Beyond COVID-19: Crisis response or road to recovery?
Crisis response or road to recovery?
Whilst no two financial restructurings are the same, a common key driver in any distressed scenario is the ongoing liquidity of the company. How a company manages liquidity is important for its stakeholders and is fundamental to understanding any potential restructuring options.
Some companies use supply chain finance arrangements as part of their cash flow management processes. Those arrangements are structured and operate in a very different way to traditional debt and bond financings.
It is important to understand the key characteristics of any existing supply chain finance arrangements and to ensure they are properly considered in any wider restructuring as well as to consider whether implementing a supply chain financing programme may form part of any turnaround strategy.
“Supply chain finance” is used in different contexts and has different meanings in different financing markets. For the purposes of this article, when we refer to “supply chain finance” we also refer to “reverse factoring.”
A basic supply chain finance may be structured on the following general lines (although there are numerous variations):
From the company’s perspective they receive the goods or services and are able to manage payments on the basis of the extended timeline. This can aid a company’s liquidity management, allowing it to better manage specific payments.
From a financier’s perspective they are able to benefit from a margin (i.e. the discount) based on the price they paid for invoice from the supplier versus the monies they receive from the company in settlement of the invoice.
From the supplier’s perspective they receive payment (at a discount to reflect the time value of the early payment) from a creditworthy source, and earlier than they would have done compared to dealing solely with the company – this may be beneficial for its own cash flow purposes.
Supply chain finance programmes are typically tailored and will be structured in different ways depending on the nature of the underlying transaction or the requirements of the relevant counterparties.
Key characteristics may include:
A number of supply chain finance structures are purposefully designed to constitute “off balance sheet” transactions from a “borrowings” perspective. They typically constitute
a sale of the relevant receivable rather than the incurrence of financial indebtedness. From the company’s perspective there is no balance sheet effect in most cases since all that happens is the payee has changed
(although this may not be the case where the company additionally undertakes direct obligations in favour of the financier).
It is beyond the scope of this article to consider the nuances of off balance sheet treatment, but it is important to appreciate this as part of any due diligence exercise of a distressed company’s balance sheet.
Such structures are usually not subject to security arrangements (although market practice differs across jurisdictions). The transactions are typically characterised as the purchase and sale of receivables. In the event of non-payment, the financier will have a claim against the company under the terms of the invoice it has purchased from the supplier.
In addition, the company may be prohibited from providing security in support of supply chain financing arrangements under the terms of a negative pledge contained in any other finance facilities.
Such arrangements are typically nonrecourse in respect of the supplier – meaning in the event the company is unable to settle the invoice the financier has no recourse against the supplier, only the company.
Some structures are supported by a corporate guarantee. In the event of non-payment by the company, the financier is able to demand payment from the third party (typically the parent or an affiliate of the company) who has guaranteed the company’s liabilities.
As with every guarantee, its strength is predicated on the underlying financial strength of the third party. Consideration as to: (i) the financial strength of a guarantor; and (ii) the potential scope and number of competing claims on an insolvency of the guarantor should be part of any credit analysis.
It is necessary to understand the relevant governing law of the invoice (this will usually match the underlying sale contract). Further consideration as to any relevant terms and conditions to which the invoice may be subject should also be a consideration from the financier’s perspective (which could include for example, prohibitions on assignment, rights to set-off payments, etc.). Both points are particularly pertinent in any scenario where a financier is purchasing a large number of invoices.
In the United Kingdom, supply chain finance has received increased press coverage in the last 18 months – predominantly due to the collapse of Carillion (being the largest construction corporate insolvency in British history). It has been reported that at the point of Carillion’s liquidation, the company had access to £500m of supply chain finance from suppliers and had drawings of around £350m under those finance programmes.
After Carillion entered liquidation, a UK parliamentary report examined the collapse of the company. The report is wide-reaching in its content and it commented upon Carillion’s supply chain financing arrangements, specifically focusing on two elements:
It remains challenging for a company with a large supply chain and which contracts with a large number of trade creditors, to effectively manage its liquidity and cash flow projections.
Senior lenders need to strike a balance between understanding the full picture of a borrower’s liabilities (not just the debt reported on its balance sheet) and allowing the directors of the company sufficient scope and flexibility to run the company as they see fit.
With supply chain finance arrangements in mind, senior lenders may wish to consider including relevant information reporting undertakings and to ensure that a company’s supply chain finance arrangements are within the scope of a reporting accountant’s work.
It is important for senior lenders to have visibility of the situation as well as an understanding of how their position in an insolvency of the company would be affected by supply chain finance.
In certain scenarios, the need for supply chain finance to improve the liquidity practices of a company may present an opportunity for existing lenders – if they have the ability to offer the financing themselves. However, it should be recognised that even if such a facility is uncommitted, a decision by the financier providing the supply chain finance to not make such financing available in a distressed scenario could result in a liquidity crisis for the company.
Supply chain financing is a widely used tool – especially in sectors where companies are dealing with a large number of counterparties. Prudent and effective management of a company’s liquidity is important at all times but especially in circumstances of a financial restructuring.
In the context of a restructuring, stakeholders should be mindful of the scope and impact of any existing supply chain finance arrangements.
Notwithstanding certain high profile cases, effective supply chain finance can provide opportunities to improve the financial performance of a company and better manage relationship with key counterparties. As with any restructuring process, the suitability of any supply chain financing is subject to the underlying nature of the business, the sector it operates in and relevant market practices.
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© Norton Rose Fulbright LLP 2020