Monday, June 29, 2009

Blanket Security vs a Security Blanket

In prior posts we’ve noted that a TRE Seller must unconditionally commit to repurchase any sold receivable that is not paid by a stated date. We’ve also discussed the advantage of Louisiana law in that regard and we’ve expressed our opinion that the financial capacity of the Seller has to be seen as the “first line of defense” in protecting a Buyer against loss.

It’s not the ONLY defense, however.

TRE, as agent for its Buyers, also obtains a lien on the receivables sold by the Sellers on the exchange and on all of the money deposited for the Seller’s account in the TRE lock-box.

TRE files a UCC Financing Statement putting everyone on notice of its liens.

The TRE approach is unusual. It is ingenious in some respects but it's also important to acknowledge its limitations.

(I have to remind readers that I’m not a lawyer; so interested parties should consult their own counsel.)

In what ways is the TRE approach ingenious?

1) Many potential TRE Sellers will already have financing in place that encumbers ALL of their receivables. In order to convey clear title to a traded receivable, any prior lien has to be released. Otherwise it would be like trying to put a first mortgage on a house when there's already a first mortgage in place.

It’s much easier for the TRE Seller to convince its lender to release its lien ONLY with respect to the receivables sold on the exchange rather than to release it altogether. I suspect this middle-ground solution allows many companies to become potential TRE Sellers that would otherwise be unable to deliver good title to their receivables.

2) If a TRE Seller wants to sell any of the receivables due from one of its customers, it has to direct that ALL of the payments due from that customer go to the TRE lock-box. So it’s possible that payments might be received in the lock-box for invoices that have not been sold. Those payments would then, in theory at least, be available to cure defaults in payment for receivables that HAVE been sold.

3) A TRE Seller might register multiple customers with the exchange. The payments from all of those customers would go to the lock-box. Under the TRE security strategy, even the payments from other customers, not involved in a defaulted transaction, might be available to make good a default.

In what ways is the TRE approach limited?

1) As we’ve noted above, the typical receivables financing relationship requires a UCC filing encumbering ALL of the seller’s receivables. The TRE UCC filing on a Seller’s receivables is limited to the receivables traded on TRE.

2) If there is another party with a first lien on the Seller’s non-TRE receivables and those other receivables represent a substantial part of the Seller’s assets, that prior lien position could limit a Buyer’s ability to enforce the Seller’s commitment to repurchase.

3) If cash is deposited in the TRE lock-box for receivables that were not traded on TRE, and those receivables were actually subject to another party’s first lien, I suspect there could be a challenge to TRE’s use of those funds to cure an unrelated default.

The Receivables Exchange wants to be a very high volume trading platform. In order for it to reach high volume it has to be a workable platform for a great many Sellers.

In order for it to be workable for a great many Sellers, the common problem of prior “blanket” liens on Sellers’ receivables had to be addressed.

The solution TRE has apparently adopted is to give up some of the value of the typical blanket lien on receivables, in exchange for the potential to receive and withhold other funds of the Seller to cure potential defaults.

From a business point of view: when added to the advantage of the “True Sale” language of Louisiana law, and the unconditional commitment to repurchase; I think the approach makes a lot of sense.

It is NOT blanket security…but it IS a security blanket. It is comforting, to be sure, but only as an addition to the primary protection i.e. the actual financial capacity of the Seller to meet its repurchase commitment.

Tuesday, June 23, 2009

The Financial Statement Assurance Continuum

When a company sells a receivable on The Receivables Exchange, the Seller agrees to repurchase the receivable if the Account Debtor (the Seller’s customer) does not pay it.

The Seller’s commitment to repurchase is the Buyer’s initial line of defense against loss.

The strength of that defense is a function of the Seller’s ability to fulfill its commitment.

If the Seller’s customer doesn’t pay, how likely is it that the Seller will be able to pay as required?

The bulk of the information available to help answer that question will come from the Sellers themselves, principally in the form of financial statements. (Even if a Buyer obtains supplementary credit information from an independent provider, much of the information will have been sourced from the company itself.)

Two threshold questions always have to be asked: a) does it appear from the information provided that the Seller has the capacity to fulfill its commitment, and b) what level of confidence should we have in the information provided?

Each Buyer will look at financial statements somewhat differently but any analysis is only as good as the information available to analyze. So we’ll focus here on the question of confidence.

There are four generally-recognized types of financial statements produced by corporate entities: 1) audited, 2) reviewed, 3) compiled, and 4) internally-generated.

In the first three cases, an independent accountant or accounting firm has had some degree of involvement in the preparation of the statements. Statements that are internally-generated have no third-party whose name and reputation is associated with the data provided.

There are important procedural, technical and legal distinctions that have to be made to accurately distinguish among the first three types of statements. For our purposes, however, I think we can use a convenient “shorthand” distinction that appeared in a paper published in March 2008 by the Reliability Task Force of the American Institute of CPAs.

That paper presents an “Assurance Continuum” that positions each of the three types of financial statements on a line that proceeds from the highest level of assurance that the information is reliable to the lowest level of assurance.

In the language of that Task Force Report:

An audited financial statement has a “High Assurance” of reliability.
A reviewed financial statement has a “Limited Assurance” of reliability.
A compiled financial statement has “No Assurance” of reliability.

It follows, I think, that an internally prepared statement, which has had no independent accountant’s review, would also fall in the “no assurance” category.

Now, the fact that an accountant has not certified the accuracy of the data presented in a financial statement doesn’t mean the data is NOT accurate. And we’re all aware of cases in which apparently diligent audits have proven inaccurate.

We also have to acknowledge that the staff of The Receivables Exchange does spend time and effort vetting potential Sellers.

All that said, however: it is still only reasonable to acknowledge that there is a higher level of reliability in the financial statements of a company whose books have been audited by a third-party professional than there is in the books of a firm that internally generates its own statements.

The level of risk in a Buyer’s analysis does, without question, vary with the reliability of the financial data.

All else equal, the lower the level of assurance that the Seller's financial data is reliable, the higher the appropriate Buyer’s risk premium.

Monday, June 22, 2009

Liability: It's Not Personal.

Most firms that buy individual invoices routinely obtain a personal guarantee of the seller’s obligations from one or more individuals associated with the seller.

If the transaction goes bad, the personal guarantee can become critical in ultimately recovering the money advanced for the invoice purchased. One of the reasons is that, if litigation is required, the litigation process can take so long that other pledged security, such as other receivables and other financial assets, can be long gone by the time there is actually a judgment for the buyer to attempt to enforce.

The Receivables Exchange does not obtain personal guarantees from its Sellers. So the Buyers’ avenues of recourse in the event payments are not properly received are more limited.

Why would personal guarantees not be obtained by TRE and what are the implications?

I think there are a few pretty obvious answers to the first question.

1) TRE aims to become a very large-volume marketplace. As a practical matter, scaling up gross transaction volume requires two components: a) more Sellers, and b) larger average transaction sizes.

2) Larger average transaction size implies larger Sellers and the larger and more substantial the Seller the less likely its principals will be willing to provide personal guarantees.

3) In order for a personal guarantee to affect a Buyer’s assessment of risk, the substance of the guarantee would have to be known to the Buyer. Few individuals, especially owners or principals of more substantial Sellers, would be willing to have their personal financial information made broadly available to Buyers with whom they have no direct relationship and over whose use of the information they would have little effective control.

As to the implications, again, I think there are a few.

1) Analysis of the Seller’s financial condition and capacity becomes more critical. If a payment is not received for a purchased receivable, does the Seller have the ability to make good the Buyer’s loss?

2) Analysis of the validity of the receivable proposed for sale, which is always critical of course, becomes even more so.

3) Analysis of the Account Debtor’s capacity to pay and likelihood of paying the invoice likewise becomes more critical.

4) In short, when one source of security is removed, all of those that remain become more important.

I think it’s quite understandable that TRE does not obtain personal guarantees from its Sellers. But that doesn’t mean that there is no impact on risk assessment. And if there is an impact on risk assessment there should be an impact on pricing.

It does mean that analysis of the Seller’s financial condition, the validity of the invoices posted for sale and the ability and likelihood of the Account Debtors to pay those invoices, all take on heightened importance.

If analysis of the Sellers' financial condition becomes more important, reliability of the financial information provided (or otherwise available to Buyers) is key.

In our next post we’ll discuss the issue of the level of assurance that can be attributed to information in various types of Seller financial statements.

Thursday, June 18, 2009

"Does this dress make me look fat?"

Wisdom from a good friend, older and wiser than I…

1. If you are asked: “Does this dress make me look fat?” and the questioner is your significant other, the appropriate answer is always “No!”. Honesty is neither virtuous (nor necessarily safe).

2. If that same person has a piece of parsley stuck in her teeth, on the other hand, you’ve just got to point it out.

I am a friend of The Receivables Exchange. I am a Buyer on TRE, so I am committed to it, and in my last several posts I’ve expressed very positive opinions on several major aspects of TRE structure, concept and operations.

But in my first post (scroll down or select the May 28 post from the sidebar) I did write:

“TRE is new and it is far from perfect. It will inevitably be required to make adjustments as experience teaches its operators and its users some valuable (and some potentially expensive) lessons. All beginnings are hard.”

So, in the next few posts I’m going to be discussing some aspects of TRE operations that I think are analogous to parsley in the teeth. You’re no less a friend for pointing it out; arguably you’re a better one; but it's less comfortable than delivering a compliment.

The issues to be discussed all bear on the assessment and pricing of risk.

More to follow.

Monday, June 15, 2009

"You've Got Bank!"

Have you heard the ads that some banks are running on the radio these days? How your banker really, really understands you and is on your side, working nights and week-ends to make sure you get great service?


If you have a small business, or even a pretty good-size business, going to your bank for financing is as pleasant as a root canal…and the odds of success these days are much lower.

The Receivables Exchange provides a truly unique alternative to traditional financing. It is not a borrowing. It is a sale of an asset. You are converting one asset…money due to you from a customer…to another asset…cash.

A Seller on TRE can choose which of its receivables it wants to sell, when it wants to sell them and how much it wants to pay for the ability to convert the bulk of that receivable into cash.

Of course, the Seller has to meet certain qualifications. The companies that actually owe the money have to agree to re-direct payment to the TRE lock-box. And there has to be a Buyer willing to bid on the receivable you want to sell.

But the qualification process appears to be reasonable and timely. I’ve already written about the benefits of the lock-box arrangement. And I understand that over 99% of the listed auctions are ultimately funded. That doesn’t mean the Seller got the terms requested; but the terms were apparently acceptable…because an agreement was ultimately reached.

The truly dazzling feature of the process is the speed. I have seen TRE transactions disappear from the auction list in, literally, a matter of seconds!

Imagine… as the owner or the CFO of a TRE Seller you determine you need some cash. You select a receivable due from a pre-qualified customer. You post the receivable for sale on TRE, specifying the pricing you’d like to obtain. Your desire gets communicated to all TRE Buyers, who are then able to bid on your receivable. When a Buyer makes a bid, you see it immediately and, at your option, you can accept it or wait for a better offer. When you do accept an offer the auction is closed and both parties are notified of the agreed-upon terms.

Now, I’m a Buyer, not a Seller, so I don’t actually know what message the Seller gets when an auction closes. But in effect the message is….

“You’ve got Bank!”

You’ve requested financing and gotten a commitment for essentially immediate funding, on terms that will not be changed by someone higher up the chain. And you’ve done it without ever having to talk to a banker.

How cool is that?

Thursday, June 11, 2009

TheTRE Value Proposition #3: The "True Sale" Issue

Trivia Question: What is the only State in the US whose civil law code is NOT based on English Common Law?

Answer: Louisiana.

One of the incorrect bits of trivia often attributed to Louisiana is that its civil law system is based on the Napoleonic Code. That, I’m told, is not actually true. It is true, though, (for you trivia lovers) that the first version of the Louisiana code was written in French.

I am not a lawyer but if you have spent any time in the financing business, especially working on problem situations, you do tend to become quite sensitive to legal “technicalities”.

Consider the following scenario: A business is owed money by a customer. It sells the right to receive that payment to a 3rd party. The seller unconditionally agrees to re-purchase the receivable from the buyer if the buyer is not paid by a stated date.

Question: Is this transaction truly a sale of the receivable or is it really a financing? Does the absolute commitment to repurchase give the transaction the character of a loan more than a purchase?

Answer: It depends on the law that governs the transaction.

Question: Where does the governing law hold that such a transaction is unquestionably a sale of the receivable and not a financing transaction?

Answer: Louisiana.

The Receivables Exchange is based in Louisiana and Buyers and Sellers of receivables traded on TRE agree to accept Louisiana law as the controlling law for disputes.

Louisiana has adopted the Uniform Commercial Code, which attempts to standardize business law across the country. But Louisiana modified a critical section of the UCC that deals with buying and selling of receivables. The modification is critical.

In Louisiana the scenario outlined above, of a sale with an unconditional re-purchase agreement, is by law a “True Sale”. That is: it will not be considered a financing regardless of the re-purchase commitment.

Why is that of critical importance? Because it takes disputes out of the realm of the laws related to loans or financings; including questions of usury, for example; and contains those disputes within the realm of laws relating to the purchase and sale of assets.

There is tremendous advantage to the clarity of position that this brings to those, especially the Buyers, who trade on TRE.

Knowing that a broad range of potentially difficult and costly legal disputes can be avoided because of the Louisiana “True Sale” language, removes an element of risk from the process of trading on TRE.

And reduction of risk has value!

Sunday, June 7, 2009

The TRE Value Proposition: #2 -- There’s Money in that Lock-Box

I admit it… I’ve had lock-box envy for years.

If you buy individual invoices, as I do, you know what I mean.

One of the difficulties of buying individual invoices is that it is typically done on a “full notification” basis. That means that every time I buy an invoice my client has to go to his customer and get the customer to acknowledge and agree in writing:

a) that the invoice has been sold to me,

b) that its check will be sent to me, and

c) that its check will be made payable to me.

(Full notification involves more than that but let’s deal with one issue at a time.)

Why is that a problem?

1) Some sellers just don’t want their customers to know they are selling their invoices,

2) Some of those customers just won’t agree to make their check payable to a third party,

3) Some customers don’t actually have the capacity in their accounts payable systems to generate payments to any entity except their actual vendor, and

4) Some customers who are willing to co-operate once or twice just don’t want to be bothered every week or even every month with the paperwork required.

Getting the notification and payment direction agreements signed is probably the biggest procedural hassle in my business. It causes quite a bit of business to be lost.

Why don’t all invoice buyers have that problem?

Some companies in the receivables-purchasing business are not single-invoice buyers. Instead they might buy or finance all of the receivables that a client generates. Or, they might buy or finance all of the receivables due to the client from certain specified customers.

In such a case only a single notification per customer, covering all current and future invoices, needs to be obtained from the customer.

That’s a huge advantage in reducing paperwork and potential customer objections!

A second distinction is even more significant…

If you, as the buyer, do enough business of this sort, you can negotiate a lock-box arrangement with a bank. In the typical case the bank will agree to accept all payments directed to the lock-box whether in the name of the account holder or not. So the customer doesn’t have to agree to make the remittance in the name of the buyer. They can cut their check or direct their wire or ACH payment in the name of their vendor!

 The customer doesn’t have to KNOW that the invoice is being sold, so

 The client doesn’t have to TELL its customer the invoice is being sold!

The only requirement is a change of remittance address...and the notice of that change only has to be acknowledged by the customer once.

The Receivables Exchange requires that those who sell invoices on the exchange direct all payments from Account Debtors to a lock-box at a major clearing bank.

TRE, as facilitator and clearinghouse for all transactions between its Buyers and Sellers, provides the missing link that has prevented buyers of single invoices from taking advantage of the substantial efficiencies of the lock-box system.

Consider this…a given seller might submit a regular weekly invoice to a customer. The TRE transaction platform and lock-box facility make it possible for a different buyer to purchase that seller's invoice literally every week, with no additional notification paperwork necessary.

TRE solves a procedural problem that, until now, has put the single-invoice buyer at a significant disadvantage in the receivables-finance market.

At the same time, it provides sellers substantially increased flexibility and control …they are not tied to a single buyer…they sell to the highest bidder every time they decide to sell…and they only need sell when they want to sell.

There IS money in the TRE lock-box…for both Buyers and Sellers!

Tuesday, June 2, 2009

The TRE Value Proposition -- #1 of an occasional series

My business is buying accounts receivable from small to medium-sized companies that need to accelerate their cash receipts. I’ve been doing that for nearly seven years. I began my investment career 35 years ago making commercial mortgages in the disastrous mid-70’s Florida real estate market. Experience has taught me that the most expensive activity in the financing business is dealing with the wrong people.

It took me quite a few years (and some significant losses) to learn that Warren Buffet is quite right when he says “you can’t make a good deal with a bad person”. But that’s actually a topic for another day.

Today I want to address the second-most expensive activity in the receivables-purchasing business. And that, for me, is unquestionably finding clients; sourcing the business. When I consider the opportunity cost of my time, nothing that I do in running my business has a cost even close to that of finding a client I want to work with.

So, when I think about the fundamental value proposition of TRE my first thought as a Buyer is of how much of the cost of finding clients TRE allows me to avoid.

That is not to say that I’d want to buy the receivables of just any company selling on TRE and it does not mean that the acceptance by TRE of a Seller carries with it any assurances; it does not.

However, as a Buyer on TRE I do know that:

a) a TRE Seller has already committed time, energy and money, demonstrating a serious desire and intent to sell,

b) the Seller has been willing to provide significant information about its business activity and finances to TRE,

c) the Seller has been willing to contact its customer(s) about changes in payment procedures,

d) certain threshold-level financial issues have been addressed, and

e) that the invoices posted for sale meet certain criteria made known to Buyers.

That’s not enough to support a “buy” decision but it is enough to take the Seller and its offer to sell seriously.

Getting to that point with a potential client in my conventional, non-TRE business would usually require a significant investment of time. The direct out-of-pocket cost might not be significant but the opportunity cost would be substantial.

As a Buyer on TRE, I get that far in the transaction-sourcing process for the relatively low cost of membership and with essentially no investment of my own time.

There is no marginal cost for the opportunity that is presented when an email arrives informing me of the posting of an auction on the exchange.

The idea that a potential transaction might just “appear” via email as I write this…and that I might be able to turn aside to consider the transaction and to potentially bid on it and buy it…and then turn back to finish the paragraph, can change a great deal about how I structure my business, allocate my time and approach my pricing strategy.

TRE does not give me everything that I believe is necessary to make a bidding decision. But it delivers the opportunity to me to analyze…it serves-up the decision for me to make. And it does that at a low cost and in an efficient manner.

That has value!