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Bankruptcy: Why the Surprise?

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In recent years, bankruptcy filings and business failures have reached an all time high. D&B has found that in many cases, timely payments can create a "cloaking effect" making it more difficult to predict bankruptcy and failure. Learn the actions you can take to avoid cloaking pitfalls

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Bankruptcy: Why the Surprise?

  1. 1. D&B White PaperBankruptcy:Why the Surprise?Best Practices and Actions toAvoid the Cloaking Effectof Timely Payments
  2. 2. June, 2012The Cloaking Effect of Timely PaymentsIn recent years, bankruptcy filings and business failures have reached an all time high. You may evenhave been caught unaware by a customer closing their doors or filing bankruptcy. If so, did you wonderwhy you didn’t see it coming? You’re not alone. Even using the most sophisticated tools, manybusinesses have found themselves blind-sided.D&B has analyzed the data and studied a range of scenarios and found that in many cases, timelypayments can create a “cloaking effect” making it more difficult to predict bankruptcy and failure. Exhibit 1: Business Bankruptcy Filings 2000 to 2011 Even with the recent decline in bankruptcy filings, the average since mid-2008 is at an all-time high. 20,000 17,500 15,000 12,500 10,000 7,500 5,000 2,500 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 Source: D&B Page 3 Why the Surprise? We will define and describe the Cloaking Effect and places in the credit process where this may occur. Page 4–6 How to Avoid Cloaking Best practices for identifying the risk of cloaking. Page 6–7 Actions You Can Take to Avoid Cloaking Actions and strategies you can put in place today. 2
  3. 3. June, 2012Why the Surprise? At most corporations, these instances do not typically represent the bulk of bad debt losses, however they areNumerous scenarios can be labeled as precursors to examples that attract attention based on the “surprise”potential bankruptcy filings—some are more obvious and lack of opportunity for early intervention.than others. D&B recognized the Cloaking Effect after receiving in- quiries from the credit community asking why we had What’s the Cloaking Effect? not predicted a filing or closing. In many of these cases, the inquiries include an accompanying comment from A situation that occurs when the credit executive confirming that they had been paid companies promptly pay their on time right up to the bankruptcy filing date—thus trade credit obligations right up creating a confusing scenario, leaving the credit execu- tive searching to understand why their debtor had not to a bankruptcy filing or failure appeared on their radar as a possible high-risk customer. Further investigations typically reveal that the cus-One way the Cloaking Effect can happen is when a tomer had satisfied the majority of their obligations incompany has established automated payment method- a prompt or discount manner. Further complicating theologies and is making timely payments to receive highly matter, any scores heavily weighted by historical pay-valued discounts or continues to purposely pay on time ment data would have reflected the timeliness of thoseto avoid setting off red flags. Whatever the reason, when payments.this happens, the payment patterns or performance ofthe troubled company mask their true financial condi- NewPage Corporation is a recent bankruptcy filing thattion, creating a Cloaking Effect. we have received many inquiries about and one where the debtor paid most obligations relatively promptly, right up to the bankruptcy filing date.Case Study: A Recent BankruptcyExhibit 2: Case Study—NewPage Corporation NewPage Corporation, Miamisburg, OH Duns Number: 19-753-3446 Case # 11-12808 Wilmington, Delaware Source: D&B Filing date: September 7, 2011 NewPage Corporation filed for protection under Chapter 11 of the Bankruptcy Code on September 7th, 2011. They are a coated paper(s) manufacturer and at the time was 2011’s largest business filing, representing $3.5 billion in assets. Archived D&B Data PERIOD CCS CLASS CCS PCTILE CCS POINTS PAYDEX FSS CLASS FSS PCTILE FSS POINTS SER CURR 1 100 551 072 5 1 1328 9 11Q2 1 100 536 071 5 1 1328 9 11Q1 1 100 536 071 5 1 1328 9 10Q4 1 100 536 071 4 3 1361 9 10Q3 1 99 586 070 4 5 1370 8 10Q2 1 99 518 070 4 5 1383 8 10Q1 1 96 500 068 5 1 1319 9 09Q4 1 100 546 068 5 1 1320 9 09Q3 1 95 496 070 4 2 1347 9 3
  4. 4. June, 2012The Best Practice remains under their credit limit will be never be identi-It is understood that this specific bankruptcy and others fied. Therefore, the question of whether to review or notlike it, will not catch everyone off guard. However, given to review the account is never entertained.the number of inquiries received against this bankrupt-cy filing, an examination of what may have allowed this Exhibit 3:company to escape additional scrutiny as a high-risk Credit Decisioning by Credit Research Foundationcompany from many in the credit community is worth Detail the circumstances that would trigger a review of ana closer look. When researching these inquiries, we existing account. (Check all that apply)uncovered a few process areas where the Cloaking Effect Customer payments have fallen past due. 95%appears to mask the inherent risk. The Cloaking Effect Customer orders exceed credit limit. 86%actually covers three of the more traditional approaches Special Event (such as Change in Ownership, Fire,related to risk assessment: Flood, Theft, etc.) 72%1. Do I Review? Received industry trade credit interchange report 68%2. What Do I Review? indicating slowing payment to trade creditors.3. How Do I Review? Received report from subscription service notifying of 57% a change in the customers credit or financial situation.All are process related. All are payment based. All have Customer has released updated financial information. 56%anchors in an over-reliance on payment performance. Received information indicating a change in the cus-The nuance between the three is a question of where 56% tomers parent company credit or financial situation.the Cloaking Effect can occur. Let’s take a closer look at Legal Filings (Suits, Liens & Judgements) 52%the impact each of these scenarios can have on the All accounts are reviewed on a specific schedule. 40%accuracy of the identification of risk. Received alert from subscription service notifying of a 37%Question One: Do I Review? change in the credit limit recommendation.In our experience, many credit departments review Rating Agency Change (Moody’s, S&P or Fitch) 30%only existing customers with past due balances or Other 9%exceeded credit limits.This may be due to the impact of downsizing resources Returning to our case study, NewPage Corporation, thiswithin the credit function. The loss of resources forces would have been the case. According to D&B data, of thethe credit professional to alter internal processes and 616 trade lines 94% of their obligations were being retiredtheir approach to risk assessment. An “exception only” in less than 30-days past due resulting in a Paydex of 72.approach to account reviews may become necessary. This equates to 12 days beyond terms—generally deemedWhatever the reason, the effect of these operational “acceptable” by most credit departments. Looking at theprocess modifications is contributes to the surprise. previous eight quarters of performance, the PAYDEX has remained fairly consistent (see Exhibit 2)—with notThis theory is reflected and confirmed in the outputs enough of a continued monthly variance to trigger or high-of the Credit Research Foundation (CRF) study entitled: light a concern. Given this, NewPage Corporation wouldCredit Decisioning (see extract in Exhibit 3). The CRF not have come up for an account review because thestudy citing “what circumstances trigger a review of an customers’ internal processes didn’t call for it.existing account” clearly indicates that accounts receiv-able past due status and/or an account having exceeded In order to avoid being hit by the Cloaking Effect, more thanan existing credit limit is what determines the point of internal payment history must trigger a review.the review. This approach results in the situation wherea potentially high-risk customer that continues to retiretheir obligations in a discount or prompt manner and 4
  5. 5. June, 2012Question Two: What Do I Review? Question Three: How Do I Review?What Do I Review to assess the credit worthiness? Our Numerous articles have been written about auto¬matedresearch shows that regardless of the number or combina- decisioning or credit scoring – often highlighting the ben-tion of elements used, credit professionals are applying too efits and advantages of automating all or some aspects ofmuch emphasis on payment related data. Some of the most the credit decisioning process.frequently used inputs in a manual credit review are: The articles help define and structure cost-benefit analy-• Internal payment history sis and related ROI type scenarios for implementing such• Payment based scores programs. They often detail everything from throughput• Payment history from a vertical trade credit group efficiencies to Sarbanes-Oxley compliance.• Trade experiences shown in the D&B report With all these benefit-related approaches, what they fail to• Calls to trade references highlight is the importance of data elements and the ten- dency for credit practitioners to place too much weight on Exhibit 4: historical payment performance in an automated process. Credit Decisioning by Credit Research Foundation To illustrate this critical point, we researched 100 active Identify the information sources that you use to make an scorecards from credit organizations where the Trade Credit existing account decision. (Check all that apply) Manager applied their own weightings and elements to drive Customer History with your organization 73% the decisioning outcomes. See the results in Exhibit 5. (A/R, payment history, etc.) Credit Trade Group Interchange Report 54% Exhibit 5: Trade Reference 54% Aggregated Scorecard from Use Case Samples Element Weight Bank Reference 53% Payment Based Scores (CCS & Paydex) 44% DNBi 49% Internal Company Payment Data (% Past Due, % 25% > 90, Total Past Due, etc.) D&B Business Information Report 36% Financial Based Scores and Elements (FSS, Rating, 23% Financial Statement Data) All other Elements (Years in Business, Employees, 8%In reality, none of the above payment data sources is either Public Filings, etc.)singularly or collectively sufficient to perform the creditanalysis needed. As you can see in this example, nearly 70% of theLet’s go back to NewPage Corporation. All of the aforemen- sample set scorecards are heavily founded on paymenttioned would have been perceived as positive or resulted performance, leaving their companies vulnerable toin positive comments/points/scores; yet none would have automated cloaking. Confirming that a company payingrevealed the underlying financial stress the company was well, even if other elements may signify high risk, willexperiencing. The bottom line is that almost everyone not accumulate enough negative points to offset thosewould have stated they were being paid according to terms points received from the positive payment performance.with only slight variances. This historical view and over The result is no red flag for the Customer Credit analyst.emphasis on payments would lead to the same conclusionarticulated above—with payments being properly handled,the line of credit would be extended and the risk of failurewould be missed. 5
  6. 6. June, 2012Taking this concept one step further, let’s Exhibit 6:review how our case study account, NewPage Case Study­­ —NewPage CorporationCorporation, would have fared using data sets Element Weight Data Set Pointsfrom six months prior to the their bankruptcy June 2011 Achievedfiling date. Payment Based ScoresExhibit 6 empirically shows that if the framed Commercial Credit Score 24 100 2.4scorecard and related data from six months PAYDEX 20 72 1.8prior to the bankruptcy filing had been used, Internal Company Payment Data Average Days to Pay 15 36 1.3the final score would have been 6.7 for New- Percentage 90+ Past Due 10 0% 1.0Page Corporation. This value would have been Financial Bases Scores and Elementssufficient for NewPage Corporation to pass a Financial Stress Score 18 1 0.0typical automated credit review. Therefore, D&B Rating 5 - 0.0without the benefit of additional information All Other ElementsNewPage Corporation would have continued Years in Business 8 6 0.2to pass monthly credit reviews and the credit Total 6.7executive would not have anticipated the To calculate the score, the original sample aggregated scorecard in Exhibit 4 was expanded into a typical configuration but retaining the consolidated weights.bankruptcy filing. Note: This is not a recommended score card but rather an example of typical elements used in many scorecards.How to Avoid CloakingThere is significant value in a customer payment pat-terns. Slow payments or increasingly slower paymentsremain a good leading indicator of concern, but it is notenough to just look at payment history. As we saw in ouranalysis of NewPage Corporation, customers often retiretheir obligations in a timely manner regardless of theiroverall financial health. To avoid being surprised, consid-eration regarding the cloaking effect of prompt paymentpatterns must become part of the overall equation whenanalyzing or assessing risk and also when developing theweighted elements of an automated decisioning system.NewPage Corporation is not an isolated case or exampleof these concepts—even since their September 2011filing there are additional examples of other notablebankruptcies such as American Airlines, Dynegy Hold-ings and even the more current filing by Hostess, whichgive evidence to this theory. Given the fact that thesepotential surprise bankruptcies continue to occur, sowill the Cloaking Effect unless credit professionalsexamine the three process questions for potentialgaps in the outcomes. This is the only way to avoidbecoming a victim of the Cloaking Effect. 6
  7. 7. June, 2012Actions You Can Take to Avoid “Cloaking” 1. Review, Review, Review. Judiciously review and re-review your credit process to be sure you don’t miss warning signs from a company. Most times, all it takes is a simple tweak to create a more thorough process. 2. Use Archived Pre-bankruptcy Data Elements (PAYDEX, Commercial Credit Score and Financial Stress Score—Class, Percentile and Points—and Supplier Evaluation Rating—SER) for NewPage Corporation in Exhibit 2; to verify that your credit process would have captured the risk in this bankruptcy situation. If not, revise your policy to receive a warning for this type of credit risk. 3. Re-examine Your Scorecards and Weights. Many times using a negative attribute for lower Financial Stress Scores (i.e. 32 or lower) may provide the desired outcome. If you don’t want to change your scorecard, create an exception rule to capture High Risk accounts. 4. Segment Your Portfolio—Create a Filter that segments good paying customers that have other signs of high risk—Commercial Credit Score 90 and a Paydex score 70 with a Financial Stress Score to 35. Remember: A bad account could be captured within this filter for a period of time before ultimately failing. Your continuous review (#1 above) will enable you to see the warning. 5. Stick to Your Scorecard—Once you’ve re-examined your scorecard, stick to it. Do not reallocate weights for missing elements in scorecards. In situations where data elements are not present, allow the score- card to remain true and only represent what points it is awarding for elements that are present.A Final Thought: We want to reinforce that accounts falling into the categories defined should not automatically bedeemed high risk—in fact, there may be no risk at all, however if you have been the victim of a surprise bankruptcy,there is a high likelihood that you were cloaked. 7
  8. 8. June, 2012About the AuthorsDavid M. EaricksonAVP—Risk Management ApplicationsDavid Earickson is AVP of Risk Management Applications at DB. David has extensive experience in helping DB’scustomers map their operational practices to the latest technology solutions. Based on his solid understanding of thespecific business needs and objectives of the risk management professional, David has been recognized by both hiscolleagues and customers for his expertise in enabling the use of DB’s solutions and capabilities to create significantbusiness process improvements and a “best practice approach” for customers. David has developed numerous trainingprograms designed to educate credit professionals on the techniques that can be used to embed scoring and portfoliomanagement methodology into everyday risk management processes.William F. BalduinoVP—Risk Management PracticesBill Balduino is VP Risk Management Practices for DB. A former credit management practitioner, Bill brings a wealthof experience and knowledge that is based on more than 25 years experience in the profession. Prior to joining DB, Billheld senior credit and financial management positions at Fortune 500 companies in multiple industries. Among thesepositions, he served as Director of Credit for Engelhard Corporation and Director of Credit for Union Camp Corporation.Bill is widely recognized as an accomplished speaker on the subject of risk management best practices. He has beenfeatured in numerous credit forums and periodicals discussing the intrinsic value and evolution of the credit discipline.About Dun Bradstreet® (DB)Dun Bradstreet (NYSE:DNB) is the world’s leading source of commercial information and insight on businesses,enabling companies to Decide with Confidence® for 170 years. DB’s global commercial database contains more than200 million business records. The database is enhanced by DB’s proprietary DUNSRight® Quality Process, whichprovides our customers with quality business information. This quality information is the foundation of our globalsolutions that customers rely on to make critical business decisions.DB provides solution sets that meet a diverse set of customer needs globally. Customers use DB Risk ManagementSolutions™ to mitigate credit and supplier risk, increase cash flow and drive increased profitability; DB Sales Market-ing Solutions™ to increase revenue from new and existing customers; and DB Internet Solutions™ to convert prospectsinto clients faster by enabling business professionals to research companies, executives and industries, over the web.For more information, please visit www.dnb.com. 8

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