THE PAYMENT RISK LADDER

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The Payment Risk Ladder

In this section we will look at the Risk Ladder in detail and explain the way in whcih the payment mechanism can affect the parties security of payment and retention of title to the goods. 


Before finalising any particular payment terms take a few minutes to work on the time line/trade cycle, list what is at risk be this money, goods, insurance, seller/exporter, transport, delivery to a third party customer etc. and think through what can go wrong and at what point, how you plan to mitigate the risk and then set about deciding what works best for you and your business. After that it comes down to who can negotiate the deal with the least risks.

Open Account

This is a popular method of payment for a buyer/purchaser/importer probably because it can save costs particularly if the buyer is using their own funds. The buyer can drive the transactional procedures which could range from what commercial documents are required, to the method of transport, the format of bills of lading/ transport documents etc.   


However where the transaction is funded using loans from finance houses or banks the flexibility is less. These institutions will have procedures and processes that the buyer will need to be adhered to if the transaction is to proceed smoothly.   


The timing of the payment to the supplier will determine the level of financial risk being carried by the buyer. 


If the buyers’ payment for the goods is made after delivery has taken place then that is probably the most secure position one can be in. Anything prior to delivery and the risks increase for the buyer. The level of the risk will be determined in part by other factors such as where in the trade cycle/time line the buyer pays the supplier. If the buyers’ payment terms are to pay a deposit with order and the balance when the goods are ready for despatch, the buyer has considerably higher transactional and financial risks.  On a sliding scale these risks can be reduced if you pay for the goods once they have left your suppliers premises and this reduces further if the payment is made on arrival at the port/airport from where the goods will be shipped/transported, and the next level would possibly be loaded on board or taken in charge and so on through to the arrival at port/airport of destination or next stage of the goods being received into the control of the buyer’s  freight forwarder, or delivery into an independent warehouse or as mentioned above, arrival at your own premises.  


On some occasions the goods go from the supplier and buyer arranges for delivery direct to their customer. This can marginally increase the risk for the buyer.  


At whatever point payment is made, without any pre-shipment inspection the buyer is still carrying risk that the money has long gone and the goods are not as ordered or the right quality etc.  


To achieve this most secure method would mean that the seller/exporter trusts the buyer’s business, integrity and ability to pay. This is fine but in an ever changing world can the seller/exporter know exactly the financial condition of the buyer?  Unless the exporter receives regular and independently verified management information, the exporter is relying on information that is either in the public domain, potential limits offered by credit insurance companies and/or possibly a satisfactory trading history albeit in the case of the latter that is no guarantee that the byer is not having difficulties.  


Many feel that Open Account terms are the only viable option. If that is the case then it is a question of managing other possible risks in trade cycle in order to minimise or mitigate any potential downside albeit the same question remains, how much can the byer afford to lose and what will it take in trading terms to recover the direct and indirect losses incurred. 


Other issues surrounding Open Account include the seller/exporter possibly losing control of the goods before payment has been received. The buyer may have committed to manufacture products using the materials sourced from the seller/exporter and late arrival or faulty goods could jeopardise the onward sale. 

Documentary Collections

Documentary collections are simply where a seller/exporter of goods/service wants to send on a secured basis to a buyer, all the original commercial/shipping documents relating to the sale. The seller/exporter sends the documentation to their bank with an application form in which they record all the documents to be sent and in the application they set out how the documentation should be processed.  The sellers/exporters bank will then send the documents with a collection schedule which it lists the documents and also provides the instructions to the buyers/importers bank on how the documents are to be processed, when and how the payment is to be made and what the bank should do in the event of non-acceptance/non-payment by the buyer/importer. In some cases the acceptance/payment may be deferred until the ship arrives at the destination port albeit the added value to this is debatable. This will be explained later. 


The parties  referred to ina collection are as follows:


Seller = Exporter =Drawer


Buyer = Importer = Drawee


More on the above later.


Documentary Collections are referred to as either be D/A/or D/P or CAD. What do these acronyms mean? 


D/A = Documents against Acceptance.  

D/P = Documents against Payment 

CAD = Cash against Documents 


Documents against Acceptance – It means that the documents sent by collection can be released (given to) the buyer/importer against acceptance to pay the amount owing to the seller/exporter at a fixed determinable date in the future. To evidence this acceptance and obligation to pay the buyer/importer may accept a bill of exchange (or they may issue a Promissory note). The acceptance would be notated along the lines of “Accepted by XYZ Ltd for payment on day/month/year at the counters of (XYZ Ltd bank) and this would be signed by them.  


The bill of exchange stands independently of any sales contract and in theory, if the buyer/importer failed to accept or pay, the seller/exporter could have two courses of action that they could take. Firstly with the financial instrument they can arrange to have it ‘Noted & Protested’ for non-acceptance and/or non-payment and simultaneously sue the buyer/importer under the contract of sale.  


However before going down either route the seller/exporter may have an agent or similar acting on their behalf in the country of the buyer/importer. This trusted party who could act on behalf of the seller/exporter is sometimes referred to as the ‘Case of Need Party’. We will refer to this later. 


We will cover bills of exchange and promissory notes and the subject of ‘Noting & Protesting’ in more detail under the section Financial Instruments. 


Assuming everything goes to plan and the buyer/importer accepts the financial instrument. Whilst this is a good start and establishes a legal undertaking to pay, it does not in itself guarantee the payment of the buyer/importer. The financial instrument may not be paid on due date for a variety of reasons. The seller/exporter has a number of options to mitigate the risk. One could be credit insurance covering commercial and political risk and possibly protracted default, another option would be to discount the invoice on a non-recourse basis and assign the payment due under the financial instrument to the IF company or as part of the ‘acceptance’ process one of the conditions is that the financial instrument is ‘avalised’ by the buyer/importers bank.  


Avalising a bill can be best described as a third party standing as guarantor. In the event that the buyer/importer cannot or does not pay, the guarantor, in this case the bank is obliged to make payment notwithstanding (Remember the financial instrument is separate from the contract and the other documents). The buyer/importer bank will charge for the ‘aval’ and this would usually be claimed from their client. 


It also worth remembering, that at the time that the buyer/importer accepts the financial instrument all the original shipping and commercial documents are released to the buyer/importer and this means that the title documents such as a full set of original bills of lading and consequently title to the goods passes. That is normally because the bills of lading are like bank notes in that they are ‘bearer’ and the holder in time has title. The seller may have a contractual retention of title until paid but in reality enforcement in an overseas jurisdiction may not be that easy. If it is a domestic sale then it might be a little easier albeit it in either case it will depend of the nature of the underlying goods and whether can be readily identified or they have lost their identity because for example they are component parts supplied which have then been fitted to another piece of equipment  . We will cover this in more detail in the section ‘Securitising the Trade Transactions’


More to follow


Documentary Credits

Information coming soon

Assignments

Information coming soon

Other methods of Securing Payment

Information coming soon