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By Roberto Bergami email
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As part of a risk management strategy, companies try to predict,
somewhat, where things could go wrong and taking preventative steps
to minimize or avoid that risk from becoming reality, thereby avoiding
potentially dire consequences. When it comes to mitigating risks
from foreign buyers, companies may decide to use a more secure method
of payment, such a Letter of Credit (L/C), also known as a Documentary
Credit.
L/C’s are not risk free, and the exporter must consider the
country risk and the bank risk prior to entering into a sales contract
with the buyer. In
the first article of this series, we looked at the risks associated
with the country in which the buyer and his or her bank are located.
In this article, we’ll look at the risks associated with issuing
banks.
Bank Risk
Given that the undertaking to pay comes from the issuing bank,
the exporter must ensure that the bank is indeed creditworthy. After
all what is the point of obtaining a “payment guarantee”
if that guarantee cannot be relied upon. An effective means to enhance
the security of payment is to trade on the basis of a Confirmed
L/C. When a L/C is confirmed, the undertaking to pay (and the credit
risk) is shifted from the issuing bank to the confirming bank.
The apportionment of credit risk across the different methods of
payment is shown in Table 1 below. Please note the shifting of risk
according to the different payment arrangements.
|
Payment
Method |
Exporter
Risk |
|
Prepayment |
There
is no credit risk for the exporter once cleared funds have
been received, as the sales proceeds are collected ahead
of shipping the goods. |
|
Non
L/C Trade
-
Bill
of Exchange
-
Open
Account
|
The
buyer presents as the credit risk, as there is no independent
“guarantee” of payment. |
|
L/C
- not confirmed |
The
issuing bank in the foreign country presents as the credit
risk, as this is where the payment “guarantee” comes from.
The buyer’s risk is therefore substituted with that of the
issuing bank. |
|
L/C
Confirmed |
The
confirming bank presents as the credit risk, as this is
now where the payment “guarantee” comes from. The issuing
bank’s credit risk has been substituted with that of the
confirming bank. |
There are several options available for L/C confirmation to be
effected:
- Issuing Bank confirms the L/C.
Confirmation means that the payment undertaking given by issuing
bank is further underwritten by the confirming bank–a guarantee
on a guarantee, if you like. Any bank can be the confirming bank,
including the issuing bank. This is just simply dangerous and
unacceptable from a risk mitigation aspect. Where the issuing
bank confirms the credit, the payment security is not enhanced
at all as the same bank that provides the payment guarantee (issuing
bank) is guaranteeing itself! This is not a good option.
- Another bank in the same country as the issuing bank confirms
the L/C.
Some export credit agencies claim that 90% of defaults in export
trade are due to country risk matters. If there is perceived risk
in dealing with the issuing bank, invariably there is an element
of country risk associated with this. Having the L/C confirmed
by another bank in the same country does nothing to alleviate
the country risk elements. This is not a good option.
- Have the L/C confirmed by a bank in a third country.
Where the L/C is confirmed outside the country of issue, there
is a different country risk profile. The trick is to make sure
that the country of confirmation is acceptable. There is no point
in having the L/C confirmed by a bank in a basket case country.
Again we return to the issue of risk mitigation and the creditworthiness
of the party giving the “payment guarantee.”
Therefore we need to specify the country we wish to have the L/C
confirmed in. The best option would seem to be for the exporter
to request the L/C be confirmed through a bank in their country,
or better still, their own bank. This is a good option, as we
should be reasonably certain about our domestic bank’s credit
risk profile.
- Seek silent confirmation.
Where trading relationships are delicate and the exporter believes
the buyer may be insulted by being asked to provide a confirmed
L/C (this being regarded as a sign of mistrust), the exporter
can seek independent silent confirmation. This means such confirmation
will be undertaken between the exporter and the confirming bank
(usually the exporter’s bank) without the buyer’s
or the issuing bank’s knowledge.
The matter does not end here. Although the seller can ask for a
confirmation of a L/C, there is no obligation for that bank to give
it under the UCP 600 rules. In other words, confirmation of a L/C
is not automatic. Just like an exporter wishes to minimise their
credit risk, so does a bank. The bank being requested to confirm
a L/C will pursue due diligence processes and, having evaluated
the credit risk profile of the issuing bank, the country in question,
and the details of the transaction, will decide whether or not to
confirm.
What should the exporter do to minimise payment default on a L/C?
- Consider export credit insurance. This is payment insurance
that may be available through a government trade facilitation
agency and/or private insurers. There are limitations to such
credit insurance contacts. The insurer will need to know ahead
of time details of the country, the buyer and the bank involved
before deciding whether or not to insure. Premiums for credit
insurance vary across the different risk profiles. Usually the
exporter is not able to obtain full reimbursement for any loss
incurred. Some credit insurance agencies offer a maximum reimbursement
ceiling of 85% against any one claim. So if your deal was worth
USD 100,000 and there was default on payment, you would only be
entitled to receive USD 85,000 maximum. Depending on the circumstances,
therefore, credit insurance may not be an answer to all your credit
risk problems.
- Be assured that the L/C can be set up the way you want it, to
minimize credit risk and ensure payment.
- Prior to the sales contract being executed, obtain from
the buyer a draft of the L/C terms and conditions, including
details of the issuing bank.
- Ask the buyer whether they are willing to have the L/C confirmed
and whether they are willing and able to have this done in
a third country (preferably in your country).
- Seek advice from your bank as to whether they would be willing
to confirm the L/C. If the answer is negative, the exporter
should not proceed. If your bank thinks this is not a good
risk, neither should you.
Finally, the exporter needs to consider the time period given to
the buyer for payment. Although supplier credit is commonplace,
this is one of the elements that contributes to the whole of the
credit-risk profile. It is generally accepted that the longer the
payment term, the higher the risk, and the L/C is no safeguard against
changing fortunes in a foreign country’s economic or political
landscape.
As much as possible, the exporter is encouraged to seek payment
at the earliest possible time. At times, an inducement to do this
is required. Do the math. Perhaps giving a small discount to obtain
payment earlier will be more than offset by the reduction in credit
risk exposure coupled with savings from having to service the sale
for a shorter period of time. It’s all about cash flow.
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By Richard Vitas Palaikis II email
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Did you know that you could be liable for merchandise that
has been exported from the United States even if your company
wasn’t the actual exporter? If you are under the misconception
that your liability ends once merchandise leaves your premises,
you are terribly mistaken!
Although you might be selling merchandise to a domestic customer,
that same domestic customer may ultimately export the merchandise
from the United States. According to the Export Administration
Regulations (EAR), your company could be liable for export
violations if you know or have any reason to know that your
merchandise is going to be exported.
It is a good business practice to gather as much information
as possible about the purchaser of your merchandise, the ultimate
end-user if it is different than the purchaser, whether there
is an intent to export the merchandise now or in the future,
and, if so, to whom the merchandise will be exported and for
what reason. If your customer refuses to provide this information
or gives you vague answers, their evasiveness should be seen
as a potential “red flag.”
The inclusion of a Destination Control Statement (DCS) on
all transactions is a good precaution to take in
order to protect yourself in the event that merchandise you
sold to a domestic purchaser is unexpectedly exported from
the United States.
According to Part 758.6 of the EAR, a destination control
statement must be entered on the invoice
as well as on the bill of lading, air waybill and any other
export control document that would accompany the merchandise
from the United States to its ultimate destination abroad.
The destination control statement is required for all exported
items listed on the Commerce Control List (CCL) that are not
classified as EAR99 unless the exportation may be made under
license exception BAG (baggage) or GFT (gift parcels and humanitarian
donations) in accordance with Part 740 of the EAR.
The destination control statement must include the following
statements at absolute minimum:
These commodities, technology or software
were exported from the United States in accordance with the
Export Administration Regulations. Diversion contrary to U.S.
law is prohibited.
Please remember that the U.S. government expects 100% compliance
with the EAR when merchandise is being exported from the United
States even if your company is not responsible for the ultimate
exportation of the merchandise.
As the old saying goes: Ignorance of the law is not an excuse!
You don’t want Uncle Sam knocking at your door for violating
the EAR.
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trade topics. Every seminar is taught by a qualified and experienced
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how to share that knowledge with attendees.
In July, we're offering classes in Cleveland,
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