(Reprinted from BarterNews issue #37, 1996.)

Part I

Managing Risks In Countertrade Transactions

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

One of the unique risks of countertrade transactions is that companies often find themselves handling products with which they are not familiar. This is probably the greatest risk in a countertrade transaction.

Liability for the Product on Resale

If you acquire title to the product (and even if you do not acquire title under certain circumstances) and the product causes damage to third parties, fails to meet the standards normally expected for the product, or fails to meet the warranties and/or guarantees for the product being sold, you can find yourself liable to third parties...including your customers and independent third parties.

As a manufacturer of a mechanical product or a supplier of technology, to find yourself the seller of medical equipment, consumer goods, raw materials, et cetera, for which there is a legal claim can be a very disturbing and expensive learning lesson.

The first suggestion for managing the risk is do not take title to the product; this should be obvious advice. One suggestion is to use a trader or other intermediary who can be responsible for the potential liability. Either they can ensure that the product does meet the requirements of the market or the contract, or they can better deal with the failure by substituting alternate product, or dealing with the claim or lawsuit.

Another option is to use an in-house trading company, which is discussed below. You could act as a broker for the transaction, thereby avoiding taking title.

If you must take title you can protect yourself in several ways. The obvious solution is to have insurance to cover the risk; this can be expensive especially if this is not your normal product.

You can attempt to ensure that your contract of purchase provides that the seller indemnifies you in the event that you receive a claim or are sued. This will be of limited value when your seller is from a developing country and is not very rich, does not carry insurance, is difficult to sue, or has not provided security or guarantees.

You can always attempt to get your supplier to provide insurance coverage or guarantees for this liability, and in certain circumstances this is a good solution. Clearly the drafting of the indemnity clause and the clause requiring insurance must be carefully done.

You could always attempt to contract away your liability in your contract of resale with the ultimate buyer, but this will not protect you in all circumstances, especially where there is damage to third parties.

In many jurisdictions it is impossible to contract away liability for this damage.

One solution is to establish an in-house trading company which is a subsidiary of the primary manufacturing or engineering company requiring the countertrade. If properly established and maintained, corporate protection may be afforded by the use of a subsidiary corporation.

There are many factors which a court will take into consideration when deciding to "pierce or lift the corporate veil."

In order to avoid this happening, corporations should consider some of the following: incorporate the trading subsidiary offshore in a country with favorable laws; joint venture with other companies, such as traders; ensure that management is not completely subservient to the corporate parent; capitalize the trading company with sufficient capital; operate it from a separate location; do not pay employees with the same checks as the parent corporation's employees; and select a law for your contracts which is most favorable to protecting the corporate identity.

Also, if the subsidiary trading company acts independently and honestly it will more likely be protected. You need to ensure that the corporate records and the requirements for corporate existence are maintained.

For example, shareholders' and directors' meetings must be held and recorded. Preferably some directors should not be corporate employees. There are other factors which any lawyer can easily describe to you.

Although the use of a captive or in-house trading company can be helpful to minimize liability, many large corporations fail to properly carry out this exercise. Usually they set up a trading subsidiary, and then run it like any other division, thereby negating the effort.

Interference Between Countertrade Contract And The Sales Contract

A unique problem for countertrade transactions is that its problems will interfere with the sales contract (i.e. the sale of your product, versus the countertrade transaction). The countertrade transaction is designed to support your sales contract, and yet could actually end up interfering with your main sales contract.

In the event that there are problems with the countertrade transaction and the supplier of the goods has a claim against your company (or your trader), it is obviously not in your company's interest that your countertrade partner (or buyer of your industrial goods or services) interfere with the contract of sale.

This interference could include seizing money which was to be used to pay for the goods or services your company sold, claims upon guarantees or bonds issued for performance under the main sales contract, or interference with the import of your original goods.

The traditional method of handling this risk is to clearly separate the two contracts without a direct link between the two, other than necessary references for clarity. Failed performance under one contract should not impact the other contract. Careful drafting may be required to ensure that the two are separated.

In some legal systems it is more difficult to do this, and European civil law systems will tend to review the entire transaction, and are more likely to allow interference between the two contracts, but the English common law systems are less likely to allow this interplay. This is a good reason to ensure that you have a good choice of law clause.

The use of an in-house trading company can help separate the two contracts; the sales contract would be signed by the company responsible for selling your product and the countertrade contract by the trading subsidiary.

Currency Risks

There are really two main currency risks. The first is non-convertibility, i.e. the currency will not be convertible when received or required. As many countertrade transactions are designed to avoid this problem, this is less of a risk than might be expected. The second risk is that the currency will have fluctuated in value, and that you will receive fewer dollars than you expected.

The risk of non-convertibility through government action can probably be covered by political risk insurance. Alternatively, you could get a government guarantee that you will be allowed to convert currency as required. Of course this may not be much of a guarantee if the government changes its mind or a new government is in place, but it also might be insurable.

Currency fluctuations are often capable of being protected by currency hedging contracts. These are possible on all hard currencies and on many soft currencies through specialist traders.

Another way of protecting oneself is to have the pricing based on a currency that can either be hedged or that you can use. For example, if the payment of a countertrade export is in a soft currency, you could price it in Deutschemarks, which is capable of a hedging contract, or you could price it in US dollars. By using this arrangement you will receive sufficient soft currency to purchase the currency which your hedge contract is in, or to purchase the currency you require.

You should ensure that the pricing is at a realistic level such that you will obtain sufficient soft currency to purchase hard currency at market rates. If there is a government or artificial rate and a more expensive gray or black market rate, then receiving sufficient soft currency to purchase hard currency at the real rate is very important. Also, you must have the ability and/or right to use this currency to purchase hard currency.

Pricing Risks

Many countertrade transactions are longer term contracts, and the price of a countertrade product may vary substantially on the world market over the term of the contract. Industrial companies are not used to dealing with the volatility and unique pricing structure of many goods and commodities which are used in countertrade, and their inexperience can often cause difficulties for their companies.

If you have fixed the price of the product you could find yourself with substantial losses or an inability to sell the product.

An additional risk is that the product varies in quality as it is delivered. While this is not really a pricing risk but rather an issue concerning quality, it can be dealt with as a pricing risk, as the solution is similar.

Understanding pricing or costs based on the use of standard trade terminology is an additional problem. For example, if you purchase goods on an FOB basis and sell on a CIF basis, you will be in for a very expensive surprise. There are a multitude of varieties of selling terminology.

The obvious solution for price variation is to have a price based on the world market price for the product being purchased or traded. This can often be done by relationship to a published price, such as the LME price for aluminum and other metals, or can be based on prices published by trade journals, or list prices of other producers or users.

Of course, these prices may be used as a base price only, and the buying/selling price can be a variable price on a formula basis. Alternatively the price can be fixed by relationship to componentsin the production of the countertrade product. The price could also be fixed by means of inflationary indices if appropriate.

If the product is likely to vary in quality (and/or quantity if this has an effect on the pricing), then this should be reflected in the pricing formula.

As for risks in using trade terminology, the best solution is either to use a trader or adviser who is familiar with the terminology, or to carefully check to make sure that you know what you are agreeing to.

There are standard definitions for trade terms and you should ensure that both parties are using the same definitions. If necessary, define the requirements in your contract. A good starting point for defining trade terms is INCOTERMS, published by the International Chamber of Commerce in Paris. It is published and revised periodically.

Non-Performance

This is obviously the most common risk in any transaction. This risk may be higher in countertrade transactions, as you are probably dealing with less developed countries and less sophisticated sellers.

Non-performance can take many forms, including complete failure to deliver, late delivery, partial delivery, or delivery of damaged, defective, or out-of-specification product.

The effect of non-performance will be different under different contracts, and depends on the nature of the non-performance. It can render the sale of your product impossible, and/or failure could leave your company open to claims or lawsuits from unhappy buyers.

This risk can be handled in many ways:

1) Make reasonable contracts. The most effective manner is to ensure that the transaction works. The surest arrangement is to deal with competent and experienced partners. But, as we are all aware, this may be extremely difficult in countertrade transactions, especially in developing countries and in countries which are changing from a centrally planned economy to a free market economy.

A good solution is to make contracts which you are comfortable that the other party can meet. There is no point in forcing another party to accept a contract which you are convinced that they cannot fulfill.

2) Use traders. Another solution is to use other parties that are experienced in the country and/or product to handle the import/export of the products. In other words, use an experienced trader.

Generally a trader can better assess and manage the risks than an industrial company attempting to sell its product to the third-world country. The use of third party experts will probably assist you to avoid many risks, and will make the transaction more likely to occur. (However, see #4 below.)

3) Use insurance. You may be able to insure the risk under certain circumstances. Political risk insurance has far broader coverage application than you might expect.

It is available to cover the failure of the seller for almost any reason, not just failure to perform because of government action. The insurance is generally available only for sales by government-owned enterprises, although other similar coverages may be available.

4) Get guarantees. If you cannot ensure that performance will occur, you should protect yourself from the effects of failure, as much as possible.

In general, some form of guarantee of performance is usually prudent, these guarantees can include standby letters of credit, performance bonds, bank guarantees, cash deposited in an escrow account, product delivered to a neutral party, or government guarantees, etc.

These do not ensure performance, but rather provide security that you will recover something in the event of the other party's failure to perform. Each of these has advantages and disadvantages.

A standby letter of credit is excellent security, especially if properly drafted, as financial recovery is basically immediate. The letter of credit is a separate contract between the bank and the beneficiary (you) and is not subject to any of the rights or defenses available under the sales contract.

Banks are obligated to pay upon presentation of the required documentation, often merely being a simpledemand letter. However, many companies cannot provide such security as they will likely be required to deposit the entire amount with the bank. Also, a standby L/C from some banks will not be worth very much, especially if it cannot be confirmed, insured, or discounted.

A performance bond is really a contract of insurance, and therefore provides some security. But recovery may be time-consuming, plus the insurer has the same rights and defenses as the insured party.

A bank guarantee is very similar to a standby letter of credit, but the bank has the right to use the same defenses as you would be entitled to use. A bank guarantee, in a sense, is somewhat like a performance bond and a standby letter of credit, but very few banks will issue such documents, other than in a form which really will operate as a standby letter of credit.

The bank, unlike an insurance company, is not interested in reviewing the transaction and ascertaining why it failed; rather the bank wants to deal with documents only.

A payment into an escrow account basically provides the same security as a standby letter of credit, depending upon the working of the trust agreement.

This is a costly method of providing security and your partner will probably resist the option. Sometimes, however, the supplier will agree to deliver product and agree that the proceeds of sale may be held as security.

Deposit of product with a third party may be a more attractive option for your partner as this does not appear to him to be a deposit of money. Of course there are issues as to location, control, cost of storage, release of the product, etc. At times this is a useful solution, especially when using aluminum or other products which can be stored in LME warehouses and are easily convertible to cash.

A government guarantee does not provide security, but may allow you to insure non-performance through political risk insurance. If you are dealing with an entity which is not insurable through political risk insurance, you may be able to obtain insurance on the government guarantee although not on the contract itself.

(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.)