The purchaser has two choices. They can either dictate the commercial terms or let them be part of the competitive tendering process. If the tenderer is given the opportunity they will want regular payment at frequent intervals in order to spread their risk; ideally, as much money as possible, as early as possible. Whereas, I have no doubts that the purchaser should not pay anything until they have received something of value. This may mean that the supplier is not paid anything until the order or contract is complete – 100 per cent upon completion. The immediate response to this situation is that the supplier or contractor complains that they have to finance the project. There is then a negotiation to find something acceptable to both parties.
The two options of 100 per cent payment upon completion, or stage payments at agreed intervals, can be applied to all the different types of contract. There can be a fixed price contract with 100 per cent payment upon completion or with payments at agreed stages. Remeasured or rates type contracts are most likely to be paid at monthly intervals. Again a reimbursable cost contract may be paid at monthly intervals or as and when the costs are incurred. On the other hand, the client may only reimburse the costs when agreed targets have been met. These terms demonstrate that just using the broad expressions fixed price and reimbursable only describes part of the risk allocation. The full payment terms need to be detailed to correctly describe the type of contract within a risk category. The shorter the payment time scale, the more risk is assumed or allocated to the client. Thus, as one moves down the list below the risk to the client increases.
Having negotiated and signed a contract, the contract creates an obligation in law to pay, if the contractor performs. However, there is probably a lack of trust between the parties. The purchaser does not know if the supplier will perform and the seller does not know if the client will pay them. Thus, there has to be a payment process agreed between the parties, and the supplier has to deliver the product or perform the service on time and in accordance with the specification. Correctly structured, the payment terms should act as a motivator to the supplier or contractor to achieve the project objectives. Consequently, issues that need to be resolved are:
How will payment take place, what process will be used?
Where should delivery take place?
What should be supplied for a payment to be made?
When should the supplier be paid?
How or in what form, and in what currency, should the supplier be paid?
How long will the payment process take?
How can the buyer and seller be satisfied that their interests are protected?
Terms of Payment
The terms of payment for goods and services performed in the same country are significantly more straightforward than when contracting between different countries. When contracting between countries for the delivery of goods, you must decide when the liability for delivery changes from the supplier to the buyer. Thus, where delivery should take place is determined by the Incoterms, and these were described in Chapter 5 which dealt with contracting issues.
It is also more straightforward to define the terms of payment for a contractor managed risk (fixed price) contract, since only the sums to be paid and the agreed intervals have to be defined. Since the intent of the contract is for the supplier or contractor to deliver an end product, then payment should only be made for the value of an item when it is delivered. However, there must be sufficient money left in the contract to motivate the supplier or contractor to complete any remaining small value items that are part of the contract.
As indicated above, payment should only be made when something of value is supplied. With progress payments, the difficulty is balancing payment schedules with the work performed. A contractor will want to, and will try to, front-end load their payment terms by placing a disproportionate overhead and profit element on early activities. For example, setting up or site establishment, site clearance, excavation activities and buying and delivering materials. This subject is discussed in detail in Chapter 12. Performing a discounted cash flow calculation for front-end loaded payments produces a significant advantage for a contractor’s project profit element. A retention helps: to guard against overpayment, to allow for errors, to enable faulty work to be put right and to inject some (although minimal) motivation.
The problem of overpayment is less likely to occur with shared risk contract forms involving schedules and rates, since regular measurements (usually monthly) need to be made to determine the value of the work performed.
If the client is controlling the risk and is reimbursing costs, considerably more checking will be required. As well as accounting procedures, the client needs to check the contractor’s procedures for:
– Is there a need for it?
– How much and on what basis?
– Is the contractor’s buying capability satisfactory?
– Do the goods delivered need to be checked?
– Is the plant requested necessary?
– How is it to be paid for?
– Will it be economic to buy and resell or should the plant be hired?
– Will the plant have any residual value?
Evidence of achieving a payment stage: If evidence has been agreed, say drawings, it is prudent to check that they are of an appropriate standard.
Availability of project funds: The initiative should be taken by the client and the contractor should be asked to supply a projected cash flow forecast, which should be included as part of the enquiry process. However, if the contractor wants to be paid promptly, they should provide advance warning that they anticipate achieving a payment milestone.
Invoice submitted on time: Too often the supplier or contractor does not submit the invoice until the due date and does not allow time for the client’s payment procedures – but this is the supplier’s or contractor’s problem.
Invoice correct: Often minor errors can be used as an excuse for delaying payment. The invoice should still be paid but minus any disputed amounts.
Any delay in any one of these stages will mean that the whole process will be started again, usually to the detriment of the supplier or contractor rather than the client.
When the order is placed – ‘with order’.
Monthly or according to agreed stages or schedule.
Upon achieving an agreed milestone.
When the goods are delivered or the project is complete – ‘100 per cent upon completion’.
It should be emphasized that the earlier the payment is made the higher the risk to the client.
Payments with order
It should be obvious that a 100 per cent payment with an order should never be used. However, in the mid 1990s, GEC received just this for a power station contract. It would have been interesting to listen to the discussions at the first meeting arguing about the lack of progress.
Any early payment must be for a justifiable reason. However, the payment needs careful structuring to prevent a supplier or contractor avoiding their contractual obligations. There is also a danger of overpayment for the goods or services provided. In civil engineering and building projects it is common to request an early payment for site establishment and/or purchase of materials. Once the materials have been paid for there is no longer an incentive to look after them and degradation will occur. The supplier or contractor can then claim for additional work to replace lost materials or repair of damaged equipment. Consequently, a contractor should be asked to purchase materials in their own name. Any payment reimbursing the costs, for materials and equipment, should not be made until they have been inspected as conforming to the specification and have been incorporated into the finished facility.
Stage payments appear to be an equitable arrangement and this is optimal when the client and contractor have a neutral cash flow situation. The contractor gets paid for work done as and when it is completed. Usually the payment intervals are at agreed ‘milestones’. There are, however, some significant problems:
The difficulty of defining when a milestone has been achieved or completed.
As already indicated, if the payments are badly ‘weighted’ there is a diminishing incentive for the supplier or contractor to complete the order or the project.
The problem for subcontractors is that they will probably have the same terms imposed upon them that the main contractor (their client) has negotiated with the owner client. The commercial situation used to be worse, in that the contractor client only paid the subcontractor when they had received payment from the owner client. Since the Latham report1 ‘pay when paid’ has become illegal.
100 per cent payment upon completion
This is the ideal from the client’s perspective. It is the natural choice for the supply of materials and equipment. It provides the client with the maximum leverage to get the materials and equipment delivered, or the project completed, and ensures that there are no loose ends. These terms should always be used for a performance specified contract. If the project, piece of equipment or system does not work then the client does not pay for it and, consequently, does not lose money (apart from the not insignificant benefit to be obtained from the project). If this approach had been used for the Stock Exchange (computerization of deals) Taurus Project then the client would have saved themselves £300m.
The contractor, on the other hand, will complain bitterly that they are bearing all the financing costs. This is true, but it is doubtful if they have taken the trouble to calculate the actual figures. Further, in a competitive tendering situation the tenderer may not include all these costs in their offer. On the other hand, with stage payments the client is losing 100 per cent of the ‘value’ of money as soon as it is paid – when it has been paid, it is not earning. On this basis it is preferable to get the supplier or contractor to bear the financing costs and maintain the financial motivation on the supplier or contractor.
The following is an example of payment terms for a large piece of equipment. In reality the equipment was sufficiently large that it had to be lifted over obstructions on site, thus requiring a special crane. It was sufficiently special that if the booked time and date were missed, the crane would not be available for another 3 months. Consequently, it was decided that the delivery risk was best managed by the supplier of the equipment, and the terms were written as ‘delivered onto foundations’. Other issues led the project team, to choose 100 per cent payment on completion of order, as payment terms. During the tender process the suppliers suggested that it was more appropriate for the construction people on site to be responsible for the lifting procedure. There was also the argument about financing costs as described above, but the temptation to change the strategy was resisted. The equipment was delivered onto its foundations without problems and an invoice issued for the £5m (early 1980s money). The buyer concerned pointed out that payment was not due until the order was complete. This went on for some time despite emphasizing to the vendor that the second item on the order had not been provided; only to be met with, ‘But we have delivered the equipment.’ Eventually, the procurement people asked me, as project manager, to get involved. I remember quite vividly that the managing director of the company concerned was confrontational and aggressive, if not insulting. Eventually he realized that, despite having delivered a £5m piece of equipment, we were not going to pay until Item 2 on the order was provided. Item 2 being various items of documentation that we needed to complete our contractual obligations. When the MD realized that £5m depended on pieces of paper, our documentation was received fairly promptly!
If we had made progress payments, such that there was only 10 per cent remaining for finalizing the last elements of the order, I doubt if we would have had the same attention. This scenario was revalidated for me when in 2003 I performed some work for a major UK rotating machinery manufacturer. They admitted to me that they had not received payment for an order, because they had not delivered the operating and maintenance manuals, a year after the equipment had been delivered!
Payment for what?
Issue of drawings or other documents.
Delivery of goods in accordance with the agreed Incoterms.
Substantial/mechanical completion or beneficial occupation as defined in the contract.
Project completion (including documentation).
Three months after achieving project performance criteria.
Again it should be noted that the earlier the payment is made the higher the risk to the client.
If goods are not delivered to the client’s premises or site, where they can be examined, there is the difficulty of proof that the goods have been delivered to the agreed intermediate location. If the goods are not physically examined then the proof of delivery is provided by documentation.
Typical documentation that is used to demonstrate that the seller has performed specific actions is listed below. Some of these may be required in combination in order to trigger the payment process.
certificate of origin
Bill of Lading
air way bill
certificate of conformity
certificate of (customer) acceptance
The documents must clearly state the criteria that will be acceptable to enable a bank to make payment, when the documents are submitted; for example, a‘clean’ bill of lading. Any annotations along the lines of: ‘crate damaged’ on any of these documents are likely to lead to a bank refusing to make payment to a supplier, thus protecting the client’s interests.
How long for the payment process?
Net monthly account.
Net cash 30 days/60 days.
End of month following month of invoice issue/receipt.
Rather than have a different number of days for each month, net 30 days is used. It is used in accounting practice to help comparison of monthly averages of certain parameters.
Professional clients should set up ‘back to back’ bank accounts so that payment funds are transferred from the client’s project account, direct to the contractor’s project account, as soon as payment is authorized.
However, it is not unknown for clients to slow down the payment in a mistaken belief that they are motivating the contractor. Sometimes this is done in order to improve their own cash flow. For example, 60 days after the end of the month in which the invoice is received: this could be 60 days or even 90 days if the invoice is received at the beginning of a month. This penalizing of the contractor slows down the work and the client suffers in the long term.
One thing that must be avoided is overpaying the contractor, which is very common in the domestic building renovation market. The contractor then disappears to try the whole process over again with another client.
How payment is to be made
– cash or cheque
– bank transfer – by BACS or CHAPS
– bill of exchange
letter of credit
Unfortunately, from the seller’s point of view and until trust has been established between the parties, there are problems with some of these mechanisms.
Open account is when the buyer pays the seller for the goods on presentation of an invoice or other documents that they agree to, for example, an inspection certificate. The buyer might pay with cash, but from the sellers point of view the cash might be forged and, in any case, it is difficult to transfer. Money laundering regulations make this option more trouble than it is worth. Similarly, there may be insufficient funds to cover a cheque and it will then be ‘returned to drawer’.
A bank transfer, on the other hand, involves a third party that has satisfied themselves that funds are available. BACS (Bank Automated Credit System – being phased out) is a 3-day transfer and CHAPS (Clearing House Automated Payment System) is an electronic same day transfer of funds. The bank transfer option will be used when the client has satisfied themselves that a payment is due and they instruct the bank accordingly. Whereas a bank transfer against documents will be used when a client has established the payment procedure and defined the documents required to prove that the supplier or contractor has performed. The bank will make payment (provided they have satisfied themselves that the documents are correct), without requiring a direct instruction from the purchaser. This option will most likely be used with a letter of credit – see below.
A bill of exchange is a type of cheque or promissory note without interest, in effect an IOU. It must be in writing and signed and dated. It is used primarily in international trade, and is a written unconditional order by a person or business which directs the recipient to pay a fixed sum of money to a third party at a future date. If the bill of exchange is drawn on a bank, it is called a bank draft. If it is drawn on another party, it is called a trade draft. Sometimes a bill of exchange will simply be called a draft but, whereas a draft is always negotiable (transferable by endorsement), this is not necessarily true of a bill of exchange.
The consideration required to form a contract must be something of value. It need not be money. This is the basis of countertrade. The consideration is in the form of goods and services.
2When governments do international trade deals, what they buy is not always the chief consideration. As a recent US Department of Commerce report to Congress explained, ‘Some governments readily admit that they are no longer concerned with the price or the quality of the defence system purchased, but rather with the scope of the offset package offered.’
‘Recently, the Czech Republic announced that in competition for its jet fighter procurement, offset would be the deciding factor as opposed to technical and performance criteria and price.’ Such nuggets help explain why interest is taking off in offset – or countertrade – as this form of finance through reciprocal trade is also known.
According to Trade Partners UK, a UK government agency that promotes British companies abroad, between 5 per cent and 40 per cent of world trade is countertrade related, an indication of how substantial a part it now plays in international political and commercial transactions.
Countertrade is also growing. For example, it is spreading from arms and aerospace purchases to civil infrastructure projects…
There are five main strands to countertrade: barter; buy-back; counterpurchase; tolling; and offset, the biggest of the lot, which in turn divides into direct and indirect offsets. Two or more of the five may be stitched together to create a countertrade and if that is not complicated enough the terms are sometimes used interchangeably.
In direct offset, the supplier agrees to incorporate materials, components or sub-assemblies procured from the importer country. It is a way of promoting import substitution and local manufacture of defence or other equipment.
With indirect offset, suppliers enter into long-term cooperation and undertake to stimulate inward investment unconnected to the supply contract – again to support, increase or diversify the local industrial base.
These investments need not be made by the company winning the original contract and may be totally different in nature from the first sale…
‘Many developing countries find it hard to buy much-needed goods or equipment due to lack of foreign exchange,’ …In some countries, countertrade may be the only effective mechanism for doing business.
The following exercise is designed to illustrate that the payment terms are an integral part of the contracting strategy.
You represent a major corporation that wants to set up a 2-year master services agreement with Cushy Consultants Ltd. Your requirements are for the occasional services of some specialists for periods of 2 to 3 weeks at a time. The market demand for the specialists is very high and their pay rates are moving up very quickly. What contract payment terms are appropriate?
The development of a suggested solution to the issues involved is described below:
Supplier – Cushy Consultants:
‘We require £X per hour with an escalation clause (based on named industry norms) revising the rates every 3 months.’
Buyer – your corporation:
‘Fine. I would like six of your best (or the following named) people for Monday.’
‘Because we may have to hire additional agency people to cover for our own work (we are very busy) we will need a minimum of 2 weeks notice and we choose the people.’
‘But you may not supply people who we regard as competent enough. Let us agree a “pool of people”, who are acceptable, and you nominate from the pool.’
‘Agreed. By the way some of them have just been promoted, so their rates have increased!’
‘No promotions allowed during the course of the work. Provided that we agree that the individuals concerned have demonstrated superior performance, we will consider a revised rate at the next joint review date.’
After 3 days you tell the supplier that your work requirements have changed. In addition, you no longer require the services of three of the people for a further 10 days.
Note: The supplier has hired additional people and is involved in more administration and costs than they had allowed for.
‘We need a retainer with a minimum hire period and 2 weeks notice of termination.’
Has this covered all the problems that are likely to occur? Is it now a workable agreement?
Payment and Contract Security
The purchaser requires security for any advance or progress payments, in case the supplier or contractor does not perform, and the supplier or contractor requires some security that payment will be made. Furthermore, a client failing to pay promptly creates a lack of trust and, consequently, reinforces the desire for security of payment when the supplier or contractor does perform as requested. This security is usually provided through an independent third party – a bank. A bank will provide what are termed ‘documentary credits’. A documentary credit is, ‘A written undertaking given by a bank on behalf of the buyer, to pay the seller an amount of money within a specified time, provided the seller presents documents strictly in accordance with the terms laid down in the letter of credit.’
It is, therefore, important to understand that banks deal with documents, and not the goods that the documents represent, and that the documents must strictly comply with the credit terms in the letter.
Letters of credit
A letter of credit is literally a letter, usually conditional, saying that the purchaser’s bank will make payment when the bank receives documents providing evidence that certain agreed criteria have been met.
The documentation required can comprise any of those listed earlier under ‘payment for what?’ For example, invoice, bill of lading, material receipt records and inspection certificate. There are three types of letter:
From the seller’s point of view the revocable letter of credit, one that can be cancelled at any time (for example, just as the ship has sailed with the seller’s goods), is not worth the paper it is written on. The irrevocable letter of credit is only slightly better in that it cannot be cancelled. However, it will have been issued by a foreign bank in a foreign country, and the seller may not be certain about the viability or integrity of the issuing organization. Further, the buyer’s relationship with the local financial organization may enable them to exert pressure (for example, a foreign government changing the local law) in order to delay payment. Consequently, the only letter of credit that, from the seller’s point of view, has any meaningful substance to it is ‘a confirmed irrevocable letter of credit’. In this situation the purchaser’s bank (the issuing bank) agrees to reimburse a bank nominated by the seller (the advising bank) provided they are satisfied with the documentation.
A confirmed irrevocable letter of credit should be as solidly reliable as a gold bar! However, on a project in Sri Lanka, the Minister of Finance boldly stated in Parliament (when equipment deliveries were in full swing), ‘This project is not financially viable.’ Accordingly, all the (rather arrogantly termed) first class western banks froze their irrevocable confirmed letters of credit. The consequence of this was that one enterprizing seller managed to have a ship arrested on the high seas in order to repossess their goods! If this can be done once it can be done again. Thus, are confirmed irrevocable letters of credit really as good as gold?
Guarantees and bonds
Guarantees are necessary to ensure that contracts can be completed in the event of the failure of the supplier or contractor. Guarantees can either be issued by a bank or the parent company of the organization with which one is contracting. Guarantees take two forms; they either provide funds or undertake to get any remaining work completed. In general, guarantees issued by banks provide for the payment of costs in the event of default of the supplier or contractor. Whereas, parent company guarantees are for the entire performance of the contract, without limitation. A common feature of guarantees is that the parties are jointly and severally liable. This gives the client the option to claim against either the guarantor or the contractor.
The wording on these documents is critical. There have been a number of examples where the intended results were not achieved because of a failure in the wording of the documents. Therefore, always employ someone who specializes in this type of work.
In a number of countries insurance companies, rather than banks, provide the guarantee. Unless the requirement for guarantees has been advised at an early stage, contract negotiations can be slowed down. This is due to the need for the insurance company to investigate the tenderer who needs to provide the guarantee.
In North America guarantees are provided by surety companies since banks are prohibited from issuing guarantees. The surety company will arrange for a contract to be completed by another contractor in the event of default. As a consequence, they may get heavily involved in the contract negotiations with the client and even get involved in the execution of the contract, as well as monitoring the client’s performance.
In the past, the use of financial guarantees in the UK has been somewhat limited since contractual remedies can be enforced through the legal system. Further, the theory was that the financial status of a company could be reasonably well established. More recent high profile company collapses have called this into question and their use should be considered more often.
Guarantees issued by banks commonly take the form of a bond. A bond is best described as a large bank note. Lord Denning, when he was Master of the Rolls, likened them to promissory notes. Naturally, the issuing bank will require the seller to provide assets, as security, to the same value as the bond. Unlike a letter of credit, a bond need not be conditional on evidence being provided for the funds it represents to be drawn upon. The advantage for the client is that they do not have to prove that the contractor has defaulted. If a bond is conditional then, once all the conditions have been met, they become ‘on demand’. A bond is an entirely separate obligation from the contract to which it is associated and cannot be withdrawn by the seller.
It is normal practice in the mechanical and petrochemical industries to request ‘on demand’ bonds. Whereas, in the building industry, ‘conditional bonds’ are normal practice. Typical project bonds are:
tender or bid bond
advance payment bond
A tender bond is necessary to ensure that a company can be held to their tender once it has been submitted. It helps to eliminate companies who do not have the financial resources to execute the proposed contract. As a result, it is most likely to be used in open tendering situations since pre-qualification should have resolved the financial issues prior to issuing the enquiry documents.
An example from the press: In October 2006, the construction of a public building requested a ‘bank guarantee/participation bond which must not amount to less than 3 per cent of the total value of the procurement.’
Advance payment bond
An advance payment bond is used, as its name implies, when a contractor has requested a mobilization or site establishment payment as a pre-condition to starting work. It should help to reduce the overpayment situation described earlier. However, the bond may be worded in such a way that its value decreases as work progresses.
The performance bond enables the client to impose a financial penalty in the event that the supplier or contractor fails to perform.
A retention bond can be used instead of retention monies. This is attractive to a supplier or contractor since it enables them to be paid the retention cash that would otherwise be withheld during the maintenance period. It should only be considered once the contract is completed.
Subcontractor bonds can be requested for a proportion of the value of the subcontracts. They are used to enable the client to pay the subcontractors in the event that the contractor goes into liquidation.
All of the issues in this chapter are designed so that a negotiated solution can be developed that meets the needs of the contracting parties.
Whilst the mechanisms described provide objective criteria for both parties, it must be emphasized that precision in the formulation and wording of the documentation is vital. Use specialists, expert in the specific areas concerned.