RegCORE Client Alert | Banking Union
QuickTake
On 12 September 2023, the European Commission (the
Commission) published a proposal for a Regulation
on combating late payment in commercial transactions (hereafter the
Proposal or Proposed Regulation)
Late payments are
payments which are not made within the contractually agreed or
statutory term and thereby have the potential to have a major
adverse impact on small and medium enterprises
(SMEs). By Commission estimates, the root cause to
one in about four bankruptcies can be traced back to invoices which
are not paid on time.
Although the currently applicable Late Payments Directive (the
Directive) was adopted in an
updated form on 15 February 2011 to protect European businesses,
and especially SMEs, against late payments and to improve their
competitiveness, still only 40% of the businesses in the EU are
paid on time. The Proposal,
which is part of the SME Relief Package, seeks to replace the
Directive. Its next milestone is set for 22 February 2024, where
the current Rapporteur for the Proposal
is tabling a vote on a report on the proposal to the Internal
Markets Committee (IMCO).
Since the introduction of the Directive, several business models have also emerged to address working capital and other trade and supply chain financing needs of the real economy. This ranges from securitising receivables through to alternative financing approaches, to address the challenges on cashflow arising for businesses when dealing with delayed or outstanding payments. Among these models are factoring or invoice financing, supply chain financing such as dynamic discounting and reverse factoring and peer-to-peer (P2P) lending which all aim to creating a more efficient payment ecosystem overall by also reducing financial stress. The development and adoption of these models may vary across the EU Member States and approaches as to how such alternative financing models are regulated are still drawn-up against national lines. This thus drives fragmentation instead of efficiency and certainty that could be achieved through pan-EU legislative and regulatory harmonisation of factoring and supply chain financing in a meaningful manner so as to make such vital and in-demand products easier to operate across the EU-27 for the benefit of SMEs and indeed all businesses. As receivables financing, receivables securitisations as well as factoring and supply chain financing transactions are often cross-border, in particular where receivables are also offered to be financed via platforms, multiple laws apply to such transactions and (competing) compliance requirements including on notification and perfecting assignments.
In a renewed attempt to nudge a decisive shift towards a new business culture in which prompt payment is the norm, the Commission has now published the Proposed Regulation. The Proposed Regulation, once it becomes effective, would be, as an EU Regulation, consistently enforceable in all EU Member States and is set to replace the Directive (and the national laws implementing the Directive). The objectives of the Proposal can be condensed into the following policy areas:
- Preventing late payment from occurring – equally by introducing stricter enforcement measures;
- Facilitating timely payments; and
- Strengthening redress mechanisms, ensuring fair payment conditions and empowering companies.
Perhaps due to the Proposal building on a broad consultation of relevant stakeholders on the revision of the Directive, ranging from EU and national business associations to companies, in particular SMEs, as well as to academic experts, the measures introduced under the Proposal were conceived with SMEs in mind but are ultimately set to benefit companies of all sizes by combating late payment, with no exceptional treatment for SMEs per se. In addition, the Proposal, in its present form, does not currently contain much in the way of specificity required for a Regulation to take direct effect throughout the EU-27 nor to delineate how and to what extent it applies to persons outside of the EU-27 dealing with an EU-27 domiciled business.
Crucially, absent some better drafting in the Proposal,
insufficient consideration seems to have been given to large parts
of financial services firms providing SMEs and larger companies
with working capital and other (secured) financing to manage their
cashflow and treasury needs as well as to refinance, including in
non-solvent situations. Accordingly, the
current (poor) legislative drafting has a number of conceptual gaps
and unintended consequences. It remains to be seen if the current
Rapporteur responsible for advancing the legislative file can
remedy the situation or whether other stakeholders, such as the
European Central Bank, may need to wade in some improvements on the
basis of its competence to deliver a legal opinion in connection with
its basic task to promote the smooth operation of payment systems
as well as the stability of the financial system and, in doing so,
warn on the risks that the current drafting could have to financial
stability as well as viability of cashflows.
This Client Alert provides an overview of the issues and challenges that could arise if the Proposed Regulation is not amended. These changes are likely to influence a significant number of financial services firms across the EU that have developed business models in reliance on late payments and as such should be closely monitored.
Key points and problem areas in the Proposal
The Proposed Regulation purports to apply to "commercial transactions" but does not define that crucial term. Based on the context, it can be inferred that the objective of the Proposal is to be applicable to contracts involving the sale and purchase of goods and services, however the Proposal does not state this. Moreover, it is not definitively clear whether the Proposal applies exclusively to parties involved in contracts governed by the laws of the Member States of the EU or whether it applies to any person or entity selling or purchasing goods or services, irrespective of the governing law of the relevant contract. In each instance, this could be construed as interfering with the freedom of EU persons and entities to choose what law governs their contractual relationships.
Aside from the uncertainties above, the key and most
controversial change in the Proposal concerns the requirement
imposing a maximum payment period of 30 days from the date of the
"receipt of the invoice or an equivalent request for
payment", provided that the goods or services have been
received. This maximum period applies to business-to-business
transactions as well as transactions between businesses and public
authorities. Importantly, the
current drafting in the Proposal does not permit the parties
involved in a contract to mutually agree to extended payment terms
as long as doing so is not "grossly unfair" to the
creditor i.e., a supplier of goods or services. The term
"grossly unfair" is absent from the Proposed Regulation
due to its perceived ambiguity by the policymakers drafting the
Proposal. It should be noted that some market sectors have
long-standing practices, often based on logistical challenges that
allow longer payment periods of up to 60 or even 90 days. The
Proposal also assumes that all parties (in a supply or value chain)
are also able to pay within the 30 day period.
Regrettably and exceptionally shortsightedly, no consideration is given as to differing needs across various sectors where longer payment terms are normal and crucial to the functioning of markets. The current drafting assumes (and perhaps confuses) late payments, which it seeks to penalise, with extended payment terms that are often very reasonable depending on the parties' commercial and logistical arrangements and differ widely on what is being bought and sold.
The same is true in the Proposal taking a far too simplistic "one size fits all" approach to payment terms of end-products manufactured or finished in the EU that require multiple components (mostly imported from outside of the EU) and thus contingent payment terms, especially where shipping or transport times need to be taken into account. For instance, a lender may be sending merchandise to a borrower, with the understanding that ownership and liability for the merchandise will be transferred to the borrower at the departure port. However, it will take 90 days for the shipment to reach the destination port, and the borrower prefers to delay payment until that period. Presumably, this will no longer be possible, and as a result, the transfer of ownership and risk will be delayed, leading to increased costs for the creditor, such as insurance premiums. Additionally, the creditor will have to keep the products as inventory on its balance sheet for a longer period, which may be disadvantageous. As a result, retailers could also be forced to adjust their pricing strategies in light of the 30-day limit, potentially leading to higher consumer prices. Equally, this change could also incentivise retailers to source more from non-EU suppliers, who are free to offer more flexible payment terms – certainly not the aim of the Commission's overall strategy to strengthen the EU's Single Market.
The current drafting in the Proposed Regulation does not impact the parties' capacity to agree on instalment payments, as long as each instalment does not exceed the maximum 30-day payment period. Nevertheless, the Proposed Regulation lacks specific guidance on the practical implementation of this process. Consequently, it is possible for the parties to mutually agree on dividing the invoice payment into two separate 30-day instalments. The initial instalment would be a nominal payment, while the second instalment would cover the remaining amount, resulting in a total payment term of 60 days. Undoubtedly, the Proposed Regulation does not aim for this outcome, although it highlights the problem that arises when transforming a Directive into a Regulation without providing further specifics and context including defining who is responsible for payments matching and who has to prove that a payment (instalment) would not be sufficient to meet the requirements.
Another critical change is to remove the election in the Directive, for parties to apply late payment interest at the rates in the Directive. This election now becomes mandatory under the current Proposal so that late payment interest must apply and must accrue at 8% above base rate. While this may act as a deterrent to making late payments, the previous freedom afforded to parties whether to elect to choose such rate or agree on a lower rate, is often one that factors into the parties overall assessment of the strength and length of their commercial relationship and perception of counterparty credit risk. Restricting such freedom to contract at a lower rate may also drive a number of other risks both in the relationship but also drive litigation.
Equally absent from the Proposal are clear rules in relation to the date of the receipt of the invoice. This may be difficult to determine as different sectors have different modalities of how and when to send invoices. Some invoices are upfront, some are split into instalments and other invoices may be voided in the event of a return or other right of withdrawal being relied upon. Different laws apply to different scenarios and so the current simplistic drafting may fuel complexity as well as possibly litigation as to when late payment interest actually begins to apply. The current version of the Proposed Regulation indicates that late payment interest, which is incurred due to a delayed payment, accumulates from the later of two dates: the date when the invoice is received and the date when the goods or services are received. Assuming that the parties had agreed upon a payment term of 30 days and the debtor is one day overdue in completing the payment, they could be liable for 31 days' worth of late payment interest.
In addition, it should be observed that the parties are unable to waive the accumulated interest on late payments. If the parties neglect to collect or pay this interest due to considering it burdensome or insignificant from an operational standpoint, it is theoretically possible for this unpaid interest obligation to persist indefinitely, resulting in undisclosed liabilities that are unlikely to be disclosed on a debtor's financial statement. Moreover, the Proposal has no concept, which does exist under national law, whereby a creditor can accommodate situations where it would be unfair or contradictory to the contractual parties' requirements allowing them to deviate from the strict adherence to the late payments interest.
The Proposal is also not clear whether it applies to an assignee of a creditor of a payment obligation. According to the current draft, this does not seem to be the case. However, if it were, it would lead to some very problematic scenarios if a creditor could transfer the responsibility of payment to an assignee, but the debtor would only be obliged to pay late payment interest that is owed to the original creditor but not the assignee. If this were to apply, then this would ignore the entirety of laws in certain Member States that address the consequences of transferring a payment obligation and it would also certainly disrupt established principles of conflicts of laws that apply in the EU.
Another change concerns retention of title clauses and that these may be concluded if parties have consented to it. While not directly related to the late payment regulations aims, as it sits in the Proposed Regulation, it would supersede long-standing national legislation regarding the contractual enforceability of retention of title clauses.
Further considerations also apply to the Proposal preventing flexibility in working capital management for both debtors and creditors. Debtors frequently extend payment periods to effectively handle their working capital requirements and provide incentives to creditors in return for prompt payments. While the intention of the Proposed Regulation is aimed improving payment discipline, the potential loss of opportunity will ultimately be transferred to creditors through alternative means, such as reduced prices. Moreover, creditors heavily depend on supply chain financing solutions to convert their receivables into cash. Implementing those solutions might be expensive for finance providers and only yield results if the finance provider can attain a satisfactory return on their investment. Although certain creditors may decrease their request for such financial solutions when payment periods are restricted to 30 days, we anticipate that numerous creditors will still seek financing within this 30-day timeframe. Creditors may discover that specific finance suppliers retract or restrict their product offerings or are obliged to impose additional finance expenses in order to sustain a feasible offering.
All of these changes in the Proposal stray woefully close to imposing restrictions on privity of contract (an area that is beyond the reach of the EU's exclusive legislative mandate) and equally cause serious challenges to (1) cashflow velocity within the EU, (2) extraterritorial issues of how to impose this requirement on non-consenting suppliers beyond the EU-27 and (3) potential disruption and restrictions to many supply chain financing, factoring and other much used, needed and trusted alternative financing solutions, some of which may offer cheaper financing at lower credit risks.
Another part of the Proposal that has been subject to extensive criticism is the administrative burden that may arise from the requirement that Member States must appoint authorities that will be responsible for enforcing the Proposed Regulation. The authorities are responsible for carrying out their tasks in an impartial and equitable way, ensuring that private businesses and governmental entities are treated equally.
Putting the above into perspective, with the Proposed
Regulation, the EU's co-legislators are now aiming to step up
their fight against late payment in commercial transactions in
order to promote overall SME liquidity and boost EU competitiveness
and resilience as a whole, the Commission
estimates that by being paid on time, companies will each year save
at least 5 man-days currently lost in chasing collection of debts.
The question is
whether 5 days per annum outweigh the restrictions on privity to
contract and to obtain as well as manage capital. To put things
into further perspective, in an estimated ca. 500 invoices which
are issued every second in the EU, only 1 out of 2 are paid on
time. Public authorities
have not come away with clean hands from late payments either, with
an estimation that the average payment by some public authorities
exceeds 200 days.
Outlook
The Proposed Regulation's strict terms raise serious questions about their practicality and the potential unintended consequences for the European business landscape. This applies not just for financial services firms but for the functioning of the real economy as a whole. The Proposed Regulation's potential problems and disruption that it could mean to the flexibility businesses currently have in arranging commercial transactions, including the provision of commercial credit could severely outweigh its benefits.
While it might be tempting to suggest that the Proposed Regulation could be scrapped in its entirety, it is far more likely that it will be reformed and hopefully made more reasonable and fit for purpose. Accordingly, financial services firms, stakeholders from the real economy and wider industry associations, working together with counsel, will likely be called upon or otherwise want to join the (constructive) criticism to point out to the policymakers and notably the (current) Rapporteur on this legislative dossier to fix the file. This includes looking at concepts more broadly as opposed to "just" on how to amend the drafting in a sensible manner and make it fit for purpose.
Similar efforts might also be useful to call on the Commission to actually direct its rulemaking effort at streamlining and drafting a new chapter in the EU's Single Rulebook for financial services to cover factoring, supply chain financing and thus make it easier for EU financial services firms to deliver (secured) financing and much needed capital to SMEs on a cross-border basis and in particular for cross-border exposures. That would be a more sensible place to start and actually add value to the supply and value chain.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
