Documentary credits can work as a method of loan payment

By Zhen Qinggui and Li Zheng, Zhonglun W&D Law Firm
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Astate policy bank has recently entered into a loan contract with a foreign natural gas development and production enterprise for the provision of a huge loan. It is agreed in the contract that the loan will be granted in instalments to the enterprise for paying contracted service fees to its contractors in China, and that prior to each payment the contractors must provide an application for payment request and a commercial invoice as set out under the loan contract. After the application and the invoice are verified by the bank, it will then pay a loan instalment in accordance with the amount specified in the application.

Li Zheng Partner Zhonglun W&D Law Firm Beijing
Li Zheng
Zhonglun W&D Law Firm

Based on commercial consideration, the enterprise wished to switch the above method to the use of documentary credits for receiving subsequent loan instalments. This means the enterprise has the right to request the bank to issue a documentary credit for the benefit of the contractors after the bank accepts an application from the enterprise.

Such documentary credit is subject to the restrictions in the International Chamber of Commerce (ICC) Uniform Customs and Practice for Documentary Credits Publication No. 600 (UCP). The bank should pay to the beneficiaries upon acceptance of the letter of credit.

Documentary credit is a common means of payment in international trade in goods, usually used for the payment and settlement for goods under trade in goods, but less used for investment and loan payment under capital account.

This has raised new problems: for one, under international loans, how to make use of this instrument for loan payments?

Key problems

After conducting legal research and seeking advice from the relevant departments, we have found that there is no precedent to follow for the modification of this payment method. A lawyer needs to master the laws and the facts to find a way out, in order to achieve the business purposes of an enterprise.

To this end, we have summarised the following key problems that need to be addressed:

Can payment be made by documentary credits under the loan contract? The entire loan contract does not contain any terms banning the loan payment by other means. The bank and the enterprise have also both agreed to make changes to the method of payment. Therefore, the two parties can make the changes by just signing a supplementary agreement in writing to detail the terms on the changes to the method of payment.

Do approval authorities allow payment by means of documentary credits? According to Chinese regulations, the grant of international loans is covered by the management of external debt, and subject to consent by relevant approval authorities.

The authorities will not interfere as long as a loan is granted within the approved total limit of foreign debt, regardless of whether the method of payment is changed or not.

Can documentary credits be used as a way to pay international loans directly? Under Chinese laws and international commercial laws, documentary credits under trade in goods and standby letters of credit are mostly used in commercial activities.

Documentary credits under trade in goods are a means of payment for the purchase or sale of goods, while standby letters of credit are a means of guaranteeing payment obligations. They are different from the method of granting loans. After all, can they be applied to the grant of international loans?

Zhen Qinggui Senior Partner Zhonglun W&D Law Firm Beijing
Zhen Qinggui
Senior Partner
Zhonglun W&D Law Firm

We believe there are legal barriers to the direct use of documentary credits under trade in goods for the payment of international loans because loans and payments for trade in goods have different legal relationships. There is no legal basis to unite the two relationships.

Standby letters of credit are a means of payment guarantee, provided that the payer is unable to perform a payment obligation when it is due, or intentionally fails to perform such obligation. This is obviously different from the way that the bank makes payment in accordance with the loan contract.

Therefore, the direct use of documentary credits as a means of payment under the loan contract presents legal issues.

Is the use of documentary credits in compliance with UCP? We have found that UCP does not limit specific areas for the application of documentary credits. It only systematically regulates the customs and practice of using standby letters of credit and documentary credits under trade in goods.

Therefore, we believe as long as the principle of customs and practice established under UCP is complied with, any methods designed from the principle should be solutions in compliance with legal requirements and standards.

How does the loan contract converge with the method of payment by documentary credits? For this, we have designed the following suggestions:

  • every time the enterprise makes payment to its contractors, the contractors should submit to the bank necessary legal documents such as an application for opening a letter of credit, an application for use of payment and a commercial invoice issued by the contractors;
  • after such documents are verified as correct by the bank and upon approving the payment of a loan instalment, the bank should issue a documentary credit to the contractors. The loan instalment will be used for guaranteeing the repayment of such documentary credit by the enterprise;
  • when the bank, which is the documentary credit issuing bank, makes payment as agreed in the documentary credit, the loan instalment will be automatically used to make the payment for such documentary credit;
  • a supplementary agreement to the loan contract should be drafted to fix these modifications in writing.

In simple terms, these suggestions are an overlay of the grant of the loan with the method of payment by documentary credit under trade in goods, and a successive convergence of the two legal relationships.

The loan is approved first and then used as a guarantee for opening a documentary credit. After the bank grants the loan according to the letter of credit, the loan is then used to repay the letter of credit. Although these steps are taken in sequence, they are completed together in operation.

Zhen Qinggui is a senior partner in the Beijing office at Zhonglun W&D Law Firm; Li Zheng is a partner at the firm in Beijing

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