FACTORING AND FORFAITING

The main problem nowadays when trading with foreign countries is to obtain payments
from importers. Financing companies offer financial support to traders in exchange for
fees, and guarantees. There are two types of financing forms: factoring and forfaiting.
They are widely used as alternative financing tools to banks.

FACTORING
Factoring is the process of purchasing invoices from a business at a
certain discount. Factors provide financing service to small an medium-
sized companies who need cash. For this the factor charges a fee equal
to a percentage of the invoices purchased generally 5%. Factoring is a
low value short term financing forms. It involves the purchase of
invoices, for an amount less than $10,000 an 90-120 days payment
terms. After shipping your goods or services, the factor purchases the
invoices, and advances cash to you company. Factoring provide liquid
assets to small business. In fact banks have strict criteria when lending
money so it is difficult for these companies to obtain loans.

FORFAITING
Forfaiting is the purchase of a series of credit instruments such as drafts, bills of
exchange, other freely negotiable instruments on a nonrecourse basis. Nonrecourse means
that if the importer does not pay, the forfeiter cannot recover payment from the exporter.

The exporter gets immediate cash on presentation of relevant documents and the importer
is the liable for the cost of the contract and receives credit for “x” years and at certain per
cent interest.

The forfaiter deducts interest at an agreed rate for credit period. The debt instruments are
drawn by the exporter, accepted by the importer, and will bear an aval or unconditional
guarantee, issue by the importer’s bank. The forfeiter takes over responsibility for
claiming the debt from the importer. The forfeiter holds the notes until maturity, or sells
them to another investor. The holder of the notes presents each note to the bank at which
they are payable, as that fall due.

Forfaiting is a high-value medium and long term financing form. It involves the purchase
of negotiable instruments for not less than $100.000 and from six month to five years
payment terms. The forfeiter needs to know some important information, such as:

• who the buyer is and his nationality

• what goods are being sold

 • date and duration of the contract

• interest rate already agreed with the buyer

• negotiable instruments used identity of the guarantor of

payment

Letter of credit
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After a contract is concluded between buyer and seller, buyer's bank supplies a
letter of credit to seller.

Seller consigns the goods to a carrier in exchange for a bill of lading.

Seller p bill of lading for payment from buyer's bank. Buyer's bank exchanges bill of
lading for payment from the buyer.

Buyer provides bill of lading to carrier and takes delivery of goods.

A standard, commercial letter of credit (LC[1]) is a document issued mostly by a

financial institution, used primarily in trade finance, which usually provides an
irrevocable payment undertaking.

The letter of credit can also be source of payment for a transaction, meaning that
redeeming the letter of credit will pay an exporter. Letters of credit are used primarily in
international trade transactions of significant value, for deals between a supplier in one
country and a customer in another. In such cases the International Chamber of Commerce
Uniform Customs and Practice for Documentary Credits applies.[2] They are also used in
the land development process to ensure that approved public facilities (streets, sidewalks,
storm water ponds, etc.) will be built. The parties to a letter of credit are usually a
beneficiary who is to receive the money, the issuing bank of whom the applicant is a
client, and the advising bank of whom the beneficiary is a client. Almost all letters of
credit are irrevocable, i.e., cannot be amended or canceled without prior agreement of the
beneficiary, the issuing bank and the confirming bank, if any. In executing a transaction,
letters of credit incorporate functions common to giros and Traveler's cheques. Typically,
the documents a beneficiary has to present in order to receive payment include a
commercial invoice, bill of lading, and documents proving the shipment was insured
against loss or damage in transit. However, the list and form of documents is open to
imagination and negotiation and might contain requirements to present documents issued
by a neutral third party evidencing the quality of the goods shipped, or their place of
origin.

Contents
[hide]

• 1 Terminology
• 2 How it works
• 3 Availability
• 4 Some of the Documents Called for under a Letter of Credit
• 5 Legal principles governing documentary credits
• 6 The price of letters of credit
• 7 Legal Basis for Letters of Credit
• 8 International Trade Payment methods
• 9 Risk situations in letter-of-credit transactions
• 10 See also
• 11 References

• 12 External Links

[edit] Terminology
The English name “letter of credit” derives from the French word “accreditation”, a
power to do something, which in turn is derivative of the Latin word “accreditivus”,
meaning trust. This applies to any defense relating to the underlying contract of sale. This
is as long as the seller performs their duties to an extent that meets the requirements
contained in the letter of credit.

[edit] How it works

A business called the InCosmetika from time to time imports goods from a business
called ACME, which banks with the ABC Bank. InCosmetika holds an account at the
Commonwealth Bank. InCosmetika wants to buy $500,000 worth of merchandise from
ACME, who agrees to sell the goods and give InCosmetika 60 days to pay for them, on
the condition that they are provided with a 90-day letter of credit for the full amount. The
steps to get the letter of credit would be as follows:

• InCosmetika goes to The Commonwealth Bank and requests a $500,000 letter of

credit, with ACME as the beneficiary.
• The Commonwealth Bank can issue a letter of credit either on approval of a
standard loan underwriting process or by InCosmetika funding it directly with a
 deposit of $500,000 plus fees which are typically between 1% and 8% of the face
value of the letter of credit.
• The Commonwealth Bank sends a copy of the letter of credit to the ABC Bank,
which notifies ACME that payment is available and they can ship the
merchandise InCosmetika has ordered with the full assurance of payment to them.
• On presentation of the stipulated documents in the letter of credit and compliance
with the terms and conditions of the letter of credit, the Commonwealth Bank
transfers the $500,000 to the ABC Bank, which then credits the account of ACME
for that amount.
• Note that banks deal only with documents required in the letter of credit and not
the underlying transaction.
• Many exporters have mistakenly assumed that the payment is guaranteed after
receiving the letter of credit. The issuing bank is obliged to pay under the letter of
credit only when the stipulated documents are presented and the terms and
conditions of the letter of credit have been met.

[edit] Availability
A letter of credit being an irrevocable undertaking of the issuing bank makes available
the Proceeds, to the Beneficiary of the Credit provided, stipulated documents strictly
complying with the provisions of the letter of credit, UCP 600 and other international
standard banking practices, are presented to the issuing bank, then:

• i.if the Credit provides for sight payment – by payment at sight against compliant
presentation
• ii.if the Credit provides for deferred payment – by payment on the maturity
date(s) determinable in accordance with the stipulations of the Credit; and of
course undertaking to pay on due date and confirming maturity date at the time of
compliant presentation
• iii.a.if the Credit provides for acceptance by the Issuing Bank – by acceptance
of Draft(s) drawn by the Beneficiary on the Issuing Bank and payment at maturity
of such tenor draft, or
• iii.b. if the Credit provides for acceptance by another drawee bank – by
acceptance and payment at maturity Draft(s)drawn by the Beneficiary on the
Issuing Bank in the event the drawee bank stipulated in the Credit does not accept
Draft(s) drawn on it,

or by payment of Draft(s) accepted but not paid by such drawee bank at maturity;

• iv. if the Credit provides for negotiation by another bank – by payment without
recourse to drawers and/or bona fide holders, Draft(s) drawn by the Beneficiary
and/or document(s) presented under the Credit, (and so negotiated by the
nominated bank )

• Negotiation means the giving of value for Draft(s) and/or document(s) by the
bank authorized to negotiate, viz the nominated bank. Mere examination of the
 documents and forwarding the same to the letter of credit issuing bank for
reimbursement, without giving of value / agreed to give, does not constitute a
negotiation.

[edit] Some of the Documents Called for

under a Letter of Credit
• Financial Documents

Bill of Exchange, Co-accepted Draft

• Commercial Documents

Invoice, Packing list

• Shipping Documents

Transport Document, Insurance Certificate, Commercial, Official or Legal

Documents

• Official Documents

License, Embassy legalization, Origin Certificate, Inspection Certificate,

Phytosanitary certificate

• Transport Documents

Bill of Lading (ocean or multi-modal or Charter party), Airway bill, Lorry/truck

receipt, railway receipt, CMC Other than Mate Receipt, Forwarder Cargo Receipt,
Deliver Challan...etc

• Insurance documents

Insurance policy, or Certificate but not a cover note.

[edit] Legal principles governing

documentary credits
One of the primary peculiarities of the documentary credit is that the payment obligation
is abstract and independent from the underlying contract of sale or any other contract in
the transaction. Thus the bank’s obligation is defined by the terms of the credit alone, and
the sale contract is irrelevant. The defences of the buyer arising out of the sale contract do
not concern the bank and in no way affect its liability.[3] Article 4(a) UCP states this
principle clearly. Article 5 the UCP further states that banks deal with documents only,
they are not concerned with the goods (facts). Accordingly, if the documents tendered by
the beneficiary, or his or her agent, appear to be in order, then in general the bank is
obliged to pay without further qualifications.

The policies behind adopting the abstraction principle are purely commercial and reflect a
party’s expectations: firstly, if the responsibility for the validity of documents was thrown
onto banks, they would be burdened with investigating the underlying facts of each
transaction and would thus be less inclined to issue documentary credits as the
transaction would involve great risk and inconvenience. Secondly, documents required
under the credit could in certain circumstances be different from those required under the
sale transaction; banks would then be placed in a dilemma in deciding which terms to
follow if required to look behind the credit agreement. Thirdly, the fact that the basic
function of the credit is to provide the seller with the certainty of receiving payment, as
long as he performs his documentary duties, suggests that banks should honour their
obligation notwithstanding allegations of misfeasance by the buyer. [4] Finally, courts
have emphasised that buyers always have a remedy for an action upon the contract of
sale, and that it would be a calamity for the business world if, for every breach of contract
between the seller and buyer, a bank were required to investigate said breach.

The “principle of strict compliance” also aims to make the bank’s duty of effecting
payment against documents easy, efficient and quick. Hence, if the documents tendered
under the credit deviate from the language of the credit the bank is entitled to withhold
payment even if the deviation is purely terminological.[5] The general legal maxim de
minimis non curat lex has no place in the field of documentary credits.

[edit] The price of letters of credit

All the charges for issuance of Letter of Credit, negotiation of documents,
reimbursements and other charges like courier are to the account of applicant or as per
the terms and conditions of the Letter of credit. If the letter of credit is silent on charges,
then they are to the account of the Applicant. The description of charges and who would
be bearing them would be indicated in the field 71B in the Letter of Credit.

[edit] Legal Basis for Letters of Credit

Although documentary credits are enforceable once communicated to the beneficiary, it
is difficult to show any consideration given by the beneficiary to the banker prior to the
tender of documents. In such transactions the undertaking by the beneficiary to deliver
the goods to the applicant is not sufficient consideration for the bank’s promise because
the contract of sale is made before the issuance of the credit, thus consideration in these
circumstances is past. In addition, the performance of an existing duty under a contract
cannot be a valid consideration for a new promise made by the bank: the delivery of the
goods is consideration for enforcing the underlying contract of sale and cannot be used,
as it were, a second time to establish the enforceability of the bank-beneficiary relation.
Legal writers have failed to satisfactorily reconcile the bank’s undertaking with any
contractual analysis. The theories include: the implied promise, assignment theory, the
novation theory, reliance theory, agency theories, estoppels and trust theories,
anticipatory theory, and the guarantee theory. [6] Davis, Treitel, Goode, Finkelstein and
Ellinger have all accepted the view that documentary credits should be analyzed outside
the legal framework of contractual principles, which require the presence of
consideration. Accordingly, whether the documentary credit is referred to as a promise,
an undertaking, a chose in action, an engagement or a contract, it is acceptable in English
jurisprudence to treat it as contractual in nature, despite the fact that it possesses
distinctive features, which make it sui generis.

A few countries including the US (see Article 5 of the Uniform Commercial Code) have
created statutes in relation to the operation of letters of credit. These statutes are designed
to work with the rules of practice including the UCP and the ISP98. These rules of
practice are incorporated into the transaction by agreement of the parties. The latest
version of the UCP is the UCP600 effective July 1, 2007[7]. The previous revision was the
UCP500 and became effective on 1 January 1994. Since the UCP are not laws, parties
have to include them into their arrangements as normal contractual provisions.

[edit] International Trade Payment

methods
• Advance payment (most secure for seller)

Where the buyer parts with money first and waits for the seller to forward the goods

• Documentary Credit (more secure for seller as well as buyer)

Subject to ICC's UCP 600, where the bank gives an undertaking (on behalf of buyer and
at the request of applicant ) to pay the shipper ( beneficiary ) the value of the goods
shipped if certain documents are submitted and if the stipulated terms and conditions are
strictly complied.

Here the buyer can be confident that the goods he is expecting only will be received since
it will be evidenced in the form of certain documents called for meeting the specified
terms and conditions while the supplier can be confident that if he meets the stipulations
his payment for the shipment is guaranteed by bank, who is independent of the parties to
the contract.

• Documentary collection (more secure for buyer and to a certain extent to seller)

Also called "Cash Against Documents". Subject to ICC's URC 525, sight and usance, for
delivery of shipping documents against payment or acceptances of draft, where shipment
happens first, then the title documents are sent to the [collecting bank] buyer's bank by
seller's bank [remitting bank], for delivering documents against collection of
payment/acceptance

• Direct payment (most secure for buyer)

Where the supplier ships the goods and waits for the buyer to remit the bill proceeds, on
open account terms.

[edit] Risk situations in letter-of-credit

transactions
Fraud Risks

• The payment will be obtained for nonexistent or worthless merchandise against

presentation by the beneficiary of forged or falsified documents.
• Credit itself may be forged.

Sovereign and Regulatory Risks

• Performance of the Documentary Credit may be prevented by government action

outside the control of the parties.

Legal Risks

• Possibility that performance of a Documentary Credit may be disturbed by legal

action relating directly to the parties and their rights and obligations under the
Documentary Credit

Force Majeure and Frustration of Contract

• Performance of a contract – including an obligation under a Documentary Credit

relationship – is prevented by external factors such as natural disasters or armed
conflicts

Risks to the Applicant

• Non-delivery of Goods
• Short Shipment
• Inferior Quality
• Early /Late Shipment
• Damaged in transit
• Foreign exchange
• Failure of Bank viz Issuing bank / Collecting Bank

Risks to the Issuing Bank

 • Insolvency of the Applicant
• Fraud Risk, Sovereign and Regulatory Risk and Legal Risks

Risks to the Reimbursing Bank

• no obligation to reimburse the Claiming Bank unless it has issued a

reimbursement undertaking.

Risks to the Beneficiary

• Failure to Comply with Credit Conditions

• Failure of, or Delays in Payment from, the Issuing Bank
• Credit Issued by Party other than Bank

Risks to the Advising Bank

• The Advising Bank’s only obligation – if it accepts the Issuing Bank’s

instructions – is to check the apparent authenticity of the Credit and advising it to
the Beneficiary

Risks to the Nominated Bank

• Nominated Bank has made a payment to the Beneficiary against documents that
comply with the terms and conditions of the Credit and is unable to obtain
reimbursement from the Issuing Bank

Risks to the Confirming Bank

• If Confirming Bank’s main risk is that, once having paid the Beneficiary, it may
not be able to obtain reimbursement from the Issuing Bank because of insolvency
of the Issuing Bank or refusal of the Issuing Bank to reimburse because of a
dispute as to whether or not payment should have been made under the Credit

Other Risks in International Trade

• A Credit risk risk from change in the credit of an opposing business.

• An Exchange risk is a risk from a change in the foreign exchange rate.
• A Force majeure risk is 1. a risk in trade incapability caused by a change in a
country's policy, and 2. a risk caused by a natural disaster.
• Other risks are mainly risks caused by a difference in law, language or culture. In
these cases, the cargo might be found late because of a dispute in import and
export dealings.