Invoice finance provides crucial lifeblood to the financing of UK PLC. The last available full year figures for 2016 reported that an average of £9.5 billion of asset based finance was lent to small and mid-sized businesses at any one time. A major portion of that was invoice finance and that figure is expected to grow.
As with any form of financing, making invoice finance more accessible to businesses is dependent on removing existing barriers to funding. So, it came as good news last Autumn that a set of draft regulations (called 'The Business Contract Terms (Assignment of Receivables) Regulations 2017' (Regulations)) had been placed in front of the UK Parliament for approval, because they sought to limit the effect of one key barrier to providing invoice finance; the 'ban on assignment clause' (BoA).
Unfortunately, due to wider concerns that the Regulations went much further than originally intended with potentially negative consequences for other areas of finance and commerce, the Regulations were withdrawn late last year.
So as we start 2018:
- where does that leave invoice financiers?
- if the Regulations are reconsidered, what issues will need to be addressed?
- is legislation the best fix for the issues created by BoAs, or could there be a better industry wide solution?
Bans on assignment - the issues for invoice financiers
Invoice finance can be attractive to businesses, as it allows them to sell their receivables to an invoice financier (IF) by way of an assignment, in return for an early payment against the value of those receivables.
That can help businesses manage their cashflow needs, because rather than waiting weeks or months for a trade debtor to pay, a business can tell its IF that it has raised invoices and then request funding against the value of them.
However, the commercial effect of a BoA is to prohibit the sale of receivables that is necessary for an IF to be able to confidently fund against invoices. That's because selling receivables to an IF in contravention of a BoA will (unless the contract between supplier and debtor (supply contract) says otherwise) be a breach of contract.
In consequence, that breach may trigger various contractual rights for a debtor. And of most concern to an IF, is any ability of a debtor to refuse or withhold payment of invoices that the IF has purchased and made advances against.
Whilst sometimes, the effect of BoAs can be mitigated against to a certain extent, where invoices subject to BoAs represent a material portion of an IF's overall funding, triggering a BoA could lead to a serious shortfall in recoveries and potentially, lead to losses for the IF.
How does the invoice finance market currently get around BoAs?
The traditional route to getting around BoAs has been to obtain a 'ban on assignment waiver' from debtors, but this has a number of problems in practice including:
- they don't work where the supplier wants to keep details of its funding confidential, because an IF will either need the waiver letter to be addressed to it or be named as a party who can seek to rely on it, both of which then disclose the IF's involvement;
- some debtors simply don't want to sign waivers, because they don't want to have to deal with third parties when paying debts; and
- even where debtors are willing to agree waivers in principle, agreeing waiver language that is acceptable to all parties isn't always straightforward. Debtors will look at what rights are being diluted by giving the waiver and will be keen to preserve them, whereas IFs will want to understand if a waiver is actually conditional and if so, how that might play out when looking to recover under invoices they have funded.
What effect would the Regulations have had?
The Regulations would have made the following restrictions in any contract ineffective:
- bans of assignment of 'receivables' (a receivable being a right to be paid);
- any term which prevented the assignee of a receivable from determining its value/validity; and
- any term which hindered the assignee's ability to enforce a receivable.
The only caveats to the above were that the contract under which the receivable was created had to be a contract for the supply of goods, services or intangible assets and could not be a contract:
- for prescribed financial services (which included certain regulated consumer credit and consumer hire agreements, but also extended to include 'any service of a financial nature');
- concerning any interest in land or national security interests;
- where any party acted for purposes which were outside a trade, business or profession;
- where the parties chose English & Welsh or Northern Ireland law to govern the contract, but, if they hadn't done that, it would have been governed by different law; or
- where a party was designated as a contracts for difference counterparty under certain energy related law (certain petroleum licences and related contracts were also excluded),
each of the above being an Excluded Contract.
So, that all sounded like good news for IFs, but on closer inspection, the Regulations would have created a number of issues in practice, as we will see below.
What issues coming out of the Regulations will need to be addressed if they are reconsidered?
The issues were twofold; both general concerns and invoice finance specific concerns.
A number of general concerns were raised by legal and industry bodies, including that the Regulations:
- caught a wide range of commercial contracts whether or not invoice finance related and irrespective of their date. That could have had undesirable consequences for many transactions because receivables are relevant in commercial situations irrespective of whether they are then used for invoice finance;
- potentially invalidated negative pledge restrictions, which are often key protections in financing transactions and other commercial contracts;
- cut across long established English law principles, that parties should be allowed the freedom to contract on terms that they agree; and
- raised cross-border law issues including whether the Regulations would have been recognised in courts outside of England and Wales.
Any re-consideration of the Regulations would therefore, need careful examination of their overall impact on commerce as a whole, which could be incredibly time consuming.
Ten invoice finance specific concerns
Alongside these general concerns, the Regulations could have become problematic for invoice finance for the following ten reasons.
1. Ambiguity over when a receivable fell within the scope of the Regulations
Contracts for the supply of goods or services sometimes contain clauses that:
- provide online platforms run by the debtor, to process and approve payment of invoices; and/or
- say how storage facilities need to be operated.
Those financial service and property related elements would arguably have brought a supply contract within the scope of an Excluded Contract, therefore keeping any BoA alive. For IFs, that could have caused a major headache, because rather than being able to rely on the Regulations, they would still have had to check supply contracts for any Excluded Contract elements and potentially consider BoA waivers.
2. Debtors may have challenged the true effect of the Regulations
The Regulations said that terms of contracts which hindered the assignee's ability to enforce a receivable had no effect. But did that potentially turn a receivable into a debtor's unconditional promise to pay the IF the full invoice amount, even if the debtor had rights in the supply contract allowing it to withhold payment or reduce the amount payable under an invoice?
We would be very surprised if that was the intention, but that's one possible interpretation and if IFs had read the Regulations in that way and debtors chose to challenge that, there could have been potential problems.
3. There was no mention of related rights (which are often assigned alongside receivables)
In addition to receivables, IFs often take an assignment of rights connected to the receivables such as guarantees, indemnities and insurances. Inspection rights and the right to returned goods can also be valuable to IFs in an enforcement scenario and are often also assigned.
However, the Regulations didn't make any mention of these important related rights and IFs could have been left in a scenario where a BoA was lifted under the Regulations for the receivable, but not for the related rights.
That means IFs would still have had to check contracts for BoAs over related rights and consider the impact of those BoAs being breached.
4. Blanket BoAs
Contracts sometimes contain BoAs that prevent the assignment of any contract rights or any receivables (sometimes called blanket bans). It wasn't clear whether the Regulations lifted blanket bans completely, whether they only lifted the receivables element, or whether blanket bans survived completely intact, which would have left this area vulnerable to potential debtor challenge.
5. Qualified BoAs
Contracts sometimes say that BoAs can be lifted with consent (and sometimes contracts say that consent can't be unreasonably withheld or delayed). The Regulations didn't make any mention of these qualifications, which could have again led to debtors seeking clarification and redress through the courts to the detriment of an IF.
6. Bans on the creation of trusts and/or security
Two common and important fall backs for IFs are taking:
- a trust over receivables (to protect the IF where the original assignment of receivables fails for any reason); and
- fixed charge security over receivables (to protect the IF where that trust also fails).
If an assignment of receivables fails, but the supply contract prohibits the creation of trusts and/or security over receivables, that could still result in a breach of contract and depending on the terms of the supply contract, enable the debtor to reduce or withhold payment due under invoices. Unfortunately, the Regulations didn't consider this, meaning that IFs would still have had to check supply contracts for those prohibitions and consider whether waivers were needed.
7. Retention of title
Supply contracts sometimes contain terms that allow the supplier to retain title to goods until invoices are paid in full (RoT). If the supplier is selling goods that it has purchased from another original supplier, that original supplier's contract may also contain RoT.
Sometimes RoT clauses are more widely drafted to prohibit dealings with receivables or sale proceeds until the supplier (or original supplier) has been paid in full. There is a question mark over how the Regulations would have affected these types of restrictions. Given that RoT is already a complex area of law, this will need careful consideration if the Regulations are revisited.
8. Restrictions on dealing with receivables in the invoice finance agreement itself
Perhaps one of the most surprising and potentially alarming effects of the Regulations was that the typical restrictions on an IF's customer being able to deal with its receivables under the terms of an invoice finance agreement would have also been made ineffective. Whilst perhaps an oversight, this is something that would need to be addressed in any revisions.
9. Impact on limited recourse and non-recourse invoice finance
Some forms of invoice finance are provided on a 'non-recourse' basis or 'limited-recourse' basis, which restricts the ability of the IF to re-assign receivables back to its customer, or limits the circumstances in which they can be re-assigned to specified events (for example a breach of a specific warranty). Because the effect of this restricts the assignment of receivables, there is a question mark over whether the Regulations would have actually turned limited and non-recourse invoice finance into 'fully recourse' invoice finance (i.e. giving IFs the ability to re-assign receivables at any time, even if that wasn't the commercial intention).
Again whilst possibly a legislative oversight, distinguishing whether or not receivables are subject to any 'recourse' (i.e. that ability to re-assign) and therefore, whether receivables still form part of a company's balance sheet can be hugely significant for accounting treatment purposes. Consequentially, this anomaly could have created an accounting headache for some.
10. Interplay between BoAs and confidentiality
Debtors may have sensitivities over suppliers assigning receivables or other contract rights to third parties for confidentiality reasons, not least to protect commercially sensitive information and details of intellectual property from disclosure to third parties.
One possible interpretation of the Regulations was that even if confidentiality provisions were breached (e.g. a supply contract was disclosed to an IF for due diligence purposes), that breach wouldn't have affected the amount due from the debtor to an IF under an invoice.
However, that position may have been open to challenge by debtors not only as a matter of interpretation of the Regulations, but also because there are other English common law principles that apply to confidential information. Under those principles, a breach of confidence may still arise if an IF knows or ought to have known that it has received confidential information in breach of confidence. That may ultimately result in a damages claim and potentially, allow a debtor to set-off any damages awarded by a court against amounts due under invoices.
Is revising the Regulations the answer?
It's clear that many concerns will need further consideration if the Regulations are revised. Unfortunately, the interplay between invoice finance and other areas of commerce is more complicated than the Regulations envisaged. Add cross border trade into the mix and it becomes more complex still.
With Brexit trade negotiations scheduled to start later this year and the scope of any trade deal remaining unclear, revising the Regulations now could result in further unintended consequences up the line and may not be the best use of everyone's time.
Before going down that road, it's worth stopping and asking, is legislation really the answer here, or is there another easier and more effective solution?
An alternative solution?
The invoice finance industry has evolved over many years. As with other finance industry bodies such as ISDA (the derivatives industry body), the invoice finance industry has via the Asset Based Finance Association ((ABFA) now part of the larger trade body, UK Finance) introduced a number of industry protocols and guidelines to make providing invoice finance simpler.
The problem with BoAs is simple. IFs may end up out of pocket if they fund receivables where the underlying contract has a BoA. Waivers aren't always forthcoming from debtors or may be subject to negotiation, which can leave IFs with potential gaps in their protections and difficult funding decisions.
But what if waivers were more forthcoming, because the market educated businesses on why IFs needed them and there was a protocol dealing with what a fair and reasonable BoA waiver looked like? Could that fix the problem that the Regulations were looking to solve?
ABFA looked at protocols in the past in relation to UK Government and Scottish Government public contracts, so there is some precedent for considering a wider model. But to do so, it's important to first understand why debtors may be reluctant to enter into BoA waivers.
Why are debtors reluctant to provide BoA waivers?
Debtors may be reluctant to sign BoA waivers because they fear:
- litigation by an IF over an unpaid debt; and/or
- an IF may try and press for recovery of amounts exceeding the value of invoices that the IF has funded (for example via damages claims).
Whether or not those fears are well grounded is always going to be open to debate, but what if those fears could be minimised, or better still, removed?
What could an industry protocol look like?
If an industry wide protocol for BoA waivers was adopted that:
- recognised and limited the amount that the IF could recover from a debtor with a BoA in its supply contract, to the face value of invoices it had funded (plus any agreed default interest for late payment);
- allowed a debtor to rely on protections in its supply contract; and
- provided IFs with the option to request the return of unpaid goods where undisputed invoices they had funded remained materially overdue,
then debtors would have the assurance that IFs could never recover more than the face value of any undisputed invoice plus agreed default interest. An IF could look to protect any residual risk by the use of existing invoice finance techniques such as guarantees, security or the operation of appropriate funding limits.
That would still leave the issue of what happens if supply contracts are amended, but if receivables under a supply contract are material to an IFs funding, amendments are always going to be of interest and an IF could insert appropriate protections in its funding agreement to ensure that amendments are approved before agreeing to continue funding.
Were the Regulations the pre-cursor to the end of confidential invoice discounting?
Whether legislation or a protocol is used to overcome BoAs in invoice finance boils down to:
- whether the law should really be used to by-pass and override what has already been commercially agreed in supply contracts; or
- whether the whole business community is willing to come together to better understand the issues created by BoAs in invoice finance and look to find a mutually agreeable solution.
A potential problem with legislation is that it may prove to be too complex and uncertain, producing undesired consequences. However, a protocol system has the advantage of promoting a consistent industry standard and providing a model that could help with similar issues in other jurisdictions. The downside to a protocol waiver system is that for debtors to buy in, invoice finance needs to be disclosed to them, which sits at odds with confidential invoice finance, where debtors aren't notified at day one.
But engaging the whole business community has a positive advantage, in that it provides an opportunity for all interested parties to discuss not only the specific question of BoAs, but the concept of invoice finance more generally. A wider discussion may also in time, facilitate wider innovation and promote business growth.
Removing the stigma of invoice finance
So, with all of that in mind, is the real underlying issue here that there is still too much stigma and mis-understanding attached to invoice finance? Suppliers may fear having their invoice finance disclosed to debtors, because of the perception that it says they may have cash flow issues. That in turn may raise debtor fears around whether a supplier will be able to fulfil supply contracts, which could have a knock on impact under existing contracts or at contract renewal time.
But isn't the commercial reality in 2018, that all businesses require funding at some point in their life cycle (whether through invoice finance, other forms of debt or equity) and the more that the whole business community understands about invoice finance, the more opportunity there is to address any misconceptions around how invoice finance works and for the invoice finance industry to understand any residual fears and concerns from wider business?
With better awareness, the need to keep invoice finance confidential from debtors may actually reduce over time. Notifying debtors at day one would have the added advantage of fixing an IF's priority over purchased receivables at its first point of funding and potentially reduce the risk of fraud and other creditors establishing competing claims over those receivables (which can be particularly problematic in invoice finance). The development of technology such as smart contracts and blockchain may ultimately play a large part in how the industry develops here.
For the time being however, whilst it remains to be seen whether the Regulations will be revisited, it's worth reminding ourselves that BoAs aren't necessarily an issue on all invoice finance transactions. Where they are, whether revised legislation is workable in practice remains to be seen. But approaching this issue through greater awareness, understanding and open discussion could forge the way to a more sustainable long term solution.
If you have any questions on any of the issues raised in this article, please contact one of our banking and finance experts who would be happy to help.