Finance Industry Update January 2010
Reverse Factoring – the new debt?
Everyone is aware that credit is more difficult to obtain as, understandably, banks are diligently assessing the lending risk involved in connection with each borrower. Therefore, any products that potentially reduce the lending risk have to be welcomed.
The traditional method of providing funding to a Supply Chain involves the Supplier obtaining working capital, which is often secured over its assets and/or debtors. However, the reverse of this, where the credit is provided to the Supplier by a facility provided to the Buyer, is now becoming more popular as it provides a number of advantages to each party involved.
The traditional working capital finance relied upon the credit risk being with the entity that required the working capital, which in the supply chain, is the Supplier. This would include covering the cost of supplying the goods until the Buyer made payment to the Supplier. In recent times, this period has been extended from 30 days, to 60 days, and in some cases to 90 days, and even 120 days.
The extension of these payment terms has increased both the cost and risk to the Supplier. The risk to the Bank is the worth of the Supplier, and the likelihood of the Buyer making payment, which sometimes is difficult to assess. As a consequence, this type of finance is becoming more expensive and less available.
The alternative route is for the Buyer to effectively borrow the working capital, with the Bank (as opposed to the Buyer) then making the payment to the Supplier.
In brief, the Supplier supplies the goods and issues the invoice for payment; the Buyer receives the goods and approves the invoice; the Bank then immediately makes the payment of the invoice available to the Supplier; and the Buyer is obliged to pay the amount of the invoice to the Bank by the end of the agreed payment term (e.g. 90 days). If the Supplier requires immediate payment of its invoice, then the Bank will do so, less an early payment discount; if the Supplier is content to wait until the end of the payment period, then it will receive the payment in full.
Supplier advantages include:
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It does not have to borrow against its own resources to cover the delay in payment;
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It can obtain an accelerated payment if that assists its cashflow (albeit at a discount, but this will be less than the cost of borrowing); and
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It can place more comfort that it will be paid, as the Bank is liable as opposed to the Buyer.
Buyer advantages include:
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Its supplier lines become more stable (if a Supplier fails, this will disrupt the business of the Buyer); and
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It can extend its trade terms.
From the perspective of the Bank:
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It will make a return on the early payment discount that it agrees with the Supplier;
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The risk assessment is easier as it is against the Buyer, as opposed to the Supplier and all its debtors; and
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The whole supply chain will be more stable (it may bank some of the other entities involved).
Whilst this type of finance could potentially benefit a number of businesses, it will best apply to the situations where the Buyer is obtaining a significant volume of goods from regular Suppliers and where the goods are of a standard nature that can be quickly approved. It will be of less benefit to occasional Suppliers of low volume specialist goods which require to be checked in detail prior to the goods being approved.
Therefore, it is worth reviewing all customers to see if the finance ought to be provided to a different part of the supply chain, and thus provide stability and working capital to benefit all businesses.
The Year Ahead – the Pre-Budget Report
The Pre-Budget Report was delivered by the Chancellor in early December and it is worth noting some of the key announcements impacting on the finance industry, a number of which touch on issues we have addressed in earlier bulletins.
Credit Guarantee Scheme
Under the Credit Guarantee Scheme (CGS), the Government guarantees eligible new debt issued by qualifying institutions to support bank access to wholesale funding markets and, in turn, lending by banks to businesses and individuals. The CGS was due to close on 31 December 2009 but is now extended to 28 February 2010.
Enterprise Finance Guarantee Scheme
The Enterprise Finance Guarantee scheme (EFG), which is aimed at encouraging lenders to make loans to viable businesses who would otherwise have insufficient security to obtain funding, had been due to end in March 2010 but is now to be extended for another year to 31 March 2011.
For more information on the EFG, refer to the articles which featured in successive bulletins issued in April 2009 (Government Help – The Enterprise Finance Guarantee Scheme) and July 2009 (A Sense of Community – Enterprise Finance Guarantee Update).
Non-Bank Lending
Following announcement in the Pre-Budget Report, HM Treasury have now published a discussion paper on developing non-bank lending in the UK, recognising that UK companies have historically relied on banks for debt and, while non-bank lenders do play a role in the market, this is considerably less than in other jurisdictions, including the US.
The Government believes that developing non-bank lending would help to improve the future resilience of the economy in the face of financial turmoil, and the discussion paper looks in particular at the corporate debt market, with a view to increasing financing choices available to large and upper mid-sized UK companies.
Among some of the potential barriers facing both non-bank investors and companies seeking non-bank financing, the discussion paper considers and seeks views on the extent to which companies should disclose information to non-bank investors; whether there is sufficient transparency in the pricing of loans to enable companies to compare the price of bank and non-bank loans; the factors influencing non-bank investor appetite for corporate debt; and the development of the non-bank loan market through increased participation of non-bank lenders.
Mortgage-Backed Securities
Although there has been some activity of late, and indeed this firm has been involved in recent securitisation deals, the mortgage-backed securities markets suffered heavily in the financial crisis. The Government believes it is important that lenders continue to have access to a variety of funding sources including the securitisation markets and so it has announced that it will explore ways of encouraging a sustainable, transparent and standardised market.
Islamic Finance
As part of the ongoing development of the UK as a centre for Islamic finance, the Government announced that it intends to introduce relief from tax on capital gains for alternative property refinance transactions and it will also publish guidance on the VAT treatment of alternative finance investment bonds.
For more information on Islamic finance, refer to our article (Islamic Finance – Moving to the Mainstream), which featured in our January 2009 bulletin.
Tax Avoidance – Finance Leasing
With immediate effect, action is being taken to counter two types of tax avoidance schemes involving the leasing of plant and machinery.
Legislation will be introduced in the Finance Bill 2010 to ensure that (i) lessor companies are unable to generate tax losses using arrangements intended to result in tax relief in excess of the value of the taxable income, and (ii) companies and other businesses are prevented from turning a tax-timing advantage into a permanent advantage by ceasing to be within the charge to tax following the sale of the right to income from a lease of plant or machinery.
Local Authority Borrowing
The Government is interested in exploring finance mechanisms which could be used by local authorities to encourage economic growth. In light of this, the Government announced that it will examine the scope for local authorities to borrow against (i) a Community Infrastructure Levy (due to be levied in April 2010), (ii) Renewable Heat Incentive and Feed-in Tariff revenue streams and (iii) revenues from new council homes.
Increased Funding and Investment Support for Low-Carbon Infrastructure
The global financial crisis has had a significant impact on the availability of finance for energy investments. The Government has therefore announced a number of measures designed to increase funding and encourage investment support for low-carbon infrastructure and the energy sector.
The measures include (i) establishing Infrastructure UK, an advisory body to help attract private sector funding and investment in low-carbon energy projects and (ii) contributing £90 million to the 2020 European Fund for Energy, Climate Change and Infrastructure which will be overseen by Infrastructure UK. The 2020 Fund is intended to operate as a model for private sector equity investment in low-carbon energy infrastructure projects, and is designed to be the fastest route for the energy sector to obtain equity investment.
Tax Increment Financing – stimulating development
One long term consequence of the property market downturn – which will be felt far beyond any short or medium term recovery – is likely to be the negative impact on the funding of major public and private infrastructure projects in the UK.
Not only will the tightening of local and central government budgets have an impact on projects which would traditionally have been publicly funded, the downturn has also affected the extent to which the private sector can fund such expenditure (often in advance of development returns), through either committed expenditure or (more usually) agreeing planning gain with local authorities.
These “Section 106” planning obligations (known as “Section 75” obligations in Scotland) often involved major capital expenditure for developers in on site and off site infrastructure improvements. Examples include new road systems, public transport contributions, extended and upgraded sewerage systems, upgrades to existing water supplies, and extension and reinforcement of other “public” utilities such as gas and electricity.
Although the cost of these planning gain obligations has tended to run into many, many millions of pounds on major projects; developers could pay – the growth in capital values allowed them to maintain profit levels whilst paying for what are effectively public works.
But the credit crunch and recession have changed all that. If major regeneration projects and developments across the country are not to be stalled or mothballed altogether, then alternatives need to be considered to the relatively recent focus on private money funding public infrastructure works.
One possible alternative is Tax Increment Financing, or TIF.
TIF is a public financing method which has been used for development and community improvement projects in many countries, including the United States, where TIF has become a common financing mechanism for local government.
Essentially, the TIF model uses potential increases in taxes in an area, through for example, business rates, property taxes (such as Stamp Duty Land Tax) and residential rates (such as Council Tax) to be channelled into the repayment of bonds issued to fund the initial capital expenditure. The bond repayment period is tied to the likely tax increment that the development will generate.
Although the subject of discussion in many property forums since the start of the downturn, there may be signs that this approach is finding favour in the UK, with The City of Edinburgh Council confirming (Homes for Scotland Associates Lunch 1 October 2009) that they are considering TIF as a means of bringing forward further development at the City’s waterfront. This would be a bold move by the City and would put them at the forefront in bringing this model to fruition in the UK.
It remains to be see whether the model will see wider adoption. TIF is often criticised for swallowing tax increases that would otherwise have gone towards the costs of additional or improved public services – which in turn then have to be funded from other sources.
For that reason alone, it’s less suited to funding for wholly residential development, because in the main any tax increases from such a development come from increased Council Tax revenue which bears a direct correlation to increased costs for supplying local authority services to the occupiers of such a development.
However, where a development contains a significant commercial element which will deliver a far more lucrative business rates increase to the local authority, TIF may very well be the answer to many developers’ and urban regeneration companies’ prayers.
Schemes of Arrangement – thinking outside the box
With borrowers continuing to hit financial trouble, a range of restructuring options are on the table and of course those will be of interest to lenders who are looking to protection and recovery of their debt.
Following our article in the last bulletin (Junior Lenders – Washed Out?), one of the options which may be available to them in this context is a scheme of arrangement, brought into topical focus in the recent case of Lehman Brothers International (Europe).
In a restructuring context, companies would use a scheme of arrangement, as governed by the Companies Act 2006, to compromise the claims of creditors (typically secured creditors), in order to improve the company’s financial position. Schemes of arrangement are a valuable tool in complex restructurings as they allow the company proposing the scheme great flexibility in defining the class subject to the scheme and the terms on which the company compromises the claims of those creditors. The stigma associated with insolvency can also be avoided with a scheme of arrangement.
It is important to highlight that provided the requisite majority of creditors approve the scheme, and it receives approval from the court, a scheme of arrangement binds all creditors of the company whether or not they voted for it.
In the Lehman Brothers case, a question arose over the definition of “creditor” for the purposes of a scheme of arrangement. Here, certain assets were held on trust for third parties (“trust clients”). Lehman then of course became insolvent and entered into administration. As it did not hold enough assets to satisfy the claims of all the trust clients, and it was not clear which assets were held on trust for which beneficiaries, the administrators recognised the need to find an efficient way of returning those assets.
The administrators proposed a scheme of arrangement to compromise the claims of the trust clients and apportion the shortfall in the assets between them. Under the proposals, a person would only be a scheme creditor if that person had both (a) a monetary claim against Lehman and (b) a proprietary claim to a security, which had been held on a segregated basis at the time of administration.
At first instance, the High Court held that, as the trust clients had proprietary claims to the trust funds, and the effect of the scheme was to compromise those proprietary rights, it was not a compromise between Lehman and its creditors. Consequently, the proposed scheme was not a scheme of arrangement within the meaning of the 2006 Act and the Court could not sanction it.
The administrators appealed, arguing that provided the proposed scheme was between Lehman and parties who had some form of claim as a creditor, the court could sanction it even though the proposed scheme compromised all the claims of the trust clients, including both the claims of the trust clients as creditors of Lehman and their proprietary claims to the trust funds.
The Court of Appeal affirmed the decision of the High Court. It concluded that its jurisdiction is restricted by the requirement that a scheme must be an arrangement between the company and its creditors, a ‘creditor’ consisting of anyone who has a monetary claim against the company that, when payable, will constitute a debt.
This means an arrangement that deals with their rights between or amongst debtor and creditor, and excludes the rights of creditors to their own property which is held by the company for their benefit. The court therefore did not have jurisdiction to sanction a scheme that compromised the rights of the trust clients over their own property held by Lehman Brothers.
The Act therefore envisaged an arrangement between a company and its creditors in relation to debts due from the company to those creditors. It does not allow a company to compromise claims of parties who had a proprietary interest in the assets of the company, even if those parties were also creditors of the company. The purpose of a scheme of arrangement is therefore to allow a company to propose a means by which it would use its own assets to settle the claims of its creditors.
Furthermore, it is worth noting that the decision expressly acknowledged that a scheme of arrangement can compromise a creditor’s rights and thereby release a third party from an obligation to the creditor. A scheme of arrangement can legitimately have the effect of compromising monetary claims that a creditor has against a third party, whether as a direct term of the arrangement or as a necessary consequence of the arrangement coming into effect.
It was thought that the administrators would appeal the decision to the House of Lords, although it seems that they have instead found a contractual solution. The administrators effectively entered into a contractual scheme of arrangement, calling it a Claim Resolution Agreement. This was approved by over 90% of creditors on 29 December 2009. The CRA is a contract on an individual basis between Lehman and its clients setting out the basis on which assets can be returned, and so there is no need for Court involvement.
While the scheme of arrangement was ultimately unsuccessful due to the unique situation in Lehman, there is no doubt that the work in setting up the defunct scheme of arrangement allowed the CRA to be approved. It might be that we see more CRA-type agreements now in place of schemes of arrangement.
For further details on the Companies Act, please click here.
Buying Out – Cross Option Agreements
A common problem for private limited companies is how to fund the buy-out of a departing shareholder. Previously it would have been seen as a mere formality to obtain bank funding for the remaining shareholders to buy the shares of the departing shareholder but in the brave new world in which we live, this is no longer guaranteed. Therefore, shareholders in management-owned businesses should seriously consider planning for such an event.
If a shareholder simply decides it’s time to leave the business, then the other shareholders will have to find the cash to buy his shares or the company can buy-back the shares (subject to the stringent provisions of the Companies Act 2006). The provisions in the company’s articles of association (and any shareholders’ agreement) will govern any transfer of the shares and these are likely to provide that the shares must be offered to the existing shareholders before they can be sold to a third party (including the deceased’s family).
Where the exit occurs due to the unfortunate death of a shareholder, the existing shareholders will want to buy out the shares from the deceased’s family as the family members are unlikely to have the same knowledge, skills and ability as the deceased. The family may also wish to exit and cash in on the value of the shares rather than have their money tied up in a company whose business they may not understand.
Unfortunately, issues over the funding and value can mean that both parties may have to wait years for these issues to be resolved. There is a classic conflict between the family wishing to maximise the value of the shares but finding no willing purchaser other than the existing shareholders; and the remaining shareholders suddenly faced with having to fund the purchase. Even the friendliest small company or family business can find great tension and problems arising over the value, which is a situation all parties wish to avoid on the death of a shareholder.
One solution to these issues may lie in a Cross Option Agreement backed up with appropriate life assurance.
The Cross Option Agreement will state that the shares must be offered to the existing shareholders for a fixed price. This price should be reviewed on a regular basis to reflect the performance of the Company, usually when the life policy is to be renewed. The Cross Option Agreement allows the deceased’s estate to force the other shareholders to buy the shares and conversely allows the other shareholders to demand that the deceased’s estate sells the shares to them.
Funding issues can be resolved by life assurance policies being effected for each shareholder. The Cross Option Agreement provides that upon the death of a shareholder, the sums received from the policy must be used to fund the purchase of the shares from the deceased’s estate.
Provided that the value of the company is reviewed regularly then the assurance policy can be for the value of each shareholder’s stake so that upon death the family has peace of mind knowing that it shall receive the agreed sum and the other shareholders know that they will retain full ownership of the Company without any direct cost to them. This means the whole process can be carried out quickly and with little scope for dispute.
The matters covered in this ebulletin are intended as a general overview and discussion of the subjects dealt with. They are not intended, and should not be used, as a substitute for taking legal advice in any specific situation. Semple Fraser LLP will accept no responsibility for any actions taken or not taken on the basis of this publication.
for further information please contact: douglas gourlay