FACTORING REGULATION ACT,

2011

Factoring is a financial transaction whereby a business sells its accounts receivable i.e. invoices to a third party called a factor at a discount in exchange for immediate money with which to finance continued business

Factoring differs from a bank loan in three main ways:

First, the emphasis is on the value of the receivables (essentially a financial asset), not the firm ’s credit worthiness

Secondly, factoring is not a loan - It is the purchase of a financial asset(the receivable). Finally a bank loan involves two parties whereas factoring involves three.

FACTORING

In this example, a factoring client has a 1,00,000 invoice ₹that they need to finance. This invoice is from a pre-approved customer who has great credit and often pays in 30 days or less.

The client gets the following terms from the factoring company:

Advance rate: 85%Fees: 2 % per 30 days

EXAMPLE

Mechanics of factoring

▪Through the use of factoring receivables are instantly converted into cash leading to improved cash flows that can help funding of future growth

▪It facilitate an efficient follow up of payments from buyers, which is made possible through relationships developed by factors with client buyers

▪Factoring provides credit protection for export sales which enables to do business with buyers who are unwilling to open letters of credit

▪Factoring also provides other peripheral services such as advisory services, credit assessment.

Why use factoring?

▪There are basically two types of factoring arrangements:

▪Domestic factoring –If you are selling in India.▪The factoring arrangement where all the three –the factor,

the seller & the buyer are in the same country subject to the same laws.

▪International factoring - If you are exporting from India.The factoring arrangement where the seller & the buyer are in two different countries involving co-operation between two factoring companies, one in the seller ’s country (export factor) and other in the buyers country (import factor).

What are the types of factoring arrangement?

Recourse factoring In this type of factoring arrangement, the factor provides all

types of facil ities except debt protection. In other words, the client is responsible for any bad debts incurred.

Invoice discounting-in this type of factoring arrangement only finance is provided and no other service is offered.

Up to 75% to 85% of the invoices receivable is factored. Interest is charged from the date of advance to the date of

collection. Factor purchases Receivables on the condition that loss

arising on account of non-recovery will be borne by the client. Credit Risk is with the Client. Factor does not participate in the credit sanction process. In India, factoring is done with Recourse.

DOMESTIC FACTORING

Non-Recourse factoring- It is the most comprehensive type of factoring arrangement offering all types of services namely: Finance Sales ledger administration Collection Debt protection Advisory services

It gives protection against bad debts to the client. In other words, in case the customer fails to pay, the factor will have “no recourse” to the client and will have to absorb the bad debts himself.

DOMESTIC FACTORING

INTERNATIONAL FACTORING

1. Single / Direct Factoring System-In this system, a special agreement is signed between two Factoring companies for single Factoring. Whereas in Two Factor System, credit is provided by import Factor and pre-payment, book keeping and collection responsibilities remain with export Factor.For this system to be effective there should be strong co-ordination and co-operation between two Factoring companies. Pricing is lower when compared to Two Factor System.

2. Direct Export Factoring-Here only one Factoring company is involved, i.e., export Factor, which provides all services including finance to the exporter.

3. Direct Import Factoring-Under this system, the seller chooses to work directly with Factor of the importing country. The Factoring agreement is executed between the exporter and the import Factor. The import Factor is responsible for sales ledger administration, collection of debts and providing bad debt protection up to the agreed level of risk cover.

4. Back to Back Factoring-It is a very specialized form of International Factoring, used when suppliers are sell ing large volumes to a few debtors for which it is diff icult to cover the credit r isk in International Factoring. In this case, International Factor can sign a domestic Factoring agreement with the debtor whereby it wil l be getting the receivables as security for the credit r isk taken in favor of Export Factor.

INTERNATIONAL FACTORING

▪The factor does not follow up or collect payments from the customer. The customer may not be aware of the factoring arrangement and pays the client directly. The factor receives payment of invoices through the client.

Factoring charges▪Finance charge-it represents the interest on funds made

available to the client by way of prepayment against purchase of approved invoices.▪Service charge-the charge levied for rendering non-funding

services such as collection, sales ledger maintenance & other advisory services.

How much advance client can get? Advances are made as a % of invoice value based on criteria, such as, quality of receivables no. & quality of buyers & clients requirements. Typically 80 % of invoice value is advanced.

Undisclosed factoring or open account receivables

To the client:

Competitive credit terms Accelerate the production cycle Free from tensions Efficient working capital management Assessing quality of debtors Expansion of business

To the buyers:

Adequate credit facil ities Getting periodical statement from the factor No effect on quality of goods, contractual obligations

etc.

Advantages

a) Where large volume of cash sales takes placeb) Engaged in speculative businessc) Selling highly specialized capital equipment's or made to order

goodsd) Where credit period offered to the buyers is more than 180 dayse) Where there is consignment sales or sale or return

arrangements.f) Where sales are to the sister/associated companies.g) Where sales are to the public at large,etc.

factoring is not suitable under following cases:

There are three elements of factoring costs:Service feeDiscount chargeOne time setup feeWhat is disclosed and undisclosed factoring?In disclose factoring, the debtor is informed of the assignment of debts to the factor. Alternatively, under undisclosed factoring, the debtor is not informed of the agreement entered into between the seller and the factor. Most of the cases disclosed factoring is happening

whereCB is the cash balancenCF is the average negative cash flow in a given period i is the [discount rate] that cover the factoring costsr is the rate of return on the firm's assets.

COST INVOLVED IN FACTORING

Though both factoring and bill discounting provides short term finance, however in bill discounting the drawer undertakes the responsibility of collecting the bills and pay the proceeds while in factoring it is the factor that usually undertakes the responsibility of collecting the bills. Given below are some more differences between the two.

Bill discounting is always of recourse type while factoring can be either with or without recourse. In case of recourse the factor does not assume the credit risk and it is the company which assumes the credit risk

Factoring is an off balance sheet entry in the sense that both amount of receivables and bank credit are not shown in the balance sheet which is not the case with the bill discounting which is shown in the balance sheet.

DIFFERENCE BETWEEN FACTORING & BILL

DISCOUNTING

In bill discounting there is only provision of finance while in factoring factor provides in addition to finance facility other facilities like sales ledger maintenance, collection etc.

Discounted bills may be re-discounted several times before they mature for payment which is not the case with factoring.

DIFFERENCE BETWEEN FACTORING & BILL DISCOUNTING

Almost since the dawn of civilization ,there has been factoring

Mesopotamians used factoring in their business dealings

The ancient Romans used a form of factoring by selling promissory notes on a secondary market at a discount

The Code of Hammurabi is a code of laws set down by the 6th Babylonian King, Hammurabi in 18th BCE. It is one of the 1st preserved written records that mentions factoring type transactions.As civilization developed, other forms of financing began to form.However, factoring remained a major funding option. Ancient Roman merchants used agents to guarantee trade credits .These agents came to be known as factors.

Factoring gained true popularity in trade between their American colonists & their European buyers.

THE HISTORY OF FACTORING

● Prior to American Revolution , merchants in colonies sent raw materials to British merchants, however sending goods over long distances could get expensive & waiting for payment to come back caused delays in processing new orders. In order to get around these problems European merchants paid in advance so that they can continue their operations.

● Factoring became a prominent practice in Elizabethan England, as the British Empire sought to colonize the New World. The East India Company and The Hudson Bay Trading Company both used invoice factoring as they established their dominant commercial empire during the Age of Discovery.

● The Massachusetts Bay Colony operated with a team of factors that made other colonial trading companies realize the benefits of factoring. With the rise of the textile industry in the 1800s, factoring became a popular method of domestic financing as well.

• With Industrial Revolution the focus of factoring changed•

Credit became more important to factoring•

The credit of company was itself not as important as credit of its clients.Factors helped companies figure out which companies were the most creditworthy. This way factors could help companies keep their cash flow moving

•Before 1930’s most popular industries for factoring were garment & Textile Industries. These industries rely on raw materials. Here factoring was used so that companies could continue to buy raw materials to produce textiles

•After WWII , it became evident that factoring could work effectively for any business that invoiced others.

The United Nations Convention on the Assignment of Receivables in International Trade was adopted to facilitated availability of credit and capital. Article 2 of the Convention defines Assignment as –

“Assignment” means the transfer by agreement from one person (“assignor”) to another person (“assignee”) of all or part of or an undivided interest in the assignor’s contractual right to payment of a monetary sum (“receivable”) from athird person (“the debtor”). The creation of rights in receivables as security for indebtedness or other obligation is deemed to be a transfer

INTERNATIONAL MODEL LAW (UNCITRAL)

The Convention generally does not apply to domestic assignments ofdomestic receivables, but some of the clauses as stated are relevant adaption and includethe following:

● Notice of assignment of receivables is required to be given to the debtor and is effective when received by the debtor. An assignment does not affect the rights and obligations of the debtor, without the consent of the debtor

● The assignee may not retain more than the value of its rights in the receivables

● The assignor makes representation that the debtor shall not have the right of setoff

● The law of the State in which the assignor is located governs the priority of the right of an assignee in the assigned receivable over the right of a competing claimant.

Factoring is of recent origin in Indian contextFactoring activities, like other modes of financing, had to operate within the existing laws such as the Indian Contract Act, the Indian Sale of Goods Act, the Transfer of Property Act etc.The Committee appointed by the Government for reviewing the working of the monetary system(1986),Vaghul Committee on Money Market Reforms (1987) all highlighted the need for factoring laws.The Reserve Bank of India (RBI) constituted a Study Group in 1988 under the chairmanship of Shri C.S. Kalyansundaram, former Managing Director, State Bank of India for examining the feasibility and mechanics of starting factoring organisations in the country and making recommendations regarding its theory, constitution, organisational set up, scope of activities and other related matters.

FACTORING IN INDEPENDENT INDIA

●Banking Regulation Act, 1949, was amended in 1991 for banks setting up factoring services.RBI has permitted banks to undertake factoring services through subsidiaries.SBI/Canara Bank have set up their factoring subsidiaries :-

SBI Factors ltd. (April 1991)Can Bank factors ltd. (August 1991)

● Apart from the two companies mentioned above, a few players have also entered into the field of factoring viz., Export Credit Guarantee Corporation of India Ltd., IFCI Factors Ltd., Small Industries Development Bank of India, Standard Chartered Bank, The Hongkong and Shanghai Banking Corporation Ltd Non-Banking Financial Companies (NBFCs)

● A special law, viz Interest on Delayed Payments to Small Scale and Ancillary Industrial Undertakings Act, was enacted in 1993, which was later incorporated into the Micro Small and Medium Enterprises Act, 2006. But in practice, these legislations did not improve the position of MSEs because of their dependence on large businesses for continued business.

● The report of the S.P. Gupta Group (Study Group on Development of Small Enterprises, 2000) recommended that in order to mitigate the post sale problems of SSI there is a need to encourage bills culture without recourse to SSI

● Report of the National Commission on Enterprises in Unorganised Sector, 2009 recommended that Innovative financing instruments such as factoring, venture capital, credit rating, and a single multipurpose Swarojgar Credit Card for the unorganised sector on the pattern of Kisan Credit Card with a limit of up to Rs. 10 lakh may be introduced

▪No of factoring companies -08▪From domestic factoring turnover- 1450(million euros)▪From international factoring turnover- 175 million

euros▪From total factoring turnover-1625 million euros.▪Large no of industries :▪Covered under factoring, including automobiles,

pharmaceuticals, textile, garment & engineering.▪In addition to the manufacturing sector, the services

sector industries, such as, travelling, telecommunications, software services etc. are suitable for factoring services.

Factoring profile India

● As per FCI, the Global turnover of factored debt i.e. the value of sales invoices factored /funded in 2013 was Euro 2.2 Trillion. One would feel that a large country like India would have a significant share of this. Unfortunately that has not been the case as factoring business over the last decade or so has failed to take off in India. As per reported data, India’s factoring turnover in 2013 was Euro 5240 Million i.e. 0.23 % share! Always compared with China in many fields, we were way behind China’s turnover of Euro 378,128 Million i.e. China’s turnover was 72 times more!! Even Taiwan and Singapore are way ahead

● India still has limited no of players engaged in providing factoring services. Problems facing the sector are : Mis-selling Wrong Market Segmentation Weak Legal System for Recoveries Rampant Fraud and Collusion Excessive Transactional Documentation

An act to provide for and regulate assignment of receivables by making provisions for registration therefor and rights and obligations of parties to contract for assignment of receivables and for matters connected therewith or incidental thereto.

The Act has 7 Chapters and 35 Sections

ACT EXPLAINED

Chapter 1 Preliminary Chapter 2 Registration of FactorsChapter 3 Assignment of ReceivablesChapter 4 Rights and ObligationsChapter 5 Registration of AssignmentsChapter 6 Offence and Penalties Chapter 7 Miscellaneous

● Any company can commence Factoring by obtaining registration from the RBI as a non-banking finance company. Such registration shall be governed by the existing law applicable to NBFCs (Chapter IIIB of the RBI Act, 1934) as well as the new Factoring Regulation Act, 2011.

● Banks or corporations established under an Act of Parliament can also undertake factoring without being required to obtain registration from RBI. Thus, organisations like NHB, SIDBI, EXIM Bank can also undertake factoring.

● Definition of factoring also includes assignment of export receivables and thus includes 'forfaiting', subject to the requirements of the Foreign Exchange Management Act.

● Term receivables are widely defined to include toll or any other charges payable for use of infrastructure facilities. However, bank loans are excluded from the definition of receivables.

The law applies to all business entities i.e. large, medium, small and micro entities, whether engaged in any manufacturing activity or trading or providing any services or in any other business activity. Applicability of the new law is, therefore, much wider and even large industrial houses and multinational corporations can avail factoring services

The definition of 'factoring' covers both, with recourse and without recourse factoring

The law requires that all transactions of assignment of receivables in favour of Factors shall be registered with the Central Registry established under the SARFAESI Act, 2002. The registry record shall be available for search by the public

Factors are declared to be credit institutions for the purposes of Credit Information Companies (Regulation) Act, 2005 and can have access to credit information relating to firms availing factoring services

Factors are not financial institutions for the purposes of SARFAESI Act and hence will not have rights of enforcement without the intervention of courts. But provisions of the Code of Civil Procedure, 1908 regarding summary suits are made applicable to claims of Factors to facilitate speedy recovery of receivables

The most important provision in the Act is insertion of section 8D in the Indian Stamp Act, 1899, granting exemption from stamp duty on documents executed for the purpose of assignment of receivables in favour of Factors notwithstanding anything to the contrary contained in any other law in force. In view of such exemption, assignment of receivables in favour of Factors becomes a viable proposition and is expected to give a boost to factoring

While the intent of the Bill may be to stimulate the growth of factoring business in India,but a close look at the Bill does not enumerate so. The Act is a regulation Act, but themuch need is for a Bill to promote factoring and not so much to regulate

Section 2 (a) of the Bill defines assignment means ” transfer by agreement, of undivided interest of any assignor in any receivables due from any debtor.The definition talks about undivided interest to be assigned only and does not consider assignment of fractional interest within its ambit. This would mean that any assignment of fractional interest would not be covered under this definition.Further whether the assignment could be in terms of money, in terms of time or rate of interest is not clear from the definition.

ANALYSIS

● Section 3(1) of the Bill says –“No Factor shall commence or carry on the factoring business unless it obtains a certificate of registration from the Reserve Bank to commence or carry on the factoring business under this Act.”The definition should have said no ‘person’ shall commence or carry on the factoring business rather than using the term factor. A person shall only become a factor after obtaining a certificate of registration from the Reserve Bank as the section suggests. However the section already terms such person as factor, making the definition circular.

● Section 3(3) of the Bill states every company carrying or commencing factoring business to be registered with RBI, and such companies would be classified as NBFCs and all the provisions applicable to NBFCs would be applicable here aswell. Section 3(4) requires existing NBFCs to take a fresh certificate of registration, if they are principally engaged in the business of factoring. However the question to be considered is whether companies carrying out the business of factoring can be classified as NBFCs as per the definition provided in Section 45I(c) and Section 45I (f) of the Reserve Bank of India Act, 1934.

● Section 7(3) states that in case the receivables are encumbered to any creditor, the assignee shall pay the consideration for such assignment to the creditor to whom the receivables have been encumbered. In case of fixed charge created over assets, the provisions of this section are well thought, as, if the consideration was paid to the assignor, it would have resulted in double funding. However in case of floating charges, this would render several difficulties for the assignor

● Section 8 of the Bill requires the notice of assignment to be given to the debtor, without which the assignee shall not be entitled to demand payment of the receivables from the debtor. However Section 7(2) of the Act, makes Section 8 redundant, as it states that on execution of agreement in writing for assignment of receivables, the assignee shall have ‘absolute right to recover such receivable and exercise all the rights and remedies of the assignor whether by way of damages orotherwise, or whether notice of assignment as provided in sub-section (1) of section 8 is given or not.’

● Import factoring is not permitted as per Section 31(1) of the ActFurther recourse to the assignor is not permitted under the Act

● The Act is silent about non recourse factoring

● The need was to bring in a set of rules which would promote Factoring and make Factors co-exist with banks and share the risks and security available. The law explicitly requires Factors to seek borrower’s existing banks’ consent before lending against receivables assigned to it. With banks in no mood to lose any business, this has been a non starter in most cases

● The law solve or streamline the fundamental requirement of issuance of notice of assignment to the debtor. Thus, while issues of product awareness, growth and cooperation between banks and factors still remain unaddressed, the effort has been to primarily protect factors if and when they need to recover

The real unmet demand for credit flow is from the lower /micro SMEs which have difficulty in availing funding. As per an IFC Washington-Intellecap research done in 2012, as much as INR 3.7 Trillions was the ‘viable and addressable credit demand’ which organized players can tap

One way to tap this could be to act like a banker i.e. set up a funding account which would be have a ‘dynamic’ credit limit based on the level of approved receivables and in addition also take control of the borrower’s current account by converting it into a de-facto collection account thereby trapping all inflows to set off advances made. All invoicing can be routed thru the factor to avoid fraud. Investment in shared technology platforms will be a useful investment.

WAY FORWARD

● Instead of operating purely as standalone outfits, Factors should consider joining hands with entities where mutually beneficial product solutions can be designed and offered. For instance, alliance with smaller banks for funding receivables of their small clients can be done

● Combine Factoring- Leasing and Supply Chain finance solutions which together represent a powerful set of cash flow solutions for growing manufacturing companies

● Tap the e-commerce boom in the B2B segment. Clearly an opportunity which regular NBFCs have started to tap. Factors need build technology platforms to offer a seam receivables finance services. E commerce majors like Flipkart, Snapdeal, Amazon etc already have dedicated divisions for financing vendors. High time that the Factoring companies are incentivised in that direction

● Factors can do with such support .MUDRA Bank will have a corpus for issuing guarantees which must be tapped

● Launch joint awareness and education program for market development. There remains a crying need to educate the market and build awareness. All parties should come together and use the network of entities like NSIC /SIDBI/ MSME –DIs and large MSME associations to spread awareness

● Debt protection to Factors and Non recourse factoring to assignors. The new Bankruptcy code should look into it

● Community factoring should be given legal backing and should be incentivised. Co-operatives and Guilds should be used for this purpose