Forfaiting and Letter of Credit

For a long time forfaiters established as a prerequisite for a book receivable to be forfaited that it was represented by a bill of international format (promissory note or bill of exchange) duly subscribed by the debtor and guaranteed by his banker. Only recently has the forfaiting market gradually enlarged to cover maturities longer than five years and shorter than six months. Up to a few years ago this would have been considered as operating limits.

As a result of that, forfaiting can also now be used as an alternative to the advising bank’s confirmation provided that the letter of credit (LC) beneficiary obtains, soon after its notification, a commitment from a reliable forfaiting house to discount the LC proceeds on a without-recourse basis.

Even in the case of a sight LC forfaiters do intervene issuing ‘silent confirmations’ in favour of the LC beneficiary when the advising bank does not add its confirmation either because the risk involved is too high or because the issuing bank does not allow it.

Forfaiting will expand rapidly in the whole short-term area and the reason for that relies on the following:

• The short-term potential market is very big if compared to the long-term one, whose size is limited to a few kinds of goods such as machinery, equipment and turnkey plants.

• The use up to now of forfaiting in that area has been only marginal since many exporting companies did not feel it as a real need

Clearing the books

Most people are still used to keeping short-term receivables and to collecting them at their maturity but I expect this policy will change in the near future because all companies doing so show a negative impact on their balance sheet, i.e. a large exposure in receivables from sales in one side and a high level in debts towards banks in the other.

The only way for those companies to improve their balance sheet is a greater use of forfaiting. In fact, the use of this instrument gives all exporting houses a lot of benefits and specifically allows them to:

• Make free all the capital invested in receivables and employ it to grow and to develop business;

• Reduce the indebtedness towards banks thus saving interest costs and improving ROI index;

• Avoid delays on collection or eventual losses on book receivables due to political and commercial risk.

In fact forfaiting does not limit its effect on solving liquidity squeeze problems, but it gets the exporting companies free from all risks connected with the payment of receivables at their respective maturity. It is therefore wrong to compare the cost of forfaiting to the cost of other types of financing as many people do.

In this regard it is advisable to emphasise once again that:

• Forfaiting is not at all a financing but a purchase-sale of credit instruments (e.g., bills, promissory notes, book receivables, etc).

• The discount rate applied in a forfaiting contract does not identify interest payable in advance and as such deductible from the face value but the parameter to be used to calculate the purchase price of a bill or a book receivable, based on its present value;

• The net proceeds of a forfaiting transaction is effectively the price paid by a forfaiter to become the new beneficiary of the payment obligation he has purchased.
  

Let us talk now about the modalities to follow when you want to sell a book receivable on the forfaiting market. As a rule forfaiters ask for bills guaranteed by a domestic bank in the importing country through an aval or a separate letter of guarantee or a documentary credit or a standby LC. But in the short-term field the most common documentation is without any doubt the LC payable at 60-90 days sight or from shipment date.

If this is the case, the procedure the exporting house has to apply is quite simple and consists of four steps:

I step: Sign the supply agreement and soon after the forfaiting contract.

Once the supply agreement has been entered between the buyer and the seller, it is advisable for the latter to get a commitment from a reliable forfaiting house to discount on a non-recourse basis his claims under the LC. This commitment will list the specific terms under which the forfaiter undertakes to purchase the LC claims, i.e.:

• discount rate, possibly on a straight basis thus waiving the fluctuation risk on Libor rate on account of the seller;

• grace days;

• commitment fee;

• documentation required;

• expiry date, i.e., the latest date within which the required documentation has to be presented at the counters of the forfaiter.
  

II step: Ship the goods and negotiate relevant documents under the LC. The LC is a very delicate instrument and to make it work, the seller must take care that all LC terms have been satisfied and that all documents complied with; evidence of that is needed for the forfaiter to materialise the transaction.

III step: Send the forfaiter all documents required under the forfaiting contract, i.e.:

• conformed copy of the LC and of any subsequent amendment thereto;

• letter of assignment of the LC claims under Article 49 of UCP- ICC Publication no. 500;

• confirmed copy of ‘notification of assignment’ addressed to all parties involved, i.e. advising bank, issuing bank, applicant, etc;

• confirmed copy of some specific documents, such as:

– commercial invoice
– transport document
– negotiating bank authenticated message confirming that all documents under the LC
have been received and found in conformity with the LC terms and fixing the due
dates for the LC payment.

IV step: This step concerns the control by the forfaiting house of the documents received and this normally requires three to 10 days depending on the complexity of the deal and on the timing to get the necessary answers from the LC issuing bank. Once the check is completed, the forfaiter arranges for an immediate remittance of the LC net proceeds to the seller on his bank account.

Actions:

1. The buyer and the seller sign the supply agreement.
2. The seller gets a forfaiter’s commitment to purchase the LC claims and both sign the
relevant contract.
3. The buyer gives instructions to his banker to open a deferred payment LC and notify it to
the seller through a correspondent local bank.
4. The seller ships the goods as per the supply agreement and then presents all the documents required under the LC at the advising bank.
5. The advising bank sends the documents to the issuing bank who negotiates the credit and
releases a swift message to the presenting bank stating that all documents are in order and comply with the LC terms.
6. The seller assigns the forfaiter all his rights deriving from the LC claims according to
Article 49 – UCP 500, and asks him to provide the seller’s banker with the agreed LC net
proceeds as per the forfaiting contract.