Credit Protection Revisited
The recent decision by one of the main bank owned invoice financiers to withdraw from the provision of credit protection has highlighted a continuing debate within the industry on issues arising from the interface between bad debt protection on the one hand and the provision of insurance on the other hand.
It is now widely understood within the industry that the provision of insurance is a regulated activity under the Financial Services and Markets Act 2000 (“FSMA”) which requires providers to be authorised and regulated by the Financial Conduct Authority.
There are serious consequences for those who provide insurance without being authorised, including potential criminal liability, and the effect of section 26 of the FSMA is that a contract of insurance made by an unauthorised party is unenforceable and the client is entitled to repayment of “any money or other property paid or transferred by him under the agreement”.
There seems to be a view among some in the industry that this is a recent development, but in fact it has long been the case that insurance contracts made without proper authorisation have been illegal and therefore unenforceable since at least the Insurance Companies Act 1982.
We are aware of an unreported Court of Appeal case decided in October 1997 involving an invoice financier which dealt head on with a challenge by the client that the effect of credit protection provided in an invoice finance agreement amounted to an illegal contract of insurance under the 1982 Act. The facts of the case, Meridian Metal Trading Limited v Trade Indemnity – Heller Commercial Finance Limited are interesting and should provide some comfort to invoice financiers who wish to continue to provide properly structured bad debt protection as part of an invoice finance agreement.
Meridian was a steel stockholder and trader who had since 1987 entered into trade indemnity and credit insurance policies with Trade Indemnity Plc (“Trade Indemnity”), which was of course the parent company of Trade Indemnity – Heller Commercial Finance Limited (“TIH”).
In 1991 Meridian entered into an invoice discounting agreement with TIH, and shortly thereafter when the Credit insurance policy fell to be renewed Trade Indemnity sought to impose a 25% increase in premiums. This was resisted by Meridian who entered into negotiations with TIH to see if TIH was willing to provide credit protection as an ancillary service under its invoice discounting agreement. Those negotiations were successful, but a few months later Meridian decided to transfer its business to UCB Invoice Discounting Ltd and then an inter factor transfer took place whereby the debts assigned to TIH were reassigned to Meridian and then on to UCB in the usual way.
A dispute arose when some of the reassigned book debts which had been subject to the TIH invoice discounting agreement were not paid due to the insolvency of the debtors, and the essential question for determination by the court was whether the risk of non-payment was to be borne by Meridian or by TIH.
In the event the Court had little difficulty in finding that the effect of the re-assignment following the inter factor transfer was to pass the credit risk with ownership of the debts, so Meridian’s claim that TIH bore the credit risk failed, but in reaching this decision there was an interesting discussion of the argument raised by Meridian that the provision of credit protection by TIH rendered the invoice discounting agreement an illegal insurance contract in contravention of the 1982 Act.
In analysing this issue Ward LJ noted that: –
“… The language used sits more easily in the framework of insurance than non-recourse invoice discounting. I refer to terms such as 100% credit protection cover, premiums, payments against insolvencies, payments against other protracted default, which were more the language of insurance than of the discount factoring that was offered by [TIH]… The new conditions were that [TIH] would “provide Credit Protection under this Agreement”.
Clause 4.8 of the invoice discounting agreement as varied provided:
“Subject to the terms and conditions of this Agreement, we will accept the credit risk on all Approved Book debts.”
The judge then agreed that “the nature of the obligation undertaken as a non-recourse invoice discounting, and hence the credit risk, would not involve the making of any contract of insurance.”
Meridian raised an alternative argument to the effect that the TIH new business manager had made express representations to the effect that the credit protection to be provided under the variation to the TIH invoice discounting agreement would have the same effect as the Credit insurance policy with Trade Indemnity which it was replacing.
The judge rejected this argument, pointing out that the new business manager had “described himself as being in the credit department and not being in the credit insurance division,” and although the discussions had been about “credit cover” and involved a statement by the new business manager that “what TIH was offering was equivalent to the Credit insurance policy that Meridian enjoyed with trade Indemnity”, the discussions when taken as a whole together with the correspondence and the terms of the varied invoice discounting agreement did not amount to representations that insurance would be provided:
“This suggests to me that [the new business manager] was indeed saying that it was not an insurance policy but that it had the same effect as one, a statement which was true if the discounting arrangement with credit protection was allowed to run its course.”
Meridian’s claim therefore failed, and this decision of the Court of Appeal should provide some significant comfort for an invoice financier faced with an argument that bad debt protection amounts to the provision of insurance, since there were two potentially negative features of the case which would not normally be present:
- The variations to the invoice discounting agreement used language which the court found to “sit more easily in the framework of insurance than non-recourse invoice discounting” but this was not conclusive;
- TIH had expressly stated that its product would have the same effect as the true Credit insurance policy which had previously been provided to Meridian by TIH’s own parent company and which TIH was replacing.
Nevertheless, each case will turn upon a detailed analysis of the contractual documents involved together with any relevant oral representations and correspondence, and it is possible that the approach taken by the court in today’s climate of increased regulation may not be as favourable to an invoice discounter.
Our advice when considering the provision of bad debt protection in the context of invoice finance therefore includes a number of recommendations:
- The language of insurance should the avoided, at least to the extent of naming the product as “Bad Debt Protection” as opposed to “credit protection” and certainly not “credit insurance”;
- it is far too simplistic to seek to pass on the benefit the invoice financier obtains from its own Credit insurance policy to the client, and likewise it is not normally appropriate to refer to overall limits of cover to which the financier is subject since these are a matter for the risk taken by the financier and should not directly affect individual clients;
- the best drafting approach is to modify the recourse provisions in the invoice finance agreement so as to reflect as far as possible the risk taken by the financier; for example if the financier’s Credit insurance policy allows for a straight 90% recovery with no additional excess, a carefully drafted clause in the invoice finance agreement could modify the usual recourse provisions by limiting their operation to 10% of the value of debts unpaid as a result of insolvency or protracted default provided that the client had otherwise complied with all its obligations;
- the drafting also has to take account of specific requirements imposed by the credit insurer, such as that the client must cease the provision of further goods or services when any existing debt generated by the client is overdue past the protracted default period.