The Good, the Bad and the Ugly

Factoring, Bankruptcy Automatic Stay and Sanctions

It is not uncommon for contemporary factors to believe that they are not subject to the bankruptcy automatic stay. In many cases they are not. However, that is not always the case.

Let’s consider old-line factoring (which has also been referred to as non-recourse factoring and full-service factoring) where the factor provides a full range of services including credit control, credit protection, collection, maintaining sales ledgers and providing financing. Old-line factoring was typically done on a maturity basis (Maturity Factoring), but over the years many variations came about including Collection Factoring.

In Maturity Factoring the factor purchases receivables and pays for them on the average maturity date which is typically 60 days after the invoice date (which is also the purchase date). If the account debtor were to file for bankruptcy or commit some other act of insolvency, the factor would, nonetheless, pay the purchase price to its factored client on the average maturity date.

Retailers were often late payers and, as a result, many factors started to purchase retail invoices on a collection basis (Collection Factoring) where the purchase price would not be paid until the invoice was actually paid. If there was an act of insolvency, the factor would then pay the purchase price (and not wait for collection which was certainly dubious). The factor (and not the factored client) would then be the customer’s unsecured creditor.

Now let’s add in the financing layer. The factored client typically cannot wait until the average maturity date or actual collection of the factored receivables and needs money sooner. In those cases, the old-line factors would make advances (loans) to the factored client which would be repaid from the proceeds when they became payable by the factor on the average maturity date or upon collection.

Thus, the factored client would have no obligation to the factor if it were to go into bankruptcy [other than for any monies that might become due to the factor by virtue of any chargebacks or other expenses, which I will defer discussing until another blog. For the purposes of this discussion. let’s assume that there were no chargebacks or other expenses they come into play.].

These scenarios do not necessarily apply to much of contemporary factoring where the factor retains full recourse to its factored client should the account debtor not pay for any reason including a bankruptcy or other insolvency event.

Now, we turn to the recent case at hand (remember, this is WurstCaseScenario) from the Ninth Circuit Bankruptcy Appellate Panel (BAP).

Jill Medley is a licensed real estate broker who entered into a number of agreements with Precision Business Consulting, LLC, whereby she assigned to Precision a portion of the commissions to be received upon the closing of homes in exchange for a 75% advance against the commission to be earned. Medley assigned replacement commissions to Precision should any deal not close and also allowed Precision to hold the deed to her home as additional collateral.

One such commission did not collect because the contract did not result in a closing, and Medley filed a petition for a personal Chapter 13. Precision filed a secured proof of claim asserting it was owed the amount of the advance plus interest at the default rate. Medley objected to the secured claim contending that the debt was properly a general unsecured claim. Precision claimed it was “a factoring company that purchases receivables . . . Factors don’t loan money.”

Precision then asserted a claim against another commission that became earned by Medley, and Medley objected claiming that her bankruptcy estate did not have an interest in the new commission. The Chapter 13 case was ultimately dismissed, and Medley retained the entire commission. She then filed a motion to hold Precision in contempt for violating the automatic stay and requested that the Bankruptcy Court impose civil contempt sanctions.

Medley argued that under the “transfer-of-risk” test, Precision was a secured creditor and not a purchaser of the commission. The bankruptcy court agreed, and Precision appealed.

On appeal, the BAP quoted Black’s Law Dictionary and stated:

“Factoring” is described as “[t]he buying of accounts receivable at a discount. The price is discounted because the factor (who buys them) assumes the risk of delay in collection and loss on the accounts receivable.”

The BAP recognized that the courts have applied this principle in various contexts (including in considering whether a transfer is usurious) based on the economic substance rather than its form.

“A loan … is the delivery of a sum of money to another under a contract to return at some future time an equivalent amount with or without an additional sum agreed upon for its use; and if such be the intent of the parties the transaction will be deemed a loan regardless of its form.”

The court considered these principles and whether the transaction was “a sale or a usurious loan. . . and the trier of fact should look to substance rather than form.” The BAP then went on to conclude:

. . . the bankruptcy court did not err when it found that the agreement was not a true sale, but rather a secured loan, and that the right to receive the commission was property of the bankruptcy estate protected by the automatic stay.

The BAP went on to affirm the bankruptcy court’s rulings including its ruling sanctioning Precision for a willful violation of the automatic stay in the amount of the debtor’s attorneys’ fees and costs in connection with the violation of the automatic stay. It went on to comment that although the bankruptcy court had considered (but not imposed) punitive damages, it would have been an error if it had.

The takeaway is that factors who purchase receivables with recourse must exercise care when their factored clients file for bankruptcy. Keep in mind that unless it is clear that the factor has assumed the risk of loss that a court will likely be severe in addressing the factor’s self-help. That said, it has been my practice in such situations to seek and obtain a “comfort order” confirming that the proceeds of the purchased receivables are not property of the bankrupt estate and, pending such order, assure that all such proceeds are being held in a?suspense account. Of course, if the factor will be providing DIP factoring or financing, the “comfort order” will be included within the DIP order.