Bank discounting: definition, how it works and what's at stake for your company

Financial oxygen is essential to the smooth running of any business. It is a constant challenge to obtain liquidity quickly in order to cope with cash flow shortfalls, finance the operating cycle or seize a development opportunity. Among the tools available to companies to mobilise their trade receivables before their due date, bank discounting has a historic and still significant place, although it is competing with more modern techniques such as cession Dailly or factoring.. However, the apparent simplicity of this mechanism masks a legal reality and practical implications that need to be fully understood. Understanding what discounting is, how it works and what is at stake is essential for any manager wishing to optimise his financial management and secure his relationship with his banking partner. This article aims to shed some light on these aspects.  

What is bank discounting?

Generally speaking, discounting is a short-term credit transaction.. More precisely, it is a contract whereby a banking institution (the discounter) makes available to its customer (the remitter or credited party) the amount of a term receivable that the latter holds on a third party (the assigned debtor, often a customer of the remitting company), in return for the remittance of the security evidencing this receivable (generally a commercial paper)..  

The bank does not pay the full nominal amount of the loan. It retains its remuneration, which includes interest calculated over the period remaining until the maturity of the debt and various commissions for the service provided. Confusingly, this sum retained by the bank is itself sometimes referred to as the "discount".. The company therefore immediately receives a sum of money, but for a lesser amount than it would have received if it had waited for the normal maturity of its debt. In return, it transfers ownership of the debt and the security representing it to the bank..  

This transaction enables a company to transform a receivable not yet due into immediate cash, thereby improving its cash position without waiting for payment from its own customer..  

The complex legal nature of discounting

The exact legal classification of discounting has been the subject of debate in the legal literature. Is it a simple sale of a debt? A loan guaranteed by the security delivered? The reality is more nuanced.

Some have analysed discounting as the sale of a bill of exchange or the assignment of a debt.. The banker would buy the forward claim, and the sum paid would be the price of this assignment.. This view emphasises the transfer of ownership of the title. and the synallagmatic nature of the transaction: delivery of the security in exchange for the remittance of funds. However, it somewhat obscures the essential credit dimension underlying the transaction.  

Another approach has been to see discounting as a loan of money granted by the bank, guaranteed by the delivery of the security.. This concept clearly underlines the economic role of discounting as a source of financing.. However, it struggles to explain the transfer of ownership of the security and equates discounting with a loan, which is traditionally a unilateral contract, whereas discounting implies reciprocal obligations.. Historically, it has been possible to use the term "loan" to make discounting subject to usury legislation..  

Today, it is commonly accepted that discounting is a transaction sui generisDiscounting is a transaction of its own, borrowing from both the assignment of a claim and a loan, while using the specific mechanisms of the law governing bills of exchange. Basically, discounting involves transferring ownership of a debt instrument, usually by means of a translatory endorsement, in order to obtain an advance of funds. It is a credit transaction based on this transfer of ownership. Case law confirms that endorsement in title is characteristic of discounting, regardless of the exact method of remuneration chosen by the discounter. You will find more details on eligible securities in our article dedicated to commercial paper and discountable cheques.  

How does discounting work in practice?

The discounting operation generally takes place in several stages, governed by an agreement between the bank and its customer.

Discounting agreement

It all starts with an agreement between the company (the remitter) and its bank (the discounter).. This agreement may be one-off, for a specific bill, or form part of a more global discounting line, a credit authorisation granted by the bank for a certain volume of bills over a given period. The contract is consensual, i.e. it is formed by the simple exchange of consents.. The company's intention is expressed by presenting the instrument to the bank, and the bank's intention is expressed by its acceptance, which may be express or tacit (for example, by the actual crediting of the account).. The discount date is the date of the agreement, not necessarily the date of the accounting entry..  

It is important to note that the bank has a fundamental freedom: it is never obliged to discount all the securities presented to it.. It may make a selection, refusing certain items deemed too risky because of the situation of the final debtor (the drawee), the nature of the underlying transaction, or doubts about the solvency of its own customer.. The bank assesses the risk according to the creditworthiness of its customer (the seller).the creditworthiness of the borrower and the very nature of the effects (real commercial, financial or even convenience). However, in the event of refusal, it must promptly inform its customer.. This one-off refusal does not automatically result in the termination of any global discounting line agreement..  

The award of the title

Once approval has been given, the company must physically deliver the certificate to the bank.. If it is a commercial paper (bill of exchange, promissory note), this is usually done by endorsement.. Endorsement is the signature on the back of the bill of exchange by the holder (the endorser), expressing his or her intention to transfer the instrument to another person (the endorsee, in this case the bank). The standard endorsement for discounting is said to "transfer ownership": it transfers to the bank all the rights attached to the bill of exchange, in particular the right to demand payment on the due date and to exercise the remedies of the exchange.. Frequently, this endorsement is made "in blank", i.e. without naming the beneficiary, which facilitates the subsequent circulation of the security if the bank itself wishes to recount it..  

Advance payment

In return for delivering the instrument, the bank pays its customer the agreed amount. In practical terms, it credits the customer's current account with the nominal amount of the bill of exchange, less the remuneration (agio and commission).. This provision of funds is an essential obligation of the bank and a decisive criterion for qualifying the transaction as a discounting operation.. This means that the funds are immediately available to the company.  

The banker's remuneration

The bank is remunerated for the service provided and the credit risk taken. This remuneration, often referred to globally as "agio", mainly comprises:  

• Interest (or discount) : Calculated on the nominal amount of the bill and for the period from the transaction date to the maturity date of the security. The rate applied depends on market conditions, the estimated risk and the commercial relationship.  
• Committees: Various fees may be added to cover handling and management costs, or the specific risk associated with certain types of items (e.g. unaccepted items).  

The precise calculation of these charges must comply with certain rules, particularly as regards the total effective rate (TEG) or annual percentage rate (TAEG) for certain transactions, although the rules on usury are largely waived for business loans.. Remuneration conditions must be clearly stipulated.  

The benefits of discounting for businesses

Despite competition from other techniques, discounting still has undeniable advantages:

• Rapid mobilisation of cash : This is the main advantage. The company does not have to wait for its customer to pay, sometimes a long time in advance, before it has the corresponding funds at its disposal. This helps to finance working capital requirements and avoid cash flow problems.  
• Relative simplicity : Compared with other forms of credit, the process of discounting a bill of exchange can be relatively simple and quick, especially when a discounting line is already open. Presentation of the endorsed bill is often enough to trigger the operation.  
• (Theoretical) outsourcing of debt collection : Since the bank becomes the owner of the receivable, it will, in principle, be responsible for presenting it for payment on the due date. The remitting company is thus relieved of this task. However, as we shall see, this outsourcing has its limits in the event of non-payment.  

Points to watch and associated risks

Discounting is not without its constraints and risks, which need to be anticipated:

• The cost : The bank's remuneration (interest, commission) adds to the net amount received by the company. This cost must be carefully weighed against the expected benefits of the cash advance.  
• The risk of refusal to discount : As mentioned, the bank is not obliged to accept all bills. A refusal could disrupt a company's cash flow if it was relying on this source of financing. The quality of the receivables and the financial strength of the drawee are therefore important factors.  
• Liability in the event of non-payment : This is a fundamental point that is often misunderstood. Unless there is a very specific and rare "non-recourse discounting" agreement, the company that has discounted the bill remains the guarantor of the final payment. If, on the due date, the initial debtor (the drawee) does not pay the bank, the latter will turn against its own customer (the remitting company) to obtain repayment of the advance granted. The preferred mechanism for this is the reversal current account. The risk of non-payment is therefore not transferred to the bank, only the advance of funds.  
• The risks associated with irregular effects : Discounting bills of convenience (drawn without any real underlying commercial transaction, with the sole aim of obtaining credit artificially) or bills affected by any other irregularity exposes the company and its directors to civil penalties (nullity) and potentially criminal penalties (fraud), as well as to complex disputes with the bank if it discovers the situation. The bank itself may be liable if it has knowingly discounted such bills.  

Navigating the world of discounting therefore requires a good understanding of its legal and financial workings. Discounting is a powerful tool for cash management, but one that involves the company's responsibility. A relationship of trust and transparency with your banking partner is essential, as is constant vigilance over the quality of the receivables used and the solidity of the final debtors. In the event of difficulties or doubts about the legality of transactions, the assistance of legal counsel with expertise in banking law can prove invaluable in protecting the company's interests. An overview of these issues is available in our a practical guide to business discounting.

Discounting is a powerful tool but requires a good understanding of its mechanisms and implications. If you are experiencing difficulties or wish to secure your discounting operations, our firm can advise you. Please do not hesitate to contact our teams to discuss your specific situation, particularly if you need a lawyer for your discount issues.

Sources

• Monetary and Financial Code (in particular articles L. 313-1, L. 313-23 et seq., L. 131-59, L. 211-27)
• Commercial Code (in particular art. L. 511-1 et seq. - Bills of exchange and promissory notes)