Invoice Finance: A gift for receivables financiers?

14 December 2018

Last January, our insight 'Invoice Finance 2018: Where next for bans on assignment' reported on a set of draft regulations which looked to reduce the effect of ban on assignment clauses (BoAs), which create a barrier to providing invoice finance.

12 months later and with some revisions to the original proposals, The Business Contract Terms (Assignment of Receivables) Regulations 2018 (Regulations) have come into force. They will apply to contracts entered into from 31 December 2018.

In this insight we will take a look at:

  • how the Regulations will help invoice financiers who fund invoices by way of receivables purchase (IFs);
  • what IFs should consider monitoring, to establish whether BoAs might still affect them; and
  • some potential grey areas, which IFs should bear in mind before making funding available.


How will the Regulations help IFs?

Subject to some important exceptions (which we discuss later), the key benefit of the Regulations for IFs is that for a contract entered into on or after 31 December 2018, if the supplier is a small or medium enterprise (SME), a contract term won't have any effect to the extent that it:

  • bans the assignment of a 'receivable' (i.e. a right to be paid any amount, for the supply of goods, services or intangible assets) arising under that contract ; or
  • bans the assignment of a receivable arising under any other contract between the same parties; or
  • imposes a condition or other restriction on the assignment of a receivable arising under that contract (or under any other contract between the same parties).

We'll refer to these collectively as 'BoA Terms'.

Good news for IFs

This is welcome news for IFs, because it removes the potential negative impact that BoA Terms have on an IF's ability to collect payment under invoices they have funded (see our January Insight for a more details on that).

The Regulations also provide further help to IFs when chasing payment from debtors, because they say that a term which prevents an IF from determining the value or validity of a receivable or the ability of an IF to enforce it will also be ineffective. So, in practice, if the contract restricts an IF from obtaining details of debtor retentions (for example discounts, credit notes or other debtor defences to payment), those restrictions will be ineffective against the IF.

What will IFs need to monitor to establish whether BoA Terms still affect them?

The main policy objective of this new regime is to remove the contractual barrier to invoice financing and to give SMEs the freedom and flexibility to make greater use of invoice financing.[1] Therefore, for monitoring purposes, IFs need to be aware that the Regulations won't lift the restrictions in BoA Terms:

  • for all of their customers; or
  • in all contracts.

IFs performing pre-funding due diligence (particularly of material debtor contracts), will need to consider both whether their customer and any contract that they propose to fund invoices under, fall within the scope of the Regulations. If they don't, BoA Terms will still bite and could still affect an IF's ability to collect out cleanly.

Monitoring the type of customer

The first monitoring test that IFs should consider is whether their customer is a 'large enterprise' or 'special purpose vehicle' (SPV) under the Regulations. If the IF's customer is classed as either of these, then BoA Terms under its supply contracts will remain effective.

Let's look more closely at how this works.

The large enterprise test

Unless one of the SME exemptions in the Regulations applies[2], then the IF's customer will be classed as a large enterprise. The SME exemptions include individual sole traders, general partnerships and unincorporated associations.

They also include companies and LLPs that fall within the prescribed statutory thresholds or account filing exemptions for SMEs, contained in the Companies Act 2006 (and other related legislation)[3]; but in each case, that is only if they aren't also part of a large group. There are also equivalent exemptions for non-UK based SMEs (which may assist IFs with overseas customers) and some further exemptions for unlimited companies.

As these SME exemptions refer to legislative thresholds, IFs should consider monitoring these for any changes.

The SPV test

If none of the SME exemptions apply, IFs should still consider whether the SPV test is met. That's because if an IF's customer is an SPV (under the Regulations), then any BoA Terms will remain effective and may still pose a funding risk.

The Regulations say that an IF's customer will be an SPV, if it is any entity (other than an individual sole trader) that carries out a primary purpose relating to either the holding of assets (except for certain specified trading stock) or the financing of commercial transactions, which involves incurring liability under an agreement of at least £10 million.[4]

When do IFs need to perform the large enterprise/SPV tests?

IFs should consider performing these tests whenever notifiable/approved classes of invoices are notified to the IF by its customer. That's because the Regulations look at the time of the assignment for testing purposes and not the date of the invoice finance agreement.

Whilst there is an argument that there is only one assignment under a typical invoice finance 'whole turnover' agreement (because both day one receivables and all future receivables are usually stated to be assigned at day one), there is a counter-argument that future receivables are only effectively assigned (so that the IF actually then owns them) once they are created under the supply contract. Unfortunately, the Regulations don't mention this important distinction, so to be on the safe side, IFs should consider monitoring these tests throughout the life of a facility.

However, in practice, as invoices are often notified weekly (and sometimes more frequently), IFs could consider monitoring this by obtaining periodic compliance certificates and/or inserting representations and warranties into invoice finance agreements to confirm its customer's status. Customers could also undertake to notify the IF immediately if its status changes. In turn, that would ease the monitoring burden for IFs, who could consider whether more robust monitoring is necessary on a case by case basis.

Monitoring the type of contract

A number of contract types are excluded by the Regulations (for example, contracts for prescribed financial services, contracts concerning any interest in land or national security interests, some petroleum and energy related contracts and some project related contracts[5] ). If the receivable being funded arises under an excluded contract, then the BoA Terms will remain effective, irrespective of whether the IF's customer falls within the SME exemptions mentioned above.

Therefore, IFs will need to monitor what type of contract funded receivables are created under to establish whether BoA Terms remain effective. For monitoring purposes, IFs should also consider whether receivables under any excluded contracts should be notified by their customers (and whether any warranty cover is included in invoice finance agreements, confirming that notified receivables do not fall within the Regulation's contract exclusions).

Grey areas for IFs

Our January insight highlighted ten grey areas that IFs needed to be aware of under the previous draft regulations. Whilst we feel that some of those are no longer of material concern (because of revisions in the final Regulations), some grey areas remain. IFs will need to consider these carefully, as they may still create elements of funding risk.

1. If a contract's main purpose doesn't relate to one of the contract exclusions, but it contains some other aspects which do, will the BoA Terms remain effective?

We mentioned earlier, that the contract exclusions include for example, contracts for prescribed financial services and contracts which concern any interest in land. But, as highlighted in our January Insight, even if the main purpose of a contract isn't supplying financial services or land, there may still be ancillary elements of contracts that do provide services of a financial nature (e.g. debtor invoicing platforms and payment systems) or concern land (e.g. storage facilities).

Unfortunately, the Regulations haven't addressed how these types of multi-aspect contracts should be treated (i.e. where it is only the contract's ancillary aspects that touch any of the subject matter relating to excluded contracts). As such, it may be safer for IFs to treat multi-aspect contracts with caution and assume that any BoA Terms in them remain effective.

However, one possible way of mitigating the risk created by this ambiguity, is to include a debtor confirmation into supply contracts saying that a contract isn't an excluded contract for the purposes of the Regulations. In turn, that may help to prevent a debtor from trying to successfully assert that any BoA Terms remained effective. However, whether that approach is watertight, would ultimately have to be tested by the courts.

2. Related Rights

Valuable related rights (for example, the right to the benefit of insurances, guarantees, indemnities, inspection rights and/or the right to returned goods) are often assigned to an IF together with the underlying receivable and IFs should bear this in mind when looking at their exit strategy. That's because the tests under the Regulations will have to be reconsidered for each related right. Even if BoA Terms that affect a funded receivable are made ineffective by the Regulations, that doesn't necessarily mean that BoA Terms that affect related rights will be too.

3. Trusts and security over receivables

The Regulations do not say whether an assignment includes a fall back trust and/or security over receivables, which many IFs funding SMEs rely on to protect their exit position (so that if an assignment fails for any reason, they can fall back on the trust or security).

Where supply contracts ban creating trusts and/or security (or impose conditions on creating them), the effect of taking those back up protections could breach the terms of supply contracts and may trigger dilutions that affect an IFs ability to collect out receivables in full.

In a well drafted invoice finance agreement where arrangements relate solely to activities and parties within England and Wales, it is unlikely that the assignment would fail in the first place, but there may be other funding complexities (for example where a debtor is based overseas, or contract obligations are performed abroad) that may affect the validity, recognition or effectiveness of that assignment for local law reasons.

If a contract is material to an IFs overall funding position, consideration should be given to whether the IF may need to collect out via a fall-back trust or its security and whether any ban on the creation of those could dilute future debtor remittances.

4. Cross border considerations

The Regulations don't apply in Scotland[6], so where a party to a supply contract is based in Scotland or where contracts are governed by Scots law, IFs will still need to consider whether a BoA waiver from the debtor is required to mitigate the effect of any BoA Terms. However, the Regulations provide that if parties try to get around the Regulations by saying that a contract is governed by Scots or other overseas law in a blatant attempt to get around the Regulations, that won't work.

In addition to dealings in Scotland, IFs also need to consider the impact of BoA Terms where:

  • one of the parties is based outside of England, Wales and Northern Ireland;
  • contracts with any English, Welsh or Northern Ireland parties are governed by foreign law.; and/or
  • contracts are performed outside of England, Wales and Northern Ireland.

That's because even if an English court says that BoA Terms are ineffective because of the Regulations, in order to collect out a receivable where there is a dispute, an IF may still need to enforce the contract or an English judgment in a foreign jurisdiction. In turn, a foreign court may refuse to recognise the effect of the Regulations, including for example, if they conflict with local law.

IFs may be able to mitigate risk here to some extent via appropriate overseas debtor concentration limits, but if there are any concerns around exit strategy relating to contracts with overseas elements, IFs should consider obtaining foreign law advice.

For IFs dealing with cross-border elements, the Regulations don't apply where none of the parties to the underlying supply contract have entered into it in the course of carrying on a business in the UK.

Other points of note

How do the Regulations affect set-off?

The Regulations don't affect the availability of set-off rights, withholdings or other defences to payment that a debtor may have (although IFs should be able to obtain details of these potential dilutions more easily as a result of the Regulations). IFs should continue to bear this in mind when performing due diligence.

How do the Regulations affect retention of title?

Retention of title provisions (RoT) sometimes operate in a way that may allow an original supplier in the supply chain to trace into the proceeds of receivables funded by an IF in the next stage of the supply chain

The Regulations don't make RoT ineffective; they only operate in a way that lift BoA Terms in contracts made between the same parties. As such, IFs should continue to examine the effect of RoT when performing due diligence and consider RoT waivers where necessary.

Confidentiality

Where BoA Terms are ineffective because of the operation of the Regulations, we have seen that terms in the underlying contract that restrict the ability of an IF to obtain details of terms that affect payment will also be ineffective.

However, IFs should remain alert to the fact that other contract terms may still be subject to confidentiality restrictions and should take care that where these restrictions exist, contract terms are not disclosed. That's because disclosure in breach of confidence may trigger breach of contract and in turn, debtor withholdings or other defences to payment.

Conclusions

Whilst the Regulations will allow IFs to fund many SME debtor books more confidently, IFs will still need to remain vigilant, because the Regulations don't apply in all instances.

To adapt to this new regime, IFs should consider creating operational procedures and/or invoice finance agreement provisions that monitor:

  • whether any given customer qualifies as an SME under the Regulations (and therefore, isn't classed as a large enterprise or SPV);
  • whether a contract falls within the scope of the Regulations;
  • whether any of the parties to a debtor contract are based outside of England, Wales and Northern Ireland (or whether contracts will be performed outside of those countries, or are governed by laws of any different country); and
  • whether BoA Terms that remain, or could remain effective, could have a material effect on an IFs ability to recover its funding, margin, fees and service charges under invoice finance facilities in full.

It remains to be seen whether the implementation of the Regulations will actually result in any significant extra funding liquidity for SMEs or whether IFs will remain cautious where grey areas remain. IFs should also keep an eye on any developments in Brexit related legislation, in case it impacts directly or indirectly.

However, on a positive note, the Regulations should at the very least, help to start to break down some of the stigma and barriers which for many years have held back the full potential of the invoice finance industry and ease some of the acute liquidity pressures often faced by SMEs.

Footnotes

[1] Source: Department for Business, Energy and Industrial Strategy Impact Assessment dated 24 February 2015
[2] See Regulation 3(3) of the Regulations for the full list of exemptions.
[3] For example, the current medium sized company thresholds are a financial year-one maximum turnover of £36 million (with a subsequent financial year balance sheet total of a maximum £18 million) and no more than 250 employees.
[4] IFs should note that the Regulations provide some further clarification on this test (see Regulation 3(5)).
[5] See Regulation 4 for the full list of excluded contracts.
[6] See the UK Government's Explanatory Memorandum for further details. They only apply in England, Wales and Northern Ireland.


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