Moving to Open Account Payments: Payment Guarantee

One of the obstacles in moving to open account payment terms is supplier reliance on the commercial letter of credit, which is also known as a documentary credit, to various forms of pre- and post-shipment financing from banks.

For pre-shipment financing, the supplier can utilize the commercial letter of credit as collateral to obtain financing from its bank, often know as packing credits, or “transfer” the letter of credit to a second tier supplier of raw materials to provide its suppliers with not only a payment guarantee but collateral for its own financing.  For post-shipment financing, under a letter of credit the supplier can ask the bank accepting the draft drawn on the bank to advance payment on the accepted draft–the banker’s acceptance– at a discount to the face value.

These forms of supplier financing are available due to a payment guarantee that the buyer extends through the issuing bank to the supplier. Ultimate settlement of the letter of credit is by the buyer, assuming that the bank has fulfilled its obligations under the letter of credit, to the bank issuing the letter of credit and through the banking chain to the supplier. Aside from requesting its bank to issue the letter of credit, the buyer does not have any further role or visibility into supplier financing.

When the buyer moves to open account payment terms, the payment guarantee on which supplier finance depends disappears.  Suppliers and banks look for other forms of guarantees with recourse–that is ensuring the bank is repaid for and supplier lending–for open account payments.  The most common approach banks use is to have the buyer guarantee that any invoice approved for payment is irrevocable.

Most banks providing open account supplier financing approach the buyer to agree to one or both of the following practices: signing agreements with the bank to guarantee that any invoice the buyer approves for payment is irrevocable, thus creating a payment obligation (sounds like letter of credit without the fees and line of credit), or sending payment instructions to the bank at the time the invoice is approved (thus letting the bank know that the buyer really intends to pay the invoice) instead of a couple of business days before the payment due date, or both.  The challenge with both approaches is that that the buyer is taking a more active role in supplier finance that under the traditional letter of credit.

Banks are investing in educating their customer–the buyer–in supplier financing and the benefits to the buyer’s supply chain by having a well-funded, liquid supply base.  Banks are finding that the reaction of the buyer is mixed–some are actively pursuing supplier financing programs with their banks while other buyers have adopted a position that the supplier needs to find its own financing sources.  Those buyers who support supplier financing programs are using these are a means of negotiating other terms in the supplier contract: adoption of a new supply chain process, such as agreeing to join and embrace a new supply chain technology platform, or agreement to extended payment terms, which help the buyer’s working capital.  This process of educating parties about open account financing, new roles and opportunities to re-define the supply chain is on-going and will take several years to gain critical momentum in market.

Moving to Open Account Payments: Selling to the Supplier

The topic of moving to open account payments comes up frequently in conversations with customers. Many companies are making the move deliberately from  documentary credit to open account payment terms aggressively, except where local regulations require the documentary credit, such as Bangladesh or Pakistan.  Other companies are moving more slowly to open account payments, usually because they have suppliers who rely on the documentary credit as collateral for pre-shipment, or packing credit, financing.  Thus, the move to open account payments is linked often to the working capital position of the supplier: those with strong cash positions will welcome open account payment terms as a mean of reducing their payment expense; those with weaker balance sheets will want to retain the documentary credit for the access to affordable financing it provides.

Many companies do not have a homogeneous supplier pool.  Typically there are a few suppliers providing the majority of the goods to an importer, with many more suppliers providing seasonal or specialty goods.  It is not uncommon to see an 80/20 or even 90/10 ratio where ten percent of suppliers are selling up to ninety percent value of goods to a customer.

When companies ponder the move to open account terms, they often go through their sourcing or merchandising groups, firstly, to communicate their intentions and, secondly, gather feedback.  All too often the sourcing managers are contacting the largest suppliers, those who would gladly move to open account, at the expense of the smaller suppliers, who still rely on the documentary credit.   It is only when the company starts to implement an open account payment that they get the push-back and find that their high goals for conversion to open account do not meet the mark.  Though small, suppliers providing that hard-to-source good will have a lot of pull with his sourcing contact at his customer.

Thus, the ability to move to open account payments may require that the customer becomes mindful of how some of their supply base funds their working capital to manufacture the goods they sell to their customer.   Is the funding required for acquiring raw material or does the supplier want to accelerate its receivables to improve its cash flow, or both?  As companies move into open account payments, unlike under traditional documentary credit-based financing, importers have to become conversant in supplier finance and working capital management in order to achieve lower import payment expense.

Moving to Open Account Payments: Managing Shareholder Value

In the last blog posting I cited three factors that a company considers in moving to open account payments. The last point, on the view of the market on moving to open account payments, is not so obvious a consideration until one understands that once a company pays on open account, it requires much lower lines of credit to sustain an important payment program. If the company is viewed as proactively managing the reduced credit, it can be rewarded by investors; however, if the move is forced on the company, its shares can take a big hit.

This was illustrated back on April 16, 2008, when stock price of Talbots fell 32 percent after it announced that two lenders, HSBC and Bank of America, would not renew lines of credit totaling USD 265 million. The credit lines were used to support import letter of credit payments to its suppliers. On the same day Talbots issued a press release commenting on the “financial arrangements” with its banks and suppliers. Portions of the release read as follows:

“As reported in the Form 8-K, the Company’s major vendors, which represent approximately 75% of Talbots offshore merchandise purchases, have agreed to “open account” terms with payment in 45 days. The revised terms extend the settlement period to 45 days from approximately 22 days on letter of credit purchases, which the Company expects will effectively add approximately $40 million to the Company’s 2008 operating cash flow.

Due to the revised payment terms with its major vendors, the Company believes that its financing needs with respect to the remaining smaller vendors, representing a minority of its purchases, have been substantially reduced and can be accommodated with a letter of credit line of approximately $50 million. In recent years the Company had letter of credit facilities aggregating approximately $300 million; however, by going to “open account” for the majority of merchandise purchases, the need for credit should significantly decrease. The Company believes that approximately $50 million will be sufficient to satisfy the financing needs in purchasing from its smaller vendors. Talbots is in discussion with several financial institutions to supply the $50 million letter of credit and expects resolution of these discussions in the next few weeks. “

Talbots most likely made the change in payment terms in response to earlier notice from its lenders that its lines of credit would not be renewed. But, what if a company were to proactively move to open account payments with extended terms? Talbots was able to improve its working capital, freeing up USD 40 million in cash flow. Even for a company not at risk of its lenders reducing their credit lines, if a company can renegotiate its payment terms to free up working capital it should do so.

In fact many companies have already done so. They are moving to open account payment terms and extending payment terms. But, many are still keen to retain lines of credit even if they are not fully utilized. Perhaps as a lesson learned from Talbots, some treasurers have been keen to retain lines of credit, or at least reduce the lines in small increments, in order to ensure that reducing letters of credit payments is not perceived by market analysts or shareholders as a symptom of underlying financial weakness. In the process of improving its working capital, management will not do its shareholders any favor if a reduction in credit lines is perceived as a weakness in the company’s financial position with a corresponding drop in share value. Thus, when moving to open account payments, companies are moving cautiously to ensure that the reasons for doing so are not misinterpreted, reducing shareholder value.

Moving to Open Account Payments

I was talking to a banker colleague who informed me that over the past two years the move from documentary credit to open account payments has been dramatic.  Certainly, companies I have spoken to all have plans to move to open account payments as fast and as completely as possible. Most of the motivation to move to open account payments is driven by the desire to reduce ongoing operating expense for its own benefits and that of its more financially sound suppliers, improve working capital through an extension in payment terms accompanying a move to open account payments and a reducing in credit expense.

So, how does a company move from payment on documentary credit terms to open account? Typically, there are three factors the company considers: (1) does the company have the technology and operating process in place to move payment processing from the bank to the company, (2) are their suppliers willing to move from documentary credit to open account payment terms, and (3) does the move to open account payment term have an inadvertent impact on the company by financial market.

Welcome to Supply Chain Finance

This year marks the twentieth anniversary of the publication of six documentary credit message standards by the then-named UN/EDIFACT organization.  These messages provide the framework for electronic exchange of documentary credit[1] messages between the importer and importer bank, and exporter and exporter bank.  They were designed by a small group of trade specialists from banks and corporations who met for the first time three years earlier in San Francisco.  Departing from current standards for documentary credits, this group developed the new standards to integrate documentary credit instruments into the order management operations of importers and exporters.  Thus began the journey to integrate, electronically and seamlessly, the financial and physical supply chains.

Since this seminal work, various industry initiatives, banks and companies—startup and established–have endeavored to take the electronic documentary credit from concept to profit.  Most of these efforts met with limited success or outright failure.  Instead of embracing the electronic documentary credit, the market has moved to another form of payment—the open account payment—to automate payments in the global supply chain.

The documentary credit—the traditional paper instrument—not only facilitates a guaranteed payment between importer and exporter—but also the transfer of credit and liquidity from importer, through banks, to the exporter.  This credit transfer mechanism has evolved over decades to provide exporters access to funds from their banks before shipping goods and to accelerate collection of funds after shipment and bank payment approved.  As payments move to open account payments, providers of trade financing services are developing solutions for pre- and post-shipment financing that work for open account payments as well as financing supported through documentary credits.  This new open account supply chain financing is still evolving.

The journey that began twenty years ago to integrate electronic documentary credits into the supply chain has taken many turns in the road, some into dead ends.  The glimmer on the horizon is a process revolving around the payment on open account terms wrapped in new supply chain financing programs that continue to get credit to the exporter.  But we are still on the journey to get to this new trade paradigm.

Welcome to “Supply Chain Finance: Perspective on Physical and Financial Global Supply Chain Convergence,” a new blog chronicling the journey to the new financial supply chain.  In the coming weeks we will cover past, present and, with some verve, the future of the global financial supply chain. 

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[1] Documentary credit is also known as a commercial letter of credit.