Policies Related to Trade Credit Finance Essay

Trade credit is very informal and is hard to monitor and therefore are often overlooked in policy and research (Paul and Boden, 2011). The common setback of trade credit management is late payment, which may arise from abusive power behavior by large companies towards small suppliers. The UK government authorities have created numerous policies that tackle the late payment. Many of existing reports have recommended the government intervention in tackling late payment problem but many of these policies were created based on empirical evidence and statistics few of small businesses which are used to represent the whole population (Auboin, 2010, Grave, 2011, Paul and Boden, 2011, ACCA, 2012, Pike and Cheng, 2002, Wilson, 2008). However, many still believe that the subject matter of late payment cannot be tackled through large sums of quantitative evidence only but through proper engagement with small business and SMEs, collecting enriching information into late payment and trade credit related issues. This chapter will examine the current policy stance of the UK government and the EU and will evaluate the proposals that are under consideration. Based on the theoretical understanding of trade credit developed in Chapter 3, this Chapter will seek to identify any theoretically sound policies that could be taken by government / the EU in order to improve the in addressing trade credit environment for SMEs.

5.2 Trade Credit Insurance Top-Up Scheme 2009

On 1st May 2009, the UK government had initiated the Trade Credit Insurance policy Top-Up Scheme (TCI) that ran from 1st April 2009 to the 31st December 2009 [1] . The scheme is designed to tackle the sudden reduction in private sector insurance cover against customer non-payment and bad debts. The trade Credit Insurance Top-Up Scheme (TCI) was a £5 billion initiative derived out of the UK government 2009 budget which allowed the businesses with trade credit insurance policies to buy an additional cover on top of their present policy cover. Under the TCI business with existing trade credit insurance policy may purchase additional insurance. The top-up Scheme was for eligible UK businesses that already have insurance cover after the 1st April 2009. The government scheme also involved various top trade credit insurance providers in such as; Euler Hermes, Atradius, and Coface e.t.c. Although, the legal relationship will be between the insurance holder and the credit insurance provider, the credit insurance provider will have a separate legal relationship with government in respect to the top-up scheme. Therefore businesses will not interact directly with the government in order to participate in the scheme. All applications, payments, claims and queries should be directed to the selected credit insurance provider and not the government. The scheme will top-up the insurance cover with a minimum credit limit of £20,000 up to £2 million as the maximum amount on any increase cover. For instance, if an insured cover of supplier has reduced from £200,000 to £100,000, the supplier can opt to buy a top -up cover from £20, 000 to £ 100,000 to restore its original value of the insurance cover. In other cases, if the cover is reduced from £50,000 to £20,000, then the level of cover provided by top-up policy will fall, since the minimum coverage limit is £20,000. Instead of having £50,000 the credit policy will be placed at £40,000 to match the amount provided in the policy. The scheme does not guarantee top-up to those suppliers or businesses that have insurance cover that is below the minimum credit limit of £ 20,000 (balance zero) [2] . Consequently many SME and business have expressed disappointment in the way the scheme has been operated, saying that the scheme only guarantees insurance cover that reduced after 1st April 2009. Many critiques the scheme as being a failure, as the scheme does not address the needs of businesses whose credit insurance limits have already been withdrawn as opposed to reduced. In addition, some companies could not benefit from the scheme because their insurance cover was reduced before 1 April 2009. A news report indicated that only £18 million out of the £5 billion have been claimed from inception in 2009, Euler Hermes also reported that 2 out of 3 clients have submitted claims to the scheme (AccountancyAge, 2012) [3] . It is therefore assumed that the negative reaction of businesses towards the scheme is as a result of the financial crisis which saw a reduction in wholesale transaction with little or no accesses to finance. However the scheme needs to widen further to address the pressing needs of even more companies were not able benefit from the cover from when the beginning of the stipulated period.

5.3 Late Payment of Commercial Debts (Interest) Act 1998

The center piece of the statutory interest is that small business can charge a compulsory interest on any late payment of commercial transaction. The legislation was created in 1997 by the Labor government, after the Department of Trade and Industry published a Green Paper, entitled "Improving the Payment Culture: A Statutory Right to Claim Interest on Late Payment of Commercial Debt". The publication outlined the best way to implement such legislation enabled the government to provide legislation that was aimed to improve the payment culture amongst UK business (Group, 2002). In the Green Paper, the Government proposed to test for 'smallness' on the two out of three criteria test stated in section 247 of the Companies Act. However, it became apparent that to take that test out of its context (i.e. Filing accounts in respect of a completed year by companies incorporated in the United Kingdom) and use it in another context would lead to difficulties of proof (Wilson, 2008). It was, therefore, proposed that the legislation should define what a small business will be (with no more than 50 full-time employees). The legislation would apply to commercial contract across the UK including foreign transaction with the UK and foreign party. Where there is no significant connection between the contract and that part of the UK, and, but for the choice of law, the applicable law would be a foreign law. Where the choice of law is a foreign law, the Bill would apply if, but for that choice of law, the applicable law would have been a law of part of the UK and there was no significant connection between the contract and any country other than that part of the UK (Wilson, 2008). Consequently there were no minimum level set for which a claim for interest could not be made. The intention of the government was to increase formal contractual agreement credit period in accordance with trade custom and practice. The rate of interest has been prescribed at 8% which was above the bank of England official base rate of 5%. The act was broken down into three distinct phases. The main provisions of the bill are summarized in the table below [4] ; Main provisions of the Late Payment of Commercial Debts (Interest) Act 1998 PHASE 1 Statutory Interest on Late Payment will depend on the form of a contract term and the kind of debts the parties have right to claim over. Secretary of state has the power to determine the provisions of a contract and the interest rate charge on late payment that could be claimed (8% over the base rate) PHASE 2 This states the provisions made over late payment with the claims that will be made once a payment is deemed late. They also restrict the freedom of the contracting parties to make any other provisions that have the effect of varying the right to statutory interest. PHASE 3 This section deals with the payment of the contract price which is due before the supplier has fully performed his obligation under the contract. This bill also covers the factoring and debt collection services that the parties to assign the statutory rights on late payment to a third party.

5.3.1 Late Payment of Commercial Debts (Provision) Act 2002

An amendment was made to the late payment of commercial debt of 1998 on the 22nd June 2002 and was enforced on 7th August 2002. Under the rule, all business owners and manager are responsible for claiming reasonable interest on late payment on any transactions. This legislation came as a result of the UK obligation to fulfil the European Directive 2000/35/EC on combating late payment in commercial transaction (Group, 2002). Changes made to the provision to the Late Payment of Commercial Debts (Interest) Act 1998 are as follows; Under this provision, the power of the Secretary of State to determine the provisions of a contract was removed especially the power to define statutory interest on late payment. This removed the excessive power of the government to dictate how business is to be run in the country. The parties can agree a different rate of interest or an alternative remedy for late payment. In the case of interest, this is usually then termed as 'Contractual Interest'. However, the Act requires that the agreement must provide for a 'substantial remedy' to commercial debts. Purchasers are not allowed to force suppliers to accept a low or nominal rate of interest, as a way of getting round the Act. Any such clause is likely to be struck out, in which case interest can be claimed at the rate described. The right for an appropriate representative body to change grossly unfair contractual terms on behalf of SME. The high court may grant an injunction to restrain the use of contract if the contract is deemed void under the 1998 interest Act. This suggests that both legislations are provisions made to help lift the burden of late payment by enforcing prompt payment culture through their trade credit practice. Unfortunately, the reality is far from the expectations, as businesses and MPs like the Minster of Enterprise, Mark Prisk, have admitted that the legislation was an ineffective tool for combat late payment. In a transaction circumstance between a small supplier and large customer, the legislation is less effective when the power asymmetry is present in that transaction. In theory, a customer may have a bargaining advantage over the supplier in cases where the credit policies are properly laid out. In that instance, the small supplier may find it difficult to take legal action on large customer because it may have serious transaction cost to the small business (Paul and Boden, 2011, Summers and Wilson, 2000, Wilson and Summers, 2002). When it comes down to promoting business and building customer relationships, the small business is sometimes reluctant to speak out against the large customer because they fear of order cancelling reprisal. Furthermore, an issue with the interest rate of 8%+base that this was set with a view to 'compensating' small businesses based on their average cost of capital. However the same rate also applies to large businesses and public liability companies; which generally have a much lower cost of capital. This is assumed that large businesses are more compensated and in fact have an incentive to enforce interest penalties. This is particularly the case if they are less fearful of losing business by applying penalties. Other likely users of the Acts are debt collection agents and factoring companies. Commercial debt collection agents can use the act to guarantee that interest is collected on the overdue debts of their clients along with some collection costs and can pass this benefit onto their clients in the form of lower commission rates. Insolvency practitioners can apply interest charges on the trade debts of insolvent companies and collect the interest going back up to 6 years on late payments. Finally, suppliers are advised to plan the period of collecting the payment using a combination of formal and informal practice of calling the customer before due date.

5.4 Project Merlin, UK (2011)

This is an agreement between the present conservative government and the four major high street banks in the UK. The bank has agreed to make lending to SME under the program the bank will lend £190bn to business during 2011 out of which £ 76bn of the loan will be available to the small business (Treasury, 2011). The program will be monitored by the bank of England to check the influence of impact on business. The bank that was involved in the deal include; HSBC, Barclays, Royal Bank of Scotland, Lloyds Banking Group, Santander bank; which had agreed with the lend parts of the deal (Treasury, 2011). Although there were some positive results, various reports show that the lending program did not go that far enough. Bank of England Trends in Lending figure of 2011 showed that bank loans to small business was totalled to about 74.9 which is about £1.1bn short of the proposed £76bn in 2011. The assumption is that many SME ignored the use of bank finance and lending because of the interest charged on bank loans. However, the number could also be interpreted to show those banks are actually committed to lending as they came close to their target. However the results show that banks failed to meet their lending targets for the smallest of UK businesses - a particular cause for concern since these are the companies that usually exhibit the most growth and innovation and employ the biggest percentage of UK workers. The Federation of Small Businesses (FSB) survey 2011 did not reflect the banks' claims that demand for bank loans have been reduced. The results of their June survey found just 20 percent of small firms had applied for a bank loan in the previous 12 months, and the December results showed that this figure was even lower at 19 percent (FSB, 2011). In June, 12 percent of those who did not apply for a loan said it was to avoid the "unsuitable" terms and conditions surrounding the process, a further 12 percent did not try because they believed their application would be refused and 7 percent said previous negative experiences with bank loans put them off. Whilst this is merely a reflection of business owners' perception of bank lending and not necessarily accurate, the statistics did show that of the companies that did apply for a loan, 33 percent was turned down and only 43 percent received the full amount they requested (FSB, 2011). The FSB surveys have also shown the consequences of businesses not getting enough financial support. Of the businesses whose loan requests were turned down (whether wholly or partially) only 16 percent avoided a negative business impact by securing finances elsewhere whereas 46 percent said they had to delay, scale down or abandon their investment plans, 40 percent said they had continued financial concerns, 31 percent missed a growth opportunity and 18 percent believed they were put at a competitive disadvantage (FSB, 2011). Long term effects were also evident, with 13 percent reporting they ended up having to make staff redundant to survive without the extra support. The Bank of England report reveals that many SME are not satisfied with the lending condition of the bank set and is particularly frustrating when banks have exceeded their overall gross lending targets of £190 billion by nearly £25 billion increase. It can be deduced that a large part of the loan was used by medium to large firms, with enough cash flow have the ability to repay the loan. In terms of trade, the program shows to that more SME are refusing to take lending because to for the transaction cost compared to transaction in supplier credit.

5.5 National Loan Guarantee Scheme

This is another initiative that was created by the government on the 20th March 2012. The scheme allowed the high street banks to provide up to loan of up to £20 billion to small businesses and will be guaranteed by the government. . The scheme was designed to reduce borrowing costs for small and medium-sized companies (SMEs), and in doing so the interest rate charged on the guaranteed loan was one percentage point lower than those outside the initiative. For instance the business can receive a discount of £10,000 for a £1million loan from the bank. Banks apply for Government guarantees against the borrowing within a 2 year window for a fee. They can use the guarantee to raise funds at a lower cost. The fees received from banks will reduce borrowing and debt. If a bank were to default, the Government would have to meet obligations arising from the guaranteed debt, but as a general creditor would have some claim on the bank's assets. Any losses resulting from the guarantee would increase borrowing and debt. The common characteristics of the National Loan Guarantee Scheme were seen on the participating banks are; Available to new and existing customers Loan amounts from £25,001 to £5million Terms from 1-25 years (discounted for the first 5 years) Interest only and repayment terms available Fixed or variable rate To ensure that the businesses benefited from the scheme, the HM Treasury had put in place strong scheme rules for participating banks in passing on the guaranteed loan. The bank will have to demonstrate that the rate charged on the loans covered by the scheme will be expected to be lower than rates charged on the loan not covered by the scheme. The scheme was unsuccessful as nearly £3 billion out of the 20 billion was given to businesses. In an assessment of the scheme carried out by Syscap limited. They reported that the scheme has had no impact on small business lending. According to the analysis the interest rate on the loan was the same with the normal interest rate charged by the bank. Syscap indicated that the scheme did not assist small business at the bank provides loans to a few businesses based on the collateral that the business possess (Syscap, 2012). It is assumed that the bank were only lending to business that can afford to provide high security for an average loan and small businesses are considered not to have high collateral to back up their loans. The interest rate on the business loan under £1 million fell only by a 0.08% difference than the 1% difference. In other words, the average rate on loans below £ 1 million still remained at 3.8% even in the month the scheme was launched in March 2012 (Syscap, 2012). Difficult economic conditions in the UK and Euro zone have also led banks to dramatically tighten lending criteria as borrowing costs increase (Dun & Bradstreet, 2010). Banks have had to protect themselves and as a result lending has been restricted in many instances to established and well-run businesses. It is therefore suggested that the government should consider giving guarantees for alternative sources of finance like asset finance.

5.6 Better Payment Practice Group (BPPG)

The Better Payment Practice Group (BPPG) was formed in 1997 as a partnership between the public and private sectors. The original Payment Practice Group included: British Bankers Association, Association of British Insurers, British Chambers of Commerce, CBI, SME Council, Factors and Discounters Association, Federation of Small Businesses, Forum of Private Business, Institute of Credit Management, Institute of Directors, National Farmers Union, The Union of Independent Companies, Department of Trade and Industry and CMRC (Wilson, 2008). Its aim was to improve the payment culture of the UK business community and reduce the incidence of late payment of commercial debt [5] . Their research on late payment was incorporated into a guide to effective credit management - 'Better Payment Practice: a guide to credit management' published by the Department of Trade and Investment on behalf of the Better Payment Practice Group. It provided straightforward guidance and advice on how to get paid on time (Wilson, 2008). The Better Payment Practice Group was a consortium of small business support and representative organizations, Government and other interested bodies. It formed an integral part of the Government's commitment to work in partnership with the business community to bring about a better payment culture in the UK.

5.7 Prompt payment Code UK

It is a joint initiative that involves the public authority and the specialized organization like the institute of credit management and the department of the business , innovation and skills seeking to identify business that are prompt payers (ICM, 2008). Prompt payment Code is about promoting best payment practice between organizations and their suppliers. Mark Prisk, MP, Minister of State for Business and Enterprise, has stressed the impact of paying on time to smaller businesses within the supply chain (ICM, 2008). He also stated that what is important in payment practice is not only the speed at which payment is made but the certainty of getting paid that is important. This initiative encourages businesses to adopt the payment code by signing up to the code, committing them to paying supplier on time and to provide clear guidance on payment procedures. The code had been endorsed by several high street banks and professional organizations. The provisions of the Prompt Payment Code stipulated the that signatories must pledge to the following [6] ; To always pay their supplier within the agreed credit term. The customer must ensure not to change payment terms within giving reasons to the supplier promptly. The code also stipulates to their signatures to make payment procedures clear to the supplier, ensuring that disputes and complains about the payments are dealt with before goods are delivered. The customer must also ensure to contact the supplier on time in case payment cannot be made on time. Our normal payment terms for an approved invoice are 30 days from invoice date. Exceptions to this may arise where there is disagreement over the invoice or it is received with insufficient time for processing. In the exception cases payment is made as soon as possible after agreement or receipt of the invoice as relevant.

5.8 EU Directive on Late Payment (2002)

This directive enforced on 8th August 2002 for official member of the European Union. The directive was designed to bring member state (which were 18 member states) into line with all payments made as remuneration for commercial transactions. The Directive was designed to remedy this situation and to ensure that the sellers of goods and the providers of services would have a number of instruments at their disposal which permit them to obtain payment on time. Due to the close link with the free circulation of goods and services, the Directive is based on Article 95 (ex-100a) of the EC Treaty (Europa, 2000). The EU legislation does not apply to contracts made before 7 August 2002, claims for interest of less than 5 (£3.95) [7] , transactions with consumers or debts that are subject to other laws, e.g. Insolvency proceedings (Wilson, 2008). Only if the payment period and interest rate on late payment have not been fixed in the contract, the statutory interest automatically becomes payable within 30 days after the goods have been received by the customer. The legislation provides the statutory rate of interest on late payment when payment is not made within the contract period, but also allows parties to agree to their own terms as well. [8] . The general principles of this directive are; The directive only reacts to transaction between private business and top public sector business. The directive stipulates that 30 days as the credit term after which interest will be charged, unless another payment period has been agreed upon by the parties. The interest rate was set the same as the rate for European Central Bank of its main refinancing operations.

5.8.1 EU Directive on Late Payment (2011)

The directive 2011/7/EU on combating late payment in commercial transaction was published on 23rd February 2011 and came into force on 15th March 2011 (Europa, 2011). This new directive attempts to modernized the previous directive (2000/35/EU) [9] .

Changes made to the provisions are summarized below;

Commercial transaction between commercial parties

The new provision states that the standard deadline for a payment period of commercial transaction between businesses should be a 30 day period, if the payment period is not set out in the contract. If a payment period is not set out in the contract the debtor must make payment within 30 calendar days as the latest alters: Receiving the creditor's invoice; Receiving the goods or services; and Completion of acceptance procedures which commence on the date of receipt of those goods or services. Such procedures shall not last more than 30 calendar days but this period can be varied by express Any payment period that exceeds more than the stipulated period will be considered grossly unfair. This same principle stated above can also be applied to transactions between businesses with a 60 day payment period. Any payment period that exceeds more than stipulated period will be considered grossly unfair.

Commercial transaction between commercial entity and public authorities

The new directive can also be applied to transaction between private or public business and public authorities or central government. This is likely due to the general scope of the European Union, which is characterized by 27 member states transacting with each other. The payment period is put at 30 days on contract on the debtor public authority unless payment period is not stated in the contract within 60 days or in very exceptional circumstances.

Interest

Public authorities are not allowed to fix any interest for late payment. The relevant interest rate applicable will be increased to 8% above the European central bank reference rate. In retrospect, a creditor may charge interest on the amount due directly from the first day after the term of payment has expired. The debtor no longer needs to be in default, which means that he need not be reminded of his payment obligation, for example by sending him a reminder.

Claims/ recovery cost

All creditors to a contract are entitled to a 40 Euros (£ 31.5p) minimum cost by the debtor. This sum is payable without the need for a reminder and as compensation for the creditor own recovery costs.

Unfair contractual terms

The provision specifies several clauses that will determine whether a contract possesses grossly unfair terms. A contract can be considered unfair when; There is a change from good commercial practice, and fair dealing; The nature of the product or service; and The debtor had any reason to deviate from paying the statutory rate of interest for late payment. If the statutory rate of interest is excluded in the contract term.

Conclusion

Despite the fact that various existing studies have pointed out the shortcoming on the government policy, one cannot dispute the positive impact of legalization have on business activities in certain power, with relative satisfaction from individual business (Project Merlin, 2011 and Prompt Payment Code). In particular the government needs to promote the culture of lending to small business at favorable rates and open up alternative routes apart from bank lending. The FSB survey 2012 shows that, 22% of small businesses use own saving and 20% use retained earnings as a major finance source apart from the bank overdraft (FSB, 2012). In addition the government ensures to promote the guarantee schemes for alternative sources of finances for businesses like trade credit and asset financing. Many of business and industry participant are advocating for more attention by government personnel into many business practices. Ultimately, businesses cannot expect that every policy or action taken by the government will completely eradicate late payment. This is because government their policy based are supported by various statistics and research papers. Moreover trade credit relationship is heterogeneous in nature, there cannot be single solutions to trade credit issues because business are different. There are general obligation expectations that are expected of the next government in tackling late payment. Since the previous governments have tried at one time or the others have failed to meet the general expectation of businesses and SME and the general public. Policies should also help to monitor the administrative practices of small businesses, whereby various regulations are to set the standard for the micro and small businesses trading practices.

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