Dutch Glass Company is in the business of manufacturing glass for residential ho

Question

Dutch Glass Company is in the business of manufacturing glass for residential home construction. In recent years, the company has suffered working capital problems caused by plant asset acquisitions and the increase of receivables due to the economic downturn and slower-paying contractors. The president, John Dutch, has tried to increase working capital by borrowing money; however, because of their deteriorating financial condition, they have been unsuccessful. The loan officer at their current bank has explained that no additional loans will be approved until they demonstrate the ability to generate positive cash flows. John considers the problem and suggests to you that to generate positive cash flows, the company could sell some of its accounts receivable and liquidate much of its raw material. These actions would be detrimental to net income but would generate a positive cash flow.

• What are the ethical issues related to John's ideas?

• As the CFO for Dutch, how would you respond to John?

Explanation / Answer

Risks of Accounts Receivable and Inventory Financing

From a supervisory perspective, risk is the potential that events, expected or

unanticipated, may have an adverse impact on a bank’s capital or earnings. The

OCC has identified nine categories of risk for bank supervision purposes:

credit, interest rate, liquidity, price, foreign currency translation, transaction,

compliance, strategic, and reputation. While ARIF has all these risks, this

booklet will focus on credit, transaction, and compliance risk.

Credit Risk

Credit risk is the current and prospective risk to earnings or capital arising from

an obligor’s failure to meet the terms of any contract with the bank or

otherwise to perform as agreed. Credit risk arises any time bank funds are

extended, committed, invested, or otherwise exposed through actual or implied

contractual agreements, whether reflected on or off the balance sheet.

Like other types of commercial lending, ARIF’s most significant risk is credit

risk. ARIF borrowers typically exhibit higher default risk than other commercial

borrowers. Credit risk is present in every part of the lending cycle — initial

credit evaluation, underwriting, loan approval, loan administration, and, if

necessary, debt liquidation.

Transaction Risk

Transaction risk is the current and prospective risk to earnings and capital

arising from fraud, error, and the inability to deliver products or services,

maintain a competitive position, and manage information. ARIF has elevated

transaction risk because of the complexity of the products and the internal

control environment. The risk encompasses product development and delivery,

transaction processing, systems development, computing systems, employee

integrity, and operating processes. Transaction risk can also develop when

management or staff does not provide sufficient oversight.

Transaction risk in accounts receivable and inventory financing is primarily

posed by:

· Internal operations of the lending department, including the need to properly

perfect liens under the Uniform Commercial Code (UCC).

· Internal operations of the borrower.

Accounts Receivable and Inventory Financing 4 Comptroller’s Handbook

· The potential for fraud on the part of the borrower.

· The failure to properly oversee ARIF computer software products offered by

third-party vendors, if applicable.

Compliance Risk

Compliance risk is the risk to earnings or capital arising from violations of or

nonconformance with laws, rules, regulations, prescribed practices, or ethical

standards. Compliance risk also arises in situations where the laws or rules

governing certain bank products or the activities of the bank’s clients may be

ambiguous or untested. Because ARIF departments exert a significant amount

of control over the borrower’s working assets, this type of lending can be more

vulnerable to compliance risk. This booklet discusses compliance risk posed

by:

· Noncompliance with federal and state laws, rules, and regulations. For

example, a borrower may suffer financial setbacks if it violates or fails to

conform to laws governing environmental contamination, health, safety, or

fair labor.

· Litigation and other legal remedies (for example, lender liability actions) that

may arise when the lender seeks to have a debt liquidated.

Credit Risk Rating Considerations

Considerable debate has surrounded the issue of whether the uniform interagency

classification guidelines are appropriate for rating ARIF loans. OCC

policy is to apply the uniform interagency rating definitions, as contained in the

“Classification of Credits” section of the Comptroller’s Handbook. These

definitions take into account both risk of default and risk of loss in the event of

default. Risk of default is generally a matter of the financial strength of the

borrower, while risk of loss upon default is generally a matter of the quality of

underwriting (terms, collateral, covenants, etc.).

When applying the credit rating definitions to individual loans, examiners

should remember that ARIF is a type of secured lending. Decisions on risk

ratings must take into account whether sources of repayment will produce

sufficient cash flow to service the debt as structured, collateral value, and

collateral liquidity. Any laxity in the bank’s monitoring and control of the

collateral can diminish the protections afforded by collateral and lower a loan’s

Comptroller’s Handbook 5 Accounts Receivable and Inventory Financing

risk rating. Inappropriate structure can also be a significant factor in assigning

an adverse risk rating.

Borrowers whose loans are administered in dedicated ARIF units, particularly

asset-based lending1 (ABL) units, often have high leverage and/or erratic

earnings or losses. These characteristics are often the norm for ARIF

borrowers; their presence does not necessarily warrant an adverse risk rating,

but may do so if conditions deteriorate further.

More pertinent to the loan’s rating is comparison of the borrower’s actual

performance with what was expected when the loan was underwritten. If the

borrower repeatedly fails to meet earnings projections, has a trend of heavy

losses or excessive leverage, needs internally approved over-advances too

frequently or for too long, fails to provide timely financial information

(including inventory and receivable aging information) fails to perform on

related debt, or unexpectedly needs to access debt outside the ARIF line, the

loan is a candidate for an adverse risk rating. An adverse rating may also be

appropriate if the bank must adjust advance rates or change definitions of

eligibility, including the addition of fixed assets to the borrowing base, to keep

the loan within formula (see glossary). If liquidation of collateral (e.g., a forced

sale by the bank or borrower), is an ARIF loan’s most likely source of

repayment, the loan would normally be classified as substandard at best.

Some industry participants contend that ARIF loans, especially those

administered in well-controlled ABL units, should be assigned a more favorable

risk rating than a loan with similar earnings and balance sheet characteristics

because of the existence of collateral and the dedicated staff’s oversight. Such a

blanket system of applying risk ratings is not appropriate — in the same way

that it is not appropriate to assign an adverse risk rating simply because an ARIF

borrower has low or deficit net worth or occasional losses. While proper

controls help to moderate the risk of asset-based lending, they do not by

themselves overcome well-defined credit weaknesses.

Additional guidance on risk rating ARIF loans is provided in appendix C, which

includes examples of adversely rated credits and the ratings’ rationale.

Decision:

As a CFO of Dutch , not suggest this type of ideas.

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