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In our previous post, we discussed alternative account receivable collection mechanisms, export insurance, trade credit insurance, and factoring – detailing the pros and cons of such tools. In this post, we will explore the ever popular letters of credit, time drafts, and finally several other best practices and alternative tools that can be implemented to ensure the efficient collection of debt.
Letters of Credit
A letter of credit is a financial document provided by a third party that typically has no direct interest in a transaction that guarantees the payment of funds for goods and services to the seller. A letter of credit has three noteworthy parties: the seller/beneficiary who is paid the credit, the buyer/applicant who buys the goods, and the issuing financial institution that issues the letter of credit on the buyer’s request. Under certain types of letters of credit, there may also be an advisory bank, often located in the beneficiary’s home country, which provides the beneficiary with advice on the international financial implications involved in dealing with the issuing financial institution.
In international transactions, it is therefore in the seller’s best interest to get a “confirmed” letter of credit (discussed below) by an advisory bank in their home country.
Letters of credit are great tools to reduce the risk of non-payment, but they require exact adherence to specific procedures to be validated. Typically, a letter of credit will set out a list of required documents that the seller must present to the bank before the bank will release payment.
This strict procedure imposes obligations on all parties, holding international parties accountable for the transaction under the letter of credit.
Letters of credit typically have more than one fee, assumed by both the buyer and seller, and only provide a guarantee for a limited time. Further, strict adherence to the specific procedure is crucial; if any document is missing, the bank will refuse pay. Letters of credit are generally only available from the issuing financial institutions if it is confident buyer will pay, making this instrument less available in riskier transactions. Further, sellers must rely on the issuing bank’s permanence, creditworthiness, and legitimacy, which is not always certain in some jurisdictions.
Below is a list of the most common types of letters of credit in international transactions:
This is the standard letter of credit as described above. A bank guarantees payment by the buyer to the seller.
This is a letter of credit designed to assure the payment of an ongoing relationship obligation. If the seller/beneficiary proves that the expected payment was not made, a standby letter of credit will become payable.
This is a letter of credit that allows the seller/beneficiary to further transfer all or part of the payment to another supplier in the supply chain. This is often seen when the beneficiary is an intermediary for the actual supplier.
A confirmed letter of credit occurs where an advising bank also guarantees the payment to the beneficiary. The letter of credit must be irrevocable to be confirmed; that is, the issuing bank may not make changes to the letter of credit without the approval of the beneficiary.
On the other hand, an unconfirmed letter of credit is one that is only assured by the issuing bank.
This is a letter of credit that is valid for several payments rather than the typical practice of issuing one letter for each transaction.
(vi) Back to Back
This is a letter of credit for transactions that include an intermediary. There are two letters of credit issued, one by the bank of the buyer to the intermediary, and a second by the bank of the intermediary to the seller.
Banker’s Acceptance or Time Draft
A time draft is a type of foreign check that is guaranteed by the issuing bank, but that is not payable in full until a specified amount of time passes after receipt and acceptance.
The time draft benefits the seller because payment is guaranteed by the issuing bank. The buyer also benefits from the delay in payment after accepting shipment of exported goods, giving the buyer the opportunity to sell some of the goods before the note is due. This instrument is akin to a bank guaranteed credit line.
The drawback of a time draft to the seller is, in addition to costs, that the seller will often have to wait longer for payment than it would have to by using the other listed tools.
The following alternatives are not instruments, per se, but contractual options that may be agreed to with the buyer to ensure timely payment. These options depend entirely on the bargaining power between seller and buyer and the inherent issues such negotiations can have on an incipient relationship. That said, the cost of implementation is low and, in many cases, the protection it affords is high.
(i) Escrow Account
Escrow accounts can take many forms depending on each particular international transaction. In some instances, where the seller is unsure of the creditworthiness of its buyer, funds can be placed in escrow (i.e. in the hands of a trusted third party that collects, holds and disburses funds) until a specified set of conditions is met based on the instructions of both seller and buyer.
In situations where the risk of nonpayment is high, the seller may retain a certain percentage of amounts due from the buyer in escrow. This amount may be collected as an upfront payment or a percentage of the commissions due. Escrows such as these are very useful in new business relationships. After the end of this introductory period, the escrow amount can be released to buyer.
(ii) Payment Terms
Payment terms are the conditions under which a seller will complete a sale. They typically specify the period of time a buyer will have to remit the amount due for the sale. Payment may be demanded in advance, upon delivery, or may be deferred, typically for 30 or 60 days. Payment terms may also provide for a certain discount percentage for early payment. Payment terms are a simple method of ensuring transparency in payment obligations and potential incentives for early payments.
(iii) Due Diligence
Self-help is a cost-effective tool to reduce the risk of non-payment or delayed payment from buyers. This requires ensuring internally that the company’s credit policy is strictly enforced and fixing inefficiencies often by updating the buyer/seller interaction. A robust vendor registration process is a great first step in mitigating the risk of unknown information eroding the likelihood of prompt payment.
The seller should, of course, conduct all due diligence before entering into a contractual relationship with a buyer, including pulling marketplace reports from trusted sources such as Dun & Bradstreet or other international databases. The seller should always request reference letters from new buyers from previous or existing clients. The seller should also run creditworthiness checks on all of their buyers.
(iv) Block Chain
A new development in global supply chain management is the use of blockchain to ensure visibility and efficiency across a seller’s entire supply chain. A blockchain is a distributed database that maintains an ever-growing list of records called blocks. The information in a block cannot be altered retrospectively as each block contains a timestamp and a link to a previous block. The nature of blockchains makes it function like a public, digital, distributed ‘ledger’. Blockchain offers a shared ledger between the buyer and seller that is updated and validated in real time at every supply chain junction in a transaction.
In practice, the buyer and seller would enter into what is called a “smart contract” which is a software program that uses blockchain to carry out the contract. This smart contract would depict all steps involved in the supply chain from manufacturing all the way to payment or post-sale services. Each step in the smart contract would need to occur before the blockchain triggers the application of the following step. As such, in a generic sense, an order, triggers the purchasing of the components, which when fulfilled triggers the manufacturing process, which when finished triggers the transportation process and so on. The parties to the smart contract would have the flexibility to create their own transactional parameters.
Its benefits include the elimination of fraud and errors, improved inventory management, the diminution of courier costs, reduced delays from paperwork, increased consumer and partner trust, and the quicker identification of issues.
Blockchain’s application in logistics, however, remains in its infancy and providers of such services are far and few. As such, the cost of implementation is likely to be high, yet the reward may be even higher.
Alternative collection mechanisms are valuable opportunities for sellers to explore, and through the introspection needed to implement these tools, a seller is likely to find further opportunities for efficiencies within their supply chain.