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.

Prepayment Guidelines

How should you assess whether to make a prepayment, or not?
Here are some areas to consider:
  • 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
Proper legal documentation offers you a basic level of protection. Good prepayment contracts provide for cash settlement of all monies due in such events, and also provisions to deal with rescheduling of cargoes and pricing implications. There is a well-trodden path of documenting prepayments and its protections, so why would you not use them?
Also, watch out for “agreement to agree” language in your contract. Once an event of default occurs, suppliers may naturally want to renegotiate the prepayment documentation or worse, decide to sell your prepaid cargoes to other parties for higher prices. What you want is an unambiguous agreement to repay in an EOD.
Due diligence provides an additional layer of protection. In many cases, the supplier may already be in financial distress when they approach you for prepayments. Having an idea of the cash margin and cash break-even levels for the supplier will provide an early warning signal to you. Ideally, you would also want to know your supplier’s debt repayment profile, to anticipate liquidity crunches as their margin changes.
What you also want to know what the supplier is going to do with the cash. We have seen suppliers using prepayment monies to finance long term payment obligations, or even subsidize sister companies that are failing. Prepayments are designed to help suppliers with working capital gaps. Any deviation from that purpose would require an understanding of the fund flows once the money leaves your bank account.
Hindsight is 20/20.
Engage us assist you with due diligence and structuring to safeguard your prepayment.