Procurement: Issues and Analysis: Payment Terms

1. Overview

Procurement

The organised procurement of goods and/or services by companies can take many forms (involving a varying degree of formality), ranging from the purchase of goods and/or services by a procurement team for a single company through to complicated arrangements where centralised procurement is undertaken for a group of companies, often on a multi-jurisdictional or even global scale. For more information on group procurement models see Structures for Group Procurement Options and Sourcing Rationalisation, An Overview of Hogan Lovells Approach.

Depending on the nature of the goods and services being purchased and their intended use, purchase agreements can sit at several levels of the supply chain. For example a purchase agreement for goods which are to be used by the purchasing company or a member of its group will sit at the end of the supply chain, whereas if goods are purchased for use in manufacturing or on-sale then the purchase agreement may sit on the penultimate level or even further up the supply chain.  The position of the purchase agreement in the supply chain should, if possible, be identified and taken into account during the contracting process.

Payment terms

The terms on which payment is to be made will be key to determining both the financial consequences and the financial risk associated with the supply and purchase contract.

As noted above, supply and purchase contracts may sit at different  levels of the supply chain and, when seen in the context of an entire supply chain, the payment terms in the purchase agreement become even more significant in both respects. 

This is simply illustrated using a 3 link supply chain for goods in which the Materials Originator and the Manufacturer each carries its own direct cost of $10,000 and makes a 10% margin and manufacturing takes 15 days.  The Purchaser is purchasing the goods for on-sale to an end user

Commercial Impact: The difference in payment terms through the supply chain will create funding issues for Materials Originator and the Manufacturer which are likely to have an impact on the payment terms which the Manufacturer seeks from the Purchaser. 

The Materials Originator and the Manufacturer will each need to fund their own costs, and the amount they have to pay upstream in the chain, until they receive payment.

A shortening of the terms of any party upstream in the supply chain without an equivalent shortening in downstream terms will increase funding costs for the Materials Originator and the Manufacturer which each will want to pass down the supply chain until they reach the Purchaser. 

In this example, if the Materials Originator requires payment within 10 days of delivery, unless the Manufacturer can secure a 20 day reduction, from the Purchaser, in the terms on which it is paid, the Manufacturer will bear an additional funding cost.  If the Manufacturer can't agree this reduction with the Purchaser, it will no doubt look to recoup the costs in other ways, for example though price increases or by cost savings (which may have an adverse impact on the quality or availability of the contract goods).

This "chain effect" is highly relevant when examining the impact of legislative intervention with regards to payment terms in group procurement arrangements and other supply and purchase contracts in the supply chain.

Risk Impact: From a supplier's perspective, the structure of payment terms will influence the risk that payments may not be made on time (or, possibly, at all). 

The converse risk, from the buyer's perspective, is that in certain circumstances amounts may be committed or paid but contract performance may be delayed (or may never take place). 

At one extreme, if the price is paid in advance the buyer will assume risk of non-performance. At the other, where payment is made after performance the supplier assumes a risk of not being paid.

There are four basic payment models: 

• Payment in advance: payment must be made before the supplier performs its obligations
• Letter of Credit: payment formally guaranteed by a bank
• Documentary Collection: Payment executed through a bank on production on documents
• Open Accounts: Payment made following performance. 

2. Global Regulatory Trends

Given the potential impact on suppliers of payment being delayed significantly, legislation has developed in a range of jurisdictions which seeks to protect suppliers.  The primary functions of many late payment regimes are (i) to control the imposition of payment periods which are deemed to be excessive or unfairly detrimental to the supplier and (ii) compensate suppliers who are paid late 

Regulation has generally looked at providing protection to four groups: (i) businesses who supply government; (ii) businesses involved in the construction sector; (iii) smaller businesses; and/or (iv) businesses generally.

However, the models are far from consistent and there is often a degree of overlap between various regimes.

Buyers need to understand and comply with the specific late payment regime in force in each individual jurisdiction from which they source goods and/or services.  The fine detail of the regimes, such as the length of payment period which can be specified in a supply and purchase contract, may vary from jurisdiction to jurisdiction (even within the EU) and it can be difficult for buyers who are procuring goods services, either on their own behalf or as part of a group procurement programme to apply a global or multi-jurisdictional payment policy.

Government buyers: A large number of economies across European, North America and Australasia have rules which are intended to protect those supplying government in certain circumstances. 

Typically the scope of these rules covers those relating contractors with a range of state related entities and agencies going beyond government departments themselves. 

In many cases these rules are contained in legislation. For example, the Miller Act in the USA requires performance and payment bonds for federal construction projects.

In other cases the protection is embodied in a "Code of Practice" which is supported by declarations of intent by Ministers or other officials. For example, in the UK, the Office of Government Commerce requires as a matter of policy that all government sub-contractors are paid within 30 days.

The detail of rules protecting those who supply goods or services to the Government can vary significantly. In the EU various directives provide fairly sweeping protection for anyone supplying Government. By contrast, in parts of North America they are focused particularly on those involved in public sector construction projects.

Construction Sector: The protection of suppliers in the construction sector is also an important standalone theme in prompt payment legislation.

The case for special treatment in the construction sector is based on the scale and duration of construction projects and the extent to which the financial position of sub-contractors can be dictated by the terms of the head contract.

In parts of Europe, the concept of protecting construction contractors, even for wholly private sector projects, is well established. For example in the UK the Construction Act 1996 outlaws "pay when paid" provisions.

By contrast the approach in North America originated in the protection of Government contractors. However, Prompt Payment Acts covering wholly private sector construction projects have been significantly since 2010 (for example the Prompt Payment Acts in Massachusetts and Vermont, among many, impose strict maximum timelines for review and action upon a contractor’s applications for payment and the making of payment).

Smaller businesses: The principle that smaller businesses require greater protection against delays in payment was reflected in the original legislation providing statutory protection in the EU, and detailed in the Small Business Act 2008.

Elsewhere protection of this nature is generally confined to codes of practice, such as the UK's Prompt Payment Code, which government agencies and larger companies may sign up to voluntarily. Such codes have been criticised for being ineffective due to their voluntary nature – in the UK, small and medium enterprises ("SMEs") are collectively owed late payments of some £30.2bn. This is because SMEs are commonly unwilling to enforce their statutory remedies and protections against late-paying customers, for fear of damaging relationships with clients and contractors.

Business generally: The European Rules  go significantly further than those in operation anywhere else in the world in providing protection for suppliers under any contract.

The European Late Payments Directive affects any supply and purchase contract involving one or more parties based in the EU. Member states were required to implement to directive by March 2013, and it obliges public authorities to pay invoices for goods and services within 30 days. This is extendable to 60 days only in exceptional circumstances. In contrast, purchasers that are businesses have discretion to extend the payment period to 60 days, but both parties to the agreement must agree to an extension beyond 60 days, which will only be valid if not "grossly unfair" to the supplier. Any defaulting purchasers are required to pay interest at 8% over the national reference rate plus the supplier's compensation costs for recovering the debt. Purchasers and suppliers can agree to replace the statutory right to interest with a contractual right, provided that the supplier is not disproportionately adversely affected by accepting a contractual right in place of the statutory right.

As noted above, however, SME suppliers are disproportionately affected by late payments, even with such legislative protection. The EC is currently working to increase awareness amongst European stakeholders, both business and public authorities, on the rights and obligations conferred by the directive.

3. Impact of Regulation on Supply and Purchase Contracts

In most cases regulation primarily applies to bilateral contracts. To a greater or lesser extent regulation will do one or more of the following:

• Set maximum payment periods
• Provide for mandatory interest
• Outlaw specific provisions (e.g. "pay when paid")

Much regulation also includes complex "choice of law" provisions which are intended to prevent parties artificially avoiding the impact of the rules by the selection of the governing law of their contract.

Differences in the impact of payment terms regulation will indirectly affect many supply chain relationships through their connection with regulated contracts. For example:

• if part of a group procurement arrangement (or its supply chain) flows through a regulated jurisdiction or constitutes a regulated relationship, the terms imposed by regulation are likely to have a ripple effect on the unregulated parts of the arrangement; 
• if payments to be made upstream of the procurement contract are regulated those payment terms will contract. This will result in the buying party in the procurement contract being under pressure to pay the supplier quickly. 

4. Consequences of non-payment 

Buyers need to understand the consequences of non-payment of the contract price for the goods or services and a primary concern for buyers is whether or not the supplier can terminate the contract on the basis of non-payment by the buyer.  The other primary remedy for late or non-payment, statutory compensation, has been explored above.

Unless the contract is explicit, in many jurisdictions it will not be straightforward for suppliers to terminate the contract for non-payment by the buyer.  Sellers who are aware of the uncertainty will try to overcome it by ensuring they have an express right to terminate for non-payment (in addition to other remedies for non-payment, such as interest on the outstanding amount due).   

For example, under English law unless the contract provides that payment is "of the essence" or otherwise provides the supplier with express rights of termination on non-payment, the supplier will need to serve a period of notice giving the buyer a further opportunity to pay before the supplier is entitled to terminate. This can be particularly difficult for a supplier in a continuing relationship as it may be obliged to continue to supply the product even in a scenario where it is not being paid. Alternatively, depending on the circumstances, persistent non-payment can amount to a repudiatory breach of contract if the consequences are serious enough. In such a case, the innocent supplier may be entitled to terminate with immediate effect, and can apply to the courts for damages. 

In contrast, in the Civil law jurisdiction of France, without a clause giving automatic rights of termination to an aggrieved party (a "clause résolutoire") written into the contract, the agreement can only be terminated by order of the court. Such clauses are strictly interpreted, and it must be specifically stated that the clause constitutes an exception to the French Civil Code rule of judicial termination of contract. Merely stating that late payment or failure to pay will give the supplier the option to terminate the contract is insufficient. The supplier must also give sufficient notice, irrespective of the contractual notice period. However, if the buyer defaults on payment or is late making payments, the seller is not obliged to deliver goods under contract. 

Conversely, under the German Civil Code, the seller is entitled to withdraw from the contract and terminate it if the buyer defaults on payment, provided it gave the buyer an adequate period of notice in which to pay (with what is "adequate" depending on the length of the relationship).

This right of termination for non-payment, subject to adequate notice, is also prevalent in Japan, where a contract is generally enforceable in accordance with its written terms.

Parties contracting under Chinese law can include a negotiated termination clause, and/or be permitted to terminate on breach of a "main obligation" of the contract which is not rectified within a reasonable time. There is no statutory requirement for notice, however. Note that termination clauses are often among the most heavily negotiated. This is because it is a common perception among Chinese parties that a foreign partner may seek to use a termination right unconscionably, either to avoid its contractual obligations or to end a partnership ahead of time that still has value to the Chinese party

In the USA, the Uniform Commercial Code as implemented in each state generally governs supply and purchase contracts. A seller is entitled to "cancel" (terminate and retain any rights for breach) the contract if the buyer fails to make a payment when due. The right for breach retained will include the right to charge interest on late payments (as long as the amount charged is not excessive, punitive, or in violation of laws with regard to usury). Note that some states require a minimum notice period for termination.  

5. Passing of title

The point at which title or ownership of the contract goods passes under a supply and purchase contract is a key consideration for both seller and buyer and the point at which title transfers has important consequences, particularly in terms of the transfer of risk and the rights of one party if the other party becomes insolvent before the contract is completed. Sellers and buyers will often take opposing views on the issue and a buyer will usually prefer to link the transfer of property to the earlier of payment and delivery whereas sellers usually prefer title to pass only upon payment in full

Sellers will usually seek to include a retention of title clause in the supply and purchase contract in the seller's favour and will usually strongly resist the removal or watering down of these clauses.  Buyers who agree to the inclusion of a retention of title clause need to understand the financial and practical implications of the clauses and to seek clarity within the contract as to what use they can and cannot make of the contract goods before title has passed, for example, can the goods be on-sold, used by another member of the buyer's group or incorporated into another product?

Such clauses provide that the seller of goods retains title, or ownership, over the goods until it receives full payment. This therefore gives the seller priority over all creditors of the buyer if the buyer fails to pay, for example due to an insolvency-related event, and entitles the seller to recover the goods to minimise its loss. An enhanced "all monies" clause can reserve title until the seller has paid for not only the goods under the contract in question, but for any other goods supplied by the seller. 

However, in the UK, if the company is in financial difficulties, it may be necessary to apply to court for permission to repossess the goods pursuant to a retention of title clause. The obstacle created by creditors of the buyer is also an issue when considering retaining title in the US. Furthermore, the clause may be ineffective in the UK if its operation is inconsistent with the overall trading relationship between parties.

A key component of any retention of title clause is the right of the seller to reclaim any goods which have not been paid for, usually by entering onto the buyer's premises.

In France, any retention of title clause must be in writing – this is contrary to the general rule that oral commercial contracts can be valid.  The clause must be clear and intelligible enough so as to establish that the buyer had full knowledge of it before contracting. If the buyer is in insolvency, though, the clause is always enforceable against creditors unless agreed otherwise. 

In Germany, the retention of title is enshrined in the Civil Code, which provides that transfer of title to the buyer only takes place when the purchase price is paid in full. In general there is no need for the retention of title clause to be written, unless the Civil Code requires the title to be in a specific form. 

In contrast in the US, as retention or reservation of title clause is only limited to a "reservation of a security interest". In practice, this means that a seller cannot use a retention of title clause as the basis for repossessing goods. Any reclamation of goods is subject to the federal Bankruptcy Code. Ultimately, a seller may not be able to take priority over a creditor with a prior perfected security interest. Therefore it is common for sellers of goods to create and enforce security interests in compliance with the Uniform Commercial Code rather than relying on retention of title clauses.