THE PAYMENT UNDERTAKING
BASED ALTERNATIVE PAYMENT SECURITY
** AN EXPLANATION **

Introduction.
Historical Development of Payment Undertakings.

Utilising Payment Undertakings as a Foundation for an Alternative Form of Payment Security.

The ‘Payment Undertaking Alternative’ Process.
Negative Points.
Positive Points.
Summary.

Appendix I (Payment Undertaking format)

The Payment Undertaking based arrangement described in these notes offers a viable and flexible alternative to payment security based on either;

Payment Undertakings are also sometimes called Purchase Confirmations. They ask no more of the Buyer than a simple but separate confirmation that the Buyer will fulfil the terms of the contract with the Seller. A Payment Undertaking does not impose any additional burden upon the Buyer over and above that already agreed in the purchase/sale contract. It is however a separate formal irrevocable document, usually addressed directly to the bank designated by the Seller.

In preparation for this type of arrangement the relevant purchase/sale contract must contain the following two clauses:

"Credit: At least five days prior to delivery Buyer will send to Seller’s bank with a copy to Seller’s financial contact a Purchase Confirmation/Payment Undertaking in a format acceptable to Seller (bank and text will be provided)."

and

"Assignment: This agreement will not be assignable by either party without the written consent of the other, which shall not be unreasonably withheld. However, in the event payment is not made by the Buyer on due date, Seller has the right to assign the financial rights under this agreement to a bank without the prior consent of the Buyer.".

Businesses which specialise in oil trading (Traders) usually have a limited financial asset or capital base since their main assets exist in the skills and contacts of their Executives. They therefore have difficulty establishing Documentary Credit facilities with international banks.

When such Traders participate in "back-to-back" deals in which, for example, they buy a cargo of crude oil from a National Producer which requires all Buyers to provide Documentary Credit (LC) payment security, and sell the same cargo to a highly credit worthy oil company (Major) which does not normally provide an LC, a mechanism is needed to enable an international bank to provide the Trader’s LC.

Some international banks found a way to do this using Payment Undertakings and so assisted in the expansion of international trade and in the safe expansion of their own business activity.

These banks ask that the Major should issue a Payment Undertaking direct to the bank, irrevocably undertaking to pay for the cargo, if it is delivered as agreed in the purchase/sale contract, and to route the payment directly to the account of the Trader at that specific bank; provided the Trader’s invoice contains details of that specific bank.

This simple device enables such banks to control the receipt of the funds from the Major and payment to the Seller (National Producer) out of those same funds, under the ‘linked’ LC.

This permits such banks to open LC’s that they could not open otherwise.

In recent times the function of the Payment Undertaking has been expanded to provide an alternative method of covering general payment risk. It has proved popular in the Czech Republic, Hungary and Poland as an alternative which is more flexible and cost effective than the use of either Documentary Credits or Domestic Bank Guarantees or Promissory Notes.

This alternative method is described below.

Utilising Payment Undertakings as a Foundation for an Alternative Form of Payment Security:

Payment Undertakings have come to be used more generally, in the international commodity trading arena, following a search for an alternative to the traditional forms of Payment Risk cover because these traditional forms suffer from the following drawbacks:

Domestic banks tend to levy high charges for the opening of Guarantee’s.

Sometimes such Guarantee’s have to be counter-guaranteed by a non-domestic bank which raises an additional charge based on the financial standing of the opening bank not on the financial standing of the Buyer.

Opening a Guarantee utilises an equivalent amount of the Buyer’s line of credit with its domestic bank until the Guarantee is drawn or expires. On the other hand the Buyer may be required to deposit cash collateral with the domestic bank until the Guarantee is drawn or expires.

It is difficult for the Buyer to arrange a partial Domestic Bank Guarantee in cases where the Seller is prepared to carry a share of the payment risk in a single transaction.

Guarantee’s opened by domestic banks do not allow non-domestic banks an opportunity to take direct risk in the name of the Buyer.

 

Domestic banks tend to levy high charges for the opening of LC’s.

Sometimes such LC’s have to be confirmed by a non-domestic bank which raises an additional charge based on the financial standing of the opening bank not on the financial standing of the Buyer.

Opening an LC utilises an equivalent amount of the Buyer’s line of credit with its domestic bank until the LC is drawn or expires. On the other hand the Buyer may be required to deposit cash collateral with the domestic bank until the LC is drawn or expires.

In cases where the Seller is prepared to carry a share of the payment risk in a single transaction, it is difficult for the Buyer to arrange a Documentary LC to cover only part of a shipment.

LC’s opened by domestic banks do not allow non-domestic banks an opportunity to take direct risk in the name of the Buyer.

Processing LC’s is a heavy administrative burden for the Buyer.

A Promissory Note (PN) creates an obligation entirely separate from the underlying purchase/sale contract. In order to create payment security before delivery a PN based on an estimated quantity and an estimated due date must be obtained. This would enable a dishonest Seller to demand payment even in the event that delivery does not take place. Therefore a significant element of trust is required on the part of the Buyer.

 

The Payment Undertaking alternative attempts to overcome all these drawbacks by providing the following features:

Unlimited unsecured credit terms for the Buyer.

No costs to the Buyer for providing payment security.

The Buyer’s traditional lines of credit are not restricted.

Lower transaction costs achieved overall since ‘intermediary bank risk’ costs and ‘intermediary bank handling’ fees are avoided. The savings can be shared by Buyer and Seller.

Full flexibility for the Seller to carry all or share part of the Buyer payment risk, transaction by transaction.

A recognised and legally binding undertaking which is directly linked to a specific and identifiable contract.

Only limited administration effort for the Buyer. This alternative means a lot less work than either an LC or Guarantee would mean for the Buyer.

Full flexibility for the Seller to manage its country risk exposures independently of its Buyer commercial risks. That is to say, if a Buyer is thought to be credit worthy in respect of a particular transaction but the aggregate of transactions with other Buyers in a particular country exceeds the Seller’s country limit, the excess risk can be covered without the need to involve the Buyer. All the credit worthy Buyers in the country in question continue to enjoy unsecured credit terms; while the Seller is able to utilise the Payment Undertaking(s) of one or more Buyer(s) to cover its excess country risk with a bank.

 

Step One:

Buyer and Seller negotiate and agree terms of a purchase/sale contract.

Step Two:

The contract is signed. It includes the following clauses:

"Credit: At least five days prior to delivery Buyer will send to Seller’s Bank with a copy to Seller’s financial contact a Purchase Confirmation/Payment Undertaking in a format acceptable to Seller (Bank and text will be provided)."

and

"Assignment: This agreement will not be assignable by either party without the written consent of the other, which shall not be unreasonably withheld. However, in the event payment is not made by the Buyer on due date, Seller has the right to assign the financial rights under this agreement to a Bank without the prior consent of the Buyer.".

Step Three:

The Seller decides how much of the commercial and/or country payment risk(s) to carry unsecured.

Step Four:

The Seller approaches several selected banks to obtain price and risk appetite indications, to cover or share the commercial and/or country payment risk(s).

Step Five:

The Seller chooses the best bank offer and asks the Buyer to issue its Payment Undertaking to the chosen bank using the text requested by the chosen bank. See Addendum I for example Payment Undertaking text.

Step Six:

If necessary the Seller (representing the chosen bank) and Buyer negotiate and agree the text of the Payment Undertaking.

Step Seven:

The Buyer issues the Payment Undertaking and asks its own bank to authenticate its signatures and deliver the Payment Undertaking to the chosen bank; either in written form or by tested telex. The Buyer’s own bank would normally not charge for this service since it takes no risk in simply confirming that the Payment Undertaking is signed by duly authorised officers of the Buyer.

Step Eight:

The Seller and chosen bank sign a Risk Participation Agreement in terms of which the bank agrees to take over a portion of the commercial and/or country payment risk for a fee to be paid by the Seller.

Step Nine:

The goods are delivered under the terms of the purchase/sale contract.

Step Ten:

The Seller sends an invoice and the required documents to the Buyer, asking for payment to be made to the chosen bank, on the due date, for the Seller’s account.

Step Eleven:

Payment is made on the agreed due date via the chosen bank and the transaction is closed.

The Payment Undertaking alternative requires the Buyer to be involved in some additional administrative procedures viz:

The Seller can fully and flexibly use its line of credit for the Buyer to average downwards the cost of payment risk cover for each transaction. This is particularly relevant when the Seller’s risk appetite does not cover the full cost of a single transaction.

The Buyer’s profile is raised amongst international banks as consideration is given at Credit Committee and Senior Executive level to the Seller’s request that the banks take on the commercial risk of the Buyer directly.

The Buyer’s reputation is enhanced by building up a history of prompt payments with international banks.

The Buyer has an option to approach participating banks later; that is when it wants to extend its range of facilities beyond those available from domestic banks in due course.

The Buyer can share in the savings accruing from the reduced overall cost of payment risk cover.

In conclusion it is submitted that the Payment Undertaking alternative provides a firm foundation for establishing a long term relationship between Buyer and Seller. A relationship which is free to expand regardless of the Seller’s need to manage its exposure to the payment risk attaching to either the Buyer or the Buyer’s country.

ooOOoo

Date: --- DATE ---

To: ---A-BANK--- ---A-COUNTRY---
Telex Number: ---123456--- OR --- ADDRESS ---
Attention: ---MRS-ACCOUNT-MANAGER---

Copy: ---YOUR COMPANY/THE SELLER---
Telex Number: ---654321--- OR --- FAX NUMBER ---
Attention: ---MR-CREDIT-ANALYST---

Message Number: ---3456XYZ78---

We, ---ANOTHER-COMPANY--- (hereinafter called ‘---ANOTHER---’ and/or ‘Buyer’), hereby confirm that we have agreed to purchase from ---YOUR-COMPANY--- (hereinafter called ‘Seller’) approximately ---AGREED-AMOUNT--- of ---AGREED-GOODS--- at a price to be calculated as below for delivery commencing during ---AGREED-TIME-PERIOD---.

The price calculation in ---AGREED-CURRENCY--- per ---AGREED-PRICE--- OR ---AGREED-PRICE-FORMULA---.

Settlement of the price for delivery of ---AGREED-GOODS--- to ---AGREED-DESTINATION--- (to be finalised by ---AGREED-DATE--- in accordance with the contract).

All as per contract dated ---CONTRACT-DATE--- and subsequent amendments, if any.

Buyer Reference ---789012---.

Seller Reference ---987654---.

Subject to performance by the Seller, we ---ANOTHER--- hereby irrevocably and unconditionally confirm that we will pay the full invoice amount without any set-off, deduction or counter claim as designated in Seller’s commercial invoice to the account of ---A-BANK--- at ---ANOTHER-BANK--- in ---AGREED-COUNTRY--- account number ---456789---, on the due date per the contract being not later than ---AGREED-DAYS--- after the delivery date (delivery date equals day zero), against presentation of Seller’s commercial invoice and the proof of delivery ---(COPY BILL OF LADING FOR EXAMPLE)---.

This undertaking is to be construed in accordance with English law with exclusive jurisdiction in the Courts of England.

Signed by:

Name: _____________________

Title: __________________

Authorised Signatory for:

---ANOTHER-COUNTRY---.

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