Wilbert Ward.

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cash at its maturity.

In the meantime the merchant who has sold the goods
can, if he needs funds, offer the accepted bill to a note-
broker for discount. The readiness with which such an
acceptance is discounted depends largely upon the repu-
tation and credit standing of the acceptor. If the buy-
ing merchant is unknown to the note-broker, his accept-
ance is not attractive and consequently is less useful to
the selling merchant. As an alternative to paying cash
for the goods, the buying merchant may find it cheaper,
in case the selling merchant rejects his own acceptance as
unsalable, to finance his purchase by paying a commission


to a better known merchant or banker to accept for

Commercial Letter of Credit Defined

It thus transpires that a bank can afford a customer
a valuable facility, not alone by furnishing him cash, but
by exchanging its own credit for that of the customer.
That is, it can accept time bills of exchange drawn on it-
self, for account of the customer. And if it is prepared
to do so, there is no good reason why it should not be
ready to evidence this agreement in writing.

A buyer who can place in the hands of a seller a writ-
ten instrument issued by the buyer's bank, authorizing the
seller to draw in accordance with certain terms, and stipu-
lating in legal form that all such bills will be honored, has
at his command an instrument which will make his busi-
ness more attractive to the seller than would otherwise be
the case. An instrument by which a bank gives formal
evidence of its willingness to undertake this class of opera-
tion for one of its customers is what has come to be known
as a "commercial letter of credit." A commercial letter
of credit is normally, though not necessarily, issued in
favor of a third party, usually a seller of goods, desig-
nated by the customer on whose behalf the credit is issued.

As we shall see, commercial letters of credit are issued
in a great variety of forms and are made available in a
great many ways. The essential object in every case is
the same to evidence to a selected correspondent, or to
bankers generally, the nature of the credit which the open-
ing bank has committed itself to extend to its customer.

Antiquity of Commercial Letters of Credit

With their general nature understood, we can turn to
the past history of commercial letters of credit. They


appear almost at the threshold of the history of banking.
Their origin runs back to the early Roman and Lombard
money-changers, to whom are also attributed the creation
of bills of exchange. It would be reasonable, therefore,
to suppose that these two instruments of finance, the let-
ter of credit and the bill of exchange, had a parallel devel-
opment. Bills of exchange and policies of marine in-
surance, which were both products of the same period,
came under the observation of Lord Mansfield, who pre-
sided in the English Court of King's Bench from 1746
to 1758. This remarkable jurist, drawing on the wis-
dom of all the continental ordinances and codes existing
in his day, and the practices and customs of the trade
which he learned from special merchantile jurors, cre-
ated the commercial law of modern England. There is
no record, however, of any case involving a letter of credit
having had his skilful interpretation. In fact, it is a mat-
ter of surprise that there has been until recently so little
litigation about instruments which have been known and
used for centuries. It is a tribute to the keen desire of
bankers to honor their obligations without quibble, though
it has contributed to the lack of understanding of the
subject, that the use of commercial letters of credit has
extended into these modern times without creating enough
litigation, either in England or in this country, to define
their legal implications.

Arrested Development

While commercial letters of credit are not a novelty
either to continental banking or continental commercial
law, their most extensive employment has been in Eng-
land. Even there their general use appears to be confined
largely to the present generation. For reasons which are
somewhat obscure, commercial letters of credit, despite


their ancient origin, seem to have undergone several cen-
turies of arrested development, while their contemporary
instrument, the bill of exchange, has run a course which
has resulted in the highly standardized and negotiable bills
of the present day.

It is likely that one cause of this arrested development
was that up to the present period, in which international
banking has undergone great expansion, the acceptance
of bills by proxy devolved upon the better known mer-
chants, who in time found the commission for "lending
their credit" to importers less well established, a source of
revenue profitable enough to displace their original mer-
chandise dealings. These houses were so few, their pres-
tige was so great, and their ramifications so extensive,
that their willingness to accept was established by a course
of dealings, or by informal correspondence, rather than
by the creation and issuance of formal commercial credit
instruments* The idea of a written undertaking that
bills to be drawn later would be honored was understood,
and was not permitted to lapse. But it was not until
comparatively modern times that the entrance of banks
into the business of accepting bills, and the widened circle
of merchants carrying on the increased volume of trade
incident to present times, operated to cast the device into
any fixed moulds.

Our Trade Financed by Foreign Agencies

Our own banking facilities were, until recently, oc-
cupied with the problems incident to internal development.
This absorbed our wealth so completely that there was no
surplus of liquid capital for employment abroad. In the
meantime our foreign trade was rapidly growing from
decade to decade. Its possibilities were not lost on foreign
private banking houses and foreign colonial banks; they


quietly settled here and monopolized the field. The New
York agency of the Canadian Bank of Commerce, for in-
stance, was established in 1872 ; it was followed by that of
the Merchants Bank of Canada in 1874. Both have since
continuously engaged in the business of establishing im-
port, and honoring export, letters of credit. These foreign
banks possessed the experience, tradition, and organization
that American banks naturally lacked, and they served
our needs adequately and well. Their aid was absolutely
essential. It takes not months but years and generations
to train a nation to be the world's banker. It would have
been an insurmountable task to have manned the foreign
departments of American banks with efficient American
staffs during this period.

Our Entry into Foreign Banking

It was inevitable, however, that at some stage in the
formative period our pride would assert itself and that we
should make a beginning toward building up purely
American institutions to finance our share of the world's
international trade.

In 1893 the Bank of New York, National Banking
Association, following the decease of the local agent for
some British banking institutions, took over the represen-
tation of these banks and thus became one of the first,
if not the first, American national bank to engage in the
issuance of commercial letters of credit. These credits
were issued solely in connection with the importation of
goods to this country and were invariably made available
by drafts drawn in foreign currencies on foreign banking

Other American banks soon followed in this foreign
trade financing. The London office of the Equitable Trust
Company of New York was opened in 1895. The foreign


department of the National City Bank of New York was
established in 1897, and the charter of the International
Banking Corporation, which has since come under the
ownership of the National City Bank of New York, was
granted in 1901 by the state of Connecticut. In 1897 the
Guaranty Trust Corporation of New York opened a
foreign department and contemporaneously established a
London office. The Bankers Trust Company has issued
import credits since its establishment in 1903; the Chase
National Bank began the issuance of import commercial
credits in foreign currencies as early as 1905. In 1913
the Irving National Bank began the issuance of com-
mercial letters of credit.

In New York the use of foreign currency credits,
available by drafts on foreign banking institutions, to
finance our importations, continued until 1915 ; and it was
at this time that the use of dollar credits to finance our
exportations began on an extensive scale. In Boston
previous to 1913 national banks neither had a foreign
department worthy of the name, nor were able to establish
credits through their own foreign correspondents or nego-
tiate export drafts direct. Such business as came into
their hands was immediately turned over to old-established
private banking houses with foreign connections.

The London Discount Market

It would carry us too far afield to trace all the causes
which made London, in the period we are now considering,
the world's financial center and the leading discount
market. Suffice it to say that most of the time bills of
exchange drawn in various countries against sales of
goods in international trade found their way, with shipping
documents attached, to London. They were drawn upon
merchants, private banking houses, and bankers, and were


accepted by these establishments on behalf of their cus-
tomers, who were the purchasers and the consignees of the
merchandise and to whom the shipping documents were
then usually surrendered. The accepted draft was sold by
the holder on the strength of the high credit standing of
the acceptor and upon any indorsements which the bills had
accumulated. The purchaser was one of the private dis-
count houses or bill-brokers, who in due course re-
discounted the bill with a joint-stock or private bank, or
with the Bank of England.

Commercial paper and bank acceptances formed the
main assets, not only of London banks but also of banks in
Paris and Berlin, where similar though smaller discount
markets existed. These bills had the widest possible market
and were exchanged daily in large volume at margins of
Vi6 to J / 8 P er cen t in the interest rate. International
money flowed to England for investment in this class of
liquid paper at around 2 per cent. The persistent demand
for London drafts resulted from the fact that they were
the most readily salable in the various foreign markets.
Our own importers and banks had to issue credits which
provided the seller with a bill on London in order to make
the bill salable. Whether they purchased in South America
or in Asia, American merchants had to provide European
bank acceptances and so paid an annual tribute of millions
in acceptance commissions to European bankers for the
financing of our trade. The acceptance of the American
banker, no matter how good his credit, was valueless to
foreign buyers.

The New York Discount Market

It was the lack of a discount market like that of Lon-
don, Paris, or Berlin, which more than anything else made
the acceptance of a New York bank useless as an instru-


ment of finance. This lack was in turn attributable in
large measure to the character of American commercial
paper. Causes which it is aside from our purpose to con-
sider made the promissory note, instead of the trade and
bank acceptance, the prevailing type of American paper.
It was possible in a sense for a bank to mobilize the promis-
sory notes it had discounted by offering them for redis-
count to other banks, but there was a feeling that this
action might be unfavorably construed. American com-
mercial paper therefore remained unsalable and unliquid
in character, because, being without the indorsement or
acceptance of American banks of known repute, it was
individual, provincial, and local in its investment appeal.
It was usually distributed to the banks by note brokerage
or commercial paper houses who purchased it from the
makers. Once in the hands of the bankers, it remained
there until maturity, even under pressure of such a de-
mand for money as would result in the calling of stock
exchange loans and the throwing of securities upon the
market. Our national banks were not at that time per-
mitted by law to accept time drafts. There was no
obstacle to the acceptance of bills by private bankers, but
the lack of anything approaching a discount market for
these bills in New York was as effective as legal prohibition
in keeping private bankers' acceptances from being created.

Passage of the Federal Reserve Act

The passage in 1913 of the Federal Reserve Act laid
the basis upon which it was possible to develop in New
York the sort of discount market that is indispensable to
the creation of a center of international finance. The
federal reserve banking system brought the gold reserves
of the nation, which had previously been carried by the
individual banks, into the federal reserve banks, and the


reserves of the member banks were carried primarily as
credits on the books of the federal reserve banks. The
secondary reserve of the member banks consisted of paper
eligible for rediscount with the federal reserve banks.
These latter institutions thus formed a great centralized
reservoir of available mercantile credits, behind which
stood the government and the national reserves.

In order to mobilize our mercantile credits, however,
it was necessary to change the business habits of the nation
by converting these credits from book accounts and promis-
sory notes into trade acceptances. The ability of the
national banks to finance foreign trade was assisted by
authorizing them to accept bills having not over 6 months
to run and growing out of the importation or exportation
of goods. Such paper, having a maturity at the time of
discount of not more than 90 days, was eligible for redis-
count by the federal reserve banks, which, moreover, were
authorized to purchase eligible acceptances in the open
market with or without a member bank's indorsement.

The Inception of Dollar Letters of Credit

At the time the act became effective, it seemed unlikely
that any very radical change would take place in the habit
of our importers and bankers in resorting mostly to credits
raised in London. It was believed comparative money
market conditions and the universal popularity of sterling
as a medium of exchange would continue to exert a com-
pelling influence in favor of London. The continued exclu-
sion of the domestic acceptance, together with the
restrictions imposed upon the acceptance of international
bills by regulations of the Federal Reserve Board, made it
also appear likely that a general acceptance and discount
market of the foreign type, including buyers and sellers
who represented a wide variety of banking and financial in-


terests, would not be possible. All these calculations, how-
ever, were based upon an outlook for no more than normal
progress in our export and import trade and naturally
could take no account of the tremendous change which was
to be brought about by the Great War.

The outbreak of the war terminated communication
with the source from which a great many of the world's
buying markets procured their merchandise and from
which they also obtained facilities for financing. As the
pressure of the war commenced to be felt the nations with
whom communication remained uninterrupted found them-
selves more and more compelled to subordinate the re-
quirements of their foreign customers to imperative
domestic needs. These customers had therefore to seek
a new source of supply and presently the United States
became the world's greatest market place. The war
brought overnight to the United States new and strange
buyers, and introduced to the generality of our mercantile
community novel exchange and shipping problems. This
demand for our goods came at a time when the delicate
machinery of international credit had been dislocated by
the political and economic consequences of the war. The
result was that many of our merchants demanded from
buyers in every foreign trade center a device which would
assure them immediate payment in dollars in exchange for
shipping documents, as soon as the documents could be

Commercial letters of credit appeared to be suited to
this purpose. And so, though they lacked uniformity of
practice, though their legal effect was undetermined, and
though our bankers and merchants were unversed in their
use, an enormous volume of business came gradually to be
done by means of these instruments. It is at this point that
the story of American commercial credits properly begins.



Some Guide-Posts

It may as well be confessed at the outset that there is
no well-worn path to tread in pursuing our subject. There
is not even a blazed trail. Before us is virgin timber,
which has grown with startling rapidity to unprecedented
dimensions. Before we can enter it boldly, with confi-
dence that we shall master its secrets and emerge safe and
sound at our journey's end, we must arrange our plan of
march. We shall, therefore, set up some guide-posts, not
simply to be able to debouch, but also to enable us at any
time to judge how far we have progressed, and the relation
which the country we have traversed bears to the whole

Haphazard Development

As we glance toward the terrain over which we must
make our way, our first impression will be that of an
inextricable confusion of false paths which lead nowhere.
Some will be broad and smooth and well-placarded with
signs by which a stranger may hope to keep his bearings ;
others will be narrow and devious and the guide-boards
will remind one of those which Bob Burdette's Rollo
encountered when learning to travel. When Rollo sought
to learn why the finger-boards were painted so dimly, that
wise man, his father, replied, "It is one of the traditions
of the office to make them in this way."

"And do I turn down this road to the left, the way the


finger-board points, to go to Kickapoo Town?" asked

"No," replied his father, "you go in exactly the op-
posite direction. That is another tradition of the office.
You see, my son, the guide-boards are set up after this
manner. The finger-board is nailed to the post in the shop,
which is the barn of the supervisor. They are then loaded
into a wagon and sent out on the road in charge of a man
who cannot read. He is instructed to set a post at every
road crossing, which he does, setting the post firmly and
making a good job of it, without any reference to the
direction in which the boards point."

So with commercial letters of credit. When we come
to examine in detail the instruments which were employed
to handle the enormous volume of our foreign business
which came on the heels of the war, we shall see instru-
ments, well adapted for one purpose, employed for others
to which they were ill suited. We shall find that instru-
ments which were in a general way adaptable lacked not
simply uniformity in form and content, but certainty in
their practical construction and legal scope and meaning.
It was inevitable that in thus introducing an unfamiliar
device wholesale into modern foreign trade financing, its
defects as well as its virtues should manifest themselves.
These defects were not inherent and inseparable, but re-
sulted rather from some peculiarities of its development
which prevented an orderly and systematic growth. These
circumstances will here be briefly outlined. Subsequently
they will be examined in detail.

The Conflict of Laws

It was essential to the development of standard forms
of letters of credit that the variety of practical questions
which hinge upon the legal theory to be applied to their


construction and interpretation should have a uniform
solution. Yet the letter of credit developed in continental
commercial law by giving effect to the mercantile idea that
a promise made in the course of business was enforcible,
while the English common law, on the other hand, reached
the decision that a merchant's promise in writing made in
a business transaction did not of itself suffice to create a
legal obligation. As the use of commercial letters of
credit was until recently confined almost wholly to over-
seas finance, it followed of necessity that they were usually
issued in one country for use in another. The application
of these conflicting laws of separate jurisdictions to iden-
tical instruments naturally threw the legal aspect of the
subject into confusion. The minor part the commercial
credit device played until recently in the world's commerce
developed merely enough litigation to enable the English
courts, as well as the continental, on one theory or another,
to give them effectiveness, without working out a con-
sistent legal theory which is the prelude to uniformity.

No International Standards of Commercial Practice

The commercial customs which are involved in inter-
national trade are, like the law, often in conflict. The
buyer who stands at one end of a commercial credit and
the seller who is at the other are bound to be influenced
in their thoughts and expressions by the habits of the com-
munities in which they live. For example, the same word
may have quite a different meaning for each man. A ton
is a ton yet it is 2,240 pounds to an Englishman, 2,204
pounds to a Frenchman, and 2,000 pounds to an American.
The same problem may have a different solution in differ-
ent countries. It is the continental practice to regard an
obligation which falls due on a Sunday or a holiday as
maturing on the preceding business day; in America we


prefer it to mature on the following business day. This
lack of common standards militated against the unification
of commercial letters of credit through mercantile usage.
To deal confidently and safely with an instrument in which
such questions come up constantly for decision, there must
be some reconcilement of the variant viewpoints. Yet in
the vast volume of commercial credit business that came
with the war demand for our goods, there was no definition
of these trouble-breeding matters of commercial practice.

Confusion in Terminology

The international character of commercial letters of
credit has brought about, in addition to the conflict of legal
theory and the clash of commercial usages, a puzzling
confusion of terminology about identical matters. And
so as we journey on we shall, like Rollo, find strange
names employed for familiar objects. Rollo thought, at
one stage in his travels, that he was approaching a railroad

"It is not a railroad," replied his father, "it is a rail-
way. What you call the tracks are not the tracks, but the
line. And the rails are not the rails, but the metals. The
yard engine is a shifting engine; the switch is a siding;
we do not switch cars, we shunt them; the conductor is
not the conductor, but the guard; the engineer is the
driver ; the fireman is the stoker ; the ties are sleepers ; the
passenger car is a coach, the baggage car is the luggage
van, and the baggage checks are the brawsses."

"But why are all these things other than what they
are?" asked Rollo.

"Because it is English," replied his father.

No better reason can probably be given for the con-
fusion in the terminology applied by the two main branches
of the English-speaking race to certain types of credits.


The British define a "bankers' credit" as "an intimation
by one bank to another that a merchant has opened a
credit with them for bills to be drawn under the terms
stated, without an undertaking by the bank in advance that
it will give its acceptance to bills so drawn." A "con-
firmed bankers' credit," in the British view is one consti-
tuting an undertaking to accept. To the American banker
these terms and definitions are alien. He calls a credit
of the first type a "revocable" credit and of the second
type an "irrevocable" credit, and limits the use of the term
"confirm" to the act on the part of one bank of under-
writing or guaranteeing the "irrevocable" credit of another

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Online LibraryWilbert WardAmerican commercial credits → online text (page 2 of 21)