Risky Business

When you are making decisions regarding what form of payment you are going to use for exports, you really need to look at all the risk involved in international trade. There are considerably more risks in international trade, just by nature, than there are in domestic trade.

These are the most important risks to consider:

• The commercial risk is your buyer risk. Insolvency and unscrupulous buyers and sellers in this world, they both exist.

• You always have a product risk in the quantity and quality of the product that is being exported.

• There is a foreign exchange risk the buyer or seller is absorbing.

• Then there is the sovereign political bank risk. In a broad sense, that’s the risk of the country you’re shipping to.

• In today’s economy, there is also risk of bank failures. It is important to highlight that not all banks are created equal, not only in the U.S., but, as we know, across the world.

• Additionally, there is a documentary risk, whether it is wrong or improperly prepared documents, they all lead to customs issues.

• Sellers have transportation risks regarding the timeliness of delivery.

• Finally, more important than ever, is compliance risk—there are U.S. and international export regulations.

Factoring for Risk

There are many factors to consider when determining what payment method to use. One of the biggest is the size of the order relative to the size of the organization. A $100,000 order—though nobody wants to lose $100,000—may be more of a concern for a mid-size or a smaller organization than for a large company.

There are additional questions an exporter must ask, such as: How does my company feel about foreign commercial risk? What type of product am I selling? What are my competitors doing? Are they offering terms? What is the industry standard?

When dealing with commodities, the industry standard is not cash in advance or open account. About 80 percent of the trade in the commodities industry that we see is done on letters of credit (LC) or a documentary collection.

Further questions include: What are my cash flow needs as an organization? What is my relationship with the buyer?

I could stand here all day and tell you how to do everything right, but there is still due diligence, and you still have to know your buyer. Is it a new buyer or is it a long-term customer? (That is a big part of the equation.)

You must also consider cost margins. In the commodities industries, the margins are not very high. When you are looking at a form of payment, you have to weigh how much you are going to make on your shipment vs. how much that form of payment is going to cost. Typically the longer the financing period with one of these instruments, the higher the cost.

THE BEST BET

From the exporter’s perspective, cash in advance is ideal because your buyers take all the risks, but it’s really not a very competitive term unless you are the only player in the market.

A letter of credit offers a more competitive method of payment. It is a letter addressed to a beneficiary (exporter) by a bank wherein the bank undertakes on behalf of an applicant (importer) to effect payment to the beneficiary for merchandise shipped or services performed provided that the beneficiary presents the required documents in compliance with the terms of the letter of credit. Once you have an LC, you no longer have a commercial risk with your buyer. For example, your Chinese buyer goes to its bank, and the bank issues a credit. Your risk now lies with the Chinese bank’s ability to pay and your ability to comply with the credit.

There are a lot of terms and a lot of parties involved in credit. The applicant on an LC is going to be the buyer. The beneficiary is the seller. The issuing bank is the applicant’s bank. The advising bank is the bank on the U.S. side of the ocean that receives the credit, authenticates it and says it is a valid instrument. The confirming and examining bank may or may not be one in the same, but it is the bank in the U.S. that is going to take possession of your documents upon shipment and examine them to make sure they comply with the credit before it goes back to the issuing bank.

What are the benefits of using LCs from a seller’s perspective? You have a pre-export guarantee. When you receive that credit, it means, "I’m shipping this merchandise at this price." It’s going to give you the ability to sell in markets that are a little higher risk. It protects you from order cancellation because, once a credit is issued, the beneficiary has to agree to its cancellation or it is a valid instrument.

An LC is going to give you the ability to offer terms to your buyer like getting paid at sight, basically, on shipment, as a seller. It provides a unique financing tool. I’ve seen in scrap markets in particular, certainly for China, the norm seems to be 90-day sight LCs. So the Chinese do not want to pay until 90 days after the documents reach their counters, which is great for them. But, concerning the cash-flow needs of your organization, an LC gives you a way of getting paid right now and allows your buyer to pay later. It’s the best of both worlds.

As for benefits for the buyer, they’re going to have documentary evidence that you have shipped the goods on time before they have to pay. They are going to have assurance that you sent all the documents that they require, including any import compliance certificates or regulation certificates, before they have to pay. Even on a sight transaction, they’re not going to have to pay until those documents make it through the banking channels back to the issuing bank, which could be 15 or 20 days. They can get deferred payment of 90 days and still allow their seller to get paid on sight through discounting.

Negotiate your LC as you would your sales and purchase orders. It is always best to negotiate the terms in your credit before you issue the credit. It is really part of your sales negotiation. If it is done after the credit is issued and there is something wrong with it, it costs everyone time and money to get it corrected. Your bank should work with you in this process to help you structure your LC to protect your interests.

PLAYING IT SAFE
The commercial risk is removed by the LC, but the bank risk is not. Some people are just not comfortable with any foreign bank risk. A confirmation of a credit by a U.S. bank removes the foreign bank risk from the equation. If we confirm a credit, you are actually looking to a U.S. bank to make your payment. People do this if they are financially conservative. As the dollar amount gets greater or as the overseas banks become Tier II or Tier III banks rather than Tier I banks, the seller may be more interested in a confirmed credit.

When a U.S. bank confirms a sight credit, once you submit documents, the U.S. bank has to pay within five days as long as the documents are clean. On an unconfirmed credit, the U.S. bank will make sure the documents are clean and compliant before forwarding them to the issuing bank for payment, because the issuing bank is the ultimate debtor.

There is a document flow of anywhere from 10 to 25 days in that process. By confirming a credit, you’re not only taking away the risk, but if you’re presenting clean documents, you are shortening your days sales outstanding on your invoice considerably. We have companies that are very comfortable with the risks, but are really just looking to accelerate payment from 20 days down to five.

One caution is that most Chinese banks do not allow their letters of credit to be confirmed. It is very difficult for U.S. sellers to get Chinese banks to allow us to add our confirmation. However, some U.S. banks offer a program called Engagement to Purchase Documents. This allows us to silently confirm that credit. We will add our confirmation unannounced to the Chinese bank and if you present compliant documents, we will pay you in that same time period. It requires more due diligence on our part and on your part as a seller. This program does work very nicely if you are looking to accelerate payments from China.

If you’ve agreed to sell on LC terms, decided you want to confirm your credit, forwarded your instructions to the buyer and you get the LC, the next step is to ask whether the bank did what you asked it to do in the LC? If it did not, go back to your buyer and request an amendment prior to shipping. You never want to ship on that LC if you are not comfortable with it.

The next step is shipping your goods and presenting your documents. You are normally going to want to route your documents back through your preferred trade bank, the bank you asked the LC to be advised through. If there is anything that is not in compliance, your advising bank will call you and work with you to correct it. Our No. 1 job as the U.S. examining bank is to make sure your documents are clean so we can either honor your confirmation and pay you out right away or we can send clean documents back to Vietnam or China and get you paid without delay. If the documents are not clean, the issuing bank will have to get the approval from the buyer to accept the documents. You lose quite a bit of your leverage.

In most cases when shippers have had issues with credits, they have knowingly shipped past their agreed-upon date. The buyer might say, "We’ll waive the discrepancy. We don’t have time to get an amendment." Then the material gets over there, and the buyer doesn’t accept the shipment and negotiates on price.

The good news is that 99.99 percent of credits are paid. It’s an extremely low default rate on trade credits.

HIGH RISKS, LOW COST

As you move from cash in advance to an LC and you get to know a buyer better, or if you are selling to countries you don’t view as risky, a documentary collection is a nice instrument between an LC and an open account that still affords you a fair amount of risk protection. It’s not a bank guarantee; it’s an instrument where the bank controls the title document. For this method, go to your bank and ask for a documentary collection letter. Fill it out, then make your shipment and send those documents—normally an invoice, a packing list and an ocean bill of lading—to your buyer’s bank.

Your buyer’s bank is going to get the documents and will call your buyer to notify him that the documents have arrived and ask for payment.

The buyer’s going to say, "Well the ship’s not here yet, so call me back in 15 days." But when the ship comes in, the bank calls the buyer back and says, "Will you pay now?"

The buyer says, "Yes, I still want the goods, so I will pay."

The buyer pays, and the bank releases the documents. The bank gets those funds and sends a message to the U.S. originating bank saying your documents have been transferred to the buyer and delivers your funds. This method has a two- to four-week pay schedule, unlike the LC, where you can get paid in five days on a confirmation.

Collection doesn’t carry an obligation from the banks. If your buyer decides that he can get a better price from someone, somewhere else, or he just doesn’t want the goods anymore, he tells the bank, I’m sorry, I refuse the documents.

However, you retain title to the documents through the bank channel and even when a ship is overseas, in commodities industries, you can often resell and trade. That’s why it is used more in commodities than for a high-end piece of capital equipment that you couldn’t typically resell. It’s very competitive compared to cash in advance or LCs.

The risk is your buyer could refuse a shipment. On an LC, if your buyer refuses a shipment, it doesn’t matter because the bank is still obligated to pay.

The benefit of documentary collection is its low cost. A typical documentary collection runs between $50 to $70. However, for a $100,000 LC, the cost might be a bit higher, around $400. So it’s very cost-effective. You don’t have to ship by a certain date, and your documents aren’t examined.

Buyers don’t have to tie up their credit line by issuing you an LC. They don’t have any up-front risk. They can refuse a shipment. They can control if and when payment is made and almost never pay until it ships there.

Presenting a risk for the buyer, there is no examination of documents with a documentary collection. You could be missing documents or the documents could be incorrect, and the buyer wouldn’t necessarily notice until it paid.

Open account, obviously, is the last step if they won’t sell in collection. Obviously as a seller, it’s very risky for you. You bear all the risk in the transaction in terms of price, quality, non-payment, commercial risk and just about every other risk.

Nevertheless, knowing the costs and benefits of your export payment options can help you minimize your overseas risk and grow your business.

The author is vice president of global trade services at U.S. Bank, Minneapolis. She can be contacted at jane.hay@usbank.com.