Sunday, August 30, 2009

A Key to Success: The Price of Failure

Those who have been in the commercial finance business for any length of time will have acquired the valuable experience of dealing with transactions gone bad.

Until you’ve had to litigate a failure-to-pay situation and pursue real-life collection efforts through local courts and sheriff’s offices it’s hard to understand just what an enormous drain on resources those activities can become. The issue of who has what “rights” in a case under the law is often far less the critical point than the calculation of how much it might actually cost to pursue those “rights”.

For a prospective Buyer on The Receivables Exchange, especially a prospect with knowledge of commercial finance and collections, the lack of experience in dealing with failed TRE transactions raises difficult questions. It’s all well and good to understand the theory but, perversely, a couple of failed transactions might be really helpful to TRE’s efforts in attracting more Buyers.

As we discussed in our post of June 11, one of the strengths of the TRE platform is its foundation on the Louisiana version of the provisions of UCC Article 9, which makes it clear that a sale of a receivable on TRE is a “True Sale” i.e. it’s not a financing. Check out that post for more detail.

But TRE also adds an element; potentially an added layer; in the process of dealing with a failed transaction that prospective Buyers might find troubling in the absence of actual experience. On the one hand it’s a good thing that there haven’t yet been failed transactions; on the other, we can’t really be sure how things are going to work when there are.

We can talk theory all day long; but until we see how it actually works; what role TRE actually plays; what the costs really are; how the Louisiana courts really work; what it really takes to enforce a Louisiana judgment when the Buyer, the Seller and the Account Debtor might all be based in different states; and so forth, we’re just not going to know.

I work with an attorney who specializes in commercial collections cases. His clients include banks, factors, asset-based lenders and other entities that routinely become involved in failed transactions. He has a “walk away” number: a potential claim amount below which he advises his clients to just “walk away” from the judicial process. That doesn’t mean he won’t use other efforts to try to get some satisfaction but it does recognize that the cost of litigation is a barrier to judicial pursuit in many smaller claims.

We don’t yet know what the “walk away” number is in a TRE transaction; but we have to acknowledge that there IS one.

Some prospective Buyers aren’t going to be drawn to the exchange until they have a good idea of what that number is. And some who are already Buyers but who are not experienced in the nitty-gritty of collecting on failed transactions may be overlooking that cost in their calculations of expected returns.

One of the unfortunate elements of the need for this experience is that the process of litigating and collecting on a failed transaction can be quite a long one. So we’re probably not going to have solid data on the real cost of failure for quite some time.

The TRE lawyers would probably strongly advise against this, but I suspect it would be really helpful to prepare a series of pro-forma failure scenarios; essentially stress-tests that use a few likely failure situations. In each situation a prospective analysis of the steps required to pursue and enforce collections efforts, and the time required and likely costs of those efforts, might be prepared.

If these analyses appear realistic to experienced prospective Buyers and demonstrate a clear-eyed understanding of the realities of the process; no matter what the conclusions might actually be, I think the effort of attracting Buyers will benefit.

Those prospects who might be frightened away by the stress tests probably shouldn't be Buyers in the first place. Those Buyers who might be moved to modify bidding strategies as a result should be grateful for the opportunity to reduce the potential of unanticipated future costs.

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