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1. Chapter 9: Legal Aspects of Trade Finance Meaning of Trade Finance Trade finance is the lending by bank for trade. A trade transaction requires a seller of goods and services as well as a buyer. Various intermediaries such as banks and financial institutions can facilitate these transactions by financing the trade. Trade finance signifies financing for trade, and it concerns both domestic and international trade transactions. Trade finance is granted in the form of fund based and non – fund based finance to enables the traders in their trading activities. If the bank extends finance mainly in rupee funds to assist his borrower to sell or buy goods and services within India, it is classified as inland trade finance. If a banker assists his borrower to handle international trade activities of export and import the banker is extending credit called overseas trade finance.

2. FUNDED AND NON FUNDED CREDIT Funded Credit Funded loans are those loans where there is an actual transfer of funds from the bank to the borrower. Borrowers are charged interest rate on this type of loan on its disbursement. Funded loans are recorded in the books of accounts and appear in the balance sheet under the heading of loan and advances Examples of funded loans are home loan, hire purchase loan, equipment loan, education loan, Credit cards, bills purchase, term loans, overdraft etc.

3. Non funded Credit Non-funded facilities are those which do not involve physical cash transfer to the borrower rather bank commits creditor of borrower to pay if borrowers fail to pay the creditor on any future date within the expiry period of facility. Bank’s commitment for the future payment or any other conditional payment on behalf of its customer is known as non funded facility. These commitments do not appear in the balance sheet. It is presented as contingent liabilities outside the balance sheet hence they are also known as off balance sheet items Borrower are charged certain commission rather than interest rate on this type of loan. Thus, income earned from this service is classified as non-interest income. Examples of non-funded loans are letters of credit, bank guarantees, acceptances and endorsement, commitments, factoring, operating lease etc.

4. Bank Guarantee A bank guarantee is a type of guarantee from a lending institution. The bank guarantee means a lending institution ensures that the liabilities of a debtor will be met. In other words, if the debtor fails to settle a debt, the bank will cover it. It is an agreement between three parties viz. the bank, the beneficiary and the applicant. Bank gets commission income from guarantee services. A Bank Guarantee can have an expiry date after which the guarantee automatically ceases. It is also used by exporters and importer because bank functions as a guarantor for the transaction. It is beneficial to the importer because it protect them when the exporter does not fulfill its obligations.

5. Continued……. It is beneficial to the exporter because it protect them from the noncompliance of the importer. Features of a Valid Guarantee The period until which the guarantee holds is clearly specified The guarantee issuance is always for a specific amount The purpose of the guarantee is clearly stated The guarantee is valid for a specifically defined period The grace period allowed to enforce guarantee rights is also stated in the guarantee

6. Importance of Bank Guarantee 1. Adds to Creditworthiness BGs reflect the confidence of the bank in your business and indirectly certify the soundness of your business. 2. Assessment of Business In the case of foreign transactions or transactions with Government organizations, the foreign party or a Government undertaking is constrained and cannot assess the soundness of each and every applicant to a project. In such cases, BGs act as a trusted instrument to assess stability and creditworthiness of companies applying for projects. 3. Confidence of Performance When new parties associate in the business and are skeptic about the performance of the company undertaking the project, performance guarantees help in reducing the risk of the beneficiary. 4. Risk Reduction Advance payment guarantees act as a protection cover wherein the buyer can recover the advance amount paid to the seller if a seller fails to deliver the goods or services. This protects against any probable loss that a party can suffer from a new seller.

7. Types of Bank Guarantees 1. Financial Guarantee A financial bank guarantee assures that money will be repaid if the party does not complete a particular project or operation entirely. According to the financial guarantee agreement, when there is a delay in the completion of the project, the bank will make the payment 2. Performance Guarantee Under a performance guarantee, compensation of money will be made by the bank when there is any delay in delivering the performance or operation. Payment will have to be made even if the service is delivered inadequately. 3. Advance Payment Guarantee This guarantee assures that they would return the advance amount in case of no fulfillment of the terms. Under this kind of guarantee, an advance payment will be made to the seller. There will also be a guarantee that if the seller fails to deliver the service or product accurately or promptly, the buyer will receive a refund of the payment.

8. 4. Payment Guarantee / Loan Guarantee The guarantee is for assuring the payment/loan repayment. In case, the party fails to do so, a guarantor has to pay on behalf of the defaulting borrower. 5. Bid Bond Guarantee Under this type of guarantee, there will be a supply bidding procedure. This will be conducted by the contractor for the owner of an infrastructure or industrial project or any kind of operation. The contractor of the project will guarantee that the best bidder or the highest bidder will have the capability and authority to implement a project as per his or her preferences. The bid bond will be given to the owner of the project as a proof of guarantee and the bond will imply that the project will have to be devised according to the bid contract.

9. 6. Foreign Bank Guarantee Foreign BG is a guarantee which is issued for a foreign beneficiary. A foreign bank guarantee is provided by a bank on behalf of a borrower. This will be offered on behalf of the foreign beneficiary or creditor. 7. Deferred Payment Guarantee When the bank guarantees some deferred payment, the guarantee is termed as Deferred Payment Guarantee. For example, A company purchases a machine on credit basis with terms of payment being 6 equal installments. In this case, since the payment is deferred to a later period, creditor seeks deferred payment guarantee for an assurance that the payment would reach him in the given time period. This refers to a bank guarantee or a payment guarantee that is offered to the exporter for a deferred period or for a certain time period. Under this type of guarantee, payment will be made in installments by the bank for failure in supplying raw materials, machinery or equipment.

10. 8. Shipping Guarantee This guarantee protects the shipping company from all kinds of loss, in case the customer does not pay. This document helps the customer to take possession of goods.

11. LETTER OF CREDIT A letter of credit represents an obligation taken on by a bank to make a payment once certain criteria are met. After these terms are completed and confirmed, the bank will transfer the funds. The letter of credit ensures the payment will be made as long as the services are performed. It can be defined as an authorization letter issued on the direction of importer by his bank to exporter’s bank at other place or country recommending to pay amount to a certain person upon presentation of cheque, draft or Bill of exchange along with necessary other documents. For example, say a U.S. wholesaler receives an order from a new client, a Canadian company. Because the wholesaler has no way of knowing whether this new client can fulfill its payment obligations, it requests a letter of credit is provided in the purchasing contract. The purchasing company applies for a letter of credit at a bank where it already has funds or a line of credit (LOC). The bank issuing the letter of credit holds payment on behalf of the buyer until it receives confirmation that the goods in the transaction have been shipped. After the goods have been shipped, the bank would pay the wholesaler its due as long as the terms of the sales contract are met, such as delivery before a certain time or confirmation from the buyer that the goods were received undamaged.

12. Processing of letter of credit 1. Buyer and seller agree to conduct business. The seller wants a letter of credit to guarantee payment. 2. Buyer applies to his bank for a letter of credit in favour of the seller. 3. Buyer’s bank approves the credit risk of the buyer, issues and forwards the credit to its correspondent bank (advising or confirming bank). 4. Advising bank will authentic the credit and forward the original credit to the seller. 5. Seller ships the goods, then verifies and develops the documentary requirements to support the letter of credit. 6. Seller presents the required documents to the advising or confirming bank to be processed for payment. 7. Advising bank examines the documents for compliance with the terms and condition of the letter of credit.

13. 8. If the documents are correct, the advising bank will claim the funds by debiting the account of the issuing bank or waiting until the issuing bank remits after receiving the documents. 9. Advising bank will forward the documents to the issuing bank. 10. Issuing bank will examine the documents for compliance. If they are in order, the issuing bank will debit the buyer’s account. 11. Issuing bank then forwards the documents to the buyer.

14. Features of Letter of Credit 1. Negotiability The LC is usually considered as a negotiable instrument and can be passed freely as money among various parties. It obligates the issuing bank to pay the money not only to the beneficiary but also to any other bank nominated by him. However, the LC is considered as negotiable only when it includes an unconditional promise of payment on demand or at a particular time. 2. Revocability The letter of credit can be either revocable or irrevocable. The issuing bank can revoke or modify a revocable letter of credit at any time without notification. In such a scenario, the advising bank will not confirm the LC. However, the use of revocable LC is very rare. An irrevocable LC is the most commonly prevalent as it is not modifiable or revocable without the agreement of all the parties in the transaction. 3. Transfer and Assignment The beneficiary of the letter of the credit can transfer or assign the LC as many times as possible. The LC will remain effective. 4. Sight and Time Drafts The letter of credit demands payment through two features: sight or time. A sight draft is paid when the LC is presented and the time draft is paid after a certain duration of time. The bank will review the LC to be sure that it is valid in both cases

15. Types of Letters of Credit Commercial Letter of Credit Most common LC in international trade. It is also known as import export LC. The terms and conditions are based on UCP (uniform Customs and Practices for Documentary Credits) under the guidelines of ICC (International Chamber o Commerce). 2. Stand by LC Beneficiary of stand by LC is paid when there is a breach of terms and conditions. Governed by International Standby Practices (ISP), ICC. 3. Revocable letter of credit It can be changed at any time by either the buyer or the issuing bank with no notification to the beneficiary. Not endorsed by UCP. Since, seller’s interest is not protected , rare in use. 4. Irrevocable letter of credit It only allows change or cancellation of the letter of credit by the issuing bank after application by the buyer and approval by the beneficiary. All letters of credit governed by the current UCP are irrevocable letters of credit.

16. 5. Confirmed letter of credit It is one where a second bank agrees to pay the letter of credit at the request of the issuing bank. While not usually required by law, an issuing bank might be required by court order to only issue confirmed letters of credit if they are in receivership. 6. Unconfirmed letter of credit It is guaranteed only by the issuing bank. This is the most common form with regard to confirmation. 7. Transferrable letter of credit These are commonly used when the beneficiary is simply an intermediary for the real supplier of the goods and services or is one of a group of suppliers. It allows the named beneficiary to present its own documentation but transfer all or part of the payment to the actual suppliers. 8. Un-transferrable letter of credit It does not allow transfer of payments to third parties.

17. 9. Sight LC and Usance A letter of credit may also be at sight , which is payable as soon as the documentation has been presented and verified, or payment may be deferred . Deferred letters of credit are also called a usance letter of credit and may be put off until a certain time period has passed or the buyer has had the opportunity to inspect or even sell the related goods. 10. Advance Payment (Red Clause) LC A red clause letter of credit allows the beneficiary to receive partial payment before shipping the products or performing the services. Originally, these terms were written in red ink, hence the name. In practical use, issuing banks will rarely offer these terms unless the beneficiary is very creditworthy or an advising bank agrees to refund the money if the shipment is not made. 11. Back-to-back letter of credit It is used in a trade involving an intermediary, such as a trading house. It is actually made up of two letters of credit, one issued by the buyer's bank to the intermediary and the other issued by the intermediary's bank to the seller.

18. Major Parties of Letter of Credit 1. Applicant of Letter of Credit. Applicant is one of the main parties involved in a Letter of Credit, who is an applicant under Letter of credit. Applicant is the party who opens Letter of Credit. Normally, buyer of goods is the Applicant who opens letter of credit. Letter of credit is opened as per his instruction and necessary payment is arranged to open Letter of credit with his bank. The applicant arranges to open letter of credit with his bank as per the terms and conditions of Purchase order and business contract between buyer and seller. So Applicant is one of the major parties involved in a Letter of credit. 2. LC Issuing Bank Issuing Bank is one of the other main parties involved in an LC. Who is an Issuing Bank under Letter of credit? Issuing Bank is the bank who opens letter of credit. Letter of credit is created by issuing bank who takes responsibility to pay amount on receipt of documents from supplier of goods (beneficiary under LC).

19. 3. Beneficiary party Beneficiary is one of the main parties under letter of credit. Beneficiary of Letter of credit gets the benefit under Letter of credit. Beneficiary is the party under letter of credit who receives amount under letter of credit. The LC is opened on Beneficiary party’s favor. Beneficiary party under letter of credit submits all required documents with is bank in accordance with the terms and conditions under LC. 4. Advising Bank Advising bank is another party involved under LC. Advising bank, as a part of letter of credit takes responsibility to communicate with necessary parties under letter of credit and other required authorities. The advising bank is the party who sends documents under Letter of Credit to opening bank.   5. Confirming Bank Confirming bank is one of the other parties involved in Letter of Credit. Confirming bank as a party of letter of credit confirms and guarantee to undertake the responsibility of payment or negotiation acceptance under the credit.

20. 6. Negotiating Bank Negotiating bank is one of the main parties involved under Letter of Credit. Negotiating Bank, who negotiates documents delivered to bank by beneficiary of LC. Negotiating bank is the bank who verifies documents and confirms the terms and conditions under LC on behalf of beneficiary to avoid discrepancies  7. Reimbursing Bank Reimbursing Bank is one of the parties involved in an LC. Reimbursing bank is the party who authorized to honor the reimbursement claim of negotiation/ payment/ acceptance.   8. Second Beneficiary Second beneficiary is one of the other parties involved in Letter of Credit.  Second beneficiary who represent the first beneficiary or original beneficiary in their absence, where in the credits belongs to original beneficiary is transferable as per terms.

21. Roles and responsibilities of different parties of LC

22. Essential Documents for Letter of Credit Applicant must submit various documents related to import/export trade as per NRB directives which are as follows: Firm registration certificate (duly renewed) Attested Photocopy of citizenship Latest tax clearance certificate Proforma invoice/sales contract (HARMONIC CODE) to be mentioned. Country of origin Delivery term Application form BI BI NI form No.3 (3 copies) Board minute MOA AOA

23. Risk Associated with the Letter of Credit

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