions and with the absence of commitment and support from the buyer, it is likely that all efforts will prove futile. So a letter of credit can turn out to become a major failure. Another disadvantage of using a letter of credit is that it is now considered as an outmoded method of making payments overseas. This is because newer and more sophisticated methods and systems of payment across borders have evolved and more improved systems and methods keep on coming up each passing day. These new systems come with faster, convenient, accurate, traceable and other verifiable systems and methods built in them. This makes the letter of credit an archaic and outmoded method of making payments to international partners. There is a chance and a likelihood that with time, parties in international trade will prefer to use EFT rather than the popular letter of credit systems. Conclusion Letters of credit are important ways of doing international business. However, due to inherent problems and challenges, half of all letter of credit transactions are doomed to fail or end up with one form of frustration or the other. The development of the system that gave birth to the letters of credit can be traced by to ancient times when kings and rulers sought to use letters to guarantee the rights of some selected persons to some benefits. However, over the years, particularly from medieval times to present times, letters of credit have evolved from being just colonial tools to an internationally recognised method of payment across borders. This is basically because it prevents traders from having to travel over long distances with huge sums of money and also enables modern international traders to live above the numerous national and international barriers to the transfer of funds. Over the past thirty years, new and more convenient methods of making payments have been discovered and are being used. These new alternatives to international payments include electronic funds transfer (EFT) systems that allow businesses to pay for cross-border transactions quickly and conveniently. Letters of credit however have the advantage of being recognised and trusted across the globe. It gives some kind of assurance to both parties and enables individuals and organisations to live above limitations of international trade. On the other side, letters of credit are undesirable because they come with very high transaction costs that can cause an account to go below the borrowing line and this will cause the banks to reject the transaction. Secondly, it poses risks to both the supplier and buyer because the buyer can easily disappear. In the case of the buyer, the use of a letter of credit can force him to be entrapped in a contract that might not be favourable. Also, due to the cross-border nature of letters of credit, failures and disappointments are difficult to deal with. References Bhalla, V. K. (2003) International Financial Management New Delhi: Annol Publication PVT Ltd Craig, R. W. (1999) Procurement Law for Construction & Engineering Works & Services Oxford: Blackwell Dewey, Davis Rich & Shugrue Martin Joseph (1980) Banking & Credit Ayer Company Publishers Dixon, William, M (2004) “As Good As Cash? 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