Switching from Export Letters of Credit to Collections

In a previous article, Deciding on Approriate Export Payment Terms, I suggested that companies should perform an annual review of payment terms for each of their customers. A company’s creditworthiness and/or their country’s risk factors may improve or decline over time, and you may need to adjust their payment terms accordingly.

The Risks of Switching Export Payment Terms

Let’s assume that you’ve been selling goods to a particular buyer for the last couple of years on a letter of credit basis. All in all, everything is going well.

Whenever discrepancies are discovered, your customer cooperates and provides the appropriate waivers in a timely manner and payment is made. The buyer knows that you’ll ship on time and present the required documents. You’ve established a business relationship that appears to be working.

Since the letter of credit process is the most expensive and most structured payment method you can choose, you may want to consider an alternative payment term: the collection.

If you never incur any discrepancies when using a letter of credit, you can be absolutely assured that you’ll receive payment from the issuing bank. A collection offers no such assurance. However, if you have experienced discrepancies in a letter of credit, your risk in switching to a collection is not dramatically different.

Whether you use a letter of credit that has some discrepancies or a collection, your risk of not getting paid is about the same. In both cases you must wait for the beneficiary to approve payment.

Payment Using a Sight Draft

Let me explain the process of a collection using a sight draft. First, the buyer and seller must agree that the collection is an appropriate payment term. The seller ships the goods to the buyer and then sends all documentation to the buyer’s bank using the seller’s bank’s direct collection form.

When the buyer’s bank receives the documentation, they will follow the instructions on the direct collection form.

In this case, they will release the documentation to the buyer only upon receiving payment. The buyer will receive a copy of the invoice from their bank and then must decide to authorize payment. Once this is done, the buyer’s bank then transfers the payment to the seller’s bank. Last, but not least, the seller’s bank makes payment to the seller.

It all sounds pretty easy!

But a collection does have some risk. When the buyer receives the invoice from their bank, they may decide not to authorized payment and instead delay, or even worse, refuse payment.

At this point, the seller has three options:

1. Negotiate for Payment

Find out what is wrong and try to come to an understanding that will result in being paid.

2. Find Another Buyer

If the buyer can’t be persuaded to make payment, the seller can try to find another buyer. Ideally, the seller will find a new buyer in the same country as the old buyer so the goods don’t have to be moved again.

3. Have the Goods Returned

This is not the best solution since the seller has already incurred a lot of expenses with no hope of recovering them. However, that may be a better alternative than writing off the entire cost of the goods.

Payment Using a Time Draft

An alternative to the sight draft is a time draft, which is always drawn on the buyer. When a time draft is being use, the collections process is a little different.

When the buyer’s bank sends the copy of the invoice to the buyer, they also enclose a time draft telling the buyer that they will need to accept the draft and return it to their bank in order to obtain the documents. By accepting the draft, the buyer makes a promise to make payment when the draft comes due. However, they are not yet authorizing payment.

Once the buyer accepts the draft and returns it to their bank, the bank releases the documents to the buyer enabling them to get the merchandise. When the time draft matures, hopefully the buyer will instruct their bank to make payment. However, they still have the right to refuse payment if they wish.

Unlike the sight draft that gave the seller three options if the buyer refuses do pay, a time draft only gives them one: negotiate for payment. The buyer has the merchandise, so the seller can’t try selling it to someone else, nor can they have the goods returned. For this reason, a time draft collection is considered one step away from open account.

It’s important to remember that the buyer’s and the seller’s banks will only follow the instructions of their customers. They have no responsibility or liability in the collection transaction. If a dispute should arise, the buyer and seller have to work out their differences without the assistance of their banks.

This article was first published in October 2002 and has been updated to include current information, links and formatting.