Legalities: A letter of credit can help guarantee payment or performance by a customer or integrator that has not yet established a credit history with the other party to the arrangement—especially if offices of the two parties are far apart.
Participants in the control systems industry are increasingly crossing borders—both national and international—to either find or provide the unique expertise that defines this industry. I am often asked what steps can be taken to ensure payment or performance by a customer or integrator that has not yet established a credit history with the other party to the arrangement, especially when the potential new contract may be with a start-up company or business that is headquartered far from the other party’s offices. While there are many techniques, I often ask if a letter of credit can be posted at the start of a new relationship.
Letter of credit can build trust
Letters of credit are widely available from banking institutions worldwide, have relatively low maintenance costs to the company obtaining the letter of credit, and can provide payment security to the other party (for payment for its services and deliverables for the integrator, or for protection from defaults from the customer) as the parties work together to establish other long-term credit arrangements or to build trust based on positive historical experiences.
Terms in letter of credit
Here are a few key terms companies and integrators should look for in any letter of credit:
Irrevocable: As the name implies, an irrevocable letter of credit (ILOC) cannot be cancelled or revised without the consent of the beneficiary (here, the company or integrator providing the services or deliverables). Such a term gives comfort to the beneficiary that payments will be made, or money will be available to address the results of a default, even if the entity providing the ILOC experiences financial difficulty.
Term: Even though the letter of credit is irrevocable, it generally will still have a defined expiration date. A beneficiary should check to be sure all payment or performance obligations are satisfied by the entity providing the letter of credit before the end of such term—or that the ILOC is renewed or replaced prior to the expiration date if there is still work to be performed, items to be delivered or payments to be made.
At sight instrument: This is a term of art used with letters of credit. Basically, it means the beneficiary is entitled to payment from the bank that issued the letter of credit by presenting a written demand for payment (or other similar documentation stated in the ILOC). The issuing bank generally is not permitted to dispute whether the entity providing the letter of credit actually owes the sought-after payment to the beneficiary. For example, the bank generally cannot refuse payment to the integrator by alleging the work was incorrectly performed or that the goods that were delivered had defects. Likewise, the bank could not dispute a default by the integrator providing the letter of credit to avoid making a payment on demand of the integrator’s customer.
Amount: All letters of credit have a maximum payment limit. A beneficiary should ensure the amount of the letter of credit is sufficient to cover the expected aggregate amount of all financial obligations that may be outstanding with its counterparty to the contract at any given time. For example, if the integrator has “net 30” payment terms with its customer, this may be the value of 2-3 months of average invoices (assuming the beneficiary suspends performance and deliveries if the outstanding balance grows too large or too delinquent).
With the added security of a letter of credit, it may be possible to expand customer or service provider base with less risk.
Brian Clifford is a partner in the automation and robotics practice of Faegre Baker Daniels, a law firm in the U.S., U.K. and China. Edited by Mark T. Hoske, content manager, Control Engineering, CFE Media, [email protected].
KEYWORDS: Legalities, letter of credit, system integrator
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When other aspects of a young system integrator firm seem positive, a letter of credit can lower potential risk when establishing a business relationship.
