Archives: payment terms

This is a guest post from Renaud Anjoran. Renaud runs a product quality inspection business in Shenzhen and he also writes the truly excellent and perennially helpful Quality Inspection Tips. My firm has worked with Renaud on a number of China product matters and we have consistently found him to be highly knowledgeable about China product sourcing. This post arose from a long email “conversation” between co-blogger Steve Dickinson and Renaud, which ended as so many of those do: with me suggesting that it be turned into a blog post.

So here’s the blog post, written by Renaud Anjoran.

 

Most transactions with Chinese suppliers are done through bank transfers. This payment method was described in a previous China Law Blog post, China Manufacturing Payment Terms. Limit Your Risks.

Many importers/foreign manufacturers are not familiar with Letters of Credit (LC) as an alternative to bank transfers. Letters of Credit were designed to protect both product buyers and product supplier in international trade. In practice, they are usually more favorable to the buyer.

How a letter of credit protects the buyer

An importer that pays by LC does not have to wire a deposit before production and it usually has the option to cancel the payment in the following cases:

  • If a supplier does not ship at the right time.  Typically if this happens, the LC simply expires, but the buyer still has the choice to pay if it wants the goods.
  • If a supplier does not honor the product specification or if there are too many defects. One of the conditions of the LC should be that the LC will not be paid on unless and until the product buyer has signed off on product quality or a specified third party QC agency has issued its certificate of inspection.
  • If the seller fails to provide any document listed as required in the LC or the documents do not fully conform to the LC’s requirements.

Why letters of credit can be cancelled by the buyer in most cases

Even something as small as a typo in the LC, or the fact that a quantity is written in dozens rather than in pieces in the invoice is usually enough to cause a discrepancy in the LC, which in turn allows the buyer to cancel payment.

In practice, a small minority of LCs are “clean,” i.e., without any discrepancy. In all other cases, the buyer has the option to refuse payment and cancel the transaction, even if the goods are already on a boat (in which case the buyer will not get the documents to get the products out of custom).

CLB Note:  We are aware of a Seattle buyer company that refused goods that had already arrived in Seattle because the street address (which was irrelevant) of one of the parties in the letter of credit was off by a single letter.

Tips for negotiating payment by letter of credit

For the reasons mentioned above, Chinese suppliers typically refuse to accept Letters of Credit. Here is how you can increase your chances of finding a Chinese company that accepts this payment method:

  • When sourcing your product, try to identify as many potential suppliers as possible. This will at least increase your chances of finding one that will accept an LC.
  • In your first conversation with your potential suppliers, mention that you always pay by LC on your first order. Try to get the supplier to accept this payment method in writing
  • Sell your project to your potential suppliers. Good manufacturers are inundated with customer inquiries, so you need to make yourself stand out. Explain why they should work with you. Call the Chinese company’s sales manager if necessary
  • Send your potential Chinese manufacturer a draft of the LC before opening it. You will usually need the commercial invoice, the packing list, the certificate of origin and/or GSM form A, the bill of lading, and an inspection certificate. Try to avoid putting “soft terms” into your Letter of Credit that will make it even more difficult for suppliers to collect payment.
  • If possible, use a major international bank. This will tend to reassure your suppliers.
  • Unfortunately, bank fees are much higher for an LC than they are for a bank wire, so an LC only makes sense for transactions of at least USD$30,000.
  • Chinese exporters are good at guessing whether a project is likely to become a source of long-term business. When they see what they think will be a a one-shot deal, they generally insist on getting a deposit and will not agree to an LC payment arrangement.

In summary, Letter of Credit are a payment tool that makes it unnecessary to transfer a 30% (or more) deposit to your Chinese manufacturer. They are usually more favorable to the buyer’s side, and for that reason, many Chinese companies refuse to accept them. But some Chinese product suppliers have been paid via Letters of Credit from some of their foreign customers for years, and sometimes Chinese manufacturers will accept your Letter of Credit if they really want your orders.

 

What do you think?

Many companies continue to purchase container load quantities of product from small manufacturers located on the southern coast of China. This trade has developed a standard form of payment, often termed 30/70 TT. This means: 30 percent down payment on placement of the order, with the remaining 70% due upon shipment. This means 30% of the price is paid before the product is manufactured and 100% of the price is paid before the product is shipped.

Here are some common results of this system:

  • Product arrives in the United States. Upon inspection, it is determined that a substantial percentage of the product is defective. The buyer demands a refund and the Chinese manufacturer refuses. In the alternative, the manufacturer offers a discount on the next order. If this offer is accepted, the buyer is forced to continue to do business with a manufacturer that makes defective product.
  • The buyer arranges for an inspection during the production process or prior to shipment. The inspection reveals a substantial number of defects. The buyer demands a refund of the deposit and the manufacturer refuses, stating that they have already spent the deposit to manufacture the disputed goods. In the alternative, the manufacturer offers to correct the defects and provide a discount on the existing order. If this offer is accepted, the buyer is forced to continue to do business with a manufacturer that makes defective product.

The foreign (usually U.S.) company buying the product then contacts my law firm about filing a lawsuit against the Chinese manufacturer, rather than accept the unacceptable terms. In virtually every case, however, the buyer ultimately determines that the cost of litigation is not justified by the amount of the potential recovery. The buyer is then forced either to abandon the manufacturer and take its losses or accept the terms proposed and continue to work with a bad manufacturer.

We continue to see this problem on almost a weekly basis. We can now describe the situation with a general rule: If you pay in advance in China and a problem arises with the product, you will likely be unable to succeed in defending/prosecuting your rights through legal action unless you have a sealed contract from the manufacturer that has been written (in Chinese) to protect you. That is, once you have made payment, the money is no longer yours. It belongs to the manufacturer and you are not likely to ever get it back.

Though this general rule may seem obvious, it does not seem to be well understood by many foreign companies outsourcing their manufacturing to China. They come to China to obtain a low price for manufacturing their product, but in analyzing the price that they will pay, they fail to account for the risk that they will make payments that will never be recovered.

I am not suggesting that the 30/70 TT system be abandoned. Frankly, for small, container load manufacturing projects there really is no viable alternative in China. What I am suggesting is that the foreign buyer realistically assess its risks and the prices being offered based on those risks. The buyer should also mitigate its risks as much as possible by doing the following:

  • Do not make the second, 70% payment until after an inspection of the goods. In this way, the buyer’s risk is limited to the 30% down payment.
  • Inspect the product as early possible. Time is a major factor in China business. If you find defects early, it is possible that you will be able to resolve the issue in time to save the shipment. If the issue cannot be resolved, then you at least can probably move on to a different manufacturer early enough to obtain acceptable product in time to meet your business needs.
  • Treat the 30/70 TT method as the price for testing out the Chinese manufacturing system. As soon as possible, move to a different method of payment. Use one that does not require payment of any funds until after an inspection has been made. There are many alternative methods of payment in China. Of course, the use of such a method will require a quantity and timing commitment from the buyer that extends beyond the spot, single container type of purchase that is typical for the 30/70 TT method of payment. If you are not Wal-Mart, you are not going to get Wal-Mart like terms.

Risk cannot be avoided in any international business venture. Due to the long history of business operations in China, the risks can be determined in advance. For success, foreign companies operating in China must account for these risks in their business planning.

What are you seeing out there?

 

With President Obama talking about doubling U.S. exports and with China’s economy booming, it seems appropriate to talk about what should go into a sales contract with China, when you, the foreign company, are the one doing the sale.

The big thing — almost, but not quite the only thing — in such a transaction is the payment terms. In turn, the payment terms greatly influence the complexity and the terms of the contract. The old saying that “possession is nine tenths of the law,” is actually great advice when it comes to international sales contracts. If you are selling product to China and you get paid in full in advance, you are at least 90% of the way towards full protection.

Unfortunately, it is the rare sale into China that involves full payment up front. So if you cannot get full payment upfront, you should consider, at minimum, getting a sufficient upfront payment to cover your costs, thereby ensuring that even if you receive nothing more, you will have covered your costs.

If you are not going to get full payment upfront, then you need to figure out what you can do to maximize your chances of getting the rest of your payments. There are many things you can do to improve your chances, including the following, many of which can and should be combined:

  1. Conduct due diligence on your Chinese buyer. There are services that can do this at relatively low cost (typically USD $500 to $1500, depending on the depth of research performed).
  2. Hold back title. Write your contract so that title to your product does not pass to your Chinese buyer unless and until you receive full payment.
  3. Choose your venue for contract disputes wisely.
  4. Secure payment by using a Letter of Credit. The International Business Law Advisor did a post, entitled, “How to Secure Payment from Your Overseas Customers with Letters of Credit” [link no longer exists] nicely explaining how these work:

There are four participants in a letter of credit transaction — two businesspeople and two banks:

  1. The buyer. That’s your customer.
  2. The opening bank. This bank normally issues the letter of credit, so it is sometimes referred to as the “issuing bank.” They assume responsibility for the payment on behalf of the buyer.
  3. The paying bank. This is the bank under which the drafts or bills of exchange are drawn under the credit. A paying bank in an L/C transaction might also act as the negotiating bank, advising bank or confirming bank, depending upon what responsibilities it accepts.
  4. The seller. That’s you.

To summarize the process: Once you and your customer agree on payment by letter of credit, it is the customer’s responsibility to take your proforma (an invoice that reflects all estimated costs involved to move product door to door) to her bank and open the L/C (letter of credit) in your favor. Once the opening bank has all the appropriate information from the customer, it advises you, the seller, that the L/C has been opened. Oftentimes this will be done by cable or e-mail to the paying bank. Your bank then forwards that information to you. The letter of credit is final and subject to correction only for errors in transmission.

The post correctly notes how “accuracy in all details of your letter of credit is critical.” The problem with letters of credit is that, contrary to what some believe, they do not guarantee you will be paid, even if you fully comply. My firm handle a case involving a fake letter of credit and another case involving a dishonest bank that failed to honor its letter of credit without any basis for doing so, beyond its own desire to stay in good stead with its client.

What do you do to make sure you get paid?

This latest recession has only caused even more small and medium sized businesses to look to cut costs by outsourcing their product manufacturing to China. Unfortunately, many of these companies now engaging in OEM (original equipment manufacturing) outsourcing to China are failing to take some or all of the minimal legal steps necessary to protect themselves. When problems arise, they can do little or nothing to protect themselves because they have no legal basis for protection.
China’s legal system for resolving commercial disputes has improved greatly over the past ten years and taking a few basic legal steps can greatly reduce your risk. The cost of such protection is modest compared to the protection it will provide.
The following five basic steps will greatly reduce your problems with Chinese manufacturers, while improving your chances of recovering should any problems arise.

1. Create and properly register your intellectual property rights in the United States or whatever country or countries in which you sell the bulk of your products. If you do not have a firm basis for your IP rights under U.S. law, you will have nothing to protect in China. Before you go to China, be sure your intellectual property is protected under U.S. law or the laws of whatever country or countries in which you sell your products. Protect your brand identity by creating and registering your trademark, slogan and/or logo. Register your important copyrights. Carefully identify and protect your trade secrets, proprietary information and know how. Patent what you can.

Doing the above will mean that no matter what happens in China, you will at least be able to protect your product to the fullest extent possible in the country or countries in which you sell your products.

2. Register your trademarks in China. Registration can protect your future access to the Chinese market, prevent the export of counterfeit goods from China, and prevent a competitor from registering your mark in China, which would prohibit you from exporting your own product from China. For more on the necessity of registering your trademark in China, check out, “WHEN To Register Your China Trademark” and “China Trademarks — Do You Feel Lucky? Do You?

3. Use a written agreement to protect your know how and trade secrets in China. Small and medium sized companies usually do not have an extensive portfolio of patents. Their most valuable intangible assets typically are their know-how and their trade secrets, which cannot be protected by formal registration. Chinese law, however, permits companies to contractually protect their know how and trade secrets by contract. Such agreements may (and in most cases should) also address issues such as non-competition and confidentiality. Without such a written agreement, no such protection is available. For more on using non disclosure agreements (NDA) in China, check out, “Why Non Disclosures (NDAs) Alone Are Not Enough For China.

4. Product Quality and Payment Terms. The rule here is simple. Do not make final payment to your Chinese manufacturer until you are confident you will be getting an on time shipment of the correct items and quantities at the quality standards you require. This usually means you must incur inspection costs in China and provide for a clear procedure for dealing with these problems as they arise. You must take the lead on this. You cannot depend on the OEM manufacturer to do this for you.

5. Use comprehensive OEM Agreements with each manufacturer. Small and medium sized businesses often enter into OEM manufacturing transactions with a simple purchase order. This is a mistake. The purchase order will not protect you. Your protection depends on your securing a signed written OEM manufacturing agreement with each Chinese manufacturer with which you deal. The ideal OEM agreement will address all of the issues discussed above while also addressing other basic legal issues such as jurisdiction and dispute resolution. This agreement should be in both Chinese and English, since the Chinese language version will control in China. For more on this, check out, “China OEM Agreements. Why Ours Are In Chinese. Flat Out.

If you do the above, you will greatly increase the chances of good results from your China outsourcing. For some more tips on China product outsourcing (including non-legal ones), you should also check out, “The Six (Not Five) Keys To China Quality” and “Six More Keys To Quality Product Made In China.