Transaction Type: New business prospect for asset-based lender. The proposed revolving credit facility totals $75 million and is to be collateralized by accounts receivable and inventory. The exam subject is a multidivision manufacturer of outdoor furniture.

Significant Finding: The exam subject has letter of credit (LC) transfer arrangements with its vendors. A transferable LC operates as follows:  A receivable debtor opens an LC for the benefit of the borrower. In this traditional LC, the borrower’s bank acts as the advising bank and the customer’s bank acts as the issuing bank. The borrower then opens a transferable LC, agreeing to transfer the portion of the proceeds of the original LC relating to the cost of the inventory to the benefit of its vendors. The transferable LC references the original LC issued by the borrower’s customer. Under this arrangement, the borrower’s bank becomes the issuing bank and the vendor’s bank is the advising bank. At this point, the borrower’s trade services bank is the advising bank under the original LC and the issuing bank under the transferable LC.

At the time of payment, the proceeds of the original LC are wire transferred to the borrower’s advising bank, and the cost of the inventory is wired to the vendor’s bank, in accord with the transfer terms. Under these terms, only the profit margin on the transaction is deposited into the borrower’s bank account. The exposure to the secured lender is accounts payable because the transfer terms secure payments for vendors from receivable collections on the original LC.

This activity was uncovered through a detailed cash application test. A sampling of invoices showed that 10% to 20% of invoice totals were reduced by cash. The other 80% to 90% showed were offset by accounts payable. A detailed accounts receivable roll-forward would also isolate this activity.

Impact on Transaction: The impact was material because approximately 40% of sales had LC transfer arrangements. This activity and 40% dilution rate negated the proposed 85% advance rate. The lender’s underwriting team had to renegotiate the proposed terms of the facility.