Tools to Manage Credit Risk

May 2009

Topics of Interest

• Open Account Terms

• Cash in Advance / Cash with Order

• Irrevocable Standby Letter of Credit

• Documentary Letter of Credit

• Credit Insurance

• Certificate of Deposit

• Payment Guarantee

• Purchase Money Security Interest

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Open Account Terms

Definition• Seller makes shipment and awaits payment direct from buyer based on

prescribed repayment terms established by seller.

Applications• Buyer has acceptable credit rating.• Buyer is usually established customer…well known to seller.• Orders are relatively small…profit margin sufficient to support risk.

Advantages• Provides seller a competitive advantage.• Limits documentation necessary to make the sale.

Disadvantages• Risk that buyer may not be willing or have means to make payment.• If buyer files bankruptcy, seller takes a low priority in recovery as claim is usually

regarded as unsecured.• Seller does not have guarantee that buyer will make payments in a timely

manner, thus jeopardizing seller’s liquidity.

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Cash in Advance / Cash with Order

Definition• Calls for payment before or at the time of the transaction and does not ordinarily

offer any discount.

Applications• Buyer has unacceptable credit rating.

Advantages• Seller assumes little or no risk.• Positive impact on seller’s liquidity.

Disadvantages• Most severe terms from the standpoint of the buyer.• Seller may give up competitive advantage.

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Irrevocable Standby Letter of Credit

Definition• Promise by a financial institution (typically, a bank) to pay the buyer’s obligation in

the event of a buyer default.

Applications• Buyer has unacceptable credit rating.• Substitution of bank credit for that of the customers. A-B policy dictates that banks

should be rated AA- or higher to issue an irrevocable standby letter of credit.• Seller invoices normally and does not call the L/C unless buyer fails to pay timely.

Advantages• Most secure method of mitigating credit risk.• Assures payment in the event of a customer default.• Seller does not have to obtain relief from automatic stay in event of a bankruptcy.• In the event of a preference action, courts generally do not view drawdown as a

preference.• Can be modified only with the consent of the seller.

Disadvantages• Seller may give up competitive advantage by asking for a standby L/C.• In some cases, costs associated with L/C may have to be paid by seller.• Documents must be carefully prepared and reviewed by A-B Legal.

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Documentary Letter of CreditDefinition• Promise by a financial institution (typically, a bank) to pay the customer obligation

upon satisfaction of selling and delivery terms, submission of confirming documents and seller’s demand for payment through the L/C.

Applications• Buyer usually has unacceptable credit rating.• Substitution of bank credit for that of the customers. Since Documentary Letters of

Credit are a lower risk instrument, A-B policy dictates that banks should be rated “A” or higher to issue a Documentary Letter of Credit.

• Mode of payment when selling to an unknown or high risk customer.

Advantages• Assures payment to seller provided seller complies with the terms of the L/C.• Seller does not have to obtain relief from automatic stay in event of a bankruptcy.• In the event of a preference action, courts generally do not view drawdown as a

preference.

Disadvantages• Seller may give up competitive advantage by asking for a Documentary L/C.• Documents must be carefully prepared and reviewed by A-B Legal.• If L/C is revocable, it is subject to modification without consent of seller.

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Credit InsuranceDefinition• Insurance policy that a creditor can purchase from a financial institution. Insurance policy

may provide protection to the policyholder from A/R losses following a customer bankruptcy or payment default.

Applications• Buyer has weak credit rating or minimal credit information available.• Substitution of insurance company credit for that of the customers.

Advantages• May provide protection to seller in event of a sudden bankruptcy of customer.• Credit protection may be obtained without contacting customer.• Provides information about the ongoing creditworthiness of a covered customer.

Disadvantages• Loopholes in insurance policy may subject buyer to risk of non-payment of claim.• Policy holder usually has to pay deductible before making claims on policy.• Various conditions in policy regarding communication with insurance company and

documentation of claims may be difficult to adhere to.• Policy usually allows insurance company to reduce or cancel coverage on a customer with

very short notice.• Only covers a customer’s inability to pay, not unwillingness to pay.• Catastrophic credit losses may not be covered because of cap on liability amount.• Small losses also may not be covered because the insurance company may not consider

them as qualifying towards the deductible.

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Certificate of DepositDefinition• A CD issued by customer’s bank in the name of the creditor, or creditor may hold

the customer’s deposit to reduce the risk of non-payment on a credit sale.

Applications• Buyer has unacceptable credit rating.

Advantages• Cash is available for the seller to drawdown in the event of non-payment by buyer.

Disadvantages• Seller may give up competitive advantage due to ill will created by tying up

customer’s funds.• In the event of bankruptcy, the creditor would need to obtain relief from the

automatic stay imposed by the courts to drawdown funds.

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Payment GuaranteeDefinition• Customer’s obligation to creditor is guaranteed by a third party (individual or other

business entity).

Applications• When the financial position of the customer is not strong enough to warrant open

credit terms.• Customer order exceeds pre-defined credit limit.

Advantages• Facilitates the shipment of goods based on credit standing of a third party• Guarantee may be used by seller to force the customer to pay by threatening to

pursue guarantor.

Disadvantages• Guarantor may not have sufficient assets to back all guaranteed claims.• Seller may be forced to initiate legal action to enforce payment guarantee.

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Conclusion

• Credit protection allows for prudent management of credit risk.

• Best protection is cash in advance or cash with order.

• Next best is Irrevocable Standby Letter of Credit from an “AA-” or above rated bank followed by a Documentary Letter of Credit.

• Credit insurance is not a good tool for protection of credit risk because of several loopholes in policy language, including the insurance company’s ability to reduce or cancel credit limits on any customer at any time.

• Payment guarantees from individuals also cannot be considered a good protection tool unless they are backed by collateral.

• Open credit with a high limit should only be granted to known and reliable customers who pay in a timely manner.

• Credit terms should not normally exceed Net 30 days unless specifically approved by Treasury.

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