Adjusting to the “new reality”, many companies have focused on all aspects of their balance sheets to improve performance for stakeholders. Companies have realized that material extensions of credit terms regarding its accounts payable result in dramatic improvement to cash flow and working capital. Changing terms from 30 days to 75 days, for example, not only frees up cash for working capital, it also reduces the need for bank financed working capital, which is more expensive than “borrowing” from suppliers. To make the extension of payment terms more appealing to suppliers, buyers have partnered with their lenders to offer a “supply chain finance” solution that allows suppliers to be paid timely if not early, despite the stated payment term extension, such that a suppliers’ DSO is actually reduced.
The Trade Credit Association of the United States reported that in the U.S. approximately $20 trillion of annual sales are made on trade credit, resulting in $2.8 trillion of trade credit outstanding in the U.S. economy, which creates a substantial market opportunity for banks to generate interest and fee income.
SCF is a global trend with foreign-based banks, such as HSBC and Deutsche Bank, as competitive participants in the SCF market. SCF programs may in fact be a valuable tool to facilitate and enhance cross-border sales transactions. Predictably, buyers, sellers, and lenders in the world’s leading economies will encounter SCF programs. Understanding how they work, the rights of the participants in the programs and the potential applicability of SCF programs for global trade is essential in maximizing business opportunities in a global economy.
This article will address the pros and cons of SCF for each of the participants, how SCF works, and issues that both buyers and suppliers need to consider on evaluating a SCF program.
SCF is an opportunity for banks to generate interest and fee income, at a low cost and risk. Typically, SCF programs are provided to a bank’s existing and best customers who pose little credit risk. The advances by the bank can be folded into an existing credit facility, are short-term exposures, and are backed by an assignment or pledge of the customer’s obligation to pay its supplier. Not only can the bank generate fee income from its borrower for providing the facility, the bank also makes a .5% or so spread on the invoice amount in 60 to 120 days, since the bank pays the supplier a discounted amount, and collects 100% from its borrower at invoice maturity. In addition, with the improvement to its customer’s bottom line resulting from the extended terms, the bank’s customer has a better balance sheet, possibly allowing for additional lending opportunities.
From the Buyer’s perspective, the “new normal” economy has resulted in more expensive and less accessible capital, demand for goods is not as brisk as before, customers are paying more slowly, and capital is tied up longer in inventory and slower moving accounts receivable. Yet, companies remain under pressure from stakeholders to manage their balance sheets and cash to generate revenue. For example, in April, 2013, the Wall Street Journal reported that Proctor & Gamble would extend payment terms of suppliers from 45 to 60 days to 100 days. Given Proctor & Gamble’s procurement spend of $50 billion annually, that would improve Proctor & Gamble’s cash flow by $2 billion. By extending DPO (days payable outstanding), a buyer not only improves cash, but reduces working capital costs and bank charges.
With low interest rates, the cost to the buyer for its bank to facilitate an early payment option for suppliers is low, especially if it is an add-on to an existing credit facility.
Buyers should understand the impact on its suppliers as extended payment terms can adversely impact the supplier’s revenue and perhaps overall financial health, heightened if interest rates increased. Prudent buyers should monitor their supply chain more closely to ensure a healthy supply chain to provide an uninterrupted flow of goods to the buyer.
A supplier wants to be paid for the goods it sells, on a timely basis. Prices charged by a supplier reflect the company’s cost structure, including the cost of extending credit to customers. A powerful customer’s unilateral extension of payment terms increases a supplier’s cost, which increase may or may not be passed on to the customer. If not, there is a reduction of the supplier’s revenue, exacerbated by having its working capital tied up in slower paying accounts receivable, and an increase in DSO. Historically, a “good paying customer” was one who paid within invoice terms, often taking a 1-2% discount for paying within 10 days.
Suppliers tend to reject the extension of payment terms, which may depend on the parties’ relative bargaining position. If a supplier is part of a diverse supply chain that sells products readily obtainable from a competitor, a supplier may acquiesce to keep sales. On the other hand, if the supply chain is limited, such that there is little risk of a losing business, or if the goods sold are unique to that buyer and seller, the supplier may have leverage to “just say no”.
On the other hand, one major U.S. corporation, in partnership with Citibank, offered an early payment option, in essence charging the supplier LIBOR (about .28%) plus 1.50%, which for 7 day payment on 120 day terms was a charge of .56%. If the supplier would have ordinarily allowed the customer a 2% discount for payment with 10 days (2/10, net 30), SCF may actually be advantageous to the supplier. With a 7 day payment model, the supplier’s DSO would be reduced.
Since SCF programs require buyers to submit the supplier’s invoices to the bank within days, suppliers benefit by an earlier reconciliation of invoices. This avoids the problem of a supplier receiving an invoice dispute when the invoice is due.
In essence, in a SCF program, a supplier is agreeing to an early discounted payment. A supplier is not really bargaining for extended payment terms, despite what the invoices state. The extended payment term is arguably an agreement between the buyer and its lender for the lender to make short-term advances to the customer’s suppliers on behalf of the customer.
While participating in the customer’s SCF program may be beneficial to the supplier, there is a risk that the extended terms become the “new normal”, causing other customers to demand extended terms, and being stuck with the extended terms if for some reason early payment is not made.
How does SCF work?
The graphic below summarizes the steps involved in a SCF supported sales transaction.
In the first instance, a supplier must agree to the SCF program of its customer, which would include a contract between the supplier and the buyer providing for the extended payment terms, and the buyer’s obligation to submit and confirm the supplier’s invoices to the bank for payment. The bank in turn acknowledges and agrees to fund payment of the supplier on behalf of the buyer. Finally, the supplier agrees to assign or pledge the right to payment from the buyer to the bank, in exchange for early payment of the term-extended invoice.
In essence, the buyer is willing to pay its bank interest and fee income to obtain the benefit of extended payment terms. The supplier agrees to nominally extended payment terms in exchange for the discounted early payment. The supplier isn’t really “bargaining for” payment on extended terms, despite the terms of the invoices.
1. What are the legal obligations of the supplier, the buyer, and the buyer’s bank?
The parties’ obligations are set forth in various legal documents including a loan agreement between the buyer and its bank, an agreement between the buyer and seller regarding extended payment terms, such as an “invoice payment terms acknowledgement”, and an agreement between the supplier and the buyer’s bank to sell or pledge the invoices in exchange for early discounted payment. Every buyer and bank use different documentation, but there are some common provisions. The parties, especially suppliers, should carefully review the documents to understand their rights and obligations.
a. A supplier’s obligation to participate in the SCF program.
If a supplier agrees to extended payment terms and the SCF program, it is clear that the supplier can only be paid by the buyer on the extended invoice due date. SCF programs generally do not obligate a supplier to submit invoices to the SCF program. However, it is difficult to imagine a supplier who would agree to extended terms but not participate in an available SCF program providing for early payment.
b. A buyer’s obligation to submit an invoice to the SCF program.
SCF programs generally do not obligate a buyer to submit the supplier’s invoice to the SCF program. One program’s applicable agreement provided:
“Upon the request of a Supplier, the Buyer may (emphasis added) confirm the amount owed . . ..”
c. A bank’s obligation to pay the supplier early.
Generally, the bank’s obligation to purchase a particular invoice at the advertised discount is discretionary. Some SCF programs provide for the banks to purchase the invoices (normally without recourse), while other SCF programs provide for the bank to merely take a security interest in the account receivables created by the invoices.
Normally, the early payment to the supplier is made by the bank not by the buyer. The bank in turn collects payment from the buyer upon maturity.
Although the bank’s obligation to purchase a particular invoice is discretionary, once it accepts an assignment of the invoice, the supplier would have an enforceable payment obligation against the bank.
Although sellers of goods do not normally resort to legal rights to be paid, having them allows a supplier to assume risks in extending credit to a customer. Such legal rights ensure an orderly conduct of business among companies.
2. What if the buyer files for Chapter 11 or other insolvency protection between the time after goods are shipped but before early payment is made?
Once a supplier ships or delivers goods to a buyer, title to the goods passes to the buyer, and under Article 2 of the Uniform Commercial Code (governing sales of goods), the supplier has a right to payment from the buyer. In Chapter 11, that right to payment is a pre-petition general unsecured claim, which generally fares poorly. Under the insolvency laws of other countries, the outcome is often quite similar.
If under the particular SCF program, the bank is paying the supplier, once the bank accepts assignment of the invoices it would be obligated to pay the supplier, regardless of the buyer’s chapter 11 filing.
If, under the particular SCF program, the bank merely facilitates the payment, using the assets of buyer, upon a Chapter 11 filing, the buyer’s “property of the estate” could not be used to pay the supplier’s invoices.
It is likely that the buyer’s bank will be aware of financial difficulties and would likely not agree to accept the invoice for payment in the first instance. In this regard, the SCF program could be an early warning mechanism for the supplier.
3. Is the payment to the supplier a potential preferential payment if the buyer should file for Chapter 11?
Assuming all of the other elements of a preference are met, a payment to a supplier can be preferential if it is a transfer of the debtor’s property to or for the benefit of the creditor. If the SCF program provides for the bank to pay the supplier using its assets, and not the buyer’s funds, there is no transfer of the debtor’s property and thus no preference. If, however, the particular SCF program provides that the bank merely facilitate payment using the debtor’s funds, then a payment to a supplier could be a preferential payment. However, the supplier would have available to it the customary preference defenses: new value, ordinary course of business, and contemporaneous exchange for value.
It appears that most SCF programs provide for the bank to pay the supplier, thus involvement in SCF programs may avoid preference risk.
4. What if interest rates increase?
When the discount payment is LIBOR plus 1.25%, it is a 2% or less discount, which suppliers routinely grant in the 2/10, net 30-day term afforded to many customers. In 2007, LIBOR was about 5.4% so LIBOR plus 1.25% would be pushing 7%. How do suppliers react if interest rates increase? Perhaps if the discount off invoice was 3%, a supplier would acquiesce. But if rates surge to 4% or 5%, do suppliers refuse to accept SCF? Does SCF only work in an environment of unusually low interest rates?
Moreover, if interest rates materially increase, the buyer’s cost of offering the SCF program may make it less attractive to the buyer.
5. Impact of covenants in the buyer’s credit facility.
If the SCF program is a sub-facility of the buyer’s credit facility with its bank, or is otherwise cross-defaulted with the buyer’s existing credit facility, then the availability of the SCF program for early payment is affected by the buyer’s loan covenant compliance. Suppliers are accustomed to monitoring their customers’ general financial health, including loan covenant compliance. Now, a supplier’s payment may be more directly dependent on its customer’s loan covenant compliance.
Depending on the magnitude of the sales involved, a supplier may be advised to negotiate periodic verification of covenant compliance, and payment despite covenant violations, certainly technical ones.
6. Supplier’s loan covenant violation.
A supplier may have its own credit facilities in which it pledges all of its accounts receivable to its lender for working capital borrowings. In this case, a subsequent assignment of invoices owed by a customer under a SCF program would be a covenant violation by the supplier under its credit facility. This would especially be the case in a typical asset based credit facility where the lender advances on “eligible” accounts receivable. The supplier would need to exclude the SCF program accounts receivable from its eligible accounts receivable. In fact, the banks involved with SCF programs may require a written “lien waiver” from the supplier’s lender. It will be interesting to see how supplier’s lenders react to such requests. Removing material receivables from the supplier’s borrowing base may impact the supplier’s working capital facility.
7. Two SCF programs?
Just to make things more interesting, it is possible that a supplier in a SCF program could also be a buyer in another SCF program. A resin supplier to plastic bottling companies, for example, could also seek to extend payment terms to its chemical suppliers.
8. Impact of SCF on factoring and letters of credit.
SCF programs will adversely impact traditional factoring, where the supplier would “factor” the accounts receivable owed by its customers, resulting in an assignment of the accounts receivable to the lender in exchange for an early or immediate advance, usually between 85% to 95% on accounts receivable. In essence, the buyer’s bank becomes the supplier’s “factor” under SCF programs, apparently at much less expensive rates. Companies providing traditional factoring may experience a loss of volume as more of its clients “factor” through their buyer’s bank. Predictably, these factors will react by providing their own SCF programs.
SCF programs are also reminiscent of letters of credit, but may provide a more efficient payment solution as a supplier is not required to wait for a default by the buyer, then process submission of documents to obtain payment from the bank, as the issuer of the letter of credit. However, a letter of credit may have a clearer obligation to pay the supplier upon presentation of specified documents. The bank has no discretion to pay, as may exist in some SCF programs.
SCF programs may provide a particularly attractive option in foreign sales. When a U.S. supplier sells to a foreign-based customer, or vice-versa, there is often an inherent increased credit risk, due to the vagaries of foreign legal systems and country risks. Historically, U.S. suppliers have demanded letters of credit, confirmed by a U.S. bank. As bargaining power has balanced, more sales have been on “open” credit, without letter of credit protection. If a supplier does obtain a letter of credit, it may be from a foreign bank, without a confirming letter of credit from a U.S. bank.
As the chart below illustrates, it is predicted that Asia will drive the growth of SCF programs in the next three years.
1. For lenders, it may be “make hay while the sun shines”. If interest rates rise materially, the SCF early payment option will become more expensive and less attractive. Regardless, SCF may have a long-term future supporting foreign sales, as a means to alleviate an enhanced credit risk.
2. In addition to push back from customers, buyers should closely monitor the financial health of supply chain to ensure no interruptions in sourcing goods.
3. Suppliers need to take note of several issues.
a Review the SCF program’s documentation to understand exactly what it can and cannot enforce (the buyer’s obligation to submit invoices into the SCF program and the bank’s obligation to pay early).
b. A supplier should evaluate the potential benefit of the SCF program, compared, for example, to a traditional 2/10, net 30 payment term.
c A supplier may consider including terms in its agreement with the buyer making clear that the “deal” is that the supplier agrees to extended terms only if there is certain early payment option available to the buyer. If the early payment option fails for any reason, including the buyer’s failure to submit the supplier’s invoices to the bank, or bank’s failure to make the early payment, the terms revert to the original payment term. Knowing that the extended payment terms may revert to the original payment terms, a buyer has incentive to make sure the SCF program works for the supplier.
4. All participants in SCF programs should consider the potential advantages of SCF programs in foreign sales transactions. Ex-Im Bank is even providing a lender guaranty to facilitate SCF programs, where for a fee, a bank can hedge its risk, backed by the full faith and credit of the U.S. government.
5. All participants should brace for a rise in interest rates, where the incentives for the participants will change and may alter their willingness to participate.
Regardless of the varying perspectives of the participants in SCF, it appears to be a fast-growing part of domestic sales transactions and international trade. SCF programs will no doubt evolve to meet the changing dynamics of its participants, but appears to be poised to take a prominent role in facilitating global trade.