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Copyright © International Chamber of Commerce (ICC). All rights reserved. ( Source of the document: ICC Digital Library )
by Guillermo C. Jimenez
Payment provisions are especially critical in international transactions because it can be so difficult to enforce contractual rights abroad. In the event of a dispute, the party in control of the payment funds has the upper hand in settlement negotiations.
Exporters and importers have opposed preferences as regards payment method. Importers’ most-preferred payment method is “open account” (payment after delivery), but this exposes the exporter to the risk of non-payment, so it is also the exporters’ least favourite option. Conversely, exporters would prefer payment in advance, but importers are opposed because it exposes importers to the risk of non-delivery.
A classic compromise is available in the letter of credit (LC) — which provides the exporter with an advance guarantee of payment but also protects the importer from non-delivery. Letters of credit are also referred to as documentary credits.
Another compromise option is found in the documentary collection, which protects the exporter from non-payment but does not provide an advance guarantee of payment as does the LC.
Many exporters seek initially to protect themselves with export credit insurance, which allows them to offer competitive credit terms (such as open account).
Since there are only a handful of international payment options, and since exporter and importer have opposed preferences among the options, it is important to be familiar with each of the options and their rank in terms of preference for either exporter or importer.
> Payment options: definitions
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> Non-payment risk: export credit insurance“Export credit” insurance or “trade credit” insurance is one of the key security devices employed by export firms. Export credit insurance is often offered by governmental entities (in the US, Eximbank). When an exporter can obtain insurance for sales to a particular importer, the exporter is much more willing to offer credit terms.
> Exchange rate risksThe easiest way for the exporter to avoid exchange rate risk is to require payment in its own currency. However, in competitive markets exporters must accept payment in foreign currencies, thereby exposing themselves to exchange rate fluctuations. The various mechanisms for dealing with exchange and currency risk are summarized in the last section of this chapter.
> Use of factors: credit-checking, advances, collectionsFactors are financial services companies that take on many of the financial and accounting management processes related to international payments. Exporters may wish to turn late accounts over to an international collection agent or factor (see Chapter 13 “Short-Term Trade Finance: Factoring and Forfaiting”).
Export payment mechanisms, such as the documentary credit, are flexible systems with three key functions:
> Means of payment There are simple ways for the importer to effect payment, such as by bank draft or wire transfer, but in an international transaction these alone would leave either the exporter or importer entirely at risk (depending on whether payment was made before or after receipt of the goods). In international trade, bank cheques are uncommon. More common is to find payment effected when the importer (or its bank) accepts or pays the exporter’s draft or bill of exchange. Drafts or bills of exchange are simply payment devices (and when used alone are referred to as clean bills). However, traders have found further protection by requiring the attachment of additional documents to the bills of exchange; these bundles of documents are then processed through banks. Hence, they are referred to as documentary bills.
> Security mechanism Documentary credits provide security for each of the parties involved. The exporter is guaranteed payment provided the shipping documents are in order. The importer is protected against paying for non-shipment; and by requiring the provision of a certificate of inspection, the importer can also have the security that the goods shipped are of contract quality.
With documentary bills, the exporter’s goods (represented by the bill of lading or other transport document) and the importer’s payment (represented by the importer’s acceptance or payment of the bill of exchange) are exchanged through a neutral third party, the bank. This removes the danger that either the exporter or importer will unfairly end up with both goods and money. Documentary bills, which are used in both documentary credit and documentary collection operations, therefore represent a linkage of payment and security functions.
Note, in contrast, that standby credits and demand guarantees are meant to be used primarily as security instruments rather than payment devices. Thus, if an exporter agrees to grant the importer 90 days credit, backed by the importer’s standby credit (or bank guarantee), the standby credit is not meant to be the primary payment device. Rather, the exporter will submit invoices for payment to the importer at the appropriate time. The exporter will seek recourse to the standby credit only if the importer should fail to pay. Security devices will be considered in detail in Chapter 14.
Each of the international payment options has different risk–reduction and documentary characteristics. Generally, the reduction of risk is purchased at the cost[Page125:]of greater documentary complexity and higher banking fees or service costs. Parties tend to choose the cheaper and simpler options when they have a great deal of confidence in each other, or when one of the parties has such a strong bargaining position that it is able to force the other to accept somewhat risky terms.
> Finance devices Finance, in contrast to payment, is related to the need to grant credit to the exporter or importer. Exporters can use letters of credit as financing devices for export operations, especially by using transferable or back-to-back credits. Bills of exchange, either alone or in combination with documentary credit or collection operations, can be used as sources of finance for both exporter and importer. Commonly, importers would like to be granted a credit period (from 30 up to 180 days or more), so they can re-sell the goods before they have to pay the exporter. Exporters may be willing to grant these terms provided the importer (or the importer’s bank) undertakes to pay at the end of the credit period, as by issuing a deferred payment letter of credit or “accepting” a term bill of exchange (in a practice known as “accepted” or “avalized” bills). Exporters are able to discount the accepted bills for ready payment. Discounting practices, such as “forfaiting”, are covered, along with factoring and other short-term finance devices, in Chapter 13.
This is the least safe method for the exporter so it should only be used when the importer is fully trusted and creditworthy. The exporter should consider the need for protection with credit insurance.
With open account payments the exporter ships the goods to the buyer and then transmits an invoice and other shipping documents, i.e. the importer “buys now, pays later”. These are sometimes called sales “on credit”, because the seller extends credit without documentary security for the buyer’s indebtedness. For the importer, of course, open account terms are quite advantageous, as there is no need to pay for the goods until they have been received and inspected. An importer may be able to sell the goods and use the proceeds to pay the exporter’s commercial invoice when it arrives.
Open account sales are common in domestic sales, but less so in international transactions because they substantially increase the risk for the seller. An export seller should only agree to open account terms if he has absolute confidence in the import buyer, as well as in the stability of the buyer’s country and its import regulations. An additional source of security is a stable market in the particular goods, because in unstable markets a sudden drop in prices will often motivate importers to try to escape their contracts.
Despite the risks, open account trading at the international level has significantly increased. In the past, major barriers, such as a lack of transparency and apprehension about cross–border exposure, limited international open account trade. Advances in technology and increased financial knowledge are diminishing these concerns, as both buyers and sellers recognize the benefits, such as reducing costs and improving efficiencies through cross-border open account trading.
Sellers on open account are well-advised to include “retention of title” clauses in their contracts. Such a clause allows the seller to reclaim the goods sold, or the proceeds from the goods, in the event the importer becomes insolvent before paying for the goods.
This option is the safest for the exporter, but it is often unavailable in competitive markets. A partial advance payment (e.g. 20-30%) may be more acceptable to the importer and therefore more realistic, but it still leaves the exporter exposed to risk on the balance. Despite the great risks to the importer of payment by cash in advance, some importers find they have no choice. Importers from developing markets may find[Page126:]it necessary to pay in advance in order to obtain high demand or luxury goods. In some cases, payments in advance may be made against the issuance of a bank guarantee issued by the importer’s bank.
With payment in advance the seller takes no risk whatsoever. Conversely, the importer is at serious risk and should never consider payment in advance unless full information on the reputation of the seller is available. If advance cash payments are made at all, they are most commonly only partial payments. Full payment in advance does occur, however, and is most common when the exporter’s products are in extremely high demand and the importer or importer’s country are not a priority for the exporter.
A variation on cash in advance is for an advance payment to be made via some form of documentary instrument, such as under a “red clause” letter of credit.
This option is sometimes neglected by strong exporters. The exporter grants open account terms backed by a standby credit or bank guarantee. If the importer fails to pay on the invoice date, the exporter draws against the standby credit or guarantee. The advantage to the exporter is that the documentation is not as complicated as with an ordinary commercial LC. The advantage to the importer lies in receiving open account terms from the exporter; if payment is made within agreed upon dates, use of the standby credit or bank guarantee will never be triggered. The danger to the importer is that the exporter could unfairly claim the standby credit or bank guarantee, so this option is to be used only with highly trusted exporters.
Many exporters fail to consider that open account payment backed by a standby credit or demand guarantee can be as secure as cash in advance (and even more secure than partial cash in advance). The ICC Banking Commission has endorsed and approved rules specifically designed for standbys and bank guarantees (see Chapter 12).
Not as safe as a letter of credit for the exporter, but significantly cheaper, and much easier for the importer. The seller must be willing to take the risk that the importer will not pay or accept the documents.
While cash in advance represents the ideal option for the exporter, and open account payments represent the ideal for the importer, the documentary collection (like the documentary credit) provides a compromise with benefits for both parties.
Note that the documentary collection is different from the clean collection. A clean collection is essentially an open account payment made via a bill of exchange. The exporter ships the goods and then sends the importer a bill of exchange via the importer’s bank.
A documentary collection, on the other hand, allows the exporter to retain control of the goods until it has received payment (or obtained an assurance of receiving payment). Generally, the exporter ships the goods and then assembles the relevant commercial documents, such as the invoice and the bill of lading, then turns them over, along with a draft, to a bank acting as an agent for the exporter. The bank will only release the bill of lading to the importer if the importer pays against the draft or accepts the obligation to do so at a future time. There are two possibilities:
> Documents Against Payment (DP) (or Cash against documents) The importer pays the draft in order to receive the bill of lading (the document that enables the importer to obtain delivery of the goods); hence, this form of collection is referred to by banks as “cash against documents”, “documents against payment”, “DP” or “sight DP”.
> Documents against acceptance (DA) Here, the importer accepts the draft in order to receive the bill of lading. By accepting the draft, the importer acknowledges an unconditional legal obligation to pay according to the terms of the draft.
The exporter’s instructions to present a draft for acceptance or payment will be transmitted through a series of banks. Usually, this will involve at least the exporter’s bank (known as the remitting bank) and a bank in the importer’s country (known as the collecting or presenting bank, because it presents the relevant documents for[Page127:]collection to the drawee). This somewhat long information chain makes it crucial that the exporter’s initial instructions be precise and complete. Thus, the process begins when the exporter fills out a collection instruction (also called a lodgement form), in which the exporter indicates the instructions the banks are to follow. On the basis of this information, the remitting bank prepares its collection instruction, which will accompany the documentary collection when it is transmitted to the collecting or presenting bank. The banking practice relating to collection arrangements is standardized in the ICC Uniform Rules for Collections (ICC Publication 522).
The advantages of documentary collections for the exporter are that they are relatively easy and inexpensive, and that control over the transport documents is maintained until the exporter receives assurance of payment. The advantage for the importer is that there is no obligation to pay before having had an opportunity to inspect the documents and, in some cases (as by an examination in a bonded warehouse), the goods themselves.
The disadvantages for the exporter are that documentary collections expose the seller to several risks: the risk that the importer will not accept the goods shipped, the credit risk of the importer, the political risk of the importer’s country and the risk that the shipment may fail to clear customs. Therefore, the prudent exporter will have obtained a credit report on the importer as well as an evaluation of importer’s country risk. Another disadvantage for the exporter is that a collection can be a relatively slow process. However, the exporter’s bank may be willing to provide finance to cover the period during which the exporter is waiting for the funds to clear.
Under a DP collection, the importer only takes the risk that the goods shipped may not be as indicated on the invoice and bill of lading. The banks assume no risks for documentary collections (other than that of their own negligence in following instructions). This is one reason collections generally are significantly cheaper, in terms of bank fees, than documentary credits.
During negotiations, a documentary collection may be suggested as a helpful compromise. In terms of relative advantages for exporter and importer, it lies midway between the sale on open account (advantageous for the importer) and the letter of credit (advantageous for the exporter). An exporter will prefer the documentary collection to a sale on open account. Conversely, the importer will prefer a documentary collection to a letter of credit.
After cash in advance, this is usually considered the next safest method for the exporter. However, because of its complex documentary nature, the documentary credit can be relatively expensive in terms of banking fees. Moreover, the exporter must have a rigorous document-preparation system in place to avoid the risk of non-payment due to presentation of non-conforming documents.
The main risks in international trade are the exporter’s risk of non–payment and the importer’s risk that the goods shipped will not conform to the contract. Both these risks may be eliminated via the letter of credit. Commercial letters of credit are referred to by bankers as “commercial credits” and also as “documentary credits” — the terms are used interchangeably. Since documentary credits involve relatively complex document processing, they are more expensive than other payment devices and are therefore not always appropriate. Parties with long trading histories or residing in adjacent countries may be willing to make sales on open account or with payment in advance — payment modes that are easier and less expensive than the LC, but which do not reduce risk.
Despite its occasional complexity, the letter of credit remains the classic form of international export payment, especially in trade between distant partners. The letter of credit is essentially a document issued by the importer’s bank in which the bank undertakes to pay the exporter upon due compliance with documentary requirements. Hence, the term “documentary credit” — payment, acceptance or negotiation of the credit is made upon presentation by the seller of all stipulated documents that comply with the terms and conditions of the documentary credit. These documents (e.g. bill of[Page128:]lading, invoice, inspection certificate) provide a basic level of proof that the right merchandise has been properly sent to the importer — although, of course, there is always the risk that the documents may prove to be inaccurate or even fraudulent. Exporters should be aware that documentary credits often require impeccable document management on the part of the exporter.
A typical procedure is as follows:
New and small exporters may prefer simply to avoid exchange rate risk altogether, thereby giving up the possibility of profiting from fluctuations.
The most common risk management techniques for avoiding exchange rate risk are: 1) insisting that the contractual currency of payment be one’s own currency and, should that fail, 2) using forward or option contracts to hedge against exposure. Larger or more experienced firms may wish to take advantage of the opportunities for profits from exchange rate fluctuations. Once a firm’s foreign exchange exposure grows to a certain level, it generally becomes advisable to assign currency management to a[Page129:]single, highly specialized person or department. This will allow the firm to apply a wider range of currency management techniques, which can even generate significant revenues for the firm.
It is generally said that foreign exchange risks fall into three categories: transaction risk, translation risk and economic risk.
When an international sales transaction involves parties from countries whose currencies are not fixed or pegged, an element of uncertainty is necessarily present. Transaction risk refers to the risk for each of the counterparties that the exchange rate will move in a disadvantageous direction between the time the price is agreed in the contract and the time payment is made or received. Both parties are always initially exposed to transaction risk.
Example
An American exporter selling to Germany is compelled to quote a price in euro. The contract specifies delivery within 30 days, payment 90 days after receipt of the commercial invoice.
The contract price is EUR 1,000,000 — and let us suppose that on the date of the signing of the contract, this is equal to US$ 1,000,000.
Both parties are exposed to transaction risk:
A currency hedge or forward exchange contract is a contract between the exporter and a bank or foreign exchange intermediary. In the above example, the exporter will agree to buy US$ 1,000,000 in exchange for EUR 1,000,000 on or after the date payment is due from the importer (in reality, the exporter will receive less than the US$ 1,000,000, because the bank or other party to the foreign exchange contract will charge a commission, for example, 0.9% (US$ 9,000), leaving the exporter US$ 991,000.
The US$ 9,000 paid to the bank or foreign exchange dealer can be looked at as a sort of insurance policy against currency fluctuation. No matter what happens, the exporter is assured of receiving US$ 991,000. He has given up the possibility of gain that would ensue if the dollar weakened, but in exchange he has received the assurance he will not lose if the dollar strengthens.
A conservative or inexperienced exporter will be primarily concerned with avoiding a loss rather than with potential gain. Therefore, he may wish to use a forward hedge, a foreign exchange contract which locks in the exchange rate in force on the day the export contract is signed.
Translation risk is derived from the periodic nature of accounting report practices. A company will periodically need to state on its balance sheet, in a particular reporting currency, assets and liabilities that may be denominated in another currency. In between two reporting periods, the relative values of the two currencies may have changed. To some extent, the exposure to translation risk can be said to be a strategic risk factor, which should be taken into consideration when weighing the potential costs and benefits associated with a foreign investment decision.[Page130:]
Economic risk is the risk of currency fluctuations over the long term, and is thus also of a strategic order. It arises from a company’s commitment over time to a particular set of counterparties and their currencies. Note that this risk cannot be avoided through simple hedging techniques. For example, an exporter may wish to transfer transaction risk to the importer by requiring payment in the exporter’s currency. However, over a period of years, if the exporter relies to a great extent on that particular market, it will inevitably be affected by substantial exchange rate fluctuations between the two base currencies.
A draft or bill of exchange (B/E) is a negotiable instrument that represents an unconditional demand for payment. Together with the bill of lading, it forms the basis for documentary collection procedures. Together with the exporter’s commercial invoice (see below), the B/E can be used to charge the importer for the goods. Bills of exchange are defined as follows: “An unconditional order in writing addressed by one person to another signed by the person giving it requiring the person to whom it is addressed to pay on demand or at a fixed or determinable future time a sum certain in money to, or to the order of, a specified person or bearer.”
Thus, the draft is written by the drawer (export seller) to the drawee (import buyer), requiring payment of a fixed amount at a specific time. A draft payable upon presentation is called a sight draft, while a draft payable at a future time is called a usance (or time) draft. The draft is legally accepted when a bank or the buyer writes “accepted” along with the date and a signature on the face of a time draft. A draft accepted by a bank is called a banker’s acceptance, while a draft accepted by a buyer is called a trade acceptance.
When the seller attaches the bill of lading or other transport document to a bill of exchange, the bill of exchange is called a documentary bill. By doing this, the seller ensures that the buyer will not obtain any rights to the goods (via the bill of lading) before having accepted or paid the bill of exchange. Since they are negotiable, drafts may be transferred by endorsement to a third party, who may become a holder in due course.
A cargo at sea while in the hands of the carrier is necessarily incapable of physical delivery. During this period of transit and voyage, the bill of lading ... is universally recognized as its symbol, and the endorsement and delivery of the bill of lading operates as a symbolical delivery of the cargo. Property in the goods passes by such endorsement and delivery of the bill of lading ... just as under similar circumstances the property would pass by an actual delivery of the goods ... [T]he bill of lading is ... a key which in the hands of the rightful owner is intended to unlock the door of the warehouse, floating or fixed, in which the goods may chance to be. — Lord Justice Bowen, Sanders Brothers v Maclean & Co. (1883)
The bill of lading (B/L) is a central document in the traditional export transaction, linking the contract of sale, the documentary payment contracts and the contract of carriage.
The marine bill of lading serves three basic functions:
A B/L may be issued in either negotiable form (an “order bill of lading”) or nonnegotiable form (a “straight bill of lading”).
Bills of lading play a key role in the documentary credit context because of their value to the intermediary banks as security for the credit amount. This security value will vary depending on whether or not the bill is a negotiable one — in which case possession of it has money value, because the bill can be auctioned off — or whether it is a non–negotiable “waybill” type document, in which case it may have virtually no security value to the bank, unless the bank is named as consignee and steps are taken to ensure that this designation is irrevocable.
This document is prepared by the exporter and generally includes: identification and addresses of the seller and buyer, a listing and description of the goods (including prices, discounts and quantities), an invoice number, packaging details, marks and numbers, shipping details and the date and reference number of the buyer’s order. Because other documents (such as the documentary credit) will be checked against the commercial invoice, it is of the utmost importance that it be correct and exact in all particulars. An inexact invoice can be fatal to a letter of credit transaction. The buyer will often need the information in the invoice in order to comply with import licences, customs duties and exchange restrictions. Because of these needs the buyer will often request an advance form of commercial invoice, called the pro forma invoice.
With documentary sales under such trade terms as CIF and CIP Incoterms® 2010 rules, the seller must procure insurance for the benefit of the buyer. A letter of credit application will necessarily reflect this insurance obligation, and an insurance document will have to be presented by the seller in order for it to receive payment. Depending on the case, the document required may be an insurance policy (or facultative policy, for single consignments), an open contract (for continuous or repeated shipments) or a certificate of insurance (indicating cover under an open contract). The Institute of London Underwriters Clauses specify the coverage required under Incoterms® 2000 rules; they are generally attached to policies and indicate precisely the risks covered and exclusions from coverage.
The most important of these is the certificate of origin, which evidences the origin of the goods and is usually prepared by the seller’s local chamber of commerce. Inspection certificates, which certify the quality of the goods, are commonly prepared by private inspection agencies. Two of the most famous are SGS (Switzerland) and Bureau Veritas (France).
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Test your Knowledge: International Payment Options
Answers: 1. Advance payment, open account backed by standby credit, documentary credit, documentary collection, open account. 2. The risk that importer will refuse to make payment and take delivery of the goods in the country of destination. 3. The risk that errors in the documents presented by exporter will constitute discrepancies and block payment to the exporter. 4. Insisting that contract be denominated in one’s own currency; agreeing contractually to split or share currency risks; entering into a forward exchange or currency hedge contract. 5. The risk that exporter will not ship goods but will unfairly draw the funds from the standby credit.