Late payment: necessity, fault, opportunity

March 18, 2024

More than a quarter of a century has passed since the first discussions in the European context that led to the launch of the first version of the Late Payment Directive, and we are on the threshold of yet another version of the legislation, this time in the form of an immediately applicable regulation. Neither the objectives nor the instruments have changed: compulsory standardisation of payment deadlines, penalties for late payment, punitive legal default interest. The classic regulatory repertoire, the first result of which is the reduction of the parties' room for negotiating autonomy, on the assumption of interpreting their actual interest.

However, the time that has passed and the experience gained in the field should suggest a minimum of critical reflection not only on the effectiveness of the instruments used, but above all on the objectives pursued. If, for twenty-five years, we continue to tighten the penalty for late payment and the situation does not improve, should we not entertain the doubt that perhaps late payment is not the problem?

Let us try to reason.

  • Background considerations

The intent of the European Union in promoting a uniform regulation of late payments in B2B and B2G transactions was to foster the punctuality of payments, thus eliminating a stress factor in financial management, especially of smaller enterprises. The legal instrumentation adopted in pursuit of these aims includes the regulation of commercial payment terms and the sanctioning of late payments, through the provision of a right for supplier companies to be awarded punitively determined late payment interest, as well as administrative compensation. 

The logical assumption of the regulation is that late payment is a behaviour predominantly due to the relational and dimensional asymmetry between 'strong' customer and 'weak' supplier and it is therefore sufficient to provide a legal instrument that imposes a balance and legitimises the weak party's claim to compensation. 

In economic reality, the problem is much more complex. It also includes the logic of determining the terms of payment for services and supplies and cannot disregard the awareness that the roles of supplier and customer are played within a network of relationships in which each company is simultaneously one and the other. Moreover, a very important part of supply relationships is but a single stretch within a longer chain. Focusing on the single stretch, ignoring upstream and downstream behaviour, significantly reduces the effectiveness of any regulatory provision. To assume that the 'normalisation' of any single stretch automatically translates into the normalisation of the entire chain and the entire network of relationships is simply naive.

There is a lot of talk about supply chains, but people forget - or fail to understand - that one of the identifying features of a supply chain is the component of common economic interest, distributed over the various links that make it up, with respect to the end result: the sale to the end customer, be it business or consumer. The intermediate steps of transformation, storage and distribution are all necessary for the final result. Payment flows within the supply chain are a way of (co-)managing the financing of the working capital necessary to achieve the end result. 

Within this context, the weak supplier harassed by the strong customer is a rare or even non-existent archetype. The reality is made up of suppliers who have a different level of involvement with respect to the end result and, therefore, different modes and intensity of participation. Suppliers of commodities and raw materials have no particular interest in supporting the individual customer who is, as a rule, easily replaceable. A marginal supplier, itself easily replaceable, has no interest in supporting the customer and can easily fall victim to late payment, but this rarely has a significant impact on its financial balance. A supplier structurally embedded in a supply chain is aware that the objective shared with the customer is the sale of the finished product and has an interest in contributing to the achievement of this result, even through longer payment terms and even if this means taking on higher risks

The fundamental error of the EU approach is to think that all supply relationships are equal and that the size asymmetry of the contracting parties is the only relevant factor in their financial behaviour. 

Instead, the real problem is that of the financing of companies' working capital. A problem that can be accentuated by long payment terms and late payments, but which should not be confused with these factors. Payment terms and late payments are some of the tools that companies use to manage the financing of working capital: focusing only on some of these tools does not help to understand the problem, nor to solve it.  

  • The potential effects of imposing standardised payment terms  

Over the past twenty-five years, we have witnessed the attempt to progressively tighten regulations on payment terms and late payments, with, however, modest effects on the behaviour of economic actors, including public administrations. 

The next step, as proposed by the European Commission, is to set maximum payment terms on a legal basis, resorting to a regulatory instrument that does not require transposition within individual countries and further tightening the penalty component in the event of late payment. What will be the effects? 

Assuming the solution is effective, the actual result will be to put all those companies operating in the processing and storage of goods, rather than in the design and construction of plants, buildings, works, etc., into financial crisis. Forced to pay their suppliers in the short term without being able to invoice their customers immediately, and deprived of financial support from their suppliers, they will have to draw on third-party credit, of which they are already large users, and their stability will depend fundamentally on the availability of bank credit or unlikely recapitalisation efforts. That is, if the solution proves successful. 

The more likely outcome, however, is that the system will tend to maintain the stability of its financial cycle by shifting the lengthening of time upstream. That is to say, future supply and service contracts will make the billing of fees conditional on onerous (and lengthy) customer approval processes. The end result will be an increase in the working capital financing difficulties of all supplier companies, which will not have documented trade receivables on which to build financing operations with the instruments available on the market. 

  • Limits of market instruments for financing working capital    

The financing of working capital is one of the key factors in ensuring sound and prudent business management. Businesses die when they can no longer find a place in the market, but they also die (much more often) when they cannot manage their operational financial cycle, when the time gap between payments and receipts becomes too wide and the company cannot find the financial resources to cover this gap. Short-term financial strain is perhaps the main factor in the crisis, even irreversible, of Italian companies, and this is reflected in all credit risk scoring models, which tend to overweight the indicators measuring this phenomenon. It is a matter of managing the short-term liquidity that the company has (or does not have), of course, but also and above all of managing the factors that this liquidity generates (customer payments) or absorbs (payments to suppliers and inventories), without forgetting that long payment times imply a higher credit risk for the customer and correspondingly higher credit needs for the supplier. 

The financial market offers a vast assortment of instruments suitable to support companies in the management of working capital (bank advances, factoring, reverse factoring, confirming, letters of credit, ...), but this abundance does not mean that the instruments are equally available to all companies. Each of these instruments tends to presuppose a minimum dimensional threshold - sometimes quite high - in the relationship with the financial operator providing it, as well as an adequate credit standing of the company receiving the relative credit, whether supplier or customer. This means that in many cases the actual availability of such instruments is severely limited or even absent. 

Within the existing framework, these limitations can be partially obviated through positive actions, such as the elimination of constraints on the assignability of trade receivables, rather than the recognition at the regulatory level of mitigating factors to the related financing transactions, so that banks have a greater incentive to increase their lending in this sector. 

However, if one recognises that the real issue is not so much to artificially reduce the financing needs of working capital by limiting payment times - an abstract objective, which disregards the reality of supply relationships and their context - but to ensure that these needs are met by improving existing instruments and aiming to overcome their structural limitations, then a little lateral thinking may also be useful. 

  • An alternative model: a commercial debt market    

The prevailing models for financing credit and commercial debt are, in fact, financing models, based on the assessment of risks: counterparty (supplier and/or customer), transaction (existence and collectability of receivables), behaviour (expected delay in payment), negotiating structure and segregation from third party claims, ... The complexity of this approach makes it difficult to achieve substantial objectives of enlarging the market and reducing barriers to entry. 

Overcoming the limitations of the existing instruments means then, for example, trying to imagine a solution similar to the venture capital market, a market for the commercial debt of companies with characteristics that guarantee: 

  • a low level of risk for investors, by at least eliminating all the uncertainty factors implicit in the collectability of the trade receivable (disputes, offsets, defects in performance, ...). This condition could be achieved if it were the debtor company that placed its debt on the market, declaring its collectability;
  • a high level of inclusiveness. A priori, any supplier company should be able to access the market to sell its debt declared collectable by the debtor, regardless of its financial rating and size. Corollary to this objective is the need for
  • a strong simplification in the onboarding and KYC processes, avoiding multiplying them for all investors and referring them, perhaps, only to debtor companies, actual risk counterparties and market feeders. 

In a scenario such as the one hypothesised, the criticality represented by long payment terms is significantly reduced, especially within supply chains whose terminal point is a company with an adequate credit standing, and therefore able to guarantee a sufficiently liquid market for its trade debt. An effective possibility of negotiating trade credit at market conditions and without prejudice to the supplier's financial soundness can neutralise the variable represented by more or less long payment terms for the company's financial equilibrium and allow it to share the financing of the overall production cycle with the customer, without taking on excessive risks. 

In addition, the existence of an active market for companies' commercial debt (a market capable of correctly pricing the risk) would have the positive effect of generating in supplier companies a greater awareness of the credit risk implicit in the supply relationship, improving their sensitivity and increasing, over time, their economic sustainability. 

  • A modest proposal

if the objective pursued in the revision of the late payment legislation is to mitigate the financial criticalities to which SMEs are exposed in their commercial relations with larger companies, one possible solution is to incentivise the creation of active trade debt markets for larger companies, by conditioning the application of payment terms above a certain level (e.g. 60 days) on a commitment to ensure the negotiability of the relevant invoices on an open and sufficiently liquid market.

Rather than intervening by severely restricting the negotiating autonomy of the parties, regardless of any assessment of their actual interest, a more circumscribed intervention might yield better results.  

From an operational point of view, the proposal could therefore be articulated as follows: 

  • provision of standard payment terms and penalties for late payment, as in the current system;
  • exemption from any restrictions on negotiating payment terms with suppliers and the possibility of agreeing on late payment interest at a rate other than the legal rate for companies that guarantee their suppliers the possibility of negotiating their credit in open and inclusive markets;
  • incentives aimed at the creation of market platforms of this kind and the membership of companies and banks and financial operators in them. Incentives for companies could refer to favourable tax treatments for the costs incurred in setting up and joining, those for financial intermediaries could take the form of a lower capital requirement for the relevant uses, in addition to possible operational simplifications in terms of compliance requirements.