TERMS OF PAYMENT

Payment for goods sold in international sales transactions is often problematic, due to the international character of the transaction. The parties usually have their places of business in different states, and are therefore subject to different national legal systems. Furthermore, the seller will often transport goods across large distances and across national borders. Under such circumstances, the seller has a great interest in ensuring that it will receive payment for goods sold once the goods leave its possession and control. The rational seller not only is concerned with non receipt of payments but also is equally concerned with when to receive the payments, because late payments could lead to additional cost of fund (e.g. banking interest for borrowed fund), foreign currency conversion exposure, diminishing real value due to inflationary effects etc. On the other hand however a seller must offer competitive terms to a potential buyer to get assurance of market. This entails a striking balance between sales and associated risks. Payment terms have been often used by parties in export business to provide comfort to the trading parties and to some extent minimize the impacts

Payment terms refer to the way with which the seller will be paid by buyer and reflects the extent to which the seller requires a guarantee of payment before he loses control of the goods. The choice is influenced by number of factors including:

• q Seller’s/Buyer’s risk appetite
• q Financing structure of the buyer or seller
• q Country risks of the buyer or seller
• q Business relationship
• q Market and Marketing strategies

There are four common terms of payment that are used in Cross Boarder Trade

• Open Account
• Advance Payment
• Documentary Collections
• Letters of Credit

Open Account:

• Here the seller dispatches the goods and trusts that the buyer will pay as per agreed terms perhaps immediately or after sometimes from shipment date. This is however not a very safe payment terms on the side of the exporter. There are number of risks which an exporter might be exposed to. The method is therefore advisable to be used with care and under certain business environment.

Advance payments

• Advance payment terms are the opposite of Open account trading, it is based on the principle that the buyer must pay first and then the seller ships the goods. It is also open to risks but mostly on the side of the buyer, and minimum risks are normally encountered by the buyer.

Documentary Collections

An arrangement whereby the goods are shipped and the relevant bill of exchange (draft) drawn by a seller accompanying with shipping document(s) is sent to the seller’s bank with clear instructions for collection through one of its correspondent bank located in the domicile of the buyer. In documentary collections the banking system acts on behalf of the exporter. Like previous terms o payment is not risk free, there are associating risks which may affect seller or a buyer which make it to not the best terms payment available in international trading. In the hierarchy however, Documentary collections is said to be superior to the Advance Payments and Open Account terms. Top in the hierarch is Letters of Credit also known as Documentary Credit.

Letters of Credit (Documentary Credit)

A Letter of Credit is a document issued by a bank (issuing bank) stating its commitment to pay a seller (beneficiary) a stated amount of money on behalf of a buyer so long as the seller meets very specific terms and conditions. Letters of credit are more formally called documentary letters of credit. The system of documentary credits that is in use in current international trade has largely alleviated these problems relating to payment. The parties establish a letter of credit, which enables the seller to obtain payment from a bank within his jurisdiction. The buyer establishes the letter of credit in such a manner, that payment is promised on presentation of certain documents, the contents of which confirm that the goods being delivered to the buyer are goods that conform to the terms and conditions of the underlying sales agreement. The seller need only comply with the documentary conditions as specified in the credit, and is thereafter assured of payment.

The commercial practice of documentary credits entails that the buyer makes an application to a bank to issue an undertaking to make payment to the seller, once the bank receives certain documentation on behalf of the buyer from the seller, indicating that the seller has dispatched conforming goods. In most cases the letters of Credit are issued in either as “Revocable” or “Irrevocable” form and are either “Unconfirmed” or “Confirmed”, payable at “Sight” or at a deferred period “Usance”. The classification of Letters of Credit also includes special types which are designed to facilitate payments under special arrangements. These include, Revolving Letters of Credit, Standby Letter of Credit (SBLC), Red Clause Letters of Credit, Transferable Letter of Credit, and Back-to-back Letters of Credit.

A Revocable Letter of Credit is the one which may be amended or cancelled by the Issuing Bank at any time with or without prior notice to, or agreement of, the Beneficiary, An Irrevocable Letter of Credit on the other hand is the one which cannot be amended or cancelled without the agreement of the Issuing Bank, the Confirming Bank (if the Letter of Credit is confirmed), and the Beneficiary.

An Unconfirmed Letter of Credit is one which the Advising Bank merely Advises beneficiary the undertaking from Issuing Bank without any engagement. Beneficiary will rely on the commercial stability of the issuing Bank and the Political and foreign exchange stability of an Issuing Bank particular when the bank is in another country. A Confirmed Letter of Credit is the one in which a Bank other than issuing bank (usually) in the beneficiary country gives its own payment undertaking in addition to that given by the Issuing Bank (Such undertaking protect beneficiary against country risk).

It is evident from the above that a seller will ask a buyer to open Irrevocable Confirmed Letter of credit (preferably confirmed by a first class bank) payable at sight. However it is important to note that while confirmation provides additional comfort to the seller, it is associated with additional costs which may be to the account of buyer or seller depending on the agreed terms of sales. Also a strong buyer may prefer deferred terms as opposed to sight terms. Sellers are therefore strongly advised to evaluate the options available to them by making reference to the influencing factors discussed earlier and underlying circumstances.

In addition to the above, Letters of Credit can often be complex and difficult to comply with terms as drawn therein. This is because although the applicant is a buyer, the issuing bank has interest to the instrument and as such additional terms can be imposed by issuing bank to ensure their interests are protected. It therefore requires expert knowledge to ensure you can comply with it. Despite the complexities, it is less riskier compared to other terms and ca be used as financing instrument either through off balance sheet financing, or under structured finance arrangements.