Legal Counsel Guides 1 - Factoring

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In my first series I decided to talk about Factoring. Imagine you own a small manufacturing company in the United States that supplies custom parts to a large automotive manufacturer. You've just secured a contract with this big enterprise, which is great for your business. However, the terms of the contract require you to deliver the parts and then wait for payment for either 60 or 90 days (NET 60 or NET 90).

While this contract is a big opportunity, it also poses a challenge for your cash flow. Your business needs to pay for raw materials, labor, and other expenses upfront to fulfill the order, but you won't receive payment from the enterprise for a couple of months. This gap in cash flow could strain your finances and limit your ability to take on new orders or invest in growth.

In this situation, factoring services could be beneficial. You could sell your accounts receivable (the invoices from the large enterprise) to a factoring company at a discount. The factoring company would advance you a significant portion of the invoice value upfront, providing you with immediate cash to cover your expenses. The factoring company would then collect payment from the enterprise when the invoices are due, effectively bridging the gap in your cash flow and allowing you to continue operating and growing your business.

Factoring contracts in the U.S. refer to arrangements where businesses sell their accounts receivable (invoices) to a third party (a factor) at a discount. This is done to improve cash flow by receiving immediate payment for invoices that would otherwise take time to be paid by customers. Here's a breakdown of how factoring works and its key components:

1. How Factoring Works

A. Invoice Generation: A business sells goods or services to its customers and generates invoices.

B. Sale to Factor: The business then sells these invoices to a factoring company.

C. Immediate Payment: The factoring company pays the business a large percentage of the invoice's value upfront (typically 70% to 90%).

D. Collection: The factoring company takes on the responsibility of collecting the full invoice amount from the customer.

E. Final Payment: Once the customer pays, the factor pays the remaining balance to the business, minus a fee for the factoring service.

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2. Commonly Required information for Proposal

Let’s collect documents for the good proposal:

A. Fill in the Credit Application form of the factoring company.

B. Financial Statements (Income Statement, Balance Sheet and Cash Flow Statement).

C. Bank Statements.

D. Accounts Receivable Report.

E. Accounts Payable Report.

F. Organization Chart.

G. Articles of your entity .

H. Invoice and purchase order (PO) example.

I. Debtor’s Information.

J. Shareholder‘s ID’s.

K. Questionnaire about the Factoring needs and your current financial situation.

3. Types of Factoring

A. Recourse Factoring: The business must buy back any invoices that the factor cannot collect payment on.

B. Non-Recourse Factoring: The factor assumes the risk of non-payment by the customer, usually at a higher fee.

4. Collaterals

A. Credit Trade Insurance (the BEST option in my opinion)

Credit trade insurance, also known as accounts receivable insurance or trade credit insurance, is a type of insurance that protects businesses that sell goods and services on credit terms from the risk of non-payment by customers. In the context of factoring, credit trade insurance can play a significant role, especially in non-recourse factoring arrangements. Here's how it works:

• Coverage: Credit trade insurance typically covers a percentage (often around 80-95%) of the amount of an invoice that remains unpaid due to customer insolvency or default.
• Non-Recourse Factoring: In non-recourse factoring, where the factor assumes the risk of non-payment, credit trade insurance can provide an additional layer of protection for the factor against customer defaults.
• Risk Mitigation: By insuring the accounts receivable, the factor can reduce its exposure to credit risk, allowing it to offer more favorable terms to the business selling the invoices.
• Premiums: The cost of credit trade insurance is generally based on factors such as the creditworthiness of the insured business's customers, the industry, and the amount of coverage required.
• Requirements: Some factors may require businesses to obtain credit trade insurance on their receivables as a condition of the factoring agreement, especially in non-recourse factoring.

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B. Other Insurances:

• Factor’s Insurance: Factors themselves may carry professional indemnity insurance and other forms of coverage to protect their operations. This might not directly benefit the client but stabilizes the factor’s business.
• Insurance of Collateral: In cases where additional collateral beyond invoices is involved (like in asset-based factoring), insurance on those assets (like inventory or equipment) could be required to protect the value of the collateral.

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C. Accounts Receivable

• Primary Collateral: In most factoring arrangements, the invoices that are sold to the factoring company serve as the primary collateral. The factor advances funds based on the perceived ability of the debtors to pay these invoices.
• Verification: Factors often verify the validity and enforceability of the invoices before accepting them as collateral. This can include confirming that the goods or services were delivered and accepted.

D. Personal Guarantees

Some factoring agreements, particularly in smaller or riskier business ventures, might require personal guarantees from the business owners. This isn’t additional physical collateral but does provide another layer of security for the factor, as it allows them to seek repayment from the guarantors’ personal assets if the business fails to satisfy the terms of the factoring agreement.

E. Validity Guarantee in Factoring

A validity guarantee is an assurance provided by the seller of the invoices (the business) to the factoring company, confirming that the invoices are legally valid, enforceable, and not subject to disputes or set-offs. This guarantee assures the factor that the receivables are legitimate and that the debtor has acknowledged the debt. Here’s how it generally works:

• Be aware, in practice, often happens that Validity Guarantee has a hybryd-narute with Personal and seeks straightforward reimbursement from the Guarantor
• Risk Mitigation: The validity guarantee serves as a risk mitigation tool for the factor, ensuring that they are purchasing receivables that are free from legal defects or disputes.
• Obligations of the Business: Under this guarantee, the business might have to attest that the products or services were delivered as agreed, accepted by the customer, and correctly billed.
• Repercussions of Invalid Invoices: If it turns out that invoices are not valid (e.g., due to disputes over delivery or the quality of goods/services), the business might have to repurchase these invoices from the factor or compensate the factor for losses.

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F. Asset-Based Factoring

In some cases, factoring arrangements may be part of broader asset-based lending practices where other assets of the company (like inventory, equipment, or real estate) might also be used as collateral. This is more common in situations where larger, more integrated financing solutions are structured to support a business.

5. UCC Filings in Factoring

A. UCC-1 Financing Statement

• Purpose: The UCC-1 financing statement is a legal document that a factoring company files with the secretary of state or similar state agency to establish its priority in the business's accounts receivable.
• Public Notice: By filing a UCC-1, the factoring company notifies other potential creditors that it has a security interest in the business's receivables. This helps prevent competing claims from other creditors.
• Scope: The UCC-1 typically covers all present and future accounts receivable of the business, providing a broad security interest to the factoring company.
• Requirements: The UCC-1 must contain specific information, including the names and addresses of the debtor (business) and the creditor (factoring company), a description of the collateral (receivables), and any other required information under state law.
• Effectiveness: Once filed, the UCC-1 remains effective for a specified period (often five years) unless terminated earlier by the factoring company.
• Renewal: To maintain priority, the factoring company must renew the UCC-1 before it expires. Failure to do so could result in the loss of priority to other creditors.

B. Impact on Business and Creditors

• Business Operations: While the UCC-1 filing does not directly affect the day-to-day operations of the business, it does limit the business's ability to use its receivables as collateral for other loans or financing arrangements.
• Creditor Rights: Other creditors who search the UCC records can see the factoring company's claim on the receivables. This can affect their decision to extend credit to the business or the terms of such credit.

6. Contractual Conditions

Factoring agreements should clearly specify what counts as collateral, the conditions under which the factor can claim the collateral, and how disputes about payments or performance are handled. This helps ensure clarity and legal enforceability for both parties.

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7. Benefits of the Factoring

A. Improved Cash Flow: Immediate access to cash instead of waiting for customer payments.

B. Credit Risk Management: Especially with non-recourse factoring, where the factor assumes the risk of non-payment.

C. Outsourcing Collections: Reduces the burden of chasing customers for payment.

8. Costs and Considerations

A. Fees: Factoring can be more expensive than traditional lending options. Fees are often a percentage of the invoice value and can vary based on the risk of non-payment, industry, and volume of invoices.

B. Customer Interaction: The factor typically takes over the management of the receivables, which can affect the original relationship between the business and its customers.

C. Dependency: Relying heavily on factoring can signal financial instability to some stakeholders.

9. Legal and Regulatory Aspects

A. Uniform Commercial Code (UCC): Factoring is generally governed by the UCC in most states, which regulates the sale and purchase of accounts receivable.

B. Contractual Terms: Factoring agreements are subject to contract law and must clearly define the rights and obligations of each party, including recourse, fees, and handling of delinquent accounts.

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