Risks and Benefits to Using Escrow Services in International Trade
USA | November 6 2013
In the 2012 edition of its Trade Finance Guide, the International Trade Administration for the first time discussed escrow service as a variation on cash in advance and a payment method available to U.S. exporters. The ITA’s inclusion of escrow services in the guide and the emergence of companies providing escrow services reflect a concern common to all exporters: the need to find a payment system that provides some level of security at a low price. Just as with bank payment obligations, escrow services are an attempt to fill the gap between open account trade and cash in advance. As escrow services are used more frequently and offered more often, exporters should be aware of some of the benefits and risks in using the service.
First, what is an escrow service? An escrow service is a third party contractor that will agree to facilitate a transaction between a buyer and seller. The escrow service accepts funds from the buyer and when payment is verified, notifies the seller that payment has been made. The seller is then expected to ship conforming goods to the buyer, and the escrow service uses tracking information to ensure that goods are delivered. The buyer has an agreed-upon time frame within which it may accept and examine goods and notify the escrow service of its decision. If the buyer accepts the goods, the funds are released by the escrow service to the seller.
Not surprisingly, escrow services have advertised their services as mutually beneficial to the buyer and seller. They point out that this option can be provided more cheaply than a letter of credit and that it ensures the seller does not bear the same risk as in open account trade. They also point to the fact escrow services can be less cumbersome than a letter of credit transaction. And indeed, these can be valid reasons to consider an escrow service in certain transactions.
Exporters should be aware, though, of some of the risks in using an escrow service. Most importantly, exporters must be aware that there are a few key differences in how escrow services compare to letters of credit. First, escrow services are third party contractors, whose trustworthiness must be assessed the same way a bank’s should be. In a letter of credit transaction, the parties agree that a letter of credit issued by an international bank is acceptable, presumably because both know and can assess that bank’s trustworthiness and assets. The same should be true of an escrow service. If that service is to be trusted to hold funds and release them when appropriate, the risk that it will not do so must be assessed by the parties. That can be more difficult when escrow services are new and have not yet established the reputations that banks have.
Second, the obligation owed by a bank that has issued a letter of credit is independent of the underlying transaction. From the seller’s perspective, that means that if complying documents are presented to the bank, demonstrating that goods have shipped, the seller is owed payment by the bank. There are limited circumstances under which a buyer may stop the bank from paying if the documents have complied with the terms of the letter of credit. In an escrow agreement, however, the escrow service will not release the funds to the seller until the buyer has authorized it. In other words, the escrow service owes no obligation to the seller until the buyer has inspected the goods, and even that obligation is dependent on the buyer’s consent.
Third, a benefit of a letter of credit is the ability to finance production or sale of the goods. Since the seller is owed an independent obligation by the bank, they can use that obligation to finance the production of the goods. In certain circumstances, they also can discount the proceeds of the letter of credit to obtain cash more quickly. And indeed, since payment usually must be made within days after documents are presented to the bank, a letter of credit can result in quick payment after goods have been shipped. Those options are at least more difficult with an escrow service, if they are available at all.
If a transaction does not warrant the costs involved in a letter of credit transaction, and an escrow service is to be used, exporters should keep other considerations in mind as well. First, the agreement with the escrow service should be reviewed to make clear what the escrow service’s obligations are, what the escrow service will do to ensure that goods have been shipped, and what independent obligations—if any—the escrow service will undertake to verify the accuracy of seller’s or buyer’s statements. The time frames that will control the escrow service’s obligations should be laid out as well as the fees that will be charged to each party. Indeed, many of these items should be negotiated between buyer and seller in their sales contract before an escrow service is involved.
Second, as with any transaction, escrow services have been the subject of fraud. The Internet Crime Complaint Center warns that fraudsters are setting up phony escrow sites which mirror true escrow services and accept funds or goods under false pretenses. Fraud is not unique to escrow services, of course, but exporters should conduct proper due diligence into any service to prevent against fraud.
There is no method of payment that is ideal for every international transaction. Some transactions warrant a letter of credit, and other transactions do not. The bank payment obligation minimized some of the gap between open account transactions and letters of credit, and there is no reason that escrow agreements cannot also work as a viable option. The most important thing is that exporters understand the risks involved, carefully choose the payment method that best suits the transaction, and follow through to ensure that the payment method is as secure as it can be.