Finance Industry: The Nature of Debt Factoring and Debt Subordination - Term Paper Example

Introduction Gone are the days when next to investments of shareholders, both common and preferred, collateralized bank loans are the only sources of cash and other liquid resources for companies. The finance industry has gotten to this time when innovative ways and means to raise cash have gained acceptance as equitable tools for the business sector. Debt factoring and debt subordination are two important mechanisms that present solutions to cash-strapped companies. While the very idea of them would have been rejected and not allowed by the financial governing bodies decades before, these two alternatives have become generally accepted globally. At present, debt factoring and debt subordination are the preferred means for companies to finance their needs for additional working capital. The financial flexibility provided by these two alternatives does not require the company management to relinquish any portion of their control or equity. They simply come with costs that then form part of the company's financing-related expenses. The Nature of Debt Factoring and Debt Subordination Many companies have huge accounts receivables in their balance sheets, relative to their other asset items. These accounts receivables can be of much better use to the company if they can be converted to cash sooner than their dates of collectability. Their conversion to cash through debt factoring should enable the company to do more business transactions and to produce higher income figures. (ABFA, 2009) Debt factoring is a three-party transaction that is consummated when a factor buys a company's accounts receivables, generally without recourse. Hence, the factor shoulders any losses resulting from the debtors' inability to pay. These debtors, by virtue of the factoring transaction, will be liable to pay the factor - not the original company creditor - the amounts due from them. (Brigham & Houston, 1998, p. 691) The factor does all three things: ensure the collection of the company's receivables, shoulder the losses resulting from bad debts and provide financing for the company through the purchase of its receivables. (Brealey, Myers & Marcus, 1995,p. 506) Meanwhile, debt subordination involves giving a specific creditor the last ranking in terms of claims on the debtor company's assets and income. Thus, subordinated debenture bonds - or uncollateralized debts - are issues that entitle owners to payments that are secured by what is left of the company after its secured debts, debenture bonds and other general liabilities have been settled. (Fabozzi, 2000, p. 86) Both debt factoring and debt subordination are available to companies with good credit records. Both can be handy tools for raising money to beef up the company's working capital, to take advantage of opportunities that require cash, to fund the company's acquisition of new plant equipments, to finance an expansion phase or to accomplish similar ventures. The Costs of Debt Factoring and Debt Subordination Factoring, then, helps to improve a company's cash flow. It also significantly reduces the expenses a company ordinarily incurs in doing preliminary credit investigation on each customer applying for a credit line and in ensuring the actual collection of their accounts receivable. In return for these benefits, debt factoring as an alternative comes with two costs that would have to be paid by the company: the interest and the fees. The interests charged amount to 1.50 to 3.00 percent over the prevailing base rate. Then fees in the scale of 0.75 to 2.50 percent of turnover are as well collected. (The UK Insolvency Helpline, 2009) Issuing subordinated debts, meanwhile, entail paying the service fees of investment companies and rating agencies and the interest rates attached to the debt instruments which may range from 10.00 to 15.00 percent. Related expenses are further incurred in the presentation, road-show and similar marketing activities that are all orchestrated to sell the company's subordinated debt instruments. Preparation for Debt Factoring and Debt Subordination Before debt factoring is undertaken, the factor performs a comprehensive check on the credit-worthiness of the company's debtors so as to avoid absorbing losses arising from bad debts. The debtors are, in turn, informed in writing regarding the upcoming change - the factor will be designated as their creditor and their payments will, therefore, have to be redirected to the factor. (Melicher & Norton, 2003, p. 492) The transactions on which the receivables are based also must be looked into as to validity and consummation. The period within which the debtors can return their purchased goods or contest the amounts due from them should have passed so that their liabilities to the factor's client, the company, would be established as legal and binding. On the other hand, a company intending to raise cash via debt subordination has a different set of procedures to go through. The issuance of bonds is best done with the help of an investment company that will package marketable securities at interest rates that the issuing companies can comfortably deliver without compromising the attractiveness of the instruments, which would either be purchased or rejected by investors, the company's prospective creditors. The latter, in turn, are expected to thoroughly study the risks and benefits that go with investing in the company's subordinated debt instruments. They are expected to have reviewed the levels of the company's fundamental stability, profitability, and financial well-being. After all, they will, in effect, be lending the company relatively big amounts and these subordinated debts or bond debentures are not backed by collaterals. These preparatory procedures are gone through with care and due diligence to foresee any untoward developments. Still, mistakes are made and fraudulent acts sometimes go undetected during this phase. What then follows is the actual purchase of the company's accounts receivable or of its subordinated debts. Risks That Go with Debt Factoring and Debt Subordination When the preliminary procedures yield no adverse findings against the company, its transactions and its debtors, the factor then proceeds to pay the agreed percentage of approved debts. The percentage normally ranges from 80 to 85, depending on the results of the investigative checks performed. The balance, less charges, is paid when customers pay. (ABFA, 2009) The factor, then, is subject to the risk of not getting back the 80 to 85 percent cash outlay, and of not earning its projected fees and interests. Factoring is considered a lending mechanism. (Simply Business, 2009) Factors lend companies money and endeavor to get paid by the company's debtors. Investors buying subordinated debt instruments of companies are exposed to similarly high risks. Subordinated debts include unsecured bonds or debentures. They are backed not by assets but only by the debtor's promise to pay. In case the issuing company ends up in bankruptcy, holders of subordinated bonds get back their investments only after the creditors that are entitled to be prioritized have been given their dues. (Reilly & Brown, 1997, p. 80) Subordinated bonds are, therefore, inherently high-risk alternatives for investors. In fact, the subordinated debenture is the riskiest type of bond in the financial markets. (Melicher & Norton, 2003, p. 257) Financial books further have divided subordinated debts into classes, namely: senior subordinated debts, subordinated debts and junior subordinated debts. (Reilly & Brown, 1997, p. 80) While bonds that are given grades below "triple B" are called speculative grade bonds or junk bonds, those that are given the "triple C" and "double C" grades are the subordinated bonds. (Levy, 1999, p. 578) While debt subordination provides companies with access to cash without having to produce required collateral, it can lead investors to loss of their money. During times of economic boom, investing in subordinated debts may seem prolific. Even without any form of fair securitization to hold on to, investors are lured by the high prospects of growth and profitability of companies issuing subordinated debt instruments. Thankfully, the good prospects materialize and bring in yields that enable the issuing companies to meet the principal and interest payments that fall due. The same applies to investing in the factoring business. Receivables have higher collection rates and bad debts are a rare thing when the prevailing business climate is generally favorable. However, it is an entirely different scenario that prevails during times of economic slump. During these times, businesses would be in dire need for cash. Debt factoring and debt subordination would be among the mechanisms that companies would try to avail of. Companies would be struggling to meet their obligations for lack of liquidity - accounts receivable and debts would be difficult to collect. During these times, investors - factors and buyers of subordinated debt instruments - should all the more exercise prudence and steer clear of taking risks. Legal Problems Arising from Debt Factoring and Subordination Just as debt factoring and debt subordination are meant to aid companies in their plight for much-needed liquid resources, they also have been used for fraudulent intent that have made victims of factors, investors and related parties. The following accounts of sample fraud cases illustrate how debt factoring and debt subordination can indeed be purportedly accomplished as means for criminal ends. In 2007, the Secretary of State of Trade and Industry has applied for disqualification orders for the period of 12 years against Kevin Smedley and David Neasham Gee, who were respectively the Finance Director and the Chairman of the City Truck Group Ltd, a conglomerate of companies engaged in trucking and distribution. Smedley succeeded to pull off a series of factoring fraud that involved substantial amounts while Gee was all the while in the know. In the process, they printed out false invoices that were supposedly issued by the Crown to the City Truck Group which, in turn, endorsed the invoices to a factor who willingly purchased the fraudulent receivables. After all, with no less than the Crown as the debtor, serving as the factor for the City Truck Group was supposed to be a safe transaction. The factor eventually discovered the fraud and was entitled to be given the sum of 16,044,000, which was to come from the defendants, Smedley and Gee. (Lawtel, 2007) David Gee and Kevin Smedley turned out to have previously figured in a similar fraud case. In 2005, GE Commercial Finance Ltd filed a case against them and two more accomplices, John Steel and Kevin Ritchie. Through false representations, they led GE to issue advances based on invoices that similarly turned out to be totally false documents. At the end of the long-standing fraud, it was discovered that false documents included notification of debts that never existed. (Lawtel, 2005) There also are instances when a company's debts happened to have been sold twice; there are, thus, two factors wanting to collect one and the same receivable amount from a debtor. Such was the case of P&O Ferrymasters Ltd, a company that filed a case in 2001 to find out the rightful creditor to send its payment to. P&O Ferrymasters Ltd originally owed Radicon Ltd the sum of 272,201 for an outsourced job. Radicon Ltd next sought the factoring services of Assetline and included such receivable of 272,201 in the portfolio. In the process, Radicon Ltd executed a debenture instrument designating Assetline's holding company, Fairfax Gerrard Holdings Ltd, as creditor for the sum covered by the original receivable worth 272,201. After this transaction, Radicon Ltd included the same receivable in a second factoring transaction. The second factor happened to be Silverburn Finance (UK) Ltd. In the light of the double-factoring of Radicon Ltd's receivables worth 272,201, P&O Ferrymasters Ltd sought the help of the court to legally identify and establish the rightful receiver of the amount that it originally owed Radicon Ltd. In the course of the court proceedings, P&O was ordered to submit in court the amount it owed (272,201) and to henceforth be free of such debt. Silverburn also bowed out of the scenario, leaving the court only Radicon Ltd and Assetline to settle their issues. (Lawtel, 2001) A case in 1997 has ruled that a variation in a company's agreement with a factor that thereby results to terms and conditions that offer more insurance protection for the company is not to be considered as automatically applicable to subsequent factoring agreements involving the same portfolio of accounts receivables. The absence of such additional benefits for the factor's client in the event that the old agreement is terminated and replaced with a new one is not to be construed as fraud through misrepresentation. (Lawtel, 1997) The plaintiff was Meridian Metal Trading Ltd, a steel stockholder and trader and the defendant was a factoring company, Heller Commercial Finance Ltd. Heller Commercial had entered into an agreement with Meridian as the factor that bought the outstanding receivables reflected in Meridian's books. Meridian successfully negotiated for trade indemnity and credit insurance terms that incorporated more benefits than the usual factoring agreement covers. Thus, the agreement between Meridian and Heller Commercial had been labelled as 'the varied agreement." The same portfolio of receivables was subsequently transferred by Meridian to yet another factor. In the process, Meridian had to terminate the varied agreement with Heller Commercial. To get back the remaining portfolio of accounts receivables, Meridian paid Heller Commercial the sum of 844,000. In return, Heller Commercial reassigned to Meridian the outstanding accounts receivable - those that were left in the original portfolio. It subsequently turned out, though, that there were bad debts amongst the receivables and Meridian failed to benefit from the extra protection that the varied agreement would have provided. Meridian, therefore, took the brunt of the uncollected accounts. However, the company did try to pass on the losses to Hellen Commercial by filing a case in court based on three allegations, which were detailed in court documents as follows (Lawtel, 1997): (i) That Hellen Commercial was liable to indemnify Meridian, construing the agreement such that Hellen Commercial remained exposed to the risk of the debts even after reassignment; (ii) That misrepresentations were made by Hellen Commercial during preliminary discussions such as could form the basis of a claim for damages; and, (iii) An estoppel founded on representations of fact so as to prevent Heller Commercial from denying that it had insured the losses. The main argument was on whether it was Meridian or Hellen Commercial that ought to shoulder the risk of not receiving due payment from any of the debtors concerned. The answer to that would establish who ought to take losses for the costs of bad debts. The court ruled in favour of the defendant, Hellen Commercial. (Lawtel, 1997) Many cases go along these scenarios, and they all mostly imperil the factors or the investors who purchased subordinated bonds of companies. Conclusion In the end, the factor and the investor cannot be too choosy and meticulous while doing adequate research on the prevalent elements of the investment being considered. The factor should endeavor to get as much guarantees for the debts he is purchasing as can be secured. The investor should at least secure from the issuer of subordinated debt a negative pledge clause, which will legally bind the issuing company to not pledge assets as security for any similar issuances in the future. This means that earlier buyers of subordinated debts will not be compromised by having to learn of fellow buyers of subordinated debts whose holdings were secured by specific assets. It is a matter of honor and goodwill when a company sells its collectibles and ensures that they are likely to be collected. The same is true when a company sells debenture bonds that are secured by nothing more than its credit line. In the entire turnout, it is the investor in debenture bonds that has more to lose than other creditors of corporations. Similarly, it is the factor that has no recourse but to take in losses resulting from receivables that eventually turned out to be uncollectible. References Fabozzi, F.J. (2000). Fixed Income Analysis. New Hope, Pennsylvania: Frank J. Fabozzi Associates. Levy, H. (1999). Introduction to Investments. Cincinnati, Ohio: South-Western College Publishing. Melicher, R.W. & Norton, E.A. (2003). Finance 11th Edition. New Jersey: John Wiley & Sons, Inc. Reilly, F.K. & Brown, K.C. (1997). Investment Analysis and Portfolio Management. Orlando, Florida: The Dryden Press. Brigham, E.F. & Houston, J.F. (1998). Fundamentals of Financial Management. Orlando, Florida: The Dryden Press. Brealey, R.A., Myers, S.C. & Marcus, A.J. (1995). 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