Part II

Managing Risks In Countertrade Transactions

By: Neil K. Rutter, President, Excom, Inc.

Force Majeure

Sometimes non-performance is due to events beyond the control of the party in default. These are generally referred to as events of "force majeure," which means a "major force."

This is a legal concept meaning that the contract cannot be performed because of a superior intervening force outside of the control of either party.

Certain events are generally recognized as events of force majeure by all legal systems, however, others may depend on the law of the contract.

Other events of force majeure may be specifically described in the individual contracts. Events of force majeure generally delay the performance of the contract until the event preventing performance has ended.

Force majeure, in its purest sense, are those events which are always recognized as events of force majeure. These can arise from several causes, the two most common being either "acts of God"/"acts of nature," or acts of government.

Common events of force majeure under the former include floods, fire, earthquakes, hurricanes, severe winds and other acts not attributable to man in general.

Acts of government which are generally considered events of force majeure include war, both civil and war involving several countries, insurrection, and acts preventing one side or both sides from performing under their contract, such as embargoes.

However, licensing is not generally an event of force majeure, as one party or the other should be able to obtain a license.

Events of force majeure must directly impact the parties preventing their performance, not merely making their performance more difficult or expensive. However, some legal systems are more forgiving than others.

As an example of the limited nature of force majeure in some courts, the closing of the Suez Canal in 1957 by invasion of Egypt by France, England and Israel was not considered an event of force majeure (which affected shipping) to the English and American courts.

Shippers which customarily used the cheaper route through the Canal and were then forced to use the more expensive route around Africa due to the Canal closing, were unable to claim that this was an event of force majeure, because the courts held that there were alternative methods of shipping, although more expensive.

The risks of force majeure are that your partner/supplier will claim force majeure whenever he wishes to stop performance for any reason. As your supplier is likely to be in a country in which government and business are closely connected, the supplier will often claim that the government has prevented it from meeting the contract obligation.

Obviously, any failure to comply can have a detrimental effect on the sale of your product and may leave you liable to your customers.

Managing the risk. The best protection is probably insurance. As the risks are generally remote, by definition, and are the normal risks for insurance, this is the best method of handling this risk.

Your insurance coverage will not be possible unless your force majeure clause is as limited as possible. And you should check with your insurer or broker to ensure that your clause is acceptable.

In order to manage this risk you should contract specifically for those events of force majeure which you cannot ensure and/or those which you can contract out of with your buyers.

In drafting your force majeure clause you should ensure that there is a provision which requires the party claiming force majeure to prove by an independent means that the event actually occurred.

A second alternative is to ensure that your contracts have the same force majeure clauses as you have with your supplier. This is sometimes difficult to arrange given the expectations of your supplier and your customers/buyers.

You should also ensure that the force majeure clause describes what effect the event of force majeure will have on your obligations.

For example, you may wish that the party claiming force majeure should only be entitled to delay performance, or you may wish that the contract be cancelled totally after a certain period of time. Lawyers can be very flexible and creative in drafting these clauses.

Caution should be exercised in using or defining certain events as events of force majeure, such as inability to perform because of labor disputes, unavailability of labor, raw materials, supplies, shipping, energy, etc. Of course, you may require these to be included to protect yourself.

A good lawyer will not include these as events of force majeure, but rather will define these as "events preventing performance" or similar wording in order to keep force majeure as a relatively dramatic and limited event, and to ensure that it is insurable.

Payment Risks & Creditworthiness

Payment risk is not a common risk for the countertrade transaction, as you are purchasing, not selling product.

However, if your barter transaction requires that a short-fall be paid in cash, there may be a payment risk. There is a credit worthiness issue if you are required to make a claim against the seller.

While corporations are familiar with handling this risk in domestic transactions through credit analysis, this is not often possible in international transactions.

While there are companies which can provide sophisticated credit analysis for many foreign companies, these are expensive. And the analysis is seldom available or reliable for third-world companies. Additionally, while litigation is fairly reliable in developed countries, it is often very unreliable in certain countries, and even international litigation between developed countries is costly and time-consuming.

A party failing to pay because it is bankrupt or because it doesn't want to pay, for whatever reason, is an extremely difficult problem in an international transaction.

Managing the risk. The traditional method is to use a letter of credit (L/C) from a reputable bank. If the (L/C) is not from a reliable bank, it can often be confirmed by a reliable bank. Or the L/C can be insured or discounted.

If you have many transactions it is possible to obtain volume discounts from certain parties through credit announcement enhancement.

Other methods of handling this risk are to insist on security deposits, or to require guarantees from other parties working with the seller who are easily sued.

Letters Of Credit

L/Cs are important in barter transactions involving parallel L/Cs, and are also important to ensure payment on resale of the countertrade transaction.

There are many articles dealing with L/Cs and therefore there is little need to spend much time with the subject here. As many industrial companies are not accustomed to international L/Cs, there may be risks attendant on using them for payment.

They are very exact documents and require experience or training to properly ensure that this excellent method of payment actually works. There are many ways that skillful traders can avoid payment under L/Cs when they are badly drafted.

Managing the risk. The best solution is to ensure that you receive advice on how to structure your L/C. Also, again, you may wish to use a trader familiar with the product and possibly the parties.

Timing Risks

Timing can be a risk in many ways. If your supplier fails to deliver in time, you may be liable to another party who was expecting to receive the product.

Other timing risks impact on currency risks or payment risks. For example, if your L/C expires before delivery, you are not guaranteed payment. Or if your hedging expires before delivery, you may not receive the money you expected.

Managing the risk. This risk should be generally managed in the same manner as non-performance. The risk of delay impacting on your hedging contracts or your L/Cs requires carefulmanagement of your countertrade contract.

This is a good reason to use a trader, as they have experience with these problems, and also have systems and personnel to handle them.

Risks Arising From Government Regulations

There are several legal risks to international trade transactions, such as anti-dumping, embargoes, quotas, licensing, sovereign immunity and foreign corruption

a) Dumping. This occurs when a seller sells a product into another market at prices less than the home market, or at prices less than its cost. Often it is more difficult to obtain the real price for the countertrade product than it is for traditional sales.

The penalty for dumping is an "anti-dumping duty" which is chargeable to the importer of the product. Obviously this could have a detrimental effect on pricing and the countertrade transaction.

Managing the risk. The safest method of handling dumping problems is to use a trader or to act as a broker and have another party import the product.

If you must be involved, you should provide in your contract that any anti-dumping duties are for the account of the seller and should obtain security for this if it is a likely risk.

The difficulty of ascertaining whether dumping is a risk is that dumping is an extremely complicated issue, and a complicated economic analysis is required which can be time-consuming.

Also, since it is often difficult to ensure that it is done properly, it probably is not worth the effort for most industrial corporations.

b) Quotas. These are agreed limits on the volume of product that can be imported into a country. For example, there might be an agreement between China and the USA in which only 20 million items of a textile product can be imported into the USA in any one year.

If your countertrade transaction involved the import of the next 2 million items, you would not be allowed to import them.

The transaction would therefore fail or be delayed until the quota opened again in the succeeding year. If you have already delivered your product to the Chinese importer, you might have to wait for some time. And this could have a negative impact on your profitability.

One of the problems with the quota system is that the Customs Service in the importing country will simply refuse to allow additional product to land.

It is difficult to obtain accurate information on what quantity has landed, and the situation can change very quickly if new product lands between your inquiry and your product's landing.

Managing the risk. Quotas should also be left to the seller to obtain, as the responsibility for managing quotas rests with the exporting country. Alternatively, you could use a trader to avoid the risk.

c) Embargoes. Certain countries, e.g. Iraq, are subject to embargo regulations, and any attempt to deal with products from these countries or to deal with companies/individuals from these countries may be a criminal offense.

Managing the risk. While you may know that you cannot deal with Iraq or other countries subject to embargo, you may not know, say, whether or not the company in Cyprus (which has offered you steel from Romania) is owned by a company in an embargoed country.

It is often extremely difficult to ensure that you are not dealing with a restricted company.

There is no easy solution to the problem, and checking the regulations to determine whether your partner/seller is subject to embargo is time consuming, and probably not reliable.

d) Licensing. Failure to obtain a required license can mean that your product is not exportable from a selling country, or importable in a buying country. And this could obviously have an extremely negative impact on your countertrade transaction.

It is standard risk in all international trade transactions, and there has been much litigation resulting from parties failing to obtain licenses and determining who had the obligation to obtain the license.

Managing the risk. In order to avoid problems with licenses, the obligation of either of the parties to obtain the necessary licenses must be clearly agreed to in the contract.

e) Sovereign immunity. This is not the result of government regulation, but is a legal doctrine which prevents lawsuits against foreign sovereigns.

In other words, you cannot sue foreign governments. Unfortunately many foreign governments operate business or quasi-business operations, and sometimes these organizations are provided with sovereign immunity.

If you deal with one of these entities and attempt to sue on a failed transaction, you will be prevented from doing so by most courts.

Managing the risk. A simple and expedient solution to the problem is to ensure that the other party waives any defense of sovereign immunity.

Dispute Resolution

One of the major risks in international transactions involves the settlement of disputes.

While it is relatively easy to sue a party in your own country, it becomes more difficult across international boundaries. And it is particularly difficult where the defendant/respondent is from a third-world country, where justice is less than fair and is never fast.

The costs of either litigation or arbitration are extremely high, and wherever possible you should avoid them.

A relatively simple arbitration proceeding can cost upwards of $150,000 to $200,000, and can easily take a year or more to complete. And this does not include the time and expense for attempting collection after the judgment or award.

Also the choice of law in a contract can impact your likelihood of success in many unforeseen ways. A choice of law clause states what law will govern your contract. (See below for a discussion of possible issues involved in a choice of law selection.)

Management of these issues/risks. The safest solution is to avoid litigation/arbitration. Carefully structure your transaction so that it is unlikely to fail, and rely on other protections than courts or arbitrators, such as insurance or guarantees.

However, if all else fails, you may need to resort to these measures. If you have failed to carefully draft your dispute resolution clause, you could find yourself in more difficulty than you expected.

A dispute resolution clause should provide for either arbitration or litigation. The choice of litigation or arbitration is not a question of legal preferences, as there are differences between the two.

Arbitration is generally faster and cheaper, can remain confidential, and in many circumstances it is easier to enforce an arbitration award in a foreign country than it is to enforce a court judgement.

Litigation is very time consuming and costly, and if a jury trial is allowed (as it usually is) it can be very uncertain.

However, litigation can allow for the best discovery of the other party's case, and has better pre-trial remedies. Although in many countries these are often also available in arbitration.

Mediation is favored by many lawyers today, but it does not provide a firm award or judgment. And it is often merely a stepping stone to litigation/arbitration which can delay justice.

Choice Of Law

A choice of law clause provides that the contract will be governed by one (or possibly more) systems of law.

In international contracts it is usually very difficult to get the one party to agree to the other party's law, and usually a "neutral" law is chosen. As American law is a development of English "common law," a good second choice for American companies is often the law of another common law jurisdiction, such as England, Canada or Australia.

Many other countries use a form of "civil law," including Continental Europe, Eastern Europe, Japan and China. Common law lawyers are less familiar with civil law concepts and vice versa.

While there can be differences in the handling of specific problems, at the time of drafting the contract you may never know what the ultimate problem is likely to be. Therefore, the choice of law really is more often an issue of cost.

If arbitration or litigation is necessary it is cheaper for your legal advisers to work with a law with which they are familiar. Otherwise you will need to hire an additional legal adviser or advisers. Obviously it is less expensive to use one set of lawyers, instead of two.

Contract Execution

A very minor point which can produce unexpected problems is the "execution" of contracts. Execution of a contract, to a lawyer, means the signing or other formal activity indicating acceptance of the contract.

Certain jurisdictions require more formal execution of documents than others. And failure to execute properly a document may result in a court deciding that there was no contract.

While this is unlikely where both parties have acted in understanding of a contract, nonetheless it is a small risk. Also some jurisdictions do not allow executions by telefax.

Managing the risk. You should check with local counsel to ensure that the contract has been properly executed. If in doubt, have two senior officers sign under seal, and provide a corporate resolution empowering their signature for the contract.

When executing a contract by telefax, ensure that you send a follow-up contract in hard copy and/or state that the parties have agreed that execution by telefax is legal and choose a law which allows such execution.

Barter Transactions

Barter transactions provide additional risks and the certainty that some of the common risks of countertrade will have to be faced.

A barter transaction involves a swap of products, without an exchange of currency; the transaction is only recorded in one contract, unlike the usual countertrade transaction. And thus difficulties in one part of the transaction will certainly impact on the other.

Some of the additional risks or some of the unique attributes of barter transactions increasing the risk are described below.

Timing

A barter transaction has a unique timing risk in that the party delivering first, under a pure barter transaction, is at risk that the other product will not be delivered.

Managing the risk. One solution is to swap the products at the same time, but this is seldom a realistic alternative.

A second solution is to secure the barter through standby letters of credit, such that the party that fails to receive the product can recover under the L/C.

A third and better solution is to have parallel letters of credit through the same bank. Recovery only occurs through shortfalls in delivery, whether expected or unexpected.

The parallel L/C option works basically as two L/Cs, with documents submitted to the bank in a standard L/C fashion. The bank then calculates the amount owing to the seller, and offsets this amount by the products exported to the seller.

Quality Issues And Claims

As there is seldom an on-going relationship between the parties, there is a greater risk of quality problems and claims.

To take an actual example, a barter involving an export of newsprint for processing equipment led to quality problems and claims. Possession of the processing equipment was required to ensure that the quality of the newsprint met world standards, and therefore early shipments were likely to be of poor quality.

In fact the newsprint was defective and the countertrade transaction was soon in jeopardy. Quality problems caused the funds, which were to be used to finance the cost of the processing equipment, to be unavailable so the manufacturer refused to send the equipment.

Also, the manufacturer of the processing equipment found itself involved in several claims, including shipping, insurance and quality claims from customers. And these are not easily handled by a manufacturing company unused to such claims.

How could the manufacturing company have avoided these risks?

Managing the risk. One method of handling the risk would be to place the proceeds of sale of the initially sold product into an escrow account, to be used to handle claims.

Of course this creates difficulties for both parties to the transaction, and will delay the ability of the manufacturing company to sell and deliver quickly into the market.

It also delays the buyer of the industrial product from acquiring the new equipment.

A better solution would have been to use a trader familiar with the product in the first place, and better able to handle the resulting claims should they have arisen.

Another solution could have been to use better insurance coverage.

Also the initial preparation for the resale of the newsprint used L/Cs which were not carefully enough drafted to protect the industrial company. Better drafting of the L/Cs would have ensured payment and passed the risk on to another party.

Unfortunately, as some of the sales were to U.S. corporations, the industrial company would have found itself involved in claims and/or litigation in any event.

Pricing Issues

There is an additional pricing risk or issue in barter transactions. While in other countertrade transactions there is an agreed price for both goods, in a true barter transaction there is an independent evaluation of the price.

For example, are two cats traded for one dog worth $5, $25, $100 or $500? Or are they worth half of a dog?

If everything works smoothly there is no problem. But if the barter involved a transaction in which the cats were delivered first and the dog owner failed to deliver the dog, what are the damages for the former cat owner?

Managing the risks. The obvious solution is to include a clause defining the value of the products being traded.

If there were a dispute, the court or arbitrator could agree on a price for the dog or whatever else was to be traded. The use of parallel L/Cs would be an excellent solution to the problem.

COUNTERPURCHASE CONTRACTS

Countertrade Products

One of the major problems with countertrade transactions is that the products you will be allowed to export will directly impact your cost, your ability to complete within the time frame allowed, and possibly even whether you can complete the transaction at all.

The impact of non-performance or delayed performance may be that your original sale will not take place, that you will pay more than you expected or budgeted for your countertrade, or that you will be subject to penalties or calls on your guarantees.

Managing the risks. As is often the case, you should engage experts who understand the country, as well as the products available and/or being offered. Experts who potentially have some leverage or previous connections in the country, to assist you in obtaining the best products.

Your sales agent or local representative may be able to assist, as well as other exporters, traders or consultants who have had experience in the country.

I also recommend that you agree with reliable third parties who will take the product from you in advance and at firm prices upon concluding your countertrade contract. To do otherwise is to invite greater costs, and greater likelihood of failure.

Also, the use of third parties will minimize your liability on the resale of the product.

Within many organizations, corporate policy requires that this obligation be totally taken over by a third-party specialist in countertrade or the product, with reliable guarantees that will protect the company in the event the third party fails to perform, which would put your company in a very unfavorable position for future sales.

Another option is to carefully contract to ensure that you can legally fulfill your obligation by "bona fide" offers, which place the risk more firmly on the supplying country or the party obligated to supply product for your countertrade.

In one such example involving my company, the cost to sub-contract the countertrade with traders would have made our bid unacceptable. And therefore we decided to undertake the countertrade on a legal "best efforts" basis, based on "bona fide' offers.

We agreed to enter into a contract in which we refused to take any local risk. We required that, if we made "bona fide" offers to purchase at world prices, at world standards of quality and from agreed suppliers in the countertrade country who were capable of meeting these standards, and the supplier failed or refused to contract, we nonetheless would be given
countertrade credit for the offer.

The credit was not 100% of the value of the offer, but rather a percentage based on various factors. While the local buyer of our product was not happy (nor were their central banking authorities), they recognized that we would honestly attempt to fulfill our obligation in order to remain a player in their market.

Best-effort contracts in offset are more common when governments recognize that it really is a political "game."

However, a counterpurchase arrangement which is designed to convert soft currency to hard currency, in order to repay an international loan, is somewhat more difficult.

Structuring Countertrade Transactions. . .
Use Of Third Parties And In-House Trading Companies

I have repeatedly suggested the use of third parties, especially traders. However, it is often difficult to obtain permission to use third parties, especially in offset contracts. And it is an issue which requires negotiation.

If your contract does not allow you to use third parties you may be faced with accepting more risks than you might prefer, as you will be obligated to complete the transaction on your own. And possibly, depending on the wording, you may also have to take title to the countertrade product.

The inability to openly use third parties can increase the complexity of the contract and therefore your costs. Also, if you take title, you are increasing your risk.

Managing the risk. You should contract to allow the use of third parties, or at least not be prevented from using them.

If the other party is reluctant, at least attempt to obtain approval to use related companies, suppliers, sub-contractors, joint-venture partners, consortium members, etc. This will provide you with more flexibility and ultimately will lower your cost and risk.

Penalties And Guarantees For Your Performance

Counterpurchase contracts often provide for penalties or guarantees of your performance. The effect of a penalty is fairly obvious, however in certain circumstances you could pay a penalty and still be obligated to complete your obligations.

Guarantees of your performance are the flip side of guarantees provided by the other side.

Managing the risk. If a penalty is insisted on, clearly you should attempt to make it as small as possible and to provide that the penalty is in lieu of performance. You should also attempt to get a provision that allows for the return of the penalty if performance is ultimately completed.

If the other party also insists on a guarantee of your performance or for payment of the penalty, you should attempt to provide the "most beneficial guarantee" that you can.

The cheapest guarantee which is sometimes accepted is a simple corporate guarantee, which may be acceptable when the contracting party has a large corporate parent, and the party insisting is happy with the parent's guarantee.

It is the cheapest and the least likely to be effective as your company controls the willingness to pay.

The second best guarantee, if it is available, is a performance bond, which is really an insurance contract in which the insurer has the same rights as the insured, i.e. as you have.

Therefore if there is a dispute, the insurance company will generally argue your case for you, and will not pay out until convinced it will lose or it is ordered to pay.

Performance bonds are usually cheaper than letters of credit, and are less likely to be used successfully by another party.

Another possibility is a bank guarantee. While this is similar to a letter of credit, in theory, the bank is not obligated to pay if you have some legal argument which you might use to protect your position. In practice it is usually treated more like an L/C.

The last guarantee is an L/C, which will be expensive and the bank's obligation is to pay out under its terms. It is extremely difficult to stop a bank paying out under an L/C, even if there is a legitimate dispute--the only possibility to stop payment is where there is obvious fraud.

Transactions With Third Parties

I strongly believe that the use of third parties, such as traders, can greatly diminish your risks and improve the likelihood of success.

Traders understand their product and probably have a better relationship and understanding of the problems of the supplier/buyer of the countertrade product, as opposed to the sale of your product.

However, you cannot simply turn your problem over to the trader, there are also risks attendant on contracting with traders.

Property Contracting To Cover Your Risks

One of the reasons to use traders is to place the risk for many trading activities on a party that has more experience in the area than your company has.

If your contract with the trader does not clearly mirror your countertrade contract, you could find that the trader has not accepted all the risks and you are left with some--probably the ones you do not want, such as the penalty!

An example of poor contracting with a trader is as follows. A German company contracted with a trader, under a firm contract, for the trader to export product from a countertrade country at an agreed disagio.

The German company then went back to complete negotiating their sales and countertrade arrangement. The negotiations went badly, and neither contract was completed with their buyer.

In the meantime the trader had exported a substantial amount of countertrade product on their behalf, and claimed the disagio.

The German company refused to pay, and was sued by the trader in German courts. It was held liable and ended up paying for the countertrade, which it did not require.

Managing the risk. You must ensure through careful review, negotiations, and drafting of your contract with the trader that the risks are passed on to the trader, or that they have been identified and you have a strategy to handle those risks which are not passed on.

In order to avoid timing problems with your trader you should contract very carefully. Ensure that your contract does not require payment until you have been given the credits by the local authorities, or you are legally satisfied that you have met your obligations.

This can be problematic where the trader has an immediate export opportunity, and you do not have an opportunity to obtain confirmation that the exporter will qualify under your countertrade or offset contract.

In these circumstances I have sometimes agreed to pay a lower fee with the remainder being paid on acceptance of the countertrade credit. Obviously, this is taking a risk which your company may not accept.

Guaranteeing Performance

If your trader is not a well known or reliable company, you will not likely be protected if the trader goes bankrupt or refuses to perform for some reason.

Managing the risk. The safest route is to use a reliable trader. However, where this is impossible due to cost or other reason, you should ensure that you get guarantees from the trader or third parties that insure performance.

These can include standby letters of credit, bank guarantees or performance bonds. You should at least ensure that the trader guarantees to pay the penalty if there is failed performance.

Other Risks

There are other risks in using a trader. If your relationship with the trader is well known, you may not be isolated from risks such as product liability or liability for injuries to third parties arising from the sale of the countertraded product.

You also cannot use a trader to avoid embargoes or other government regulations.

A poorly chosen trader can ruin your relations with your customers or their governments by their different approach to business.

Traders deal quickly and work on extremely low margins. The trading mentality is different from the mentality of a business executive in a manufacturing corporation.

The trader is always out for maximum profit on each transaction, and this may conflict with your attempts to develop a long-term relationship with your client.

Managing these risks and issues. Careful drafting may avoid legal liability issues including product liability and other government regulations, but your best protection is always to use a reliable trading partner.

As for the difference in mentalities, this can be best handled by an intermediary, such as an in-house countertrade coordinator in either the industrial company or the trader, who understands the difference in approaches and mentalities, and can smooth over the relations.

Summary

To avoid risks in countertrade, the best advice is to retain professional, experienced help. Generally this is a reliable trading company familiar with either the country or the product.

Your own company is best able to handle the risks associated with its own products or services.

The risks of countertrade can be considerable, both in designing and negotiating the countertrade contract, and in its execution. And the smartest and safest solution is to use experienced third parties.

Editor's Note: This article was reprinted from Countertrade Review. John Holmes is the editor of this outstanding monthly newsletter of the Australian Countertrade Association, 31 Mawson Drive, Mawson, ACT 2607, Australia.