This Article was published in the Summer 2013 Newsletter of the International Commercial Transactions, Franchising, and Distribution Committee of the American Bar Association’s (ABA) International Law division. The ABA is the largest association of attorneys and lawyers worldwide.
If a company is exporting goods to Saudi Arabia, the Middle East, or anywhere else for that matter, a key consideration is how to collect payment from the importer or buyer. A risk assessment of the underlying transaction and the buyer is necessary to determine what option to choose. For the exporter, on the risk spectrum, the least risky is to request that the importer pay up front prior to shipment. However, unless there is an established history between the parties involved, it is highly unlikely for the buyer to do so. On the other end of the spectrum is the option to sell on an open account – which involves simply shipping the goods to the foreign buyer along with an invoice. Again, this method of payment is ill-advised, because the U.S. company may end up not getting paid and, instead, quickly finding out how difficult it is to collect debts in foreign jurisdictions.
An alternative to both these options is the use of a Letter of Credit (“LC”). Frequently used in international transactions, LCs are a document issued by a bank in which the bank agrees to pay money upon the presentation of specified documents. The transactional costs in obtaining LCs are miniscule compared to the risk of loss that comes with nonpayment. The most basic LC transactional structure is one where the buyer-importer opens a LC with an agreed-upon bank (the issuing bank) in favor of the seller-exporter (the beneficiary). The Letter of Credit is then transmitted to the seller’s bank (usually, the advising bank) which releases the funds to the seller upon the seller’s presentation of a bill of lading or any other agreed-upon documents. In the event the issuing bank’s credit rating is low, a third bank, a confirming bank, can act as a surety for payment.
Terms for Letters of Credit are strictly defined in an internationally-agreed upon nomenclature. In addition, an uniform set of rules are used to govern the interpretation of terms as well as the rights and obligations of each party involved. Today, these payment instruments are used in complex financing transactions which may involve multiple banks, parties and stipulations. There are two main types of LCs: a standby LC and a performance LC. The standby LC is used to guarantee payment in the event of default or non-performance by a party; while a performance LC is used to guarantee payment for performance (usually the shipment or receipt of goods).
In some transactions I have structured, a combination of both types is used to ensure compliance by the buyer and the seller. One example involved a U.S. manufacturer of custom-designed casework and a Saudi Arabian subcontractor who contracted for the supply and installation of laboratories in connection with the construction of a new hospital complex in the Kingdom’s Eastern Province. The total value of the contract exceeded several million dollars. Due to the highly technical and specialized nature of these goods, the challenge was to design a financing mechanism that protected the interests of both the buyer and the seller. The U.S. manufacturer was hesitant to begin fabrication and manufacturing without an advance payment. On the other hand, the Saudi subcontractor did not want to bear the risk of losing the down payment in the event of the manufacturer’s default. In addition, there was still the need to secure payment for the remainder of the project.
First, to provide security for the down payment, the U.S. manufacturer was asked to issue a standby letter of credit through its U.S. issuing bank to the subcontractor’s bank in Saudi Arabia. The bank in Saudi Arabia would in turn issue a guarantee against default only for the advance payment amount. The standby letter of credit would be triggered in the event of the U.S. manufacturer’s non-performance.
Second, to ensure that the U.S. manufacturer would be paid, the subcontractor issued a (performance) letter of credit for the remaining amount through a Saudi Arabian issuing bank to the manufacturer’s bank in the United States. The terms of the LC stipulated payment to the manufacturer against presentation of Bill of Lading documents, which allowed staggered payment for each phase of the project. This structure allowed minimal risk exposure for all parties involved.
The following sketch illustrates the steps performed by each party, numbered in the order they were performed.
- U.S. supplier instructs its advising bank to issue a standby letter of credit to the importer’s bank in Saudi Arabia;
- Saudi bank, using the standby letter of credit of collateral, issues a bank guarantee to the importer for the advance payment;
- Saudi importer wires the advance payment to the U.S. supplier’s account;
- Saudi importer instructs its bank to issue a performance letter of credit for the outstanding amount;
- Saudi bank issues the letter of credit to the supplier’s U.S. bank;
- U.S. supplier ships goods to Saudi importer;
- U.S. supplier presents bill of lading to its bank for payment against the letter of credit;
- If documents presented conform to the letter of credit requirements, U.S. supplier’s bank releases funds, pro-rata, according to the bill of lading.
Disclaimer: These materials have been prepared by Wassem M. Amin, Esq. for informational purposes only and are not legal advice. The material posted on this web site is not intended to create, and receipt of it does not constitute, a lawyer-client relationship, and readers should not act upon it without seeking professional counsel.
Wassem M. Amin, Esq., MBA is an Associate Attorney at Dhar Law LLP in Boston, MA. Wassem has extensive experience in the Middle Eastern region, having worked as a consultant in the area for over 9 years. Wassem currently focuses his practice on Corporate Law and International Business Transactions. For more information, please visit the About Us page or http://www.dharlawllp.com.