What Is a Prepayment Contract?
The prepayment contract is a form of commercial contract that is used when one party wishes to prepay the other for a good, service or even loan. These types of contracts are often used in relation to product sales. They can also be used in situations involving the lending or borrowing of money, services or even people (such as with a lease agreement).
A prepayment contract is not a lending contract because it does not use any language regarding "interest" or "loan repayment." The buyer actually places value on the good or service before receiving it, paying the market rate up front . It is more like a prepaid credit card, where the user must pay into the card before they can use it.
A prepayment contract is beneficial for a few reasons. The customer has the capital to pay for the product upfront, so there is no need to secure financing. The seller knows the purchase is guaranteed because the customer has already paid for the good or service. This also eliminates the chances of default, as the seller does not have to wait to receive payment and the buyer does not have to finance the payment.
This type of contract is common in industries that deal with high-value products or services, such as real estate, antiques and some areas of the banking sector.
Prepayment Contract Elements
There are essential pieces of information that must be included in a prepayment contract. Most essentially, any prepayment contract should identify the parties to the agreement. This can be critical for establishing the accounting starting point. In a prepayment scenario, one issue that often arises is that the buyer makes a commitment to purchase from Seller A as of a certain date; however, the parties have been operating under a different agreement, governing different hedging strategies, and may have moved sales from Seller A to Seller B to Seller C during that time period. So, regardless of which seller and which agreement covered the time period from which the prepayment is structured, which company or division in the holding company was actually performing the sales and purchases may not be clear. When dealing with an affiliated group, it is not always easy to determine whether a sale was made by subdivision 1 or division 2, and whether the appropriate transfer price was used. Further complications arise if more than one of the divisions participates in this prepayment contract, or if it is part of a much longer transaction chain. Thus, avoid the dispute over which documents "say when" by simply identifying the parties to the agreement and setting the parameters clearly from the start.
A prepayment agreement also must address the terms, conditions, and calculation of any payments to be made. If the seller is being pre-paid for its future shipments, the contract must address how to account for those shipments. A buyer contemplating a prepayment contract should consider what types of changes and how frequently the parties may want to use different prices and price indices such as Platt’s Dated or Platt’s The Oil Price Letter. A contract may specify that a prepayment should be repaid at the market price on the date of delivery or the price effective on the date of the agreement. Even in cases where there is no specific language in the contract, the consistent industry practice is to use the posted price or the average of all posted prices for that day. As such, the language in a prepayment contract should clearly explain which date governs this payment(s). Most frequently, this type of adjustment will fall into a market-adjustment category or a lawfully enacted price formula/price series. Keep in mind that more frequent payments are generally going to be better for tax purposes because they generate a quicker tax benefit. Remember to think through whether there is a limit to such payments, i.e., a floor or ceiling.
As with any agreement, a prepayment contract should allocate responsibilities and obligations between the parties. This should include provisions requiring the seller repay the prepayment under certain conditions, i.e., if the shipment does not occur or the throughput provisions are not met, if the parties do not agree to extend the contract, or if the parties terminate the contract. Similar to a rebate program, the seller should receive a set amount of payments per shipment or at regular periods, rather than a set dollar amount or percentage of the total shipment to the seller. This should be based on the price on that day and must be clearly explained in the agreement (i.e., the seller receives 10 NOB when the price on the date of shipment is $50 per barrel, but 0 NOB when the price is only $10 per barrel.)
Finally, there should be provisions explaining what happens if either side no longer wants to continue the prepayment. This should include provisions for calculating a termination fee based on the original agreement or based on the current spot price. The prepayment contract should also address the steps to be taken if there is a change in control of any party to the agreement. That will vary widely depending on the priorities of the buyer and the seller. For example, for tax purposes, it is generally better for a sale transaction than for an asset purchase transaction because of the potential cost recovery already incurred by seller and because the buyer recognizes gain or loss at close. A change-in-control transaction creates a risk that buyer could lose a favorable tax treatment, thus nullifying a key benefit of the agreement.
The above is not an exhaustive list of the pieces of information that should be included in a prepayment contract. Still, it is strong starting point for negotiating the appropriate elements. One fundamental question is how many of these decisions the parties are willing to hand off to the liquidated damages/tracking price provisions. In some cases, the better approach is to select some of these types of lease provisions and then follow the standard guidance for the type of well and/or property that is the subject of the contract.
Advantages and Disadvantages of Prepayment Contracts
Prepayment contracts can provide several potential benefits that can help guard against risks. That said, prepayment contracts also carry substantial risks that consumers must consider before agreeing to enter into one.
Financial Security or Prepayment Liquidity. Persons entering into prepayment contracts may benefit from having confidence that their prepaid funds will be returned. Prepayment contracts allow consumers to recover prepaid funds in a lump sum when they have an available balance less than $5,000.00. For amounts less than $5,000.00, prepayment contracts containing qualifying prepayment liquidity features permit consumers to recover their balance within 5 business days after requesting it. In that way, prepayment contracts can help provide financial security or liquidity to pay for non-gratuity funeral goods and services. Prepayment contracts can also help consumers budget for funeral expenses. In most cases, the contract buyer pays for his or her funeral expenses several years before the services are performed. By paying the funeral home for services in advance, consumers can benefit from what is, in essence, a long-term, low-interest loan.
Cash Flow Risks. Just as prepayment contracts can give consumers a way to help protect against rising prices, they can carry cash flow risks. In some cases, consumers’ prepaid funds are not returned for several weeks after being requested. Also, all or part of the prepaid funds may be unavailable when consumers need them to pay for funeral goods and services. This can occur when there’s a delay between when the funeral home provides services and when the price is paid in full or when the prepaid funds aren’t sufficient to cover the entire cost of the funeral.
Death at Home. Prepayment contracts can also create cash flow risks in situations where the deceased dies at home. A prepayment contract’s purchase price, including any refundable balance, typically must be refunded if the death is not within a specified time period (usually 60 days of purchase) and if the consumer has not pre-selected the funeral services or did not enter into any other services contract, such as an irrevocable prearrangement contract that may be a "legal substitute" for the preneed contract.
Drafting a Prepayment Contract
In order to create a legally binding prepayment contract, it is important that you follow a specific process. After determining the amount of the prepayment, and writing a receipt, you can begin drafting the contract. Step 1: Parties – The first step in drafting a prepayment contract is to identify the parties to the contract. The parties should be identified by their legal names. In addition, the address of each party should be included in the contract. Step 2: Contract amount – The next step in the process is to identify the contract amount or the purchase price of the underlying transaction. This should be broken down into two parts, the portion of which will be funded through the prepayment and the portion which will be financed through other means. Step 3: Prepayment terms – Since the ultimate purpose of the prepayment contract is to identify the terms of the prepayment, particular attention should be paid to the terms of the prepayment. For example, if there is an interest charged against the prepayment, this should be clearly spelled out in the contract, including any methods or assessments for determining how much interest is due. Step 4: Payment method – Another area that receives special attention in the prepayment contract is the payment method. This includes how payments are made, as well as the consequences of late payments or pre-payments. Step 5: Default provisions – Another important aspect of a prepayment contract is the default provisions. These often include what happens if either party does not meet their obligations under the contract, and spell out any penalties for default.
Prepayment Contract Mistakes
One of the most common mistakes is not understanding the implications of the part of the agreement that says the provider can increase their pricing at any time after a certain date, and you are obligated to pay the increased rate. If that happens, you will likely be shocked, as the price of service for a user has been increasing fairly consistently, and the provider has taken advantage of the out clause by increasing the rates incrementally.
Another issue that comes up is making sure everyone who is a party to the agreement understands the implications of what they are signing. The paralegals and other non-attorney personnel usually have no clue what that means, so make it a point to follow the chain from whether proper authority to sign has been invoked to ensure everyone is on the same page before the contract is executed.
One of the biggest oversights that happens is when the services provider does an annual price review increase. What that means is, that the provider looks at what they charged you over the year, then they look at what their competitors are charging, and then they make a proposal to increase your pricing. I have seen this happen in instances where the initial pricing was based on the entire enterprise being on the same contract. If you have agreed to prepayment, you have now locked in the increased prepayment amounts. So, if you have five different work stations and the provider suggests the increase of 10%, one work station will get 10% of the 10% increase, which is $100, not $1,000, but that amount is still pretty significant if you are only paying one person to do that entire job.
Another common mistake is agreeing to prepay the minimum utilization agreement at the same time as the SCC. In a lot of cases, providers will negotiate that you are under the minimum utilization, so they will deduct a percentage off the total of your minimum utilization in conjunction with the SCC. So , you are now agreeing to a lower total price for the minimum utilization. If you sign an addendum with the prepayment, you have now agreed to prepay the minimum utilization at a 15% discount each month, instead of the 20% discount that you were given in conjunction with the SCC.
But there are two caveats. One, the value of the services have increased, (more on that in a minute) so the 10% increase is no longer gonna be offset by the discount. The second is… after a certain point, now the provider has no incentive to negotiate. You have already prepaid them. They have plans to use that money to train their people, build new software, and increase the value of their services. Now, I say that and I mean it. The value of your services has increased. It is no longer the minimum utilization you were getting, but it is what it was before the discount.
The last mistake I see come up a lot is people being pressured into prepayment because the proposal states that they will only accept 5 prepayments a month. This brings about a challenge to overcome from a value perspective it is looking at the proposal not as a whole. They pressure you into moving forward, and tell you that you are going to be disappointed with the 4th quarter prepayment opportunity if you don’t get on board.
What the provider is really trying to do is get you to sign the agreement before the end of the 4th quarter. This means they can book the revenue for it, and if you choose not to renew or prepay for the following year, they have already booked the revenue for the next year.
The prepayment is for one system. You have given them the revenue assurance that they have wanted to get rid of for the enterprise. They now have one year guaranteed revenue for this one system. What that means is that they are more likely to give you discounts in the future, because the revenue is guaranteed for the next year.
Contract Review and Finalization
Once a prepayment contract has been negotiated, the renewing or new carrier should be contacted to review the contract with respect to the proposed agreement. Often times the carrier will have their in-house counsel review the prepayment contract, but experienced legal counsel can also streamline the process and achieve a satisfactory prepayment agreement for the company. Some issues that are not be taken lightly as the parties reach an agreement on the prepayment arrangement include:
• Certainty as to whether the obligation is secured by a prepayment of freight, or constitutes a loan or advance;
• The interest rate applicable to the advance. In addition to the foregoing, there are a number of topics that either party would be wise to better understand before execution of the contract. These topics include the following questions:
• Whether the contract is full or limited recourse;
• How often and under what conditions the carrier can call the prepayment obligations;
• Whether the prepayment obligation is a secured or unsecured obligation;
• What the reclaim rights are with respect to the freight; and
• Whether the contract permits a broker or forwarder to assign its financial interest to its client (for example one of their importers).
All of the owner-operator arrangements are structured around a prepayment agreement with some third party sources, which are fundamentally similar.
Prepayment Contract Sample
[Date]
[Customer’s Name]
[Customer’s Address]
[City, State ZIP Code]
Dear [Customer’s Name],
We are very pleased that you have chosen our company to be your [nature of the pre-payment] service provider. Following is an agreement that outlines our commitment to you.
Terms and Conditions:
- Payment. I understand that I must pay in full the amount of $[Amount] to have this contract considered valid. The total balance due must be paid in full on or before the following date: [Due Date]. I understand that any remaining balance at the end of the period specified will be forfeited and no refunds will be made.
- Pricing. I understand that I have decided to prepay for my orders for the period of [time period]. I understand the following pricing structure will apply: (specify pricing) I also understand that if I do not have any orders during the applicable time period, I will still be subject to chargebacks at this agreed rate.
- Service Level. I understand that the [nature of the pre-payment] services included in this agreement are as follows: (specify any terms and conditions that are mutually agreed upon . Any applicable terms and conditions should be included here as well.)
- Enhancements. Any changes to the designated service level (upgrades, downgrades, etc.) as specified above will be treated as a mutually agreed amendment to this contract.
- Termination. This agreement shall automatically renew for the same initial term. However, either party may terminate this agreement by providing written notice to the other party at least [30] days before the end of the initial term or any renewal term.
There are no understandings, agreements, representations or warranties between the parties other than the foregoing agreement that supports this contract.
[Please add any miscellaneous terms and conditions that apply to this agreement.]
Sincerely,
[Prepayment Contract Company]
[Prepayment Contract Company’s Contact Name]
[Prepayment Contract Company’s Title]
[Prepayment Contract Company’s Address]
[Prepayment Contract Company’s City, State and ZIP Code.]