The following story could have been taken from a business management course where each student would be assigned to write his “response scenario.” Sadly the story is true and it happened this week.

A major privately-owned Swiss-based high-end retail jeweler with flagship brand-name boutiques in Switzerland and Europe, and retail partners in virtually every country in the world, mailed a letter to his diamond suppliers that had as the subject matter “your overdue invoices.” It reads, and I quote, “we are pleased to inform you that, as of today, our company can count on financing in order to further pursue its activities. Unfortunately, the company is not in a position to fully settle your invoices, but some payments will be effected within the next coming days.” Wow – that’s good news (the jeweler can continue its business) and then there is bad news (you won’t get all of your money). The letter clearly was more painful for the recipient than for the sender.

Actually, the president of the jewelry firm is a well known and trusted figure with intimate family ties to other respected names in the jewelry business and perceived to be quite wealthy – with the market always expecting that some related party would be ready to invest whenever needed. In other words: a very unlikely party to get into financial trouble. But these are not normal days.

In the management class assignment, you are the diamond supplier that has extended credit on the strength of the president’s record, reputation and personal relationship. The letter shows a side of the jeweler’s president you didn’t know existed. The letter says, “We have recently hired a restructuring committee which main task will be to solve the problem of overdue payments. A member of the committee will contact you shortly by separate mail in order to discuss in detail our settlement possibilities. Effective immediately, your contact person is neither the undersigned [i.e. the president of the jewelry firm], nor Mr. So-and-So, but the person who will contact you soon.”

“Soon” came quickly thereafter – in a separate letter. At least the bad tidings came in stages – not all at once. Focusing on the “good news,” the restructuring contact advises the suppliers to whom the jeweler is essentially in default of his obligations, that the “[jewelry company] can count on new financing to further pursue its activities, but this funding does not allow us to settle the whole of your invoices, as part of it must be dedicated to the continuation of the company’s activity.” [Emphasis added.] Must be dedicated? Who says? Who decides?

Maybe all the money is quite sufficient to pay all the outstanding overdue invoices, but the jeweler may then have to cease its operations. No. That’s no option. The management school students now learn that the defaulting party becomes the dictator-of-terms to the supplier of his goods, to the supplier of his credit.

A weird reality emerges: maybe the jeweler will survive, but you, the diamond supplier, may have to face insolvency.

You Must Forgive 25% of the Debt

Let’s see what the committee contact person suggests – and I quote again from the letter to suppliers, “Therefore, we offer you the following: (1) immediate payment of 30 percent of our debt against your agreement to abandon 25 percent of the said debt; (2) settlement of the balance in 24 monthly installments. This proposal ….will allow us to further pursue our business relations in the future.”

We must give it to them: the man has style. The verb “abandon,” according to Merriam-Webster Dictionary, means, “to give up with the intent of never again claiming a right to the money.” It sounds nicer than words like “waiving,” “forsaking,” “forgetting” or “writing off.” My preference would have been debt forgiveness – because that’s what economic powers grant to poor indebted underdeveloped nations. This will help these nations survive.

As we have said on other occasions, debt restructuring takes place all the time and it is legitimate and maybe appropriate in most instances. But not always. Each and all of us would like to have a chance to get rid of 25 percent of our debts and the repayments of the balance spread out over a few years. If one agrees to waive parts of the loan, one certainly wants to have comfort that the debtor has really no other choice – and that this is my best chance to get something, rather nothing.

Here the customs in the diamond business clash with those prevailing in the jewelry sector. In the diamond business, all the creditors would pool together and jointly deal with the debtor to ensure an equitable arrangement. By dealing with each creditor on a one-to-one basis, the debtor has an opportunity to prioritize, to prefer one creditor over another. To chart the names of those who he still might need in the future – and those he won’t buy from again in any event. As it involves a private company, which avoids legal bankruptcy by dealing with each creditor one at a time, there will be no transparency, no accountability – and one may never know if the problem was “real” or merely “imagined.”

In the diamond business there are near automatic sanctions against non-payment. One is suspended from bourse membership; one’s name is prominently posted on bulletin boards in all major diamond cutting and trading centers. You really cannot do business anymore – until you have paid your debts. What the Swiss jeweler is doing lacks transparency. The letter only went to suppliers who had overdue invoices. Maybe other suppliers are being paid – they don’t know about this. Maybe the revenue of the sales of your unpaid goods are applied to pay off other suppliers, with whom the company wants to remain in good standing – or used to reduce bank debts.

Impact on Financing in the Diamond Industry

Frankly, what this jeweler does, or does not do, to his clients is not our business. We should wish him well – and we do. We are, however, worried that in any diamond exporting center there may right now be an exporter shipping a few million dollars worth of goods to this jeweler. We are not aware – and will gladly stand corrected – that the company has warned all of its stakeholders that it is demanding debt abandonment.

As we are going through an extreme credit crunch, we are mostly concerned about the diamond industry’s sustained access to financing facilities.

Virtually all, or let’s say most, of the diamond sales to jewelers involve supplier credit. The suppliers in the cutting centers are utilizing revolving (short term) credit facilities with his banks. In many instances, the accounts receivables of the supplier are pledged to the financing banks. Moreover, in many instances the banks even hold a lien to (an interest in) the diamonds – an interest that is only cancelled when the remittances are actually received.

In line with the starkly diminished business activity since the onset of the credit crunch and the economic crisis, most diamond banks have decreased their clients borrowing facilities. In some banks, the credit lines were cut by anywhere between 30 percent and 50 percent. Most facilities are “revolving” and technically renewed every six months. When remittances are not made in the agreed period, the borrower is technically in default, which often provides the lending bank with the right to accelerate the payment of the loan. This has happened recently. The bank may even demand the immediate payment of the entire loan, which, quite likely, would create irreparable damage to the diamantaire, if not worse. This has happened as well.

The Supplier’s Dilemma

The jeweler’s restructuring committee contact will soon find out that his suppliers have a dilemma. If the shipment was financed, accepting a change in payment terms, or agreeing to waive part of the debt, is most likely a violation of covenants agreed with the lending banks. Most revolving credit facilities will have in its covenants a prohibition of the sale, discount or other disposition of accounts receivables with or without recourse. If the supplier credit terms are known to the lending bank, surely a diamantaire cannot just simply change the terms or agree to “abandonment.”

In an ideal world, the supplier would forward the Swiss jeweler’s and the committee contact person’s letters immediately to his own bank. This will happen most of the time – as the supplier will assume that the bank will already have seen these letters from other creditors. The banks would know – at least some of the time.

We don’t want to prejudge what a bank may advise to its clients – and this will differ from case to case. But it will cause a diminishing of the bank’s collateral base, or an erosion of the quality of the security pledge to the bank. The bank will likely demand that the supplier deliver some extra alternative collateral to the bank. Where will this come from?

This goes only to illustrate some of the “unintended consequences” of the Swiss jeweler’s efforts to save its own business at the expense of his diamond suppliers. One wonders whether the jeweler himself has exhausted all the financial recourse he has before asking his supplier’s to sacrifice. What about his/her own personal capital, the funds of spouse, family, friends, ex-spouses, parents or in-laws, or whatever the situation might be. Did the jeweler ask its downstream retail partners around the world for assistance? Did the jeweler’s own bankers also waive 25 percent of the jeweler’s own corporate debts? Did its own bankers liquidate the collateral pledged to it?

It so easy to get at the “suppliers” – because you already have the goods. The key question each “letter recipient” must ask himself – what will happen if I don’t agree? Or if my bank will not agree? Will the Swiss jeweler simply stop paying me anything? Is this an offer I better not refuse?

Nobody likes to make decisions without having far more information. We assume that, in this case, such added information will be forthcoming – but most selectively, most secretly, and differing from case to case. I would feel much better if all suppliers would meet with the jeweler somewhere in a hotel room – or in lawyer’s office. The fact that the president of the company, who clearly is defaulting on his obligations, refuses to continue to deal directly with his suppliers doesn’t seem to auger well for the future of company – and may raise doubts about the seriousness of the intentions regarding tomorrow and the days thereafter.  

Cost and Consequences

If this was an isolated case, it wouldn’t warrant the attention we are giving it. But in one way or another, debt restructuring has become almost an integral part of business management in the current credit crunch, a situation exacerbated by the declining values of the collateral pledged to banks. This, one might say, also happens in Chapter 11 type of restructuring. This is quite different: in Chapter 11 situations lists of secured and unsecured creditors will be made public. All creditors will at all times have a clear picture of the total situation and the various degrees of payment priorities that had been concluded will be honored. All non-impacted suppliers will have this information when they make their next shipment – if they make a shipment.

In the Swiss example, there is, apparently, no court involved. It is the Restructuring Committee a person, a body, appointed on behest of a local Swiss bank?

It is the diamond suppliers (and their banks eventually) that carry the brunt of jewelry defaults. So far, most retail jewelry insolvencies have taken place in the United States or in the Far East. We don’t want to say that Europe may be next. We hope not. But private, non-transparent, and even opaque restructuring exercises seem to be contagious and, apparently, increasingly gain acceptability and legitimacy. This should worry us all.

If this non-transparent hush-hush kind of restructuring becomes an epidemic then the outcome will be a foregone conclusion – the industry will transform into a cash-against-delivery business and lose its access to bank financing. Each time one waives an agreed payment for diamonds sold and delivered, the total equity in the business contracts slightly, and access to finance become more problematic.

We would rather report now week after week on a single case than having to reflect six months from now on the disastrous consequences of dozens of restructuring exercises – of which many companies weren’t aware.

The business school graduates reviewing this Swiss case will probably lament - we don’t have enough data to make an intelligent, well-reasoned and defendable decision. Are we talking about tens or hundreds of millions? Will the restructuring merely postpone bankruptcy and benefit preferred parties, or does the company have a realistic chance to make it? This piece of Swiss cheese has just too many holes.

That is exactly the point I tried to make.

Have a nice weekend.