Managing Supplier Credit Risk in a Cross-Border Sale of Goods

Managing Supplier Credit Risk in a Cross-Border Sale of Goods

Most sale of goods agreements involve a supplier extending credit to a purchaser, exposing the supplier to credit risk (i.e., the risk associated with the purchaser’s failure to fulfill its payment obligations). As the globalization of our economy continues, an increasing percentage of these agreements are being entered into by parties located in different countries. With this cross-border element added to the mix, supplier credit risk increases, oftentimes dramatically. This Practice Note presents several of the factors affecting supplier credit risk (with a focus on U.S. suppliers), along with recommended actions that may be taken in order to mitigate this risk.

Governing Law and Judgment Enforceability

When a U.S. supplier enters into a sale of goods agreement with a purchaser from a different country, the contract will most likely be governed by the United Nations Convention on Contracts for the International Sale of Goods (CISG). Why? Because the U.S. and over 80 other countries (including China, France, Canada, and Mexico) have adopted the CISG treaty. Notable absences include: Hong Kong, India, South Africa, Taiwan, and the UK. The CISG applies to all cross-border sale of goods agreements unless its applicability is expressly excluded.

As the UCC-2’s international counterpart, the CISG sets forth a wealth of default provisions applicable to sale of goods agreements where the parties are silent.  While the CISG attempts to simplify the parties’ relationship in its application of a uniform set of rules, its language is interpreted in different ways by the courts of different countries (including with respect to enforcing foreign judgments), and as such, the outcome of their application to any particular dispute remains difficult to predict. This problem is compounded by an extreme lack of guidance from past court rulings (which go largely unrecorded), and therefore, as compared with the UCC-2, the CISG offers much less settled law, precedence, and consistency (and therefore, more risk). Additionally, a tremendous amount of research is required in order to really understand how the CISG applies to a specific transaction. On top of that, a dispute under a CISG governed contract is often heard on foreign ground. Finally, the CISG is considered very ‘purchaser friendly’ as it incorporates extensive warranty protections, many of which cannot be disclaimed by a supplier (as they can under the UCC-2). For these reasons, a supplier will usually seek to apply its own laws, although there would still be a very real risk that judgments rendered thereunder go unrecognized and unenforced in foreign territories. With respect to U.S. suppliers in particular, the U.S. is not a party to any international treaties or conventions that require the recognition of U.S. judgments by foreign jurisdictions. Therefore, even where U.S. federal and state laws apply, a supplier must rely on the foreign jurisdiction’s willingness to recognize and enforce a finally rendered judgment, which is far from guaranteed, particularly when such jurisdiction’s public policies, economic condition, political climate, and/or established customs encourage non-cooperation.

In order to address this uncertainty and minimize its associated credit risk, a U.S. supplier should seek to have the foreign purchaser represent and warrant that its local courts will:

• accept the agreement’s governing law (and venue) provisions; and

• recognize and enforce any final, binding judgments rendered pursuant thereto (i.e., without requiring a hearing, litigation, or other re-consideration of the disputed facts).

This representation should always be supported by a legal opinion issued by the purchaser’s counsel, which should include, among other things, any special requirements for judgment recognition and enforcement (if any). In this way, the credit risk associated with an unenforceable judgment rendered against a defaulting purchaser, while not eliminated, is greatly reduced. 

Alternatively, a supplier could mitigate the credit risk associated with judgment non-enforceability by requiring that all disputes be settled by binding arbitration, but only if the purchaser’s country is a signatory to the U.N. Convention on the Recognition and Enforcement of Foreign Arbitral Awards (which allows U.S. companies to arbitrate disputes in the U.S., and requires foreign courts in signatory countries to enforce the awards). 

Foreign Exchange

When a supplier and a purchaser from different countries with different currencies enter into a sale of goods agreement, the supplier is subject to additional credit risk stemming from the following:

• capital controls/government intervention; and

• ongoing exchange-rate fluctuation.

Capital Controls: 

Capital controls are government-imposed foreign exchange regulations that restrict the free flow of currencies. An example of some actions that could be taken by a government to impose such restrictions include:

• limiting or barring locals from receiving, holding, or using any foreign currency without government authorization;

• limiting or barring locals from exporting its local currency without government authorization; and

• setting fixed exchange rates.

Capital controls are often promulgated in an effort to either prevent currency devaluation, limit access by foreigners, and/or prevent capital flight (which is commonly associated with economic, political, or civil unrest).

To address the credit risk associated with such restrictions, a U.S. supplier should require the purchaser to provide a representation & warranty (along with a corresponding legal opinion from its counsel) stating that:

• it can fulfill its payment obligations (a supplier could require this statement be supported by documentary proof); and

• it has received all required government authorizations (and will provide copies to supplier as a condition precedent to supplier’s distribution of goods).

The supplier should also seek to obtain immediate termination and payment acceleration rights in connection with any breach of this warranty.  Its effectiveness is limited, however, by the fact that future economic and/or geo-political events can quickly and significantly affect the purchaser’s ability to fulfill its payment obligations. If a supplier believes that it is dealing with a high-risk jurisdiction (i.e., where economic, civil, or political unrest is frequent, such as in most third world nations), it should consider obtaining ‘political risk insurance’ to protect against any and all losses associated with such risks. 

Exchange Rate Fluctuations: 

Fluctuations in exchange rates are perpetual, even without the catalyst of a particular political, cultural, or economic event. A purchaser’s ability to fulfill its payment obligations (and the real value to a supplier of such payments) is oftentimes contingent upon the prevailing exchange rate at the time payment is made. A supplier should address this risk by seeking to include an “exchange rate price adjustment” (ERPA) clause in the applicable sales agreement, effectively requiring the parties to adjust the purchase price in order to accommodate a material change to the applicable exchange rate. A supplier should also seek a representation from the purchaser attesting to its ability to fulfill its payment obligations (with supporting proof), along with immediate termination and payment acceleration rights in the event that a material change in the applicable exchange rate affects, or is reasonably likely to affect, the purchaser’s ability to make any required payment. 

Political, Economic and Cultural

Before entering into a cross-border sales agreement, a supplier should pay close attention to the political, economic, and cultural climate of the purchaser’s country. Proper due diligence should be exercised, and the supplier should engage local counsel in the foreign jurisdiction in order to identify all key issues and requirements applicable to the proposed transaction. Even when U.S. law applies, a supplier cannot escape the imposition of a host of the laws, rules and regulations of the applicable foreign jurisdiction (including those respecting business licenses, the perfection of security interests (where title to the goods is sometimes retained by a supplier as collateral), and applicable taxes, among others).

Additionally, many jurisdictions enact or change laws without advance notice, and require their retroactive application to existing agreements. For example, a government may:

• engage in expropriation (potentially taking collateralized property used to secure payments);

• augment its capital control;

• establish a debt moratorium;

• repudiate contracts; and/or

• devalue the local currency;

as an emergency response to a financial, civil, and/or political crisis. Once again, a supplier should consider obtaining political risk insurance to ensure against losses stemming from such risks.   

Local business practices should also be understood and addressed where necessary. For example, in many cultures, making payments to government officials to ‘facilitate’ transactions and generate leads is commonplace and expected. The U.S. Foreign Corrupt Practices Act (FCPA) was enacted to prevent the bribery of foreign officials by U.S. (and in some cases, foreign) entities, and therefore, to the extent that a purchaser violates the applicable provisions of the FCPA, it subjects itself (and the supplier in certain instances) to hefty fines and other penalties which could affect its ability to fulfill its payment obligations.

Finally, understanding a purchaser’s current financial situation is critical. With the assistance of experienced counsel, a supplier should research a purchaser’s credit standing, financial statements, and third-party debt obligations. In high risk situations, a supplier should seek to obtain from the purchaser:

• an irrevocable letter-of-credit (i.e., from a bank agreeing to the purchaser’s payment obligations); and

• a representation that its payment obligations rank at least pari passu in right of payment with all present (and future) unsubordinated and unsecured indebtedness.