Should Australia Ratify the UN Convention on Independent Guarantees and Standby Letters of Credit - Coursework Example

Name Course Number Professor’s Name 19th September 2009 International Trade Finance Law: Should Australia Ratify the United Nations Convention on Independent Guarantees and Standby Letters of Credit? This paper examines the procedures involved in International trade and finance law with specific reference to the independent guarantees and standby letters of credit, their use and significance in international trade. Broadly defined International Trade refers to the exchange of services and goods between countries, giving rise to a global or world economy. Today the ‘new trade theory’ that highlights in its literature ‘geography and trade’ has made a huge impact on the manner in which economists’ understand trade. According to this theory, it is established that trade and gains from trade can occur and is not dependent on comparative advantage pattern. This means that firms can take advantage of the economies of scale and follow strategies that focus on product differentiation in an imperfectly competitive environment. Available content with regard to trade and geography is but an expected extension of this research theory, as it focuses on how “industry agglomeration and regional differentiation can arise endogenously as a consequence of transport costs, market sizes and the trade policy regime”i 1(Markusen 169). This kind of global business allows consumers in one country the option of buying services and goods that are not available in their own regions. This could be banking services, transport and tourism services etc. This kind of import and export of goods and services accounts for a country’s current account in the balance of payment. International trade and finance law is a rapidly expanding areas with regard to international law and this defines the appropriate customs and rules to regulate trade between countries. This also includes regulation of laws between private companies across borders. My goal in this paper is to decide whether Australia should ratify the United Nations Convention on Independent Guarantees and Standby Letters of Credit. To achieve this goal, the paper has been divided into eight sections. First, the paper will explain Independent Guarantees and Standby Letters of Credit and describe their use and Significance in International Trade. We will also describe in detail the URDG (Uniform Rules for Demand Guarantees) and the ISP98 (International Standby Practices). This will enable us to provide the right course of action for a commercial party to use in international trade. The paper then will look at the United Nations Convention on Independent Guarantees and Standby Letters of Credit that has been adopted by eight nations. Next we will compare the United Nations Convention on Independent Guarantees and Standby letters of Credit with the URDG. Finally we will arrive upon a conclusion on whether Australia should ratify the convention. Independent Guarantees and Standby Letters of Credit Independent Guarantees are defined by InvestorWords.com2 as ‘to accept responsibility for an obligation if the entity with primary responsibility for the obligation does not meet it.’ In today’s context, Independent Guarantees and Standby Letters of Credit mean one and the same thing. “There is a widespread belief that American standby letters of credit are different from the European independent guarantee. This is a fallacy3 (Bertram 7).” A letter of credit is a stand-or substitute of the credit of the bank for that of the customer, and facilitates trade. There are two kinds of letters of credit – commercial letters of credit and standby letters of credits. The first is a primary payment mechanism and the second is a secondary payment mechanism. Standby Letters of Credit (Standby L/Cs) are often used goods - but like Bonds and Guarantees, they can cover a number of different transactions. Basically this is how it works - an importer can issue a Standby letter of Credit in favor of an exporter in order to cover any possible non-payment by the importer. This would include monetary obligations; insure the refund of any payment advance, to support bid and performance obligations etc. Should the importer not deliver on his promise to pay, the exporter can use the Standby L/C to claim the unpaid amount. In markets like the United States, Standby Letters of Credit are preferred over Bank bonds4 (Royal Bank of Scotland n.d.). The fact is that all participants who are involved with the transaction do not expect the Standby letter of credit to be utilized. The Standby L/C is an important tool that is utilized to guarantee performance and in addition also strengthens the customers’ credit worthiness. As per the Credit Research Foundation 1999, a Uniform Commercial Code governs a domestic standby L/C. According to this , a bank is granted time until the close of the third banking day (after receiving the relevant documents) in order to honor the draft. For the use of the Standby L/C, the procedures are quite simple and not too rigorous, as it does not involve a correspondent bank (advising or confirming). “Independent guarantees and documentary credits (or letters of credit) share many significant features, such as the commercial context – often in an international setting – their structure and mechanics, the way they come into existence, the fact that the bank’s customer is the account party and hence a truly interested party, risk allocation, and their purpose, namely the furnishing of security5 (Roeland 68).” The URDG (Uniform Rules for Demand Guarantees) A demand guarantee is a written undertaking by a guarantor (in most cases a bank), to pay the importer the maximum sum quoted on the document. The exporter takes on responsibility to repay the bank6 (SITPRO 3). These demand guarantees serve as substitutes for cash and are frequently used in construction project contracts and has even replaced rent deposits in leases on homes in the Middle East. The difference between a Standby letter of Credit or Independent Guarantee and a Demand Guarantee is that the former provides the exporter against non-payment whereas the latter provides the importer against non-performance, late or defective performance etc. by the exporter. A Demand Guarantee may be either Direct or Indirect. A Direct Guarantee is one that is provided directly by the exporter’s bank to the importer, giving its bank an indemnity or sufficient funds, or some other means of security, against the cost of non-payment and meeting claims. This involves three distinct steps – the contract between the importer and the exporter, the re-imbursement contract (counter-indemnity between the bank and the exporter and the guarantee between the importer and the exporter’s bank. Reimbursement Guarantee Contract Underlying Contract Courtesy:SITPRO An indirect guarantee is the one provided by an importer’s own bank. In this case, there are four different contracts: the contract between the importer and exporter, the reimbursement contract between the bank and the exporter, the counter-guarantee between the exporter’s bank and the bank in the importer’s country and finally the counter guarantee between the importer’s bank and the importer. Counter-guarantee Guarantee Reimbursement Contract Underlying Contract Demand Guarantees are used in several situations – tender or bid guarantees, performance guarantees, advance payment guarantees, retention guarantees and Warranty guarantees. The International Chamber of Commerce (ICC), has formulated a Uniform Rules for Demand Guarantees (URDG) that was published in 1992. The URDG consists of 28 articles that clearly lay out the obligations for the guarantors, principals and beneficiaries; chalking out the nature of a demand, the liabilities and responsibilities of the parties, the circumstances of expiry, the governing law jurisdiction for the guarantor or counter guarantee. The rules have been expressed in an easy to understand manner and concisely. The rules in the URDG apply to all kinds of guarantees – from those payable on simple written demand to others that require a judgment presentation or arbitral awards. They also apply to immediate forms of guarantee such as those that require a statement of default by the beneficiary (this is with or without an indication of the nature of default. In order to bring security to international business practices, the URDG rules have become a part and parcel of the ICC Rules. The World Bank also has begun using the ICC’s Uniform Rules for Demand Guarantees (URDG) as of May 2002 (International Chamber of Commerce). These rules have been gaining popularity with both the contracting parties and the banks especially in the area of international transactions as they provide consistency of practice and a fair balance of interest while safeguarding the essential needs of the beneficiaries in terms of obtaining payment in case of default. The ISP98 (International Standby Practices) Standby letters of credit began in the 1950’s as an appendage to commercial letters of credit and today they have ‘evolved into a workhorse of commerce and finance’ 7(Byrne, 1998). They have donned the role of more permanent and important fixtures in international banking and commerce. The reason for this is that the outstanding amount of standbys has exceeded commercial credits hugely. Although standby letters of credit were considered popular in the United States at first, today they have become increasingly prevalent in Europe (where independent demand guarantees were the order of the day). Earlier in this paper we have already discussed the Standby L/C and its uses. Now let us look into the ISP98 (The International Standby Practices 98). This is a document that has been developed by the Institute of International Banking Law and Practice Inc, after 5 years of deliberation, exclusively for the domestic and international use of standby Letters of Credit. The ISP98 is a standardized text that has been drafted for use worldwide offering a detailed and precise framework for practitioners utilizing Standby L/C. The fact is that these ready-to-use rules drastically help reduce the time and cost of having to draft rules. In addition, these role help contain problems that could otherwise arise and help avoid countless disputes and unnecessary litigation that could have taken place in the absence of internationally accepted rules and regulations on standby. The ISP98 rules contain precise definitions of terms like ‘automatic amendment’ and ‘original’, provide neutral acceptable roles in most situations, cover in detail the standby processes from ‘obligations’ to ‘syndication’, help avoid unexpected losses etc. (International Standby Practices 1998) The ISP98 will aid in the streamlining of the preparation and negotiation process when drafting standby letters of credit. This document has helped change the format for standby L/C and has even changed practices in terms of reimbursement agreements and applications, allowing parties to focus on what they earlier used to overlook. It also provides parties with a great deal of flexibility – some parties opt for the ISP98s default rules, while others may want to make variations in the same. The ISP98 has been drafted keeping in mind legal scrutiny that this document is subjected to in the event of insolvency or dispute. . Standby L/C and Independent Demand Guarantee in International Business It is without doubt that both the standby letter of credit and an independent demand guarantee are both essential tools, if one were to look at providing the right course of action for a commercial party to use in international trade. The Standby L/C allows a business party to obtain and secure a financial or performance obligation with the beneficiary. In an international business, it caters to businesses that need a surety performance, it may be used in conjunction with or substituted for a bid bond, it may also be used for the issuance of a performance bond and for down payment and warranty requirements. According to Schaffer (248), a standby L/C is adaptable and flexible and can be customized for any use. They are used is large and complicated transactions. As discussed earlier, an independent demand guarantee can be either direct or indirect. A demand guarantee is an undertaking by a financial institution regarding the ‘payment of a stated or maximum sum of money against a demand for payment and documents as stipulated in the guarantee8 (Sitpro 2003)’. They can be used in many different contexts – a warranty guarantee, retention guarantee, advance payment guarantee, tender or bid guarantee or a performance guarantee. With the economic downturn, many companies are realizing that their customers are struggling to meet their payment commitments these days. According to the Credit Research Foundation, 55% of the 1,027 corporate credit-department managers surveyed in August 2009, have stated that they are more conservative in credit extension, while 64% have responded that they have tightened up their collections of accounts receivable. Companies have also begun to focus on risk management in the area of trade credit with 16% of the credit managers mitigating their risk through credit insurance. A third of them use irrevocable standby letters of credit as a tool for risk-mitigation9 (CFO.com). In addition to the claim of the purchase price by an exporter, there are several other movables in international trade that need to be secured. This would be issues such as performance guarantee, advance payment guarantee, loan repayment guarantee etc. For these situations a standby L/C will not be suitable as a means of security. This is where independent guarantees come in useful. United Nations Convention on Independent Guarantees and Standby Letters of Credit The United Nations Convention on Independent Guarantees and Standby Letters of Credit was adopted by the General Assembly on Dec 11, 1995 and the convention entered into force on January 1, 2000. The convention has been designed to allow the use of independent guarantees and stand-by letters of credit, in particular in regions where only one or the other of these two instruments are used traditionally. It has been drafted by the Working Group on International Contract Practices of the United Nations Commission on International Trade Law (UNCITRAL 1995). The International Chamber of Commerce (ICC) endorsed the United Nations Convention on Independent Guarantees and Stand-by Letters of Credit in 1999 on the unanimous consent of its commission of Banking Technique and Practice. The thing is that the ICC has been instrumental in taking a stand in the field of international banking operations. However the ICC laws cannot be implemented in all countries unless local law recognizes the same. The United Nations Convention on Independent Guarantees and Standby Letters of Credit provides an impetus for more nations to adopt the same. The Convention lays out law principles for independent undertakings, in a style and approach, which fully assures their independent nature. This guarantees the most possible autonomy to the parties and helps establish a uniform international legal standard for limits, even laying out exceptions for abusive or fraudulent drawings” 10(Eagletraders 2009). The convention has been ratified by Belarus, Ecuador, Panama, El Salvador, Kuwait Tunisia, Gabon and Liberia. Comparison of the United Nations Convention on Independent Guarantees and Stand-by letters of Credit and the URDG and the ISP98 The ISP98 deals with the norms of custom, practice and usage of standby letters of credit. The United Nations Convention on Independent Guarantees represents a useful and practical formulation of basic standby and independent guarantee law. The URDG provides rules for commercial letters of credit and independent bank guarantees. Let us look at the URDG and Standby Letters of Credit in detail. Standby L/C have been used for many decades and have been subject to the Uniform Customs and Practices (UCP). This is due to the fact that the UCP was initially the reference point for use in commercial letters of credit. However, the fact is that the provisions contained in the UCP are not relevant to the standby L/C context in that they are inappropriate and inapplicable. The URDG could be incorporated by Standby L/C as in a sense, Standby L/C’s are the legal equivalent of independent guarantees. Yet, the URDG is rarely used when compared to the Standby L/C. Also the International Chamber of Commerce (ICC) recognizes that standby letters of credit are covered in the UCP, while the URDG is not. The URDG is technically applicable to standby credits so as to allow banks the option of selecting rules that govern both their demand guarantee transactions and their Standby L/C requests. Next let us look at the ISP98. This refers to a document that deals with the practices of standby L/C’s and meant to replace the rules of the UCP. In addition to governing Standby L/C’s, it can also encompass the rules for an independent undertaking. The ISP addresses issues in the commercial credit context in a much more detailed manner when compared to the UCP. The ISP98 is more detailed than the UCP and URDG. Some important points in the ISP98 is that rules have been formulated for the electronic presentation of documents and demands under standby credits (Rule 1.09 ( c) ), vague terms that used to find their way in credit terminology have been deleted (Rule 1.10), there is an emphasis on irrevocability (Rule 2.03), and independence of credits (Rule 1.06), lays out rules for stolen, lost or destroyed credits (Rule 3.12). The ISP98 also clarifies the norms on the assignment of proceeds (Rule 6.06-6.10) and transfers (Rule 6.01.6.05), it also adopts the current rule that a beneficiary’s successors may draw on the credit (Rule 6.11.1), imposing reasonable time limits, with a serious minimum and maximum, on issuers who examine the document (Rule 5.01 (a) )11 (Mugasha, 56). Should Australia Ratify the United Nations Convention on Independent Guarantees and Stand-by letters of Credit After a thorough analysis, it is my opinion that the UN Convention on Independent Guarantees and Standby L/C will be of assistance to Australian business parties that conduct business that involve letters of credit and independent guarantees. In my opinion, the convention will bridge the gap that exists in countries that lack modern credit law. It will also close the divide between standby and guarantee law and practice in Australia. The bottomline is that the Convention reflects and encourages sound banking practice. A great thing about the Convention is the fact that the parties have the option of contracting out of the convention and even modify its provisions. This allows for a great deal of flexibility and will allow parties in Australia to avoid application of all or part of the convention. WORKS CITED Bertrams Roeland Bank Guarantees in International Trade. Paris. ICC Publications. 2004. Print Byrne, James E. New Rules For Standby Letters of Credit – the International Standby Practices/ISP98.1998. Web. 20 Sep 2009 CFO.com. 2009. Web. 24 Sep 2009 “Credit Research Foundation”. 1999. Web. 20 Sep 2009 Eagletraders. 2009. Web. 20 Sep 2009 ICC Business Bookstore. International Standby Practices ISP98. ICC Publication No 590, 1998 Edition. Web. 20 Sep 2009 ‘International Chamber of Commerce’. 2009. Web. 20 Sep 2009 ‘Investor.Com’. 2009. Web. 20 Sep 2009 Markusen R James, The Boundaries of Multinational Enterprises and the Theory of International Trade, Journal of Economic Perspectives – Volume 9, Number 2, 1995. Print. Mugasha, Agasha, The Law of Letters of Credit and Bank Guarantees, 2003. Federation Press. Print ‘Royal Bank of Scotland’. 2009. Web. 20 Sep 2009 ‘SITPRO’. 2009. Web. 20 Sep 2009 Schaffer, Filiberto, Beverley Earle. International Business Law and Its Environment. South Western Educational Publishing. 2008. Print. Simplifying International Trade. SITPROs Report on the Use of Demand Guarantees in the UK. July 2003. Web. 20 Sep 2009 UNCITRAL. United Nations Convention on Independent Guarantees and Standby Letters of Credit. 1995. Web. 20 Sep 2009. Read More