Holder of an MBA and a masters degree from Oklahoma City University in the US, Linsen Zhang has lectured on L/C practice in several banks, including Bank of China, Communication Bank of China and ICBC. He is presently a lecturer on international payments in the Banking Department of Tianjin College of Finance and Economics, Tianjin, P. R. China and spends considerable time analyzing bad debts in Chinese state-run banks.

On 10 October 1998, a clothing manufacturer in the City of Wuhan, P. R. China (referred to as 'Exporter' below) entered into a contract with a trader from Saudi Arabia (referred to as 'Importer' below) for the sale of garments. The total price was USD902,500.00 and the average unit price was USD13.00. In view of the generous profit potential, and in order to ensure that the transaction went ahead, the Exporter tried by every means available to meet a series of requirements imposed by the Importer. Among these was a performance guarantee of 10 per cent of the contract value. This had to be submitted by the Exporter to the Importer before the Importer arranged for the issue of an L/C in favour of the Exporter.

Zhang: "Sometimes, huge profit really means trap".
To make sure the deal went forward as quickly as possible, the Exporter applied promptly for the guarantee at Bank A in the City of Wuhan. Taking into account its previous positive relationship with the Exporter, Bank A demanded a deposit of only 30 per cent of the contract value from the Exporter, with the balance taking the form of a written undertaking by the Exporter. Bank A then issued a counter-guarantee with a value of USD90,250.00 to its correspondent in the Importer's country, requesting that the latter establish a performance guarantee in favour of the Importer.

The guarantee specified that payment under the guarantee would be made on receipt of a statement by the Importer claiming that the Exporter was in default. On receipt of the guarantee, the Importer demanded an addition to the terms and conditions of the guarantee. This addition was to the effect that the guarantee was subject to the exclusive jurisdiction of Saudi Arabia and to arbitration in that country. The Exporter suspected nothing, and accepted the amendment without demur.

The L/C

On receipt of the guarantee, the Importer arranged for the L/C to be issued. It was advised to the Exporter through Bank A, which considered that two of the conditions in the L/C were abnormal. One of these specified that the consignee on the B/L should be the issuing bank. The other stated that payment would not be made under the L/C until the issuing bank had received payment from the Importer. After examining the L/C, Bank A advised the L/C to the Exporter in good time and drew the Exporter's attention to the unusual conditions. The Exporter expressed no concern about the abnormal conditions, and presented the L/C to Bank B in Wuhan as security for a loan (pre-shipment finance).

Bank B was inexperienced in international finance, and it did not carry out a thorough examination of the L/C terms and conditions. Instead it relied on the creditworthiness of the borrower and a pledge over the L/C, and it extended the first tranche of the loan totalling USD400,000.00 to the Exporter. The Exporter dispatched the goods and delivered the documents to Bank B, which sent them to the issuing bank for reimbursement. However, the issuing bank did not respond within a normal period of time.

After repeated reminders, the issuing bank finally paid USD190,000.00. It declined any responsibility for paying the balance, however. The issuing bank stated that it adopted this position in compliance with the terms and conditions of the L/C, since it had received only USD190,000.00 from the Importer. Only at this moment did Bank B realize the gravity of the matter.

The Exporter

Meanwhile, the Exporter - who was still unaware of the flaw in the L/C - complained about Bank B's slowness in obtaining payment under the L/C. At the same time, the Exporter presented the documents concerning the second shipment (valued at USD200,000.00) to Bank A, which had more experience in handling L/C transactions. The Exporter also requested Bank A to negotiate ("discount") the documents as a means of obtaining finance for the remaining shipments. After examining the contents of the L/C, Bank A reminded the Exporter of the potential risks inherent in the L/C. The bank refused to negotiate the documents, but agreed to remit them to the issuing bank for payment.

Still cherishing some illusions, the Exporter accepted Bank A's suggestion. Again, the issuing bank delayed. After repeated enquiries, the issuing bank cabled back, claiming that the Importer had refused to take up the documents and requiring that the documents be released without any payment being made. This meant that the Exporter would not receive the L/C balance still outstanding of USD210,000.00. The issuing bank added that if the documents were not released, a claim under the performance guarantee would be made against the Exporter. When the Exporter was informed of this, it realized the awkwardness of its situation, and tried by every means at its disposal to work out a solution with the Importer, but to no avail.

Expiry date

Time was now growing short, since the expiry date of the performance guarantee was approaching. Bank A's correspondent cabled Bank A - the counter-guarantee bank - calling for the expiry date of the guarantee to be extended. The Exporter had no option but to agree, and the expiry date was extended twice, adding six months to the period of validity of the guarantee.

When the guarantee was about to expire again, Bank A's correspondent sent a further cable to Bank A. In this cable it claimed that it had received a statement from the beneficiary asserting that the supplier (the Exporter) had violated the terms of the contract, and demanding that Bank A should either agree to a further extension or make payment under the guarantee.

Bank A did not reply immediately, but instead it contacted the Exporter with a view to finding a solution.

Because of this the correspondent lodged a complaint with the head office of Bank A, claiming that Bank A was guilty of non-performance of its counter guarantee obligations. Bank A was well versed in matters of this kind. Accordingly it debited the Exporter's account with the sum in question under the guarantee, in case payment of the guarantee ultimately had to be made. At the same time it sent a cable to its correspondent stating that the supplier (the Exporter) had fulfilled all its contractual obligations, and that no question of non-performance arose.

This was a tactical move by Bank A, aimed at gaining time. Bank A also asserted that the Importer was being deliberately provocative in demanding release of the documents without payment, while the Importer itself was still in arrears with regard to payment of the balance due for the first shipment. Bank A claimed that, accordingly, the Importer was, de facto, the party in violation of its contractual obligations.

Meanwhile, the Exporter applied to the courts for an order freezing its deposit at Bank A in case Bank A reimbursed its correspondent. This action by the Exporter manifestly ran counter to international usage. Bank A explained its case to the court with the aid of the documents released by its head office. This led the court to cancel its freezing order on the deposit.

Subsequently, the Exporter was obliged to send a representative to the Importer's place of business in order to settle the dispute. Not long after this - and after making vigorous representations Bank A received a tested telex from its correspondent cancelling the performance guarantee and discharging Bank A from liability under the counter guarantee.

The Exporter did not fare so well. The goods had been delivered. The Exporter did not agree to release of the documents without payment, and he failed to come to an agreement with the importer for a reduction in the price. Accordingly, the goods had to be sent back. To make matters worse, there was no hope of recovering the balance due on the first shipment. The Exporter, therefore, had to face up to the time and expense of an international lawsuit.

Analysis

From the above case, we can conclude that the growth of international finance exposes all parties involved - including banks - to risks of many different kinds. These include the risks of fraud and blatant profiteering. As a specialist in international payment procedures, I strongly believe that prudence should be our watchword in this context.

The lessons that can be drawn from the above case may be summarized as follows:

1. Great caution should be exercised when international financial transactions incorporate abnormal terms and conditions. For example, both a documentary credit (L/C) and a guarantee were called for in the case outlined above. This is a very rare practice in international trade. It brings a particular risk factor into play, since the L/C and the guarantee are two separate contracts. On the one hand, there is the risk that the beneficiary of a performance guarantee payable on demand will claim and obtain payment in the absence of breach by the other party. On the other hand, the unusual condition in the L/C in this case constitutes a disguised payment risk. Consequently, whenever they encounter abnormal situations, all parties concerned should investigate the reasons for the abnormality.

2. Advising banks should carefully examine all L/Cs received from other banks. This helps to maintain good relations with both correspondents and clients. To avoid adverse consequences, the beneficiary's attention should be especially drawn to any exceptional conditions in L/Cs. Competition among banks should not lead advising banks to relax their vigilance with regard to L/C conditions of this kind.

3. The lending bank bears all the risks when it provides pre-shipment finance secured by a pledge over an L/C. Accordingly, the lending bank, when it is considering making such a loan, should pay attention, not only to the credit-worthiness of the borrower, but also to the terms and conditions of the relevant L/C.

4. In the particular case outlined above the unit cost of the goods was at the most USD5.00, while the bid price was USD13.00 per unit. In our world of advanced communications, the Importer could hardly have been unaware of the international market price. Accordingly, the Exporter should have kept a cool head, and should not have allowed himself to be carried away by the apparent prospect of making a huge profit. Sometimes, huge profit really means trap.I

Linsen Zhang's e-mail is zlshxtj@public.tpt.tj.cn