From time to time, your suppliers may want partial payment or full prepayment to be made before you receive the goods.
Where goods are delivered in large quantities per shipment, such as 500,000 barrels of gasoline on-board an oil tanker, each prepayment you make will consume multi-million dollars of your working capital.
We have seen commodity traders lose supply – especially supply they have been purchasing regularly – to their competitors because they could not make prepayments to their suppliers. And where substitutes for such goods are not easy to find at the right price, we have seen competitors reselling the cargo to the original buyer at a higher price.
In many ways, making a prepayment to your suppliers is similar to financing them, and extends beyond the usual buyer-seller relationship.
You would not make a loan to just anyone on the street, and especially not without a proper IOU.
Similarly, you should not agree to make a prepayment without first putting the right structure in place and finding the capital to make the advance.
- Term of contract
- Quantity of goods
- Cargo value
- Supplier’s delivery / contract performance risk
- Supplier’s credit risk
- Prepayment coverage ratio / deduction amounts
- Top-up mechanisms in case price falls
- Information covenants
- Financial covenants
- Tax / permanent establishment risks
- Credit mitigation available (trade credit insurance, silent risk covers, risk participation)
- Refinancing from potential financiers via back-to-back loan finance agreements or other trade finance structures
- Assignment of contracts
- Delivery undertakings
- Parent guarantees
- Controlled bank accounts
- Events of default
- Dealing with off-spec cargoes, force majeure
- Cost of financing
- True-up calculations
- Commodity price hedging
- Governing law and jurisdiction
- Sanctions provisions
- Compliance with local regulations
- Legal opinions to rely on
How do prepayments go wrong (and how to mitigate risks)
What if you decided to proceed with the prepayment without proper due diligence and legal documentation?
Initially, you will feel that everything is smooth sailing.
Problems with prepayment typically arise because of failure by the supplier to deliver prepaid goods to its customer. Suppliers don’t intentionally sign contracts to default on them the day after. It is usually because of unforeseen problems that results in non-delivery.
There could be many excuses for failure by the supplier, including:
- Financial distress when profit margins are unexpectedly compressed
- Declaring force majeure on a prepaid cargo
- Using delivery / export regulations to invalidate making delivery