Market commentators are expressing concerns about an increasingly used form of credit: supply chain finance. Although not a new product, demand for such financing has risen and may continue to do so due to the Covid-19 pandemic. Many are now concerned that this “hidden” form of financing a company’s supply chain may become more prominent, or be subsequently revealed as more commonly utilised, as companies globally manage cash flow needs. In addition to credit and default related risks, such arrangements may reveal other forms of fraudulent or inappropriate conduct.
What is supply chain finance?
What is supply chain finance or reverse factoring as it is commonly known? At first look, a supply chain finance arrangement has several benefits for the supplier, purchaser and lender. The purchaser arranges a facility with a lender, the lender sets lending terms on the credit history of the purchaser. The purchaser offers its suppliers the option to participate in the arrangement whereby invoices they submit are approved by the purchaser but paid by the lender well in advance of the credit terms (e.g., 20 days vis-à-vis 90+ days), albeit at a discount to the invoiced amount. Purchasers will then settle the obligation to the lender on extended payment terms. Suppliers get paid early, purchasers can protect supplier relationships and extend their credit terms, and the lender earns interest on debt secured by the purchaser.
So what are the problems? Such arrangements can create liquidity risk, credit and default risk, fraud risk, involve complex arrangements, and, significantly, lack transparency. Credit rating agencies, financial press, auditing firms and market regulators have expressed concerns, most notably over the lack of disclosure and accounting requirements for such arrangements. At present, supply chain finance arrangements are typically recorded within accounts payable, with little to no disclosure that such arrangements exist or under what terms. Supply chain finance arrangements are therefore considered as an undisclosed form of debt that might extend creditor payment terms considerably (even up to 9 – 12 months), thereby possibly overstating the financial health of purchasers. Any non-renewal or termination of finance arrangements would have a significant impact on working capital outflows for companies within a very short period of time.
All three credit rating agencies have raised such concerns. The Big 4 accounting firms sought clarification from the Financial Accounting Standards Board on the issue of required disclosures and classification. The SEC has taken a hard line stance that these arrangements should be disclosed in filings, which is within the scope of Item 303 of Regulation S-K, management’s discussion and analysis of financial condition and results of operations (MD&A), requiring disclosure of known material trends or uncertainties. The SEC’s Division of Corporation Finance has placed renewed attention to such programs in recent comment letters, and in June 2020, the Division of Corporation Finance issued CF Disclosure Guidance: Topic No. 9A, titled “Coronavirus – Disclosure Considerations Regarding Operations, Liquidity, and Capital Resources,” which encouraged companies to assess supply chain financing disclosures. In the UK, the FCA has also issued guidance on expected disclosures.
It has already surfaced on large scale failures
Supply chain financing has been cited as a significant contributing factor in a number of high profile business failures and scandals, including Carillion that had previously undisclosed debt, including supply chain financing arrangements of between GBP 400 – 500 million that was approximately double the GBP 219 million of reported net debt when it collapsed in early 2018.
NMC Health Plc, a former FTSE 100 company, disclosed as part of an investigation that “supply chain financing arrangements were entered into by the Company and used by entities controlled by both founding shareholders.” With undisclosed reverse factoring obligations of approximated $335m (£251m) revealed in February 2020, in addition to other undisclosed debt facilities, NMC was forced into administration, had its shares suspended on the London Stock Exchange and is under investigation by numerous regulators around the globe.
Active inquiries and response is essential
FRA’s team of forensic accountants and former investment bankers are familiar with supply chain finance terms and agreements having been involved in several investigations in which such facilities were used to obscure borrowing practices, facilitate accounting fraud and/or misrepresent the companies’ financial health to the market.
Senior management, Boards and Audit Committees should actively inquire of their treasury and accounting teams around the world as to the existence, terms and use of such facilities. Where identified, such facilities should be appropriately disclosed, factored into cash flow projections and the calculation of present and future debt covenant calculations.
The failure to do so could have significant implications for the Company ranging from negative issues with lenders, shareholders and regulators, to potential fraud, and as demonstrated from the previous examples, a liquidity crisis and potential bankruptcy.
Byline by Neil Keenan, Partner, Forensic Risk Alliance