Global markets are a great solution as companies continue to expand business reach. The issue to date has been how to efficiently extend payment terms to overseas customers but this issue can be minimized by offering documentary collections terms to customers. These terms offer a mid-level of risk between open account and letter of credit. With credit still tight or prohibitively expensive in many global markets, providing overseas customers with alternative payment solutions can give your company a strong edge in today’s hyper-competitive global markets.
While there are quite a few alternatives to extend credit to overseas customers, one relatively easy approach is documentary collections. Documentary collections (DC) provide an intermediate level of risk between open account and letter of credit (LC). Thus, a DC is cheaper than a letter of credit and pays faster than an open account. There are two types of documentary collections: Documents Against Payment (DP) and Documents Against Acceptance (DA). With DP, you retain control of the goods until payment and with a DA you gain a potentially negotiable financial instrument in the form of a document pledging payment within a certain time period. DA terms are more secure and enforceable than open account terms while DP terms still provide the seller with considerably less risk than open account.
How It Works
Banks will still serve as the medium for collections but take no legal responsibility regarding payment. The International Chamber of Commerce has nevertheless established rules that govern use of these document terms, as outlined in the ICC publication, Uniform Rules for Collections (URC). DP and DA share the following features:
- Documents (ocean bill of lading and accompanying documents) are consigned so that title and possession do not automatically pass to the buyer.
- The documents go to the overseas collecting bank (not the buyer), along with a collection letter containing instructions and a demand for payment or draft.
- The buyer cannot obtain the documents, and thus possession of the goods, until the specified instructions from the seller’s bank are performed.
- The overseas bank functions as the collection agent for the seller’s bank.
The more commonly used DP works as follows:
- The seller draws a draft (also called bill of exchange) on the buyer for the sale amount, specifying which commercial documents (bill of lading, commercial invoice, packing list, and so on) will be required for the buyer to take possession of the goods at the port.
- The seller’s bank (or freight forwarder) sends the documents to the specified overseas bank.
- The overseas bank informs the buyer it has the documents and endorses them over to the buyer upon payment.
- On presentation of the documents, the buyer obtains the merchandise from the shipping line or otherwise gains possession for import clearance purposes.
- The overseas bank transfers the funds to the seller’s bank.
The procedures for DA are the same as for DP with one crucial difference – instead of paying on presentation of documents, the buyer signs a usance (time draft), a pledge to pay, usually within 30 to 180 days. This is in contrast to the sight draft used with a DP transaction.
As with any extension of credit, DP and DA are not free of risks but there are strategies to mitigate:
- Risk: The documents could accidentally be handed over to the buyer prior to payment. Strategy to mitigate: Do not show the buyer’s name on the documents, but rather that of a third party as consignee (for example, collecting bank, foreign customs broker, agent).
- Additional risk mitigation strategy: Elect to check the protest box on the standard collection instructions form sent to the overseas bank. This obliges the collecting bank to make a formal protest in the event of nonpayment, which can be of value if you must take the collection to court, and can aid in foreign risk insurance claims.
Documents Against Payment (DP) and Documents Against Acceptance (DA) are just another way for a business to think outside the box and sell globally. Both methods are cost effective but you should still perform detailed due diligence on your overseas buyer. Collecting on foreign soil is not easy and usually ineffective.