Executive summary
The Principal & Agent Agreement (or ‘P&A product’) is a well known credit creation technique which has been used in Australian business finance for many years. It is in essence a ‘flow-through’ lending technique. Utilising the flexible nature of the law of agency, the P&A product enables the rights and obligations of the Agent (introducer) to become the rights and obligations of the Principal (financier).
This legal mechanism works simply and easily, provided the Agent acts within the terms of its authority under the P&A Agreement when it procures and contracts with each customer. The Principal may remain undisclosed to the customer for as long as it wants. This non-disclosure has no effect on the rights and obligations between the Principal and the customer.
The P&A product’s advantages include the fact that the Principal can grow and diversify its asset base much quicker than if it were seeking to locate and lend to the customers directly. The disadvantages include the need for the Principal to monitor not just each customer, but the Agent’s diligence in performing its obligations.
Introduction
The P&A product has been in use in the Australian banking and debt markets at least since the mid-1980s. In 1981 the Australian banking industry was de-regulated. The most obvious impact of de-regulation was the arrival of many foreign-owned banks, predominantly from the UK, Europe and North America. The foreign banks brought increased competition and innovative lending techniques.
One of those techniques was the P&A product. However, it is equally likely that the P&A product had already been introduced into Australia’s large business finance sector. This sector comprised a group of financiers that were historically called the Non-Bank Finance Intermediaries (or ‘NBFI’s). The NBFIs existed basically because of the strict regulation of Australia’s licensed banks up to 1981.
Prior to de-regulation, licensed banks were constrained by strict capital adequacy requirements and could offer only a limited range of retail and business products. They were also prevented from acquiring each other. As a way of getting around these restrictions, most of the banks, along with other investors, established their own NBFIs during the 1950s and 60s. The NBFIs became commonly known as “the finance companies”.
The P&A product most likely had its origins in the finance companies, rather than the local licensed banks or the newly arrived foreigners. Nonetheless, it is likely that de-regulation in general, and the arrival of banks from overseas in particular, accelerated the adoption of the P&A product across the Australian finance markets.
Rationale
The original purpose of the P&A product was to enable ‘vendors’ (basically, manufacturers and/or suppliers of physical goods), to increase sales by offering their customers the lease or buy alternative. With the financier’s approval the vendor would lease/rent goods to its customers on behalf of the financier, rather than make an outright sale.
In return, the vendor functioned as a kind of outsourced marketing channel for the financier. The vendor had a client pool and database which the financier could not otherwise access, unless it employed vastly more marketing staff (and probably not even then).
The outsourcing advantages of the P&A product soon became apparent to other tiers in the credit hierarchy, including smaller financiers and brokers. The ‘agent” in the P&A Agreement now included not just vendors, but these other kinds of introducers (all subject to the financier’s prior investigation and approval).
The major advantage of the P&A product is that the Agent under the Agreement can both source and sign up the goods’ end-user/customer. The financier or “Principal” funds either the goods’ vendor/Agent, or pays a supplier/re-seller introduced by the Agent. In the case of smaller financiers or broker agents, the Principal can either pay the Agent for the goods, on the understanding that the agent will remit the payment to the good’s original supplier, or pay the vendor/ suppler direct.
Another advantage of the P&A product is that the formality and risks of transferring title to the financed goods are averted. To implement the leasing transaction the vendor/Agent is not required to sell (or on-sell) the goods to the financier/Principal. Under the P&A Agreement, when the Agent pays the supplier (if it is not itself the supplier), title to the goods automatically passes to the Principal without more. Also any security agreement affecting the Agent is not infringed, and (historically) any liability to conveyance stamp duty was not enlivened.
Legal Aspects
Under the terms of the P&A Agreement, when the financier (Principal) advances funds, it acquires ownership of both the goods and the goods’ lease/rental receivables. The receivables comprise repayment of the credit provided by the financier to pay to the goods supplier. In return this payment allows possession and use of the goods by the end-user/customer.
The key legal requirement is that the Agent (as introducer of the customer) must be acting under the powers and within the authority conferred upon it by the P&A Agreement. Provided the Agent does so, it has the right to bind each customer to the lease/rental agreement on behalf of the Principal. Conversely, as the Agent has the power to bind the Principal to the terms of the lease the Agent signs with the customer..
If the Agent acts outside its authority (as defined in the P&A Agreement) or randomly introduces a potential customer to the Principal without any pre-existing authority, the Principal is not bound to provide credit to that customer unless it specifically gives its approval at the time.
In addition, the P&A product cannot be offered retrospectively. The Agent must first be approved and signed up under the P&A Agreement. Then it can act to seek out, and hopefully procure, potential customers for approval by the financier. An introducer cannot sign up a customer and then present that contracted customer as having been procured pursuant to an agency under a yet to be signed P&A Agreement. A different financing technique (for example, a sale of receivables) is required in those circumstances.
The law also permits the Principal under a P&A Agreement to remain undisclosed to the customer. This law offers commercial advantages to the vendor/introducer, who may wish to be seen as the customer’s exclusive relationship for the goods (and/or services). It may want to appear to be providing the finance as well as the goods. Also the validity of the underlying lease agreement is not affected by the fact that the vendor is no longer the true owner of the goods, even though it may be identified as such on the lease (or rental) agreement..
On the other hand, the Principal/ financier retains the right to disclose its role to the customer at any time. This usually happens when the customer defaults under the lease, and the Principal needs to commence recovery action against the customer.
Conclusion
The P&A product, as embodied in a P&A Agreement, is a flexible and well understood technique for financing business assets, predominantly equipment. Capable introducer/agents can grow a lender/principal’s book far quicker than if the lender were acting alone. However, the P&A product is a delicate instrument. Care must be taken, and diligence exercised, in identifying, appointing and monitoring the performance of agents contracted under P&A Agreements. Well managed, the P&A product allows for rapid asset growth, combined with the economic and tax effects on the principal being virtually the same as if it were lending direct to its customers.