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Financing
12
I. Text Materials
Introduction
International financing encompasses the financing of foreign trade and the underwriting of
investments in foreign countries. Foreign trade financing is primarily concerned with how goods
and services are paid for across international borders. Long-standing mechanisms for expediting
international trade include bills of lading, bills of exchange, and letters of credit.
Financing Foreign Trade
Most domestic sales are financed through open-account credit arrangements. That is, the buyer
does not sign a formal debt instrument. Formalities are not needed because the seller enters into
sales only after investigating the buyer’s creditworthiness.
In international sales, buyers and sellers are separated both by distance and by the differing
financial practices of their home countries. It is difficult for the seller to determine the credit
standing of a foreign buyer and equally difficult for the buyer to establish reliably the foreign
seller’s integrity and reputation. To compensate for this, foreign traders use formal documents
that assure the parties that their sale will go forward as agreed. The most important of these
documents are (1) the bill of lading, which is the transportation document and document of title;
(2) bills of exchange and promissory notes, which are, respectively, orders to pay money and
promises to pay money; and (3) the letter of credit, which is a third party’s guarantee of a buyer’s
creditworthiness.
Bills of Lading
The essential document for all international sales is the bill of lading. It is a document of title.
That is, it represents the goods.
In international trade, goods shipped from one country to another might be in the possession of a
carrier or warehouseman for several weeks: from the time they are shipped to the time they are
delivered. The bill of lading is important because it lets the buyer and the seller exchange control
over the goods while the goods are in the possession of the warehouseman or carrier. This ability
to transfer title by the transfer of a bill of lading is central to the use of bills of exchange and
letters of credit, the two basic financing and payment instruments used in international trade.
Bills of Exchange
A bill of exchange or draft is a written, dated, and signed instrument that contains an
unconditional order from the drawer that directs the drawee to pay a definite sum of money to a
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Financing
payee on demand or at a specified future date. It is a useful instrument because it allows one party
(the drawer) to direct another (the drawee) to pay money either to himself, to his agent, or to a
third party. Bills of exchange are important devices for facilitating international trade because
they are negotiable instruments.
The order is valid only if the drawee has an underlying obligation to pay money to the drawer.
This can arise in situations where
the drawee is holding money on account for the drawer (the bill involved is known as a
check),
the drawer lent money to a drawee (the bill involved is known as note), or
the drawer has sold goods to the drawee and the drawee owes the sale price to the drawer (the
bill involved is known as trade acceptance).
The Law Governing Bills of Exchange – At the end of the nineteenth century, the lex
mercatoria was codified in England in the Bills of Exchange Act (BEA) of 1882. Today, the BEA
continues in force in the United Kingdom and in virtually all of Britain’s former colonies.
In 1896, in the United States, the National Conference on Commissioners of Uniform Laws
drafted a Uniform Negotiable Instruments Law (UNIL), which was largely based on the BEA.
Then, in the 1940s, the UNIL was modernized and integrated into the more comprehensive
Uniform Commercial Code (UCC).
In 1930, three Geneva Conventions on the Unification of the Law Relating to Bills of Exchange
(ULB) were signed. The following year, two additional Geneva Conventions on Unification of
the Law Relating to Checks (ULC) were also signed. Within 15 years, the ULB and ULC had
been ratified by most continental European countries, and today they are the standard laws
governing bills of exchange and checks in virtually every nation.
Although there are currently no uniform worldwide rules governing bills of exchange and
promissory notes, the International Chamber of Commerce’s (ICC) Uniform Rules for Collections
is a widely followed set of international rules governing the collection of checks.
Types of Bills of Exchange – A bill of exchange is an unconditional written order. The party
creating the bill (the drawer) orders another party (the drawee) to pay money, usually to a third
party (a payee). The form that a bill of exchange must take depends on the governing law. The
common law requires only that a bill (or draft) be in writing and be payable either to order or to
bearer. The ULB adds to this the requirements that a bill:
contain the term “bill of exchange” in the body and language of the check,
state the place where the bill is drawn,
state the place where payment is to be made, and
be dated.
Time and Sight Bills
Bills may be either time bills or sight bills. A time bill is payable at a definite future time. A sight
bill (or demand bill) is payable when the holder presents it for payment or at a stated time after
presentment.
Trade Acceptances
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Financing
A trade acceptance is the bill of exchange most commonly used in the sale of goods. On this bill,
the seller of the goods is both the drawer and the payee. The bill orders the buyer—the drawee—
to pay a specified sum of money.
Checks
When the drawee of a bill of exchange is a bank, the bill is known as a check. Unlike other bills
of exchange, checks are always payable on demand.
Promissory Notes
A written promise to pay a determinate sum of money made between two parties is a promissory
note, or simply a note. The party who promises to pay is called the maker; the party who is to be
paid is the payee.
The rules governing bills of exchange apply to promissory notes as well. Whereas the common
law does not require that a note contain the words “promissory note,” the ULB does. The only
difference between a promissory note and a bill of exchange is that the maker of a note promises
to personally pay the payee rather than ordering a third party to do so.
Notes are used in a variety of credit transactions and are commonly given the name of the
transaction involved. For example, a collateral note is one secured by personal property; a
mortgage note is secured by real property; an installment note is payable in installments.
When a bank is the maker promising to repay money it has received, plus interest, the promissory
note is called a certificate of deposit (CD). CDs in amounts up to $100,000 are customarily called
small CDs; those for $100,000 or more, large CDs. Most large CDs and some small CDs are
negotiable.
Negotiability of Bills and Notes
Bills of exchange and promissory notes may be either negotiable or non-negotiable. So long as
the form and content of the instruments are proper, the law guarantees the full transferability of
the right to receive payment. If there is any limitation on this right, an instrument is said to be
non-negotiable. To be negotiable, a bill or note must (1) be in the proper form and (2) contain a
promise by the maker or drawer to make payment.
To meet the promissory requirements, a bill or note must do the following:
State an unconditional promise or order to pay.
State a definite sum of money or a monetary unit of account.
Be payable on demand or at a definite time.
Be signed by the maker or drawer.
Unconditional Promise or Order to Pay – A bill or note must contain a promise or an order to
pay that is unconditional.
Promise or Order
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Financing
A bill or note must contain an affirmative promise by the maker, or an order to a drawee, to be
negotiable. The promise is inadequate if it is only implied.
Unconditionality
The promise or order to pay made in a bill or note cannot be conditioned upon the performance of
some other obligation. The reason for this is basic to the concept of negotiability. If the holder of
a bill or note had to determine whether a collateral promise had or had not been fulfilled, the
utility of these instruments would be greatly reduced.
Both the law and the pragmatic requirements of trade dictate that a bill or note containing a
promise or order to pay that is conditioned on the performance of a collateral obligation is
non-negotiable. Statements that the bill or note arises out of a separate agreement, or that it is
drawn under a letter of credit, or that the ability of the drawer or maker to perform is secured by a
mortgage or a security interest do not affect negotiability.
Definite Sum of Money or Monetary Unit of Account – A bill or note must be payable in
money, which must be for a definite sum.
Money
Both the common law and the ULB specify that the sum paid must be money. The common law
defines money as “a medium of exchange authorized or adopted by a domestic or foreign
government and includes a monetary unit of account established by an intergovernmental
organization or by agreement between two or more nations.” The ULB provides that the “usages
of the place of payment” determine the meaning and the value of money.
Both the common law and the ULB allow bills and notes to be payable in the currency of one
country, of several countries, or a monetary unit of account defined by an intergovernmental
organization (IGO).
Definite Sum
The sum to be paid must be certain or determinate. In other words, the amount to be paid must be
ascertainable from the bill or note itself without reference to an outside source. Both of the
principal negotiable instruments laws set out exceptions to this basic rule by allowing the parties
to define the sum to be paid in one currency while requiring payment to be made in another, even
though this requires the parties to refer to exchange rates that are not embodied in the bill or note.
In addition, the common law allows for payments to be made in installments (the ULB does not).
While the ULB does not allow for variable interest rates, the UCC now does allow such rates.
Payable on Demand or at a Definite Time – For a bill or note to function reliably in commerce,
the time when it is payable has to be on demand or ascertainable from its face. The time
requirement actually serves several functions. It tells the maker, drawee, accommodation maker,
or acceptor when he is required to pay. It allows secondary parties, such as drawers, endorsers,
and accommodation endorsers, to determine the date when their obligations arise. It establishes
when the statute of limitations will run. And finally, with interest-bearing bills or notes, it defines
the period for calculating the present value of the instrument.
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Financing
Signed by the Maker or Drawer – Bills of exchange must be signed by the drawer and
promissory notes by their maker. A signature can be any symbol executed or adopted by a party
with present intention to authenticate a writing. Signatures do not have to be put on bills or notes
at any particular time. Bills and notes lacking a drawer’s or maker’s signature are simply
incomplete.
The Negotiation and Transfer of Bills and Notes
To satisfy commercial needs, bills and notes have to be freely transferable. Contract law governs
the relationships between the original parties to a bill or note. Once a negotiable instrument
circulates beyond the original parties, however, the laws governing negotiation come into play.
Assignment – The transfer of rights under a contract is called an assignment. When an
assignment is made, the assignee acquires only those rights that the assignor possessed.
Moreover, any objections to honoring the assigned obligations that could be raised against the
assignor can also be raised against the assignee. Bankers and merchants prefer to be paid in cash
or by a negotiable instrument.
Negotiation – Negotiation is the transfer of a bill or note in such a way that the recipient becomes
a holder. Unlike an assignee (who acquires only the rights of the assignor), a holder can acquire
more rights from the transferor than the transferor possessed. The rights that a holder acquires
depend on the manner in which the instrument was negotiated and the governing law.
Negotiating Order Paper
Order paper is a bill or note that either (1) contains the name of a payee capable of endorsing it,
such as “Pay to the order of Francisco Madero,” or (2) contains as its last endorsement a so-called
special endorsement. Order paper is negotiated by delivery and endorsement.
Negotiating Bearer Paper
Bearer paper is an instrument that either (1) contains on its face an order to pay the bearer or to
pay in cash, or (2) contains as its last endorsement a so-called blank endorsement, that is, the
signature of the payee or the signature of the last endorsee named in a special endorsement.
Bearer paper is negotiated by delivery alone. If the bearer paper is lost or stolen, it must still be
paid.
Case 12-1: Miller v. Race
Facts: Finney owed £21 10s to Odenharty, and he purchased a bearer note from the Bank of
Issue: Does a holder in due course of a stolen bearer note issued by a bank have title?
Holding: Yes.
Law: A bank’s bearer note is equivalent to money. One who (a) paid reasonable value for it, (b) in
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Financing
Explanation: The innkeeper had not taken the note under suspicious circumstances. “If it had
Order: The bank had to pay the note.
Endorsements
An endorsement is required to negotiate a bill or note that is in the form of order paper, and it
may optionally be added to bearer paper. Endorsements are signatures, with or without additional
statements, that are commonly written on the back of the instrument.
Qualified Endorsements: Normally, an endorser guarantees that the instrument will be accepted
and paid by the drawee or maker. The endorser can avoid this guarantee, however, by making a
qualified endorsement. Commonly, this is done by adding the words “without recourse.”
Qualified endorsements are commonly used by persons acting in a representative capacity.
Restrictive Endorsements: Restrictive endorsements limit the rights of subsequent holders. There
are several types, including conditional endorsements, endorsements for collection, endorsements
prohibiting further endorsements, and agency endorsements. None of these prevents the further
transfer or negotiation of a bill or note.
A conditional endorsement contains a statement that conditions payment on the occurrence of a
specified event. The effect of this endorsement is to make the bill or note a nonnegotiable
instrument as to the endorser only. No subsequent holder has the right to enforce the payment
against a conditional endorser until the condition is met.
An endorsement for collection makes an endorsee a collecting agent for the endorser. In common
law countries, such an endorsement is usually written as “for deposit only,” “for collection only,”
or “pay any bank.” In civil law countries, the phrases “value in collection” and “by procuration”
are also commonly used.
The effect of an endorsement for collection is to put the instrument into the bank collection
process. In common law countries, only a bank can become a holder once this endorsement has
been added to a bill or note, unless the instrument is specially endorsed by a bank to a person who
is not a bank. Under the ULB, anyone can become a holder, but he can only endorse the
instrument for the purpose of making collection.
An endorsement prohibiting further endorsements states that the instrument may be paid only to a
particular person. This endorsement is treated differently by the two main commercial law
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Financing
systems. In common law countries, an endorsement prohibiting further endorsements is treated as
if it were a special endorsement. The ULB treats such an endorsement as if it were a qualified
endorsement.
An agency endorsement requires the endorsee to pay the proceeds from the negotiation of a bill or
note to the endorser or to some third party. Under the common law and the ULB, an agency
endorsee may properly negotiate the instrument only as directed. This restriction on rights,
however, applies only to the immediate endorsee and not to any subsequent holder.
Forged Endorsements – When an endorsement is a forgery, the question arises as to who should
have to sue the forger or, if the forger cannot be found, who has to assume the loss. The ULB
makes a forged endorsement fully effective, and both the person taking an instrument with such
an endorsement and all subsequent holders are entitled to payment.
As a general rule, the common law makes a forged endorsement ineffective, placing the burden
for determining the validity of an endorsement on the endorsee taking an instrument from a
forger.
Case 12-2: Mair v. Bank of Nova Scotia
Facts: Mair hired Hill to help him with an architectural project, and he gave her an advance of
Issues: (1) Had the check been materially altered such as to make it void? (2) Was the bank a
holder in due course? (3) Was the plaintiff injured by the bank paying the wrong person?
Holdings: (1) Yes. (2) No. (3) No.
Law: (1) A material alteration of a check makes it void. However, if “the alteration is not
Explanation: The added word was in a different handwriting, so it was both a material and an
Order: Plaintiff is entitled to only nominal damages.
There are two major exceptions to the general common law rule that a forged endorsement is
ineffective. One is the imposter rule. This rule provides that when a drawer, maker, or endorser
draws, makes, or endorses an instrument to an imposter, the imposter’s subsequent endorsement
is effective.
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The second common law exception to the rule that a forged signature is ineffective is the
fictitious payee rule. This says that when the instrument is issued in the name of a fictitious
payee, the person purporting to be that payee can make an effective endorsement.
The difficulty with the general common law rule is that the determination of whether one or the
other of the two exceptions applies has to be made after the fact. In the meantime, the maker,
drawer, or drawee can refuse to make payment, and the last holder will have to initiate suit
against the dishonoring party to determine who is responsible for pressing the claim against the
forger.
Limitations on the Excuses That Drawers and Makers Can Use to Avoid Paying Off a Bill or
Note – The major disadvantage of taking a bill, note, or other contractual obligation by
assignment is that the maker or drawer can make a wide range of excuses for not having to pay
off the instrument. The most extensive limitations imposed on the excuses of makers and drawers
are those contained in the ULB. Anyone who acquires a bill or note by negotiation is a holder
who is entitled to payment from the maker or drawer. Three excuses available to these parties:
The possessor is not a holder because he did not acquire title through an uninterrupted series
of endorsements.
The holder acquired the instrument in bad faith. Bad faith includes such things as the actual
theft of the instrument; having actual knowledge that the instrument is stolen, lost, or
misplaced; or having actual knowledge that the payee, or some prior holder, is not properly
entitled to payment.
The holder acquired the instrument through gross negligence. The holder does not have to
have actual knowledge. He must, however, have acted in a truly careless manner in failing to
detect some defect in the instrument or in the rights of the maker, drawer, or a prior holder.
In contrast to the ULB, the common law imposes very few limitations on the excuses that makers
and drawers can use to get out of their obligation to pay off a bill or note. A possessor must first
be a holder. A person who is not a holder is not entitled to the instrument and must give it up.
When the possessor of a bill or note is an ordinary holder, a maker or drawer can draw upon a
lengthy list of excuses for not paying. The list is narrowed, however, if the holder can prove that
he is entitled to the additional status of a holder in due course (HDC). An HDC is a holder who
acquires an instrument (1) for value, (2) in good faith, and (3) without notice that it is overdue,
that it has been dishonored, or that the maker, drawer, or a prior endorser has a valid excuse for
not paying it off.
Liabilities of Makers, Drawers, Drawees, Endorsers, and Accommodation Parties – Two
kinds of liability are imposed on makers, drawers, and endorsers of bills and notes. One is
liability on the instrument—that is, liability arising out of a signature. The other is warranty
liability—that is, responsibility arising out of the implied guarantees a person makes at the time
he transfers or presents a negotiable instrument. In neither case is liability based on the
underlying contract.
Liability on the Instrument
A person who signs an instrument has a contractual obligation to make payment. For makers,
drawees, and accommodation parties, this obligation is primary; that is, they must make payment
on presentment of the instrument. If it is other than a demand instrument, it must be presented on
the day it is due. If it is a demand instrument, it must be presented within a reasonable time after
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it was signed. Sometimes the failure to present a check for payment within a reasonable time will
prevent the holder from collecting on the instrument.
Case 12-3: Far East Realty Investment, Inc. v. Court of Appeals
Facts: On September 13, 1960, Tat drew a check for 4,500 pesos on his account with China
Issue: Was the check presented for payment within a reasonable time?
Holding: No.
Law: When a negotiable instrument is payable on demand, presentment must be made within a
Explanation: Far East undoubtedly failed to exercise prudence and diligence in what it ought to
Order: Far East may not collect on the check.
Liability on the instrument for drawers, endorsers, and accommodation endorsers is secondary;
that is, they have to pay only if the maker, drawee, or accommodation maker fails to do so. When
a holder or transferee is unable to obtain payment from the maker, drawee, or accommodation
maker, she must take three preliminary steps before she can seek recourse from the parties with
secondary liability:
The instrument has to be properly presented.
The instrument must be dishonored.
To give notice to the parties with secondary liability.
Warranty Liability
In Europe, liability can arise only on the instrument. That is, unless someone signs an instrument,
he will have no liability for its payment. In sum, there is no warranty liability. In the United
States, any person who transfers an instrument in exchange for consideration makes five
warranties, or implied guarantees, to his immediate transferee and to every subsequent holder
who takes the instrument in good faith. These are as follows:
The transferor has good title to the instrument or is otherwise authorized to obtain payment or
acceptance on behalf of one who does have good title.
All signatures are genuine or authorized.
The instrument has not been materially altered.
No defense of any party is good against the transferor.
The transferor has no knowledge of any insolvency proceedings against the maker, the
acceptor, or the drawer of an unaccepted instrument.
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Financing
The Role of Banks in Collecting and Paying Negotiable Instruments – Banks perform at least
four functions in connection with the negotiation of bills and notes:
They may issue instruments themselves, such as certified checks or certificates of deposit.
They may function as the drawee on a bill of exchange or as the acceptor of a bill or
promissory note, assuming primary liability for payment.
They can act as an agent for a holder or transferee to make collection.
They can take an instrument as an endorsee, paying the endorser and presenting the
instrument for payment in their own right.
Case 12-4: Charles R. Allen, Inc. v. Island Cooperative Services Cooperative Association
Facts: Island Coop prepared a trade acceptance in the sum of $19,620 with it as the drawer, the
Issue: Does a bank that purchases a bill of exchange from a customer, while retaining the right to
charge it back to the account of the customer in the event of dishonor, have title in the bill?
Holding: Yes.
Law: The rule (in both Canada and South Carolina) is that title to commercial paper passes to a
Explanation: Because the law holds that title passed to BNS, Island Coop no longer had an
Order: Allen had no right to attach the proceeds from the bill.
Letters of Credit
If the seller is unable to determine the buyer’s creditworthiness, he may insist upon cash in
advance. If the buyer wants to confirm that the goods have been shipped, the term documents
against payment can be used. If the buyer insists upon taking delivery before making payment, a
documents against acceptance term can be used.
The terms imply that both sides distrust each other. To avoid this, contracting parties use a letter
of credit (or documentary credit or banker’s credit or, simply, a credit). A letter of credit is an
instrument issued by a bank, or another person, at the request of a customer (called an account
party). It is a conditional agreement between the issuer and the account party that is intended to
benefit a third party.
In accordance with this agreement, the issuer is obliged to pay a bill of exchange drawn by the
account party, up to a certain sum of money, within a stated time period, and upon presentation by
the beneficiary of documents designated by the account party.
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Financing
The function of the letter of credit in international sales transactions is to substitute the credit of a
recognized international bank for that of the buyer. In such an undertaking, the buyer is the
account party, the buyer’s bank is the issuing bank, and the seller is the beneficiary. Letters of
credit exist in a wide variety of forms that are not necessarily mutually exclusive.
Governing Law – Virtually all letters of credit are governed by the ICC’s Uniform Customs and
Practices for Documentary Credits (UCP). A few countries do have legislation governing letters
of credit. In the United States, for example, Article 5 of the UCC has been adopted in all 50
states. One of the goals of the new revisions is to reduce the discrepancy rate of letters of credit.
The UCP gets revised about once every 10 years by the ICC. The latest version, UCP 600, took
effect June 1, 2007, replacing UCP 500, which had been in force since 1994. The rules are
extremely important, since more than $1 trillion worth of world trade changes hands every year
using letters of credit.
One change in the rules is reducing the number of days a bank has to examine the documents
from seven banking days to five. Another change in the revised UCP rules makes it more difficult
to issue a revocable letter of credit. Other modifications of the UCP rules include:
the word clean is not required to appear on a transport document;
the addresses of the beneficiary and applicant on the letter of credit do not need to match
those on the invoices, since a company may have multiple addresses;
inclusion of the 12 articles of the e-UCP, the ICC supplement governing the presentation of
documents electronically in letter-of-credit transactions; and
a definitive description of the negotiation as purchase of drafts of documents.
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