4 Techniques to Manage the Risk When Advancing Payments to Suppliers

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In bond parlance, if rates fall there is a higher risk of debtors paying off their bonds if they are callable and refinancing at lower rates. This is a risk investors of callable bonds take. But what about prepayment risk? Why would any buyer want to prepay for goods or services knowing the slow growth world economy we are in today?

Where the buyer prepays, the supplier’s insolvency, illiquidity, or outright bankruptcy prior to delivery can cost the buyer its prepayment and leave it with no right to the goods.

In some industries, it may be necessary or desirable to use advance payments to purchase from suppliers to pay for moldings or castings, or to provide an upfront assurance to begin the building of a good, which can be customized or unique. Buyers agree to prepay (or partially) in exchange for some other advantages. Most companies should have a policy around advance payments, including business process, ie, purchase order notation, the submission of invoice, accounting reconciliation, sales tax treatment, receiving and documentation.

Advance payments can come in a few forms – there are full or partial payment for goods, progress payments and down payments.

If the seller becomes insolvent, the buyer’s rights and remedies collide with those of the seller’s other creditors. Brian Hulse, partner at Davis Wright Tremaine LLP wrote about what a prepaying buyer can do to protect itself and I summarize his remedies. I encourage you to read his piece here

So what steps can a prepaying commercial buyer take to avoid potential problems?

  • Obtain and perfect an appropriate Article 9 security interest
  • Get lien searches against the seller to identify any conflicting security interests; and
  • Establish the priority of the buyer’s security interest by getting subordination agreements and consents to the sale from the holders of conflicting security interests. While these precautions are not necessary (or likely to be agreed to) when the seller is highly credit-worthy, if there is a risk of the supplier becoming insolvent, they are critical.

I would argue there is a fourth method to control risks when making larger advanced payments to suppliers particularly for custom-manufactured product. It is not surprising that suppliers in technology, aviation or others building infrastructure ask for partial payment upfront to cover materials to be used under the contract. Any buyer would want assurance if the supplier defaults on the contract the advance payment will be returned.

Standby Letter of credits can fulfill this role as well. While a credit product, it can be called about in the event of a supplier default by the buyer demanding payment and the event of supplier failure being confirmed.

When an event happens, ie, bankruptcy, the buyer can demand payment because the applicant, in this case the seller, failed in its contractual obligations. 

It should be noted that standbys are not always easy for sellers to provide and can be expensive, but if you don’t ask the answer is already no.

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First Voice

  1. George Papanikolopoulos:

    Good Call. Unfortunately Standby LC’s have diminished in use as capability in managing the paperflow has been gutted in banks and corporates alike as there is a relatively high admin burden that goes with issuing and claiming on these instruments. While I don’t know much about the ins and out of tech like blockhain, i can imagine that these developments may add some efficiency to the use of standby’s in time

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