– How passing on risk without the client’s consent increases the risk of insolvency –

An alternative to expensive supplier credit

Retailers frequently make use of so-called supplier credit; that is, they agree a payment term and have often long since resold the goods they purchased by the time payment actually falls due. The supplier can also insure himself against bad debts – for premiums of usually around 1 to 3 per mille. With a 3% discount for payment within 10 days rather than 30, the effective interest rate on a supplier credit exceeds 50%. Larger retailers in particular therefore turn to interim financing through private banks or savings banks as an alternative to supplier credit. In many cases the banks then also seek to pass the bad-debt risk on to insurers in exchange for part of their interest margin.

Insurance cover instead of equity

This is a good deal for the bank: by passing on the risk, it no longer needs to hold equity capital against this exposure as its own collateral, and can therefore expand its lending business still further. From the insurer’s perspective, its commitment is tied to real-world, genuinely existing assets.

When rating agencies and credit insurers come calling on SMEs

Armin Schlau (*name changed) ran his retail chain on credit financing undisturbed – until his principal bank resold “its risk” to an insurer by insuring the default risk alone. The unsuspecting medium-sized business then received a courteous invitation from its bank to open its books and to submit a range of reports at regular intervals, entirely unprompted. There was no legal basis for this – only the de facto, unspoken threat of having the loan called in by the house bank, which was in any case permissible at any time and without any justification. He was bluntly told that one wrong move on his part would lead to termination of the loans, because since the “sale of the default risk to the insurer” the house bank no longer had the final say on questions of creditworthiness.

A poorer credit rating – even where it results merely from a failure to submit documents proving the contrary – leads to the insurance risk being declined or to higher premiums on the loan, and thus ultimately erodes the bank’s margin, right up to the point of a loss-making engagement for the bank or a loan-default risk that is no longer calculable and which the bank must then bear itself. Unfortunately, a willingness to pay higher interest then drives creditworthiness down even further and pushes insurance premiums up even higher, so that the bank realises an even greater loss. This is because the borrower thereby signals that he can no longer obtain a cheaper loan anywhere else and that he is up to his neck in debt.

The entrepreneur had no choice but to bow to the wishes of his bank, which made clear that it lay in the insurer’s hands to cancel the loan should creditworthiness become insufficient, and that the insurer would then no longer bear the risk, or only at far higher premiums.

He himself had no contractual relationship with the insurer until the bitter end of the engagement, brought about by his own insolvency. The credit insurer appeared out of nowhere and vanished again – then came the actual loan termination by the house bank. To the expert, this is an economically wholly comprehensible process: the expertise of a credit insurer enables the bank to assess its risk more accurately, to reduce it overall, and ultimately to lend at interest rates that reflect creditworthiness, rather than on equally favourable terms for good and poor credit risks alike – which is no more than fair.

Debt collection by financial locusts

Another game played by some renowned savings banks and private banks is the bundled sale of credit claims against their own customers to financial locusts. Many a medium-sized business has had to experience how this then provokes a loan termination, seemingly almost without reason – though not without legal justification – simply because, by all accounts, the management had so decided. This need not even relate to the debtor’s creditworthiness, because the swiftest possible, indiscriminate loan termination is often built into the profit-maximisation logic of the loan purchase from the outset. Profits are realised as quickly as possible and the capital is freed up again for fresh credit purchases – and the margin-reducing cost of ongoing credit monitoring is likewise saved where loans are terminated indiscriminately.

After a brief visit from smartly dressed gentlemen of the “Moscow debt-collection industry”, this kind of approach leads to insolvency or company liquidation, especially where the credit rating is poor. Experts know that refinancing through another bank often involves months of lead time – regardless of how good the credit rating actually is.

Insurers, too, pass risks on

It is customary in the industry for some primary insurers who have undertaken to bear their customers’ credit risk to share that risk with other insurers – what the experts call reinsurance against a partial passing-on of the premiums. Here, too, the SME need not be asked, even where the additional contractual partner contributes its own expertise in still more sophisticated credit assessment, to everyone’s benefit.

Banking secrecy, insurance secrecy and data protection offer no protection

The sale of credit claims against predominantly commercial customers is, as a rule, prevented neither by data protection law nor by banking secrecy, which is not regulated by statute (BGH (Federal Court of Justice) ruling of 27.02.2007, ref. XI ZR 195/05). Better protection can be afforded by individual agreements, which can, for example, prevent the claim under the land charge from later being asserted in full plus interest – even where the loan has already been largely repaid. Otherwise, in case of doubt, the customer would first have to act on his own initiative and bring a lawsuit in the event of such a splitting of the loan claim and the loan collateral in the land register. An individual agreement that is not only discussed but genuinely negotiated in the legal sense will alter the legal position in the borrower’s favour over the long term – though often the credit customer is not even aware of the disadvantages of standard terms and conditions.

The Federal Court of Justice (BGH) protects bank customers

In its ruling of 30.03.2010 (ref. XI ZR 200/09), the BGH (Federal Court of Justice) held that, on the sale of a land charge, the new holder of this claim in rem must also enter into the security agreement with the original bank. The debtor is thereby once again entitled to all the corresponding defences – yet the credit customer remains, in practice, unable to defend himself against a changed business policy or against a refusal to renew credit agreements.

Until this BGH decision – or until the Risk Limitation Act of 2008 – the game could play out as follows: the house bank had “sold” the land charge, whereupon “Moscow Debt Collection & Co.” could insist that, say, EUR 100,000 plus 18% interest stood in the land register, and the borrower could not invoke the restrictive security agreement against them.

When the borrower then asked his bank to clarify the matter, the answer would run along the lines of: “We have already sold your actual loan debt to another financial locust – why not take it up with them?” From the customer’s point of view, his debt had effectively doubled, split between two new counterparties. Sorting such matters out takes patience and a war chest.

In 2008 the Risk Limitation Act laid down that there is no good-faith acquisition of a land charge free of defences. The borrower can therefore assert the security agreement against the acquirer of the land charge. The previously possible good-faith acquisition of a land charge free of objection – owing to ignorance of the security agreement – is now barred by § 1192 (1a) BGB.

The customer nevertheless continues to bear the risk of a costly legal dispute with the purchaser or purchasers of the receivables. How many fall victim is determined by the banks’ business policy. If it comes to it, bankruptcy may loom – though often it simply arrives sooner, and with less damage.

The Risk Limitation Act protects only consumers directly

Since 19.08.2008, the assumption of a contract by credit purchasers can no longer be effectively agreed in the small print where the customer is a consumer. Start-up founders, too, regularly fall within this category of persons. In other cases – in particular for merchants – it is possible to agree a prohibition of assignment for the loan taken out, § 354a (2) HGB. In any event it is advisable to spread the risk and, as a borrower, to put appropriate safeguards in place against less reputable debt enforcers. Notice periods for loans should match the lead time required for refinancing.

by Dr. Johannes Fiala and Dipl.-Math. Peter A. Schramm