50 3 Reduction of External Funding Needs
If the supplier chooses a letter of credit instead of documentary collection, the goods
will not be shipped to the buyer unless a bank has already paid. Less trust is therefore re-
quired. Letters of credit are often used in developing countries.
In all forms of cash against documents, the goods will be in existence before payment is
made. If this is a problem, the supplier may prefer payment in advance.
Payment in advance occurs frequently in situations where expensive goods are
manufactured to the specifications of the buyer. For example, advance payments
are used in contracts for the building of ships or aircraft. The buyer will often not
agree to advance payment unless the supplier provides a demand guarantee.
In transactions that involve the sale of an expensive item that is tailor-made for
the buyer and installed by the seller (for example, large diesel engines for ships),
the parties often agree to apply the cash against delivery principle (the Zug-um-
Zug principle)^112 in the following way: (1) The price is paid in instalments. (2) The
seller becomes entitled to each instalment after fulfilling a certain part of its
obligations under the contract. (3) If the parties agree that the buyer pays
something in advance, the parties usually agree that the seller shall furnish a
guarantee (often a so-called demand guarantee). (4) These are the usual stages:
pre-installation period (payment: %); installation period (payment: %); testing
period (payment: %); agreed delivery date; acceptance of delivery (payment:
%); effective delivery date (if the effective delivery is later than the agreed
delivery date, the buyer may be entitled to liquidated damages – if the parties have
agreed on liquidated damages – and termination); and warranty period and
maintenance period (payment: _%). (5) Trade debts are often secured by a
retention of title clause (see Volume II).
Default interest. There are many ways to reduce counterparty credit risk and the
risk of payment default (Volume II). For example, the parties may agree on collat-
eral and remedies available to the supplier in the event of default. The contract
usually provides for default interest in the event that the customer fails to pay on
time.^113 Default interest is usually higher than the normal interest rate.
For example, the parties may agree that if the customer fails to pay the invoice
in full within the payment period, the customer will automatically be in default
without any notice of default or further warning being required. The parties may
also agree that the firm as the seller may charge interest without further notice.
The parties may choose a fixed interest rate for payments in arrears or decide to
use a variable interest rate (for example, the European Central Bank’s refinancing
rate plus a surcharge of 7% in the same currency as the amount invoiced to the
customer).
Unreasonable payment terms are generally prohibited in most jurisdictions (see
Volume II).
(^112) CISG Article 58.
(^113) CISG Article 78 also contains a rule on interest: “If a party fails to pay the price or any
other sum that is in arrears, the other party is entitled to interest on it, without prejudice
to any claim for damages recoverable under article 74.” However, the CISG is silent on
the interest rate. The interest rate thus depends on the governing law and the terms of the
contract.