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The US’ federal securities regulator is supporting calls for better disclosure standards around reverse factoring, following concerns that a lack of transparency around firms’ supply chain financing programmes could contribute to liquidity issues and even company collapse.

The Securities and Exchange Commission (SEC) notes in its annual investor advocate report for 2019, published in late December, that the use of reverse factoring appears to be becoming more frequent but is often not disclosed in companies’ financial filings.

The practice typically involves a bank or other intermediary paying suppliers early – at a discount – while granting the buyer extended payment terms and, as a result, easier cash management.

Supporters argue reverse factoring frees up liquidity for the buyer while letting suppliers accept prompt payment, potentially on better terms than through other means of financing. However, it has been linked to high-profile scandals, including the collapse of UK construction firm Carillion, prompting ratings agencies to warn it can be misused as an “accounting loophole” to obscure company finances.

The SEC says that as things stand a company “may not disclose its use of reverse factoring at all in its annual report, even though an analyst or other investor would want to know what the company’s programme terms were, what portion of the supplier base was utilising the programme, who the capital providers were … and the level of risk on the supplier side”.

“Reverse factoring as a business is not cycle-tested, which means that it is unclear what might happen in an economic downturn (ie, there may be a snap-back in working capital),” the report warns.

“The worry is that curtailment of reverse factoring availability represents a liquidity risk which could lead to an immediate and material working capital outflow. Unfortunately, without greater disclosure, many investors are left wondering how sustainable reverse factoring is as a source of capital.”

It cited a joint letter sent by the ‘big four’ accounting firms in October to the Financial Accounting Standards Board (FASB), an independent organisation that produces financial accounting and reporting standards for US companies.

The letter urges the FASB to add supply chain financing to its agenda and consider setting standards on how such arrangements should be presented and disclosed in firms’ financial statements.

The SEC paper repeats the letter’s claim that clearer disclosure standards would give investors and auditors “a better basis for making informed decisions with respect to the entity’s financial position, liquidity, and cash flows”.

“We agree and look forward to monitoring the FASB’s action in this area,” the regulator adds.

FASB spokesperson Christine Klimek tells GTR the board is “currently evaluating the agenda request submitted by the accounting firms and, as with all agenda requests, will consider it as part of its due process”. She adds it would generally discuss such requests in a public meeting, though has not yet set a date to do so.

 

Risks versus rewards

The SEC’s involvement is in part driven by an apparent mismatch between the popularity of supply chain finance programmes among buyers and their disclosure in financial statements.

Its report cites research from UBS that found less than 3% of nearly 1,500 companies reviewed globally publicly disclosed their reverse factoring programmes “despite evidence indicating that a much greater percentage – perhaps as much as 40%” were using the technique.

Matthias Heck, vice-president and senior credit officer at Moody’s in Germany, gave a presentation at an International Trade and Forfaiting Association (ITFA) educational seminar in December and said: “With careful use, benefits can outweigh risks.”

However, he said arrangements become risky if the buyer does not have sufficient liquidity to survive if their reverse factoring facility is suddenly withdrawn. Heck added this is most likely to happen when a company is already under stress, meaning that “a sudden liquidity shortfall can magnify operational problems and turn an otherwise manageable problem into a crisis, with a risk of default”.

A September paper by Moody’s said the “debt-like features” of reverse factoring programmes at Abengoa contributed to its bankruptcy in late 2015, and that the rapid withdrawal of supply chain finance arrangements at Distribuidora Internacional de Alimentacion “contributed materially to the company’s liquidity crisis” during 2018.

Risk can also be exacerbated by bloated financing programmes – Carillion’s payables finance programmes were worth nearly £500mn, yet it disclosed liabilities to banks of just £148mn in its 2016 filings – and extended payment terms beyond industry norms. The Moody’s paper also raised concerns that some suppliers report feeling pressured by buyers into agreeing reverse factoring programmes as a condition of contract when bidding for new work.

The ongoing regulatory attention to supply chain financing is sparking a backlash from the trade finance sector. The Global Supply Chain Finance Forum (GSCFF), which brings together five influential banking and finance industry associations, argues that high-profile company collapses and unwanted pressure on suppliers are examples of where payables financing programmes are misused by companies.

GTR understands that a forthcoming publication by the forum will advocate for the continued use of payables financing programmes as a means to optimise working capital, arguing that harmful conduct – though worrying and prominent in media reports – is relatively rare.

 

Unintended consequences

Sean Edwards, chairman of ITFA, believes the introduction of new disclosure standards is “almost inevitable”.

“Because there are no standards there’s been extremely variable presentation, and I think what the ratings agencies were unhappy about was the lack of transparency,” he tells GTR. “It’s a real problem that there’s been so much of a grey zone.”

But for Edwards, the way in which reverse factoring would be disclosed is vital.

“You’re opening a Pandora’s Box here potentially, and that is the worry,” he adds. “Better disclosure standards could certainly stop these rotten apples from reoccurring in the future, but if they are too prescriptive or too severe in how they treat the characterisation of trade debt, you might find banks are less willing or less able to provide supply chain finance and all the benefits might disappear.”

For instance, authorities may decide to go beyond disclosure rules and introduce further restrictions. Edwards is urging standards-setters to avoid discouraging the use of irrevocable payment undertakings – where the buyer will commit to repaying the bank regardless of any shortfall or defect in the goods – or placing restrictions around the days payables for buyers.

Two options mooted by Moody’s have been to require the disclosure of payables financing programmes as a debt-like obligation to a bank, or as a potential risk to liquidity. Its September paper said there is “a strong case” for the latter option.

Eric Fenichel, partner at Eversheds Sutherland’s financial services practice in Atlanta, says disclosure as liquidity risk “makes sense” to him.

“It should be driven by the substance of the transaction, and how that relates to the traditional kind of measures of the financial health of a company, including liquidity, cash flow and amount of leverage,” he tells GTR.

“That’s always the challenge, to adopt standards that are clear so people know how to apply them, but also aren’t so specific that people find ways to structure around them.”