The Freedom of the Uncommitted

Early in my career I was in the commercial mortgage business. A colleague used to warn me that as long as the money had not been disbursed the lender had the power. But as soon as the check had cleared, the balance of power shifted toward the borrower: the larger the loan, the greater the shift in power.

When things start to get tough, the analysis of who has more to lose in an investment relationship begins to change.

The underlying cause for the shift in power in that business was two-fold:

1) the size of the investment relative to the assets of the borrower, and
2) the duration of the commitment.

In the case of a mortgage the lender will typically have a much more substantial investment than the borrower. A long-term commitment is formed in which the lender has a significant stake in the health of both its collateral and its borrower. And when times get tough the lender often will find itself essentially forced to help keep the borrower and the property afloat in order to protect its investment.

Behavior also changes as the duration of the commitment increases. In a traditional factoring arrangement, for instance, there might be an agreement to do a minimum volume of business for perhaps a year. Commitments are made whose duration extends beyond the immediately predictable horizon. Relationships are inevitably formed.

Even in the business of single-invoice purchasing, commitments can become implicit even if not explicit.

I had one client, for example, with whom I did 180 consecutive weekly transactions. I had no legal obligation to fund the 100th transaction any more than I did the third transaction, for instance; but by that time there was a relationship; both business and personal; and I felt a moral and personal commitment even in the absence of a legal one.

So, what’s the point? How does this relate to The Receivables Exchange?

Pardon the analogy, but the TRE formula is modeled on the commitment level of the “one-night stand”.

No relationships are formed; no commitments are made; the duration is limited; the shift in power is relatively predictable; and, the risk calculation has fewer variables.

Applying that analogy to an investment program….

As a TRE Buyer; at any moment of any day I can choose to just say no. I can stop buying altogether or I can stop buying the invoices of a particular Seller.

On the other hand, if I want to exit a stock portfolio or a real estate portfolio I have to take action: I have to sell.

If I want to exit a bond portfolio I have to either sell or wait for a potentially substantial length of time for a portfolio to self-liquidate.

If I want to exit a portfolio of options or futures I have to either sell or hold to expiration with significant uncertainty of exit price.

As a Buyer on The Receivables Exchange I can just stop buying and my portfolio will self-liquidate at a substantially-predictable price over a substantially-predictable period.

I can stop Buying without needing to negotiate a termination agreement.

I can stop buying the invoices of a particular Seller without having to sit across the table from someone with whom I have a relationship and having a “break-up” conversation.

TRE provides a platform in which there is no commitment, no relationship, no unspoken promises; in betting parlance: “no tears”.

That works for me!

An Inconvenient Essential--Part Two

In our last post we identified the invoice verification process as a potential source of “friction” in TRE operations; potentially a threat to both its speed of growth and even to its scale.

We discussed the steps taken by TRE to mitigate the friction and concluded that there appears to be a reasonable balance between: a) the risks posed by forgoing certain typical verification requirements, and b) the risk-mitigation elements in the TRE process.

But the issue cannot be left there. The fact that there are procedural protections that mitigate the apparent risk does not address the question raised by the fact that TRE, itself, verifies the receivables proposed for sale.

Given TRE’s rapid growth goal and the potential for the verification process to impede that growth, there is a potential conflict of interest that has to be acknowledged.

According to the materials available on the TRE website, it was initially expected that the verification process would be outsourced. The idea that a reputable third-party would be handling the verification process was expected, I assume, to give Buyers comfort that there was no potential conflict.

In fact, however, the process in place does not include an independent verification agent.

I do not know what caused the change in direction so my comments here have to be understood as no more than my own speculation.

If I were going to identify a list of candidates for the job of verification agent I would probably start with the big accounting firms: well-known, respected and knowledgeable; the names you find on public companies’ audit reports. They also employ hordes of relatively inexpensive, entry-level professionals.

The second group that I’d reach out to would be the credit rating firms with high name recognition i.e. D&B, Experian, Equifax, etc. These firms also employ large numbers of relatively inexpensive information gatherers.

From the perspective of an accounts payable person in a Debtor’s office it would probably not seem unusual to get a request to verify information from either a well known accounting firm or from a credit reporting agency.

From there, though, I begin to scratch my head. I’m not sure what other type of firm would have the capacity, the name-recognition, the staff resources and a willingness to consider the job, at a pricing level that would make sense.

If a well-established accounting firm or credit reporting agency were to consider the assignment, what would be the likely outcome? My guess is that they would quickly get tied-up in problems of definition, procedure, authority, work product and potential liability.

What level of authority must the individual providing verification possess? How is that authority ascertained? What reason can the verification agent give for wanting the information? After all, the Debtor isn’t told the invoice has been sold. What is the minimum evidence of acceptable confirmation? What specific assertions are required? How does the verification agent assure TRE that it has actually obtained the information if it is obtained only orally? Would it be feasible to obtain any written verification and, if so, at what cost in terms of transaction speed? What level of liability, if any, would the verification agent assume for the accuracy of its information? If no liability is assumed, what is the quality-control leverage?

You get the point!

The IDEA of an independent verification agent is unquestionably an appropriate one. The difficulties in implementing the idea are just as obvious.

The question now becomes: given that there IS an apparent potential for conflict, how real is the likely risk to a buyer?

In order for TRE to grow as it wants to grow, it needs more than anything else to establish credibility early. Better to lose potential business through excessive caution than to subject Buyers to losses through lax underwriting.

There is also meaningful value to TRE, I suspect, in doing the job itself (at least for a time), since the experience it gains will help it better fashion an effective relationship with a third-party should it attempt that in the future.

My own view is that, while the potential for conflict is obvious, the current risk is minimal. The stakes for TRE are too high at this point to jeopardize its long term goal by taking shortcuts this early in its development.

However, as the exchange ages a bit and the time approaches to actually meet the growth goals on which its establishment and financing were based, the level of risk could well rise.

As one who wishes success to the TRE enterprise, I hope that its management plans to ultimately establish the independent verification process that was apparently contemplated in its initial conception of the exchange.

An Inconvenient Essential--Part One

Among the essential numerical values that we learn in high school physics is the number that defines the speed of light. If we go on to other, non-scientific pursuits in our lives, it is likely that we’ll forget an important qualification in that definition. The number we learned represents the speed of light in a vacuum. In the presence of any source of friction, that speed cannot be reached.

In our last post we noted the desire of The Receivables Exchange to become a very large-volume platform. Growing from an initial transaction in late 2008 to a targeted $1 billion in volume in 2010 might not challenge the speed of light in literal terms but it comes close in financial terms. An essential element in its success must be the elimination of as much friction as possible.

We’ve already identified a few of the sources of friction usually encountered in purchasing individual invoices and the ways that TRE has devised to lessen their impact.

Now we need to address another major one: the issue of invoice verification. The buyer of a receivable needs to verify that the receivable is valid.

Most buyers of individual invoices will want assurances that: the Account Debtor acknowledges that it contracted to purchase the goods or services; that the goods or services have actually been provided; that they meet the criteria established in the contract; that the invoice being purchased states the correct amount due and the correct terms of payment; and, that the invoice is scheduled to be paid.

That’s a lot of friction! It’s often difficult or impossible to find anyone in a Debtor’s organization willing to sign-off on such assurances.

After the initial qualification of a client, the invoice verification process represents the major impediment to the speed of invoice purchase transactions. Given the need for TRE to minimize such impediments, it’s clear that this issue has had to be a focus of their operational design.

TRE has to have a process that provides appropriate comfort on the verification issue without causing so much friction in the system that it is impossible to meet their speed-of-growth and scale objectives.

The procedural solution is a compromise. Many of the typical elements of “full verification” are sacrificed, but the loss of those assurances is balanced by other elements of the TRE system.

What are the assurances that are sacrificed?

1) Neither TRE nor the Buyer has a direct relationship with the Account Debtor; so the Debtor does not provide either TRE or the Buyer with a direct assurance of the existence of a contract or purchase order.

2) The Debtor does not provide a direct assurance of the receipt of the goods or services.

3) The Debtor does not provide a direct assurance that the goods or services meet the requirements of the contract.

4) The Debtor does not provide a direct assurance that payment will be made.

In what ways is the sacrifice of those assurances balanced?

1) Prior to approving the invoices of a Debtor for posting on the exchange, TRE will investigate the history of transactions between the Seller and the Debtor to determine that a relationship does exist.

2) The history of the relationship between the Seller and Debtor will be examined to provide context for the analysis of invoices proposed for future sale.

3) The agreement of the Debtor to make all future payments to the TRE lock-box provides additional evidence of the validity of the relationship.

4) TRE will independently acquire contact information allowing it to access appropriate individuals within the Debtor organization who can verify that an invoice is “in the system for payment”.

5) TRE employs experienced fraud investigators to help it to detect any potentially fraudulent relationships or transactions.

The only piece of directly-sourced information regarding a specific invoice is that it is “in the Debtor’s accounts payable system”. That might seem to provide much less security than typically required by single-invoice buyers.

However, by the time a TRE Buyer sees that invoice posted for sale, the invoice will have been analyzed within the context of a great deal of previously-verified information about the relationship and the historical transactions between the Seller and the Debtor.

It’s certainly possible that, from time to time, specific invoices will prove problematic; and it is possible that the TRE verification process will have failed to uncover those problems in advance.

On the other hand, if such a problem occurs:

a) Within a verified pattern of transactions between the Seller and the Debtor,
b) In the presence of a continuing payment-direction agreement,
c) In the context of a security system that provides meaningful recourse, and
d) In an environment of a robust fraud-detection effort,

it is likely that a solution to an isolated problem can be found.

There is no guarantee that no losses will occur, but losses can occur when buyers obtain ALL of the typical assurances. Stuff happens!

There is a good argument to be made, I think, that the sacrifices made in the TRE verification system, for the sake of reducing friction and accommodating scale, are reasonable and that the apparent additional risks are balanced within the operational system of the exchange.

An important question remains, however, that will be addressed in our next post.

TRE itself, with its very aggressive growth goals, acts as its own verification agent. The question of potential conflict between growth goals and transaction quality goals has to be addressed.