The bill of exchange is often mentioned in connection to payment agreed in international commercial contracts. The purpose of the bill of exchange, seen from the risk perspective, can be explained by an example where a seller has agreed with a foreign buyer to deliver the goods to the foreign buyer and receive payment of the contractual price 180 days after delivery. In other words, the payment is agreed on credit terms. During this relatively long period, the seller needs money for its regular business, for example, to purchase labour and material for new deliveries to other buyers, which will also pay the contractual price on credit terms.

The seller may approach its bank to sell its claim for payment against the foreign buyer to the bank at a discount. This means the bank would pay the contractual price to the seller immediately, reduced for the interest rate during the period of 180 days. After paying the seller, the bank would wait 180 days to receive payment from the foreign buyer.

Before discounting the seller’s claim for payment, the bank will assess the foreign buyer’s financial standing and risk for non-payment of the credit. Even when such an assessment shows that the foreign buyer is financially strong and the risk of non-payment of the credit is low, the bank may refuse to discount the seller’s claim for payment. The reason for refusal is the so-called ‘performance risk’, which is the risk of disputing payment by the foreign buyer due to the seller’s breach of the commercial contract. For example, the foreign buyer may allege that the goods delivered by the seller do not function properly, in which case the foreign buyer may be entitled to withhold payment as a remedy for the seller’s breach of the commercial contract. In such a situation, the bank would not receive payment from the foreign buyer even though the bank has already paid that amount to the seller at a discount. This risk might be hypothetical, but if the bank assesses that it cannot take such a risk, the seller will be prevented from discounting its claim for payment.

See the eLearning courses Post-shipment Finance, Export Factoring and Export Credit Insurance.

What can the seller do to avoid the ‘performance risk’ problem?

The seller may request that the foreign buyer accept the bill of exchange, by which the foreign buyer undertakes to pay the contractual price 180 days after delivery. It is the same payment obligation that has been agreed in the commercial contract, but there is an important difference when this obligation is documented by a bill of exchange.

The difference is that the payment obligation accepted in the bill of exchange is unconditional and independent from the commercial contract between the seller and the foreign buyer. Since the foreign buyer’s payment obligation is unconditional and independent, the foreign buyer is prevented from disputing payment under the bill of exchange by alleging that the seller has breached the commercial contract. This effect of the bill of exchange is sometimes explained in a way that the foreign buyer’s payment obligation has been disconnected from the underlying commercial contract. Due to such characteristics of the bill of exchange, it is easier to discount it in a bank and obtain money before the payment becomes due, compared to discounting the claim for payment arising from the commercial contract. The bill of exchange is negotiable, which means it can be transferred to the bank without the foreign buyer’s consent.

It is good to know that the bank will not purchase, in other words, discount, all bills of exchange offered to it. If the bank’s assessment of the commercial risk shows that the foreign buyer’s financial standing is not satisfactory and the foreign buyer may have difficulties paying under the bill of exchange, the bank will not discount it.

See the eLearning courses Post-shipment Finance and Export Credit Insurance.

What can the seller do if the bank refuses to discount a bill of exchange accepted by the foreign buyer?

In such a situation, the seller may ask the foreign buyer to obtain a guarantee, issued by the foreign buyer’s bank, for the foreign buyer’s payment obligation under the bill of exchange. Such a guarantee is included in the bill of exchange document and is called an ‘aval’. Under such a guarantee, the foreign buyer’s bank agrees to pay the amount stated in the bill of exchange if the foreign buyer does not pay it when due. An avalised bill of exchange is seen as a much better risk than the bill of exchange accepted by the foreign buyer only. An avalised bill of exchange is easier to discount and obtain money before the payment under the avalised bill of exchange becomes due. Since the payment obligation of the foreign buyer and the avalisation added by the foreign buyer’s bank are unconditional, neither the bank nor the foreign buyer is entitled to make any objections in connection to the underlying commercial contract.

Foreign buyers are not always willing or able to obtain a bank aval for the bills of exchange they accept. This is because their banks may be reluctant to accept the risk of becoming the aval/guarantor for the foreign buyer’s payment obligation.

See the eLearning course Documentary Collection.

What is the best way to use the bill of exchange?

From the risk perspective, the best way to use the bill of exchange is to agree with the foreign buyer that the foreign buyer’s bank, instead of the foreign buyer, accepts the bill of exchange. This means the bank will make payment under the bill of exchange when due. Since the bank is always seen as a much better risk than the foreign buyer, such a bill of exchange is easy to discount and obtain money before the payment under the bill of exchange becomes due. Bills of exchange are used in this way in letter of credit transactions.

See our eLearning courses Letter of Credit and Export Credit Insurance