Picture yourself starting a new relationship with a new contact and future distributor in South America. You checked references, as far as that goes, but there are not many companies with experience with your products in the region. Do you take the plunge and hope for the best relying on your arbitration provision or choice of law to recover your losses if things go south?
Manufacturers with global supply chains growing their business internationally run into these types of problems often. They know there are hurdles at every phase of the supply chain, from securing raw materials, dealing with suppliers, transportation and customs, and, of course, local distributors and agents. On top of this logistical complexity, many of these stakeholders, spread out around the world, operate in countries with widely divergent legal systems and traditions.
What could go wrong?
If you have a collections issue, your entire supply chain risks seizing. In that scenario, what can you do? To litigate or arbitrate these claims can take years to resolve, can be very costly, and recovery, at best, uncertain.
This two-part series will explore the possible alternatives to litigation/arbitration you can implement at the outset of the relationship or before shipment that may protect your outstanding accounts and prevent preventable losses. We will also discuss each one of these options, benefits and known drawbacks and, when available, provide you with relevant online resources available to sellers/exporters in international commercial transactions.
Export insurance is an insurance policy offered by private insurance companies and government export credit agencies that can be purchased by an international seller to provide assurance for the payment of goods. In a typical transaction covered by export insurance, the seller chooses a policy based on the risk to be covered by the insurance. Coverage can include both commercial risk, such as potential bankruptcies or defaults on payment, and political risk, such as war, inconvertibility of currency, or even cancellation of licenses.
Export insurance has certain other added benefits in addition to payment assurance, including the increased ability to borrow against insured receivables, and in certain instances, the premium paid for an export credit insurance policy may be tax-deductible. An added benefit is that the costs of the premiums are within the control of the seller, and may be passed on to the buyer depending on the price tolerance of the business.
This insurance includes threshold eligibility requirements, often including the need for a positive net worth of the business, durational requirements of the business, and certain restricted sectors such as imports, grants, early stage starts ups, crude oil, and land purchases, to name a few.
We discuss the three main types of export insurance policies depending on the type and number of transactions covered below:
(i) Express Insurance
In a typical transaction covered by an express insurance policy, the seller first must transact with the buyer, offering credit terms appropriate for the level of coverage chosen in its express insurance policy. Then, the seller ships the product and invoices the buyer. The seller reports the shipments to their insurance broker, and pays premiums pegged to the value of the shipment. This premium is usually split into two categories: an advanced premium, which is an upfront refundable payment that gets applied to exposure fees, and an exposure fee, which is a percentage of the value of the invoices shipped. This percentage is determined by the duration of the payment terms. The account receivable is then satisfied either by the buyer, or in the event of non-payment, by the insurer.
Express insurance will cover all transactions entered into by a seller, ensuring all accounts receivable are satisfied either by the buyer, or by the insurer and as such is the most comprehensive and expensive policy to maintain.
(ii) Single Buyer Insurance
Single buyer insurance mirrors express insurance discussed above, but typically covers only a single buyer or transaction over the course of a twelve-month period. This is particularly advantageous to sellers who do not have an overarching need for export insurance in their typical practice, but have an atypical transaction that requires a further layer of protection than the standard practices performed by the seller.
For sellers with typically low risk transactions, single buyer insurance affords them the ability to ensure payment of a specific transaction on a case-by-case basis depending on the perceived risk. Naturally, the cost of a single buyer policy is costlier than express insurance policies for equivalent transactions.
(iii) Multi Buyer Insurance
Multi buyer insurance policies cover a select portfolio of buyers. Multi buyer insurance blends the benefits of the above two mentioned policies, maintaining the flexibility of insuring only the at-risk transactions with the further benefit of a lower premium tied to the quantify of buyers and transactions insured.
Accounts Receivable Credit Insurance is an insurance policy offered by private insurance companies and government export credit agencies to sellers who wish to protect their account receivables from loss due to credit risks such as protracted default, insolvency, bankruptcy, or even political risk. Trade credit insurance usually covers a portfolio of buyers and pays an agreed percentage of an invoice or receivable that remains unpaid resulting from protracted default, insolvency or bankruptcy. Sellers must impose a credit limit to each of their buyers for insured receivables. The premium rate reflects the average credit risk of the insured portfolio of receivables. In addition, credit insurance can also cover single transactions or trade with only one buyer.
Accounts Receivable Credit Insurance traditionally has similar benefits and pitfalls characteristic of export insurance discussed above. However, unlike export insurance, what is insured with this tool is the line of credit offered to a buyer, whereas with export insurance, what is insured are the transactions or the buyer payments themselves, notwithstanding whether there is a line of credit extended or not.
Factoring is a transaction in which a business sells its invoices, or receivables, to a third-party financial company known as a “factor.” The factor then collects payment on those invoices from the business’s customers.
Factoring is beneficial to sellers because it allows them to receive the value of the invoice usually within 24 hours. It is not considered a loan, so the seller is not deemed to have incurred a debt when they factor.
However, the factor’s fee or discount is usually between 5-20% of the value of the purchased invoice based on the creditworthiness of the buyer rather than the seller.
With the high costs of litigation and arbitration and the uncertainties of foreign legal systems, alternate collection practices may be a more cost-effective means of ensuring your accounts receivables are satisfied. Check back soon for the second part of this two-part discussion where we will explore the likes of escrow accounts, letters of credit, and even blockchain.