Thursday, June 23, 2011

Appropriate Compensation #6: The Notification Issue

No single issue has been discussed in as many of our posts as the issue of invoice notification versus verification.

See the following for prior comments:

 An Inconvenient Truth Part One: July 6, 2009
 An Inconvenient Truth Part Two: July 8, 2009
 Whose Ox is Gored? : October 19, 2009
 Half a Bubble Off Plumb: November 30, 2009

Why has this issue been given such attention?

Because, in my view, it represents the single largest potential threat to TRE Buyers. And, as such, the compensation it deserves is meaningful.

That compensation should be considered both at the level of the entire TRE platform as compared to systems that DO include full notification and among TRE auctions and Sellers, where differential risks can often be identified.

Let’s review the general issue.

In a “full notification” invoice purchase the Account Debtor will be asked to confirm that:

1) It has a contractual relationship with the Seller,

2) The invoice presented has been generated under the terms of that contract,

3) The work done by the Seller has been completed AND meets the terms of the contract,

4) The amount of the invoice is correct,

5) The payment terms are correct, and

6) Payment will be made as instructed in the notification document.

Problems might (and do) still arise, of course, even given all of the assurances listed above, but the general approach should go a long way to minimize surprises.

TRE does not use a “full notification” system. Instead, it uses an invoice “verification” system.

Under the TRE verification system the Account Debtor is asked to verify that an invoice matching the one posted by the Seller for sale DOES exist in its Accounts Payable system. That is: there is an invoice from the Seller in the Debtor’s AP system that has matching identification and amount details.

Essentially this tells us that the Debtor has SUBMITTED an invoice. It does not necessarily tell us that the invoice is valid, that the goods or services meet contract requirements or that the Debtor actually acknowledges the obligation.

TRE is understandably reluctant to make public in any detail the exact mechanics of the verification system it uses. Too much transparency would risk allowing Sellers to “game” the system.

However, it did notify Buyers in 2009 that it would not verify 100% of the invoices posted for sale on the TRE platform. Instead, after gaining a certain (unspecified) amount of experience with a Seller/Debtor pair, it would employ a statistical sampling process that it said would at least match the best practices of the factoring industry in terms of the percentage of invoices verified in given Seller/Debtor relationships.

There are Sellers whose auctions routinely consist of dozens of individual invoices and some of those Sellers post auctions of invoices due from the same Debtors quite frequently. It is understandable that asking the AP department of a Debtor to frequently verify dozens, or even hundreds of individual invoices might generate a little “push back” from the Debtor after a while.

While I have no knowledge of the actual sampling system employed by TRE, I’m willing to accept the idea that sampling can be an appropriate practice IF, of course, you’ve already accepted the verification versus notification alternative.

But that’s not really the issue here. The issue is: “what level of additional income should a TRE Buyer receive to compensate for the added risk inherent in accepting the verification versus notification alternative?”

There are two points that can be made immediately:

1. As we've said on other points of risk assessment, we just don’t have the data to measure this risk factor with any meaningful level of statistical reliability; any "answer" will be a judgment call; and

2. The answer is not “zero”. There IS an incremental risk to the TRE Buyers that should be compensated and that, over time, MUST be compensated if the exchange is to thrive.

So, how can we approach the problem?

Is the experience of TRE, itself, a useful guide?

In terms of quantifying the appropriate risk premium I don’t actually think the experience of TRE to date would be particularly meaningful even if complete data were available.

First, the level of transaction volume is still in its early growth phase and too small to provide a reasonable denominator against which to measure default/loss experience.

Second, the public default information involves ongoing litigation whose outcome continues to be uncertain. So the numerator is also problematic.

Third, while the details are not public, it is certain that TRE has made changes to its practices on the basis of what it’s learned in the early cases of default.

That being said, however, we CAN identify the kinds of things that cause a verification process to carry with it a higher level of risk than a notification process.

These tend to fall into two categories:

1. Falsification of, or fraudulent offering of, invoices: by completely fabricating the invoice or by materially misstating its amount or payment terms or by selling invoices that have already been sold to others or that are subject to the specific claims of others.

2. Diversion of payments either by actively causing payments to be made to an incorrect party or passively by accepting and retaining payments mistakenly received.

There are a lot of variations on these themes, of course, but most situations will fall into one of these two broad categories.

I think it is unquestionably easier to sell false or fraudulent invoices in a factoring system that is based on verification than it is in one based on full notification.

The case of diversion is not as straightforward. Diversion certainly occurs in both its active and passive forms in notification systems as well as in verification systems.

It can be argued that active diversion is easier in a verification system because the only point of contact between the factor and the debtor is at the level of an AP person who might have no knowledge of the substance of the relationship between the Seller and the Debtor.

I suspect that the chances of a payment being sent improperly to an invoice seller are probably just as high in either system. On balance, given the level of uncertainties in trying to analyze any of these issues, I’d probably call the diversion risk a “wash” for our purposes.

But the falsification or fraudulent offering issue (including the various forms involving collusion) is, I would argue, a significant differential risk factor. Buyers deserve to be compensated for assuming that risk.

What would represent adequate compensation?

In this case, as in the case of personal guarantees, we have no evidence to offer in support of a specific incremental return requirement.

In this case, as in that one, however, both the incremental risk and the appropriate return premium are “significant”.

There ARE auction situations on TRE in which this risk factor is significantly mitigated; such as in the case of Ariba Network invoices. There are also cases where the Seller documentation provided with an auctioned invoice gives the Buyer substantial comfort that the invoice is valid.

We'll discuss ways in which TRE and its Sellers might provide risk-mitigating information with auctions in a later post.

But, in general, our view is that an invoice verification process carries significantly higher risk to the Buyer than would a notification process and its pricing should reflect that reality.

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