Tuesday, July 19, 2011

Appropriate Compensation #8: Once Removed

If I were forced to take a test that measured knowledge of genealogical matters I would fail abysmally!

I could get as far as defining a first cousin but I have no sense at all of what a second cousin might be and if that second cousin were twice removed I would have to assume it was for some sort of repetitive misbehavior.

In the case of my relationship with a TRE Seller, however, the idea of being “removed” is easily understood. In fact, it’s contractual.

I am prevented by agreement from having direct contact with a TRE Seller except under very narrowly-defined circumstances.

TRE provides Buyers a defined set of minimum due-diligence materials describing the Seller. That set of materials can be supplemented at the option of the Seller (and perhaps at the suggestion of TRE) to clarify or expand upon issues that the standard documents suggest need elaboration.

Public records and credit evaluation services can be utilized to augment the data available to assess the Seller’s business and financial condition, of course, and there are services that can be used to periodically scan media and public records to pick up items relating to specified companies.

So, what’s missing and how does the missing element contribute to the incremental risk of trading on TRE?

The short answer is that the TRE Sellers are “removed” from the Buyers. The Buyers’ relationship to the Sellers is intermediated via TRE.

It is a TRE person who sits across the table from a prospective Seller and talks about the Seller’s business. It is a TRE person who visits the Seller’s place of business and gets a sense of condition and activity. It is a TRE person who examines the prospective Seller’s financial records. It is a TRE person who gets a “feel” for the type of people who own and run the prospective Seller. It is a TRE person who determines that the prospective Seller appears to be credible and trustworthy.

TRE, of course, assumes no liability for its investigations or judgments but if it proves to be off-the-mark too frequently its business and reputation will certainly be damaged.

Once a Seller is approved and posting auctions for sale on the TRE platform, a Buyer may ask questions about the details of due diligence materials and about specific auctions. Those questions are asked of TRE, of course, and it is TRE that calls the Seller and relays back whatever information, if any, the Seller might provide.

I don’t agree with those who argue that the lack of liability will make TRE careless of its responsibilities to carry out its tasks prudently. But it does have to be acknowledged that, especially in the early growth phase of the business, TRE has a substantial incentive to approve Sellers. Sellers are harder to come by than Buyers (at least for the time being) and good Sellers are likely to be given the benefit of the doubt wherever reasonably possible.

But the fact is that the Buyers are limited in their decision making process to analysis of the available information, none of which will typically give them a sense of the PEOPLE on the other side of a transaction. The Buyers have no opportunity to form an opinion of the HONESTY of the Seller.

Why is that important?

As we’ve discussed, most financial statements provided by Sellers are internally generated. Anyone who has worked with Quickbooks or similar bookkeeping software packages will know just how easy it is to create a “second draft” of the statements. And, by the time the statements are posted, they are dated in any event.

As we’ve discussed, the invoice verification process used by TRE is not designed in a way that is likely to catch invoices that are actually fraudulent until damage has already been done.

And, as we’ve discussed, the owners and principals of the Sellers have no personal liability to TRE or its Buyers in the event of default.

Those issues and others make the assessment of a Seller’s character and honesty a critical part of the decision to buy. But the Buyer can’t make that assessment. The Buyer has to depend on TRE to be clear-eyed and unmoved by the incentive to attract Sellers.

A recent factoring industry survey quoted a contributor as saying “every factor experiences fraud every year”. The need for due diligence that extends beyond the four corners of a page of financial data is obvious.

The TRE Buyer is once-removed from one of the most important assessments in the decision to do business with a Seller.

I know that TRE takes the job of assessing Seller honesty seriously, even if it is not actually liable for the judgments made. I know that there have been situations in which prospective Sellers have been denied TRE membership because of uncertainty about character and veracity. And I know that TRE has to take the long view in balancing the desire for growth in the Seller base against the risk to which Buyers are subjected.

But I also know that face-to-face assessments of the counter-party in a transaction can have a big impact on decisions.

I know that having the ability to pick up the phone and ask a Seller direct questions about auctions, Debtors, invoices, changes in financial condition, and so forth, in real time, would have significant value. But the TRE Buyer can’t do that.

Being once-removed; being isolated from the Seller; unquestionably adds risk to the TRE Buyer's activity.

It is another risk element that deserves to be compensated.

Thursday, July 14, 2011

Appropriate Compensation #7: The Lien Position

In this series of posts we've identified a number of ways in which the TRE Buyer is assuming incremental risk when compared to typical factoring transactions. The goal is to ultimately draw a conclusion regarding the appropriate level of incremental return necessary to compensate for that additional risk.

Today I want to return to the issue of the lien position that the TRE Buyer acquires in the assets of the TRE Seller. We’ve addressed this issue before.

Please see:

• Caveat Emptor #2: December 15,2009, and
• Blanket Security vs. a Security Blanket: June 29, 2009

There are two principal conditions in the Buyer’s lien position that give rise to risk in TRE transactions that would not normally be accepted in typical factoring transactions:

1) The TRE Buyer obtains a lien ONLY on the invoices purchased from the TRE Seller, and

2) It is often the case that other parties already hold prior liens on the receivables of a TRE Seller, so the TRE Buyer might hold a second or even more-junior lien position on the receivables it purchases.

The fact that the Buyer’s lien attaches only to the receivables purchased is made more problematic by the lack of a full notification process that we’ve recently discussed. If the invoice purchased is defective and the Buyer’s lien attaches only to that invoice, the value of the lien is questionable.

And the fact that other parties might have superior lien positions with respect to the assets of the TRE Seller, puts the TRE Buyer at risk that the rights and actions of others, which neither TRE nor the Buyer can control, can substantially reduce the value of the Buyer’s lien.

Compounding that problem is the fact that I know of no truly reliable warning system to alert the TRE Buyer to the existence of action or threatened action by a 3rd party in time for protective measures to be taken by either TRE or the Buyer.

In typical factoring relationships there is an opportunity for ongoing dialog and business-condition assessment. That is not the case in the TRE environment.

In the TRE environment the Buyer is almost always going to be behind the curve, learning of problems after the fact. Even if a Buyer is an astute analyst of financial data, able to tease out indicators of developing problems, the information available on the TRE platform is always dated. And, as we’ve discussed, the quality of the information contained in internally-generated financial statements – always less-assured than audited data – is far more likely to be inaccurate in conditions where Sellers are in trouble or heading in that direction.

Becoming aware of a threat to one’s position via notice of a superior lien-holder’s action is unpleasant.

On the subject of the breadth of the Buyer’s lien position I’d like to add a point to the prior conversation that I haven’t brought up before. The UCC filings in typical factoring relationships very often extend beyond creating a security interest in all accounts receivable. Often they are either “all-asset” liens; or extend to all of the personal property of the Seller in addition to its accounts; or specifically include other named property.

More and more often, especially in the cases of companies that are in the various “tech” sectors, the critical assets of the TRE Sellers are intangible. A Seller that is a software development firm, for instance, might have a copyright, trademark, patent or other intangible as its primary revenue-producing asset. Without some means to control or, at least, threaten that asset, the leverage of a creditor is substantially diminished.

This limited security position in the assets of the Seller is obviously quite attractive to the Seller. It is used to attract Sellers to the TRE platform in the same way the lack of a personal guarantee requirement is used. It has a flavor of the “you can’t get this anywhere else” to it.

Of course, there’s a reason it’s not generally available and that reason is that it increases the risk to the provider of funds.

It increases risk not only because the security might be defective or a because a superior lien position might be asserted but also because any action to cure a default that depends on attaching assets that have limited lives (i.e. the receivables portfolio of a Seller might be liquidated and its proceeds “evaporated” before any substantive court action can be commenced) carries the incremental risk of dependence on a wasting asset.

There is no question that the TRE Buyer should demand incremental compensation for the incremental risk assumed because of the limited security provided by its lien position.

[Note: To be fair, there is a potentially mitigating factor in the form of the right of TRE and its Buyers to attach Seller cash balances in the TRE lock-box. Mitigating factors will be discussed as a part of the wrap-up of this series of posts.]