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Supply Chain
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Cross-Border Trades Against Standby LC
By Nironjan Roy, CPA, CMA, CAMS, Banker, Toronto, Canada
International trade is going through phenomenal change, and the structure of cross-border trade has taken different forms. Once upon a time, Commercial LC (Letter of Credit) was the most acceptable means of international trade, but now the situation has dramatically changed.
An LC is no longer the only acceptable means of cross-border trade as different trade finance products are now used to undertake export-import business. It is now apparent that the use of LC is rapidly disappearing from international trade.
LCs are hardly used in export-import business in the developed world, particularly in North America and Europe. Even most Latin American countries, including Chile, Peru, Costa Rica, and Uruguay, do not use commercial LCs to carry out cross-border trade. LCs are now primarily used to conduct export-import business in Asia and Africa. Open-account trade, advance payment, and sales contracts are substituting the use of commercial LC in conducting cross-border trade.
Reason for disappearing commercial LCs: There are multiple reasons behind the disappearing use of LC from international trade. LC is technically a document-based undertaking wherein payment is guaranteed if and when documents are presented complying with the terms and conditions of the LC. A transaction of LC starts through the issuance. It goes through several phases, including advising, confirmation, handling discrepancies that are very common in export documents, negotiation/discounting thereof, and finally, settling the payment. Each phase of the transaction involves costs and fees, which eventually make handling the LC expensive. Also, the landscape of international trade has widely changed.
Once upon a time, the importer found a good exporter and placed orders through the opening of LC. The reverse situation now prevails because exporters find the importers and take the risk of delivering goods to their outlet. Again, the lion’s share of trade is now controlled by a handful of giant trading houses and retail stores like Amazon and Walmart, whose reputation is so high that exporters are ready to ship billions of dollars of goods at their verbal instruction, so the question of LC does not arise at all. Although LC is the payment undertaken by the opening bank on behalf of the importer, experience reveals that the final payment is always settled between the importer and exporter. If the importer does not pay, it is challenging for the exporter to realize the export payment. Since the final payment is always settled between the importer and exporter, most of the importers have decided to import directly without the use of commercial LC, and hence, import/export under a sales contract has come into use. The popularity of export against sales contract: Nowadays, exporting under a sales contract is gaining rapid popularity because this straightforward method is based entirely on the relationship and experience between buyer and seller. There is no third-party involvement, and no additional cost is involved. An agreement is reached between the importer and exporter based on which a specific contract stipulates the quantity of goods to be shipped and the terms of payment to be made against this sale. As per the terms and conditions of the sales contract, the exporter ships the goods first and then directly dispatches the shipping documents to the importer, who releases the consignment using those shipping documents and makes payment to the exporter as agreed upon. As long as the shipment of goods goes well and payment under each shipment is received on time, the export under the sales contract performs very well. However, a problem arises when any payment is not received because the exporter does not have adequate legal right to repatriate export proceeds. Exporters’ payment risk: Exporters’ credit risk is always exorbitantly high when export business is undertaken against a sales contract, which primarily depends on the importer’s solvency and commitment. Moreover, there is the enforceable difficulty of a sales contract when the importer breaches the terms of the contract. If the sales contract is governed by the law of the exporter’s country, the importer will be unlikely to appear in the court of the exporting country. Similarly, if the sales contract is governed by the law of the importer’s country, then the exporter may not find initiating legal action in the importer’s country justifiable and viable at all. So, if payment against export under the sales contract is not repatriated at all, the exporter will have no other option but to withstand the loss. Cross-border trade under a sales contract protects the risk of the importer but exposes the risk of the exporter.
Once upon a time, the importer found a good exporter and placed orders through the opening of LC. The reverse situation now prevails because exporters find the importers and take the risk of delivering goods to their outlet. Again, the lion’s share of trade is now controlled by a handful of giant trading houses and retail stores like Amazon and Walmart, whose reputation is so high that exporters are ready to ship billions of dollars of goods at their verbal instruction, so the question of LC does not arise at all. Although LC is the payment undertaken by the opening bank on behalf of the importer, experience reveals that the final payment is always settled between the importer and exporter. If the importer does not pay, it is challenging for the exporter to realize the export payment. Since the final payment is always settled between the importer and exporter, most of the importers have decided to import directly without the use of commercial LC, and hence, import/export under a sales contract has come into use. The popularity of export against sales contract: Nowadays, exporting under a sales contract is gaining rapid popularity because this straightforward method is based entirely on the relationship and experience between buyer and seller. There is no third-party involvement, and no additional cost is involved. An agreement is reached between the importer and exporter based on which a specific contract stipulates the quantity of goods to be shipped and the terms of payment to be made against this sale. As per the terms and conditions of the sales contract, the exporter ships the goods first and then directly dispatches the shipping documents to the importer, who releases the consignment using those shipping documents and makes payment to the exporter as agreed upon. As long as the shipment of goods goes well and payment under each shipment is received on time, the export under the sales contract performs very well. However, a problem arises when any payment is not received because the exporter does not have adequate legal right to repatriate export proceeds. Exporters’ payment risk: Exporters’ credit risk is always exorbitantly high when export business is undertaken against a sales contract, which primarily depends on the importer’s solvency and commitment. Moreover, there is the enforceable difficulty of a sales contract when the importer breaches the terms of the contract. If the sales contract is governed by the law of the exporter’s country, the importer will be unlikely to appear in the court of the exporting country. Similarly, if the sales contract is governed by the law of the importer’s country, then the exporter may not find initiating legal action in the importer’s country justifiable and viable at all. So, if payment against export under the sales contract is not repatriated at all, the exporter will have no other option but to withstand the loss. Cross-border trade under a sales contract protects the risk of the importer but exposes the risk of the exporter.
We must keep in mind that importers in the developed world sometimes cannot keep their commitment for reasons beyond their control, and one such reason is declaring bankruptcy. Declaring bankruptcy by a company in the developed world is a very common phenomenon. Overnight, many companies, including renowned ones, declare bankruptcy and enjoy creditors’ protection. A few years back, one US-domiciled renowned retail store, Sears, declared bankruptcy. Very recently, a large Canadian company, Hudson Bay, filed for creditors’ protection and went bankrupt. In both situations, many suppliers suffered huge losses. So, the exporter is always exposed to high credit risk if and when foreign trade is undertaken against a sales contract because there is neither a third-party nor institutional payment guarantee.
The sales contract with Standby LC is the best option: A sales contract, when accompanied by Standby LC, mitigates the exporter’s credit risk substantially. This is a very new form of trade finance product that is gaining rapid popularity. This instrument is almost similar to a Bank Guarantee; however, there is a subtle difference between a Bank Guarantee and a Standby LC. A Bank Guarantee cannot be confirmed by a third bank, i.e., confirming bank, while Standby LC can be confirmed by a third bank, i.e., confirming bank. Besides, a Guarantee is governed by the local laws of the issuing bank, while Standby LC is governed by ICC (International Chamber of Commerce) rules, although local law applies to resolve any dispute that arises out of any transaction, irrespective of its type.
How Standby LC mitigates exporters’ payment risk: Initially, the importer and exporter execute a sales contract that incorporates all terms and conditions, among others, including pricing, shipment details, payment method, documents exchange, and maximum amount of outstanding trade balance at any given point of time. Under the executed sales contract, the exporter completes the shipment and dispatches the relevant shipping documents to the importer, who will then remit money to the exporter using the payment method described in the sales contract. In this way, from the exporter’s perspective, exporting goods and receiving payment will continue from the importer’s perspective; receiving goods and remitting payment to the exporter will also continue regularly as long as both parties desire to continue trade.
The risk of uncertainty over the payment of exported goods is well mitigated by issuing a Standby LC by the importer’s bank in favor of the exporter for the amount equal to the maximum value of outstanding trade at any given time. Under Standby LC, the issuing bank or confirming bank where Standby LC is confirmed unconditionally and irrevocably undertakes to make payment on demand to the beneficiary, who is the exporter. So, for any reason, if the exporter does not receive any payment from the importer against the shipment, he/she can draw under Standby LC.
Two key factors related to managing Standby LC are very important here because the maximum outstanding trade volume at any given point of time must not exceed the value of Standby LC, and the expiration of the Standby LC must remain valid as long as the trade continues and payment remains outstanding. Standby LC provides a kind of payment guarantee to the exporter who periodically exports goods under a sales contract executed with the importer. The necessity of drawing under Standby LC does not arise as long as the importer remits the value of imported goods to the exporter. Text and clauses of Standby LC are drafted in such a way that this instrument, once issued, remains valid as long as it is needed.
Usually, Standby LC is used for undertaking non-trade transactions, particularly bidding, construction work, performance guarantees, advance payment guarantees, etc. But its use is now being extended to the trading area where the supply of goods under sales contract is undertaken. The use of this instrument in securing trades/supply is getting rapidly popular, but its use is mostly limited to large corporate traders. However, this instrument as a means of cross-border trade should be more conducive and convenient for small and medium businesses. It may be mentioned here that although trade under open contracts supported by Standby LC is most suitable for cross-border trade, it can easily be utilized for domestic trade, too, especially where payment uncertainty arises. So, trade under sales contracts accompanied by Standby LC can be the best option because this will not only allow the suppliers/exporters to sell/export under sales contracts but also ensure security against the risk of non-receipt of payment.