The Greensill case and other recent corporate breakdowns have turned the spotlight on the risk of supply chain finance. Since the outbreak of COVID-19, demand for supply chain finance has soared. The main concern is a lack of transparency. The implications of supply chain finance on capital market transactions are highlighted in this article. 

By Ralph Malacrida (Reference: CapLaw-2021-33)

1) Supply Chain Financing

Companies are focused on access to capital during times of economic uncertainty. As a result of the COVID-19 pandemic, issuers have aimed at strengthening the balance sheet and improving the liquidity management. One way to manage liquidity is by focusing on payments to suppliers. Various supply chain finance solutions exist. An increasingly popular method involves what is commonly referred to as “reverse factoring”.

a) Reverse Factoring

In a conventional factoring arrangement, a company sells its accounts receivable, i.e. unpaid invoices sent to customers, to a factoring company. By contrast, in a reverse factoring transaction, a company transfers its accounts payable, i.e. the invoices it receives from manufacturers or wholesalers, to a financial institution, which intermediates the accounts payable process at the debtor’s behest. 

The financial institution pays the debtor’s bills to the suppliers upfront so that the suppliers can immediately cash in the money at a small discount. The debtor then pays the financial institution back in full over time. The financial institution may also package the debt into securities and sell the securities to investors or funds, as with any other asset class. Thus, the money raised from investors is used to pay the debtor’s suppliers. The discount (less the financial institution’s take) represents the investors’ return. Securities that are wrapped up in a fund and sold to investors are usually backed by credit insurance. 

Therefore, reverse factoring solutions give companies access to funding that may not be available otherwise and allow (large) companies to negotiate extended payment terms with suppliers, while the suppliers get paid on time or early against a small fee. This way some debtors have pushed out payment terms for substantial periods of time, from 30 to 60 days in the past to 180 or 210 or even 365 days subject to a reverse factoring arrangement.

b) Commercial Risks

Reverse factoring optimizes cash flows and reduces working capital needs. This is legitimate to increase a company’s financial sustainability. The issue is that the company’s delayed payment obligation to the financial institution or the investors of securitized products can have the commercial effect of borrowing and be equivalent to obtaining a credit or issuing a bond. 

Nevertheless, reverse factoring liabilities are mostly classified as ‘trade payables’ or ’other payables’ with at best some disclosure in the notes. This may provide insufficient information of the technique’s impact on a company’s financial position. The effect of reverse factoring can consist in reducing the company’s reported debt and improving the return on capital employed, impacting debt covenants (debt-to-equity ratio and credit utilization ratio) and triggering vesting conditions for employee incentives (if executives are held to a working capital improvement target).

In addition, the disruption to the worldwide economy due to the COVID-19 crisis has exposed reverse factoring as a liquidity risk, even though one of its main purposes is to deal with liquidity needs efficiently. If a company goes down the route of supply chain financing, but then suddenly interrupts the process, mostly involuntarily because supply chain finance providers have tightened credit terms or credit insurers have refused the renewal of insurance policies, it may end up with a cash flow squeeze at a time when sufficient liquidity would be paramount. 

These issues have come to the forefront in a number of high-profile cases gone awry in the recent past, such as the U.K.’s largest bankruptcy case involving Carillion, the construction company collapsing in 2018. It had labelled debt of GBP 500 million as “other payables”. Abengoa, the Spanish clean energy business, and the United Arab Emirates’ NMC health care provider represent other prominent cases where reverse factoring resulted in forced liquidation. The latest case in point is the demise of Greensill Capital, a financial services company focusing on the provision of supply chain financing and the securitization of the related asset class. Greensill Capital was supposedly headed for a large IPO before imploding when a required insurance policy lapsed and the insurer refused to renew it.

Rating agencies have been warning about the high, but hidden, risks of reverse factoring for some time, pointing out that the goal of transparency could be achieved by re-classifying any payment extension related to a reverse factoring transaction as financial debt on the balance sheet and the related cash flow movements as cash flows from financing. 

In addition, reverse factoring has been on the agenda of the International Accounting Standards Board for the purpose of discussing the adequacy of the existing IFRS accounting standards (https://ifrs.org/projects/completed-projects/2020/supply-chain-financing-arrangements-reverse-factoring/; last accessed on 18 April 2021).

c) Legal Implications

Under certain circumstances reverse factoring can result in sudden and significant working capital outflow and financial distress. This is because of the short-term nature of supply chain finance agreements involving the risk of providers pulling facilities and not renewing them. As a result of this, financial covenants in other finance arrangements may be breached, events of default may occur, and/or liquidity squeezes may arise. In consequence, share and bond prices may collapse and insolvency may loom.

Financial covenants in credit facilities and terms of high yield bonds serve the purpose of providing a safety net for the finance provider. If a reverse factoring scenario results in the breach of a financial covenant, such breach gives the finance providers the right to ask for immediate repayment, collect collateral, or charge a higher interest rate.

If the financial distress of an issuer is such that it is generally unable to meet its financial obligations to creditors as debts become due, the issuer is insolvent and must file for bankruptcy.

In scenarios where share or bond prices collapse or issuers become insolvent, the investors and/or finance providers will seek ways to recover part of their damage. Against the backdrop of a recent capital market transaction, the most likely remedy would be a lawsuit on the grounds of prospectus liability.

2) Relevance for Capital Market Offerings

a) Swiss Prospectus Liability Regime

Under the old prospects liability regime of article 752 of the Swiss Code of Obligations (CO), each person that was involved in the drafting or distribution of an offering document containing incorrect, misleading or legally insufficient information was liable to the investors for any damage caused as a result of it. According to the Swiss Supreme Court, however, each party involved in a capital market transaction could rely on the advice of experts, such as lawyers or auditors, provided that there was no reason to assume a lack of diligence on their part or any other ground to be concerned requiring closer examination. Moreover, the Supreme Court pointed out that as a rule the underwriters had a duty to verify statements only if they were made by the issuer as opposed to third party experts (BGE 129 III 71, 75 f.). 

The new Swiss prospectus regime under the Financial Services Act (FinSA), on the one hand, has expanded its scope of application, now including secondary offerings, disclosure for derivatives transactions, and criminal liability for willful breaches. Article 69 FinSA states that whoever fails to exercise due care and therefore makes inaccurate or misleading statements or statements that fail to comply with statutory requirements in prospectuses, key information documents or similar communications is liable to the purchaser of a financial instrument for any loss caused. On the other hand, the FinSA prospectus regime has limited the standing to be sued on the grounds of prospectus liability to whoever makes statements in an offering document, as opposed to those who are assisting in the drafting or distribution of a document. In addition, each prospectus must indicate who is responsible for which part of it (as set out in article 4 of Annexes 1 – 5 of the Financial Services Ordinance). Therefore, legal scholars have pointed out that investors should be able to sue only the person taking responsibility in the prospectus, which in practice would be the issuer. 

In consequence, the issuer’s directors and managers, outside legal and tax counsels, accountants, and underwriting banks would no longer be liable to investors that suffer a damage because they relied on an incorrect or misleading prospectus. This notwithstanding, the issuer may have recourse against these participants in a capital market offering. Underwriters as well as legal and tax counsels will continue to be liable for breach of due care in relation to their contractual obligations to the issuer (based on article 398 CO), whilst other participants may be liable to the issuer – or the investors in the event of the issuer’s insolvency – on the grounds of statutory law, such as the issuer’s directors and managers (based on article 754 CO) and the audit firms if the audited financial statements included in the offering documents are incorrect (based on article 755 CO).

Would investors that have suffered a damage as a result of reverse factoring of an issuer, be likely to succeed with a claim on the grounds of prospectus liability?

b) Prospectus Liability Due to Reverse Factoring?

For the reasons set out below claims of investors related to reverse factoring are prone to fall between the cracks of both the old and the new prospectus liability regime. 

Issuers applying supply chain financing are acting in the interests of the company by reducing working capital needs. Assuming that issuers comply with the applicable accounting and disclosure rules, it will be difficult to prove a lack of diligence on their part when it comes to (theoretical) future risks related to reverse factoring, which does not have to be accounted for as debt.

Underwriters will assume that due diligence investigations related to reverse factoring fall within the responsibility of the experts, be it the accountants when it comes to the appropriate financial disclosure in the accounts or the lawyers concerning the qualification of reverse factoring in relation to financial indebtedness and compliance with debt covenants in existing finance documents. 

From the auditor’s perspective, the issuer’s decision not to record financial debt and cash flows from financing related to reverse factoring, will be in line with the (existing) accounting principles so that accountants will not red-flag reverse factoring due to its risk of being similar to undisclosed debt. 

From a legal perspective, the question how an entity presents liabilities to pay for received goods or services is not a contractual, legal or regulatory risk as long as the issuer’s approach complies with the accounting rules. If invoices are part of a reverse factoring arrangement, lawyers will assume that any relevant financial information is required to be disclosed in the financial statements.

Hence, the highlighting of potential risks related to specific facts of reverse factoring in any particular case may lay outside the responsibility of the issuer and outside the fields of expertise for which the underwriters, auditors or lawyers would (need to) feel responsible. As of today, though, in the absence of a body of court precedents the risk exists that a Swiss court may take a sterner view of issuers dealing with liquidity strains by opting for reverse factoring without ample disclosure.

c) Due Diligence

The purpose of conducting due diligence is varied but always includes the aim to establish a defense for the parties drafting an offering document. Especially the underwriters seek the assistance of outside counsels and advisors to establish the proof for reasonable grounds to believe that there is no misrepresentation or misleading statement or omission in a prospectus.

Despite the recent change of the Swiss prospectus regime, it is safe to assume that the standard of diligence applying to underwriters as laid down by the Supreme Court will continue to apply, irrespective of whether the underwriters are liable to the investors directly or only to the issuer (or, in a worst case scenario, the issuer’s bankruptcy estate). 

Therefore, the adage is still valid that due diligence by experts and disclosure in the offering document are effective antidotes to prospectus liability, also as far as reverse factoring is concerned.

Even though reverse factoring has been recognized as a potential issue when it comes to undisclosed financial risks, the situation will not be remedied in the short term in the absence of tighter accounting regulation and greater transparency requirements for supply chain finance. Recently, the IFRS interpretations committee concluded that the existing principles of IFRS standards and requirements provide an adequate basis to present liabilities and the related cash flows, and to disclose risks arising due to such arrangements in the notes, albeit a possible narrow-scope standard-setting project to develop specific disclosure requirements will be discussed in 2021 (see IFRS decision published on 14 December 2020; https://ifrs.org/content/dam/ifrs/project/supply-chain-financing-arrangements/supply-chain-financing-arrangements-reverse-factoring-december-2020.pdf); last accessed on 18 April 2021). Issuers will therefore need to apply judgement and consider the facts and circumstances when determining the appropriate impact of reverse factoring on their financial statements and financial sustainability in general.

Based on this, when it comes to due diligence in capital market transactions, reverse factoring arrangements should be generally characterized as potential red flags on the list of questions that the underwriters prepare with the assistance of their legal counsels. In addition, responsibilities need to be clearly communicated and documented at the outset of each due diligence investigation.

It may be difficult in any given case of trade finance to implement a clear distinction as either debt or accounts payable. Therefore, the matter may have to be investigated through more enhanced due diligence during management meetings and auditor diligence with the aim of eliciting assessments from the issuer on the immediate, ongoing and future impact of possible disruptions due to reverse factoring arrangements. When performing documentary due diligence, one telltale sign of reverse factoring is a jump in the line item “accounts payable” or “other payables” of a company’s balance sheet. This is where the debt may hide that a company may have created by entering into reverse factoring agreements.

Given the rating agencies’ insistent warnings in relation to reverse factoring, when drafting the offering document it will also be crucial to read the credit rating agencies’ commentary on the issuer, potentially including useful information on supply chain financing.

d) Disclosure

Once the impact of reverse factoring on the issuer has been ascertained, the disclosure and risk factors in the offering document should reflect the due diligence results and provide investors with an accurate assessment of the situation. 

Swiss law and regulators generally require the inclusion of risk disclosure statements in offering documents, but remain silent on the precise scope. By contrast, some international regulators have been explicit and highlight the need for robust disclosure in offering documents specifically as to potential effects of COVID-19 on matters related to supply chains and liquidity (see e.g. SEC disclosure guidance; topic no. 9A; 23June 2020; https://www.sec.gov/corpfin/covid-19-disclosure-considerations; last accessed on 18 April 2021). They highlight the importance of robust and transparent disclosures of how companies are dealing with short- and long-term liquidity and funding risks in the current economic environment, particularly to the extent efforts present new risks or uncertainties to their businesses.

Moreover, in the face of a general trend in international capital markets towards more and better disclosure, careful consideration should be given, and discussions should be held between the issuer and advisers, as to whether supply chain financing may warrant a separate risk factor or, in light of its potential materiality, require information to be included in the MD&A section of an offering document. 

These days, in response to the effects of COVID-19, issuers have obtained and utilized (government supported) credit facilities, accessed public and private markets, implemented supplier finance programs, and negotiated new or modified customer payment terms. Thus, they have spun a complex web of finance transactions that complicate the analysis of financial statements. As a result of this, now more than ever, in preparing offering documents issuers, underwriters, counsels and auditors need to cut to the chase of financial risks and disclose what really matters to the investors, including, in particular, reverse factoring.

Ralph Malacrida (ralph.malacrida@baerkarrer.ch)