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Methods of Payment for International Sales Open account terms is when a seller ships goods to a buyer before payment is made, and relies on the buyer's willingness and ability to pay when the invoice comes due. The seller places a high degree of trust in the buyer. In addition to the obvious advantage for the foreign buyer of not having to pay for the goods in advance, the buyer also has the additional benefit of being able to inspect the goods prior to payment. This also gives the buyer leverage over the seller in any dispute over the quality or quantity of merchandise shipped by the seller. Seller's Risk: Exporting goods on open account terms carries the highest risk to the seller. In export sales, risks are classified as either commercial or political risk. Commercial risk involves the possibility that the buyer cannot pay or cannot pay on time. Political risk (sometimes called country risk, or sovereign risk) involves the possibility that a foreign government will take action that prevents the importer from paying the exporter. Buyer's Risk: From a buyer's point of view, open account terms are the best and most desirable way to import merchandise. In the event that the buyer chose not to pay, the seller can place the account for collection or begin the process of suing the debtor in a foreign court over the unpaid balance. However, the buyer has several advantages in a collection scenario. The first is location. An exporter in the U.S. cannot sue a debtor in a U.S. court, with all of the costs and logistical problems associated with doing so. The foreign debtor must be sued in their country where the language, the customs, the laws, and the court procedures may be vastly different than in the United States. Add to this home field advantage the fact that corruption is rife in some parts of the world and it becomes relatively easy to understand why creditors try to avoid suing foreign customers. Protection: For a seller to consider an open account arrangement, it is important to obtain reliable credit information, and then make a comprehensive analysis of the risks associated with exporting to a particular customer in a particular country on open account terms. The buyer should learn as much as possible about the creditworthiness of the applicant/buyer, as well as learning as much as possible about the risks associated with doing business in the country in which the applicant is located. Cash In Advance Under cash in advance terms the seller receives a cash payment from the buyer prior to shipping the merchandise ordered. Under this arrangement, the buyer must have a great deal of trust in the seller. The major risk is that the seller will receive payment but not ship the merchandise, or will not ship the quantity or quality of merchandise ordered. Most buyers are reluctant to purchase on cash in advance terms. In fact, buyers will normally only purchase on cash in advance terms if there is no other alternative source of supply willing to offer terms more attractive than cash in advance. The buyer's right of inspection is meaningless under cash in advance terms unless inspection takes place prior to shipment. This could be expensive for the buyer to arrange. The seller is fully protected by requiring cash in advance. In general, payments of this type are made by wire transfer payment. The seller should be sure that its bank confirms that the wire transfer payment has been received before releasing the shipment. The seller should never take the customer's word that the wire transfer payment is on its way, even if the statement is supported by official looking documents indicating that a wire transfer payment has already been made. Protection: Buyers should pay cash in advance only after thoroughly evaluating the reputation of the seller. The dictum of "let the buyer beware" applies under these circumstances. In the event that the merchandise does not meet the buyer's requirements, the buyer could sue the seller. Unfortunately, foreign lawsuits can be very costly and may prove fruitless. Foreign Collection Collections can be defined as documents against payment (D/P), or documents against acceptance When a drawee acknowledges in writing on the face of the draft that the buyer will pay the draft at maturity. (D/A). "Acceptance" does not mean acceptance of the goods. Instead, it means that the importer "accepts" his or her obligation to pay for the merchandise at a specific date in the future. Documents that permit the buyer to obtain possession of the merchandise are exchanged only on receipt of a cash payment (in the case of documents against payment) or a promise of future payment (in the cash of documents against acceptance). The important factor under this procedure is to ensure that the merchandise is consigned through a carrier in such a way that the buyer cannot obtain title to or possession of the merchandise without making a payment or making a promise to pay for the goods at a later date. This procedure entails consigning the merchandise to "the order of the shipper," employing the use of negotiable bills of lading. Bills of lading should not be consigned to the buyer's bank without the bank's agreement. In either case, under the control of the seller's bank the relevant shipping and collection documents are sent to a foreign correspondent collecting bank. This bank is instructed to release the documents only against payment (D/P) or documents against acceptance (D/A). If negotiable bills of lading are part of the documents, the buyer cannot obtain the goods from the carrier or customs without having a properly endorsed bill of lading. Foreign documentary collections through banks is a payment procedure that (in theory) enables the seller to prevent the buyer from gaining possession of the goods until the buyer pays the amount due, or executes an IOU in the form of a "trade acceptance." Under a domestic transaction it is a common practice to instruct a common carrier not to deliver goods to the buyer until and unless the customer pays in advance. Some air carriers will also undertake this responsibility; however, their common charge for a C.O.D. collection is 2% of the invoice value. Using sight or time drafts, the seller's main risks are:
If a foreign buyer rejects a shipment, the seller then has the following options - none of which are attractive to the seller:
Many sellers elect to have rejected merchandise returned to them. Doing so means the seller incurs the costs of freight out and back. The main risk factor of the transaction becomes the freight costs. Another factor that could increase the cost is if a buyer rejects a custom made product, a perishable product, or a specialty product item not readily resalable. This risk includes both freight costs and risk of loss on the eventual sale or disposition of the product. One of the most troublesome country risks involves the confiscation of the seller's merchandise. Many events could cause confiscation such as war, martial law, importation of illegal merchandise, and invalid import licenses. Even if the merchandise is not confiscated in customs but is only delayed, the seller may have to pay holding and storage charges. These charges quickly add up, and sometimes exceed the value of the merchandise. Buyer's Risk: In any international sale, the principal risk and concern of a buyer is paying for goods without having the opportunity to inspect them. In effect, the buyer is paying for documents which he or she must trust to represent the quality and quantity of the goods ordered and shipped. Country Risk: The leading country risk would be merchandise, markings, or products that do not conform to government rules and regulations. In addition, an unexpected increase in local tariffs or a devaluation of the local currency could make the imported product so expensive that it would be unprofitable for the buyer to accept the merchandise and try to sell it. Protection: Neither the buyer nor the seller is completely free of risk factors under foreign collections. At the same time, there are various protections for each. The seller has a degree of control of the goods and retains title to the shipment. On the other hand, the buyer does not have to pay until there is actual evidence that the goods have been received. Due to the potential for non-payment, or rejection of the order, or confiscation of the merchandise it is important for the exporter to have credit information about the buyer and about the foreign government. Letters of Credit A letter of credit is a contract. It is a formal, conditional undertaking in writing issued by the buyer's bank and addressed to a seller. It specifies the terms and conditions under which the seller (called the "beneficiary") will be paid. The contract specifies what documents must be presented, and when they must be presented to the issuing bank. The letter of credit states the amount of money available, and whether or not partial shipments will be accepted or if partial payments will be made. In a letter of credit, the buyer's bank (the issuing bank) agrees to make payment in a specified manner if compliance with its terms and conditions is met in accordance with the International Chamber of Commerce rules governing letters of credit (UCP 500). Letters of credit substitute the creditworthiness of a bank for that of the buyer. It assures a seller that if it conforms to all of the terms and conditions in the letter of credit as well as the rules contained in UCP 500, the bank issuing the letter of credit will pay regardless of the wishes or financial ability of the buyer. In this manner, the seller is assured payment through the replacement of the buyer by a financial institution that is assumed to be reputable and creditworthy. Seller's Risks: There are two main risks for a seller under a letter of credit transaction. The first risk is nonperformance. This involves a situation in which the seller fails to comply with every term and condition listed in the letter of credit. If every term and condition is not met, then the issuing bank is not obligated to issue payment against the past due invoice. The second risk is the risk of the issuing bank. The ability of the issuing bank to make the payment must be considered. This risk extends not only to the bank itself but also to actions taken by the central bank or the government in the country in which the issuing bank is located. If there is a second guarantor, a confirming bank, then the creditworthiness of that bank must also be considered. Buyer's Risk: Some would argue that most of the risk rests with the buyer under a letter of credit transaction. For example, the buyer has no right to inspect the merchandise before entering into the transaction, and has no right of rejection. The only advantage to the buyer is that its bank (the issuing bank) will carefully examine documents presented by the seller to assure that the documents are in order prior to payment. If the bank determines that the documents conform to the letter of credit terms and conditions, they will pay without consulting the buyer. The bank will pay despite objections from the buyer. If a bank has proof of a fraud involving the letter of credit transaction, a Court can place payment in escrow pending a determination. The issuing bank makes its determination to pay on documents alone. It is not responsible for the genuineness or legal effect of any documents. It is not responsible for interpreting the intentions of the parties. It does not look at the underlying sale. It looks only at the documentation presented in support of the request for payment. Protection: The seller is only protected by a letter of credit if it can meet all of the letter of credit's terms and conditions. This requires the seller and its credit department to review the letter of credit for inconsistencies. It also requires the seller to understand the requirements of the International Chamber of Commerce rules governing letters of credit (UCP 500). If a seller fails to meet any of the documentation requirements under a letter of credit, then the issuing bank has the right not to fund the letter of credit. Due to carelessness, lack of knowledge, or circumstances beyond the seller's control many companies fail to meet the burden of providing the required documentation within the time frame required under UCP 500. Statistically, as many as 50% or more of letters of credit are rejected when first presented for payment due to documentation irregularities. If a discrepancy is found, the seller can sometimes convince the buyer to instruct the issuing bank to fund the letter of credit anyway. However, the buyer is under no legal obligation to do so, and the issuing bank can at its discretion disregard the request by the buyer to fund a letter of credit if a discrepancy exists or if the required documentation was presented after the due date as specified in UCP 500. Combinations Some international sales transactions involve not just one term of sale, but rather a combination of two or more. For example, the seller may wish to receive 30% in advance with the balance of 70% payable on an open account terms 30 days after delivery. Another example would be a 15% cash-in-advance down payment, a 60% collection item (D/P), combined with 25% on open account. Upon closer examination of the second example, various protections and counterbalances for the buyer and seller emerge. Starting with the 60% D/P portion, this provides certain protections to the buyer and the seller. Part of the risk of the transaction is covered by the fact that the seller receives 15% in advance of shipment as a down payment. This is offset by the fact that 25% of the transaction is on open account terms. This demonstrates a degree of trust in the customer, and provides a certain amount of protection for the buyer. There could be many variations to the idea of selling to foreign customers using multiple terms of sale. One variation would be a letter of credit with an advance clause permitting advance payment Funds given by the buyer of goods to the seller prior to shipment, often just a percentage of the value of the goods with the remainder paid after shipment. to the seller once the merchandise is ready to ship. The buyer could be protected by requiring a performance bond letter of credit issued on behalf of the seller in favor of the buyer for the amount of the advance. This bond would enable the buyer to recover the amount of money advanced if the seller did not ship the merchandise within a specified period of time. Under the regular portion of the letter of credit, the seller would draw for the remaining transaction value against presentation of specified shipping documents. A final portion of this variation could be another performance bond issued on behalf of the seller, in favor of the buyer that would be, in effect, a "warranty" as to the quality of the merchandise. This would replace the open account portion. If the buyer subsequently inspected the goods, and found them to be deficient in some way then he or she would simply draw under the warranty letter of credit and recover the final 25%. Sellers may prefer this approach so they can receive full payment, which may cut down on their borrowing costs or otherwise allow them to use the funds more productively. Combinations will vary from transaction to transaction. The prudent credit manager and purchasing agent should strive to form a payment procedure that will reduce their mutual risks. Circumstances of product, credit, integrity, and country will all play a part in the decision. Combinations of this type are becoming increasingly rare. Open account terms are becoming far more common in international sales transactions. One reason is the globalization of the marketplace. America does not hold the monopoly that it once had on certain goods. Foreign buyers often have multiple potential sources of supply, and as a result exporters that do not or will not offer open account terms are at a serious disadvantage if their competitors are willing to extend credit to the foreign buyer. Edited by Michael Dennis, author of "Credit and Collection Handbook" available at the NACM Bookstore. |
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