An introduction to factoring and factors chain international

For the purposes of this Convention, ”factoring contract” means a contract concluded between one party the supplier and another party the factor pursuant to which: a the supplier may or

An Introduction to

Factoring and Factors Chain International

Copyright © Factors Chain International, Amsterdam

Originally issued: October 2001

Latest Revision: July 20062003

Table of Contents

Chapter One 1

An Overview of Factoring 1

What Is This Chapter About? 1

A Brief Historical Background 2

Definition of Factoring 4

Assignment of Accounts Receivable 5

United Nations Commission on International Trade Law (“UNCITRAL”) 7

The Four Main Functions of Factoring 8

Cost Components of Factoring 12

Some Varieties of Factoring 13

An Overview of Credit Insurance 16

Comparison of Export Credit Insurance and FCI Export Factoring 19

Chapter Two 1

Factors Chain International 1

What is this chapter about? 1

A Brief Historical Background to the Formation of FCI 2

The Constitution of FCI 4

The FCI Private Forum 9

Summary 13

Chapter One

An Overview of Factoring

What Is This Chapter About?

The purpose of this chapter is to give you a general understanding of factoring

Historical background We shall look briefly at the historical background of factoring and see

how it has developed into the range of services which factors can offer today

Definition of factoring We shall then define factoring and analyse that definition in more

detail

Assignment We define assignment and consider its importance in the context of

factoring

UNCITRAL A United Nations Commission was set up to draft a convention for the

regulation of assignments in international trade We study briefly its conclusions

components to create products, which may better suit the needs of our sellers

Credit insurance Finally we shall take a look at credit insurance which can be a

competitor and a friend of factoring We end this section with a comparison of credit insurance and international factoring

A Brief Historical Background

The origins The concept of factoring is not new Its origins have been traced back

to ancient Rome where rich manufacturers and merchants used a mercantile agent or factor to administer the sales of their merchandise Records show that the use of these factor agents grew throughout the Middle Ages

During the period of colonisation by European countries from the sixteenth century onwards exporters of consumer goods from the mother countries sought the help of these mercantile agents or factors to promote their trade

This was especially important in the United States Their rapidly expanding population in the 19th century added significantly to the demand for European merchandise, particularly textiles, which were used in making clothes, bedding and furnishings In those times without air transport, telephones and faxes the exporters knew little about the market and the customers They also needed to maintain stocks in the country to provide prompt delivery

The services of these factors usually included the following :

 taking physical possession of the goods on consignment;

 storing them;

 finding buyers and delivering the goods to them;

 collecting payment from the buyers;

The factor’s remuneration for these services was a commission on the value of the goods sold and was deducted from the payments made to the principal

Many factors flourished and in time were able to help the exporters with finance by making loans against the goods sent to them on consignment The security for these loans was the factor’s long-standing right to reimburse himself from the sale of the goods This right was later ratified by statute in several states by the adoption of the Factors’ Acts, which gave the factor a right of lien on his principal’s goods This right entitled the factor to hold on to goods in his possession until the loan was repaid

The development of

modern factoring

- in the United States

In the latter part of the 19th century the role of the American factor changed radically The improvement in communication and transport systems meant that an exporter no longer needed to send goods on consignment The products could be sold by a local sales agent using

samples and dispatched direct to the buyer

The exporters, therefore, no longer needed the factor’s warehousing, marketing and distribution services but many wanted to retain the factor’s financial services

The legal basis of these financial services had been the sale of the actual goods by the factor and his right to recover his financing from the proceeds In the changed situation this could no longer happen and the factor had to rely on the exporter’s assignment to him of the accounts receivable arising from the direct sales of the goods to the buyers

The basis of the factoring of accounts receivable was created by the factors’ recognition of the changing needs of their clients

- and in Europe The method of raising money by assigning accounts receivable had

been used in European countries for centuries The assignments were evidenced simply by copies of the relevant invoices and were not notified to the buyers This practice grew significantly in the 1950’s particularly in London It was attractive to companies in need of additional finance because of its simplicity of operation and confidentiality The discounters wrongly believed that they had the same protection as discounters of bills of exchange

Many invoice discounters, however, suffered severe financial losses when some of their important sellers became insolvent They then discovered deductions from the receivables by the buyers for counterclaims or set-offs from which they had no protection and of which they had had no prior warning

This experience together with the introduction of the American

“model” in the early 1960’s encouraged the method of taking over the A/R on a whole turnover basis It was sometimes with and sometimes without recourse to the seller but always with notification to the buyers The financier also managed the collection of payments from the buyers

In other words it was factoring in the modern sense of the word

- and in Asia-Pacific In South East and East Asia the main instrument of ensuring payment

and raising finance from trading, at least up to the beginning of the 1980’s, was the Letter of Credit But as in the American development, the modern revolution in communication and travel methods has created situations where the Letter of Credit is no longer appropriate The increasing demands of competition have also meant that the buyers are not so willing to commit their funds before they are able to inspect and use the products ordered This is particularly true when Asian Pacific exporters are trying to increase their trade with European and American buyers Thus the early impetus in the development of factoring in this region was in cross border factoring but the FCI

statistics of World Factoring Volumes show that domestic factoring is also growing rapidly

- and in the rest of the

world StartingThe development of factoring began in South Africa in the early

1970’s,factoring has developed in many other countries particularly in the last ten years Factoring companies or factoring departments of banks can be found now in most parts of the world and almost all of these are members of FCI Other than in Morocco where it started in the 1990’s it has yet to be used in other African countries The 1990’s also saw the development of factoring in several countries in Latin America and its introduction in two countries, Israel and Oman, in the Middle East

Definition of Factoring

To find one definition that will cover the various forms of factoring arrangements that occur in one country is a difficult task To find one which will apply internationally is almost impossible Each country has its own particular language, customs, financial and business needs and law Each factoring company has different names for certain types of factoring and often different types of factoring under the same name UNIDROIT At a diplomatic conference in Ottawa in May 1988 the International

Institute for the Unification of Private Law in Rome (commonly known

as UNIDROIT) presented " uniform rules to provide a legal framework that will facilitate international factoring " The full text

of their definition contained in Article 1.2 and 1.3 is as follows (see also Legal circular 0.5 in the Legal Manual):-

The definition used by

the UNIDROIT

convention

“1.2 For the purposes of this Convention, ”factoring contract” means

a contract concluded between one party (the supplier) and another party (the factor) pursuant to which:

(a) the supplier may or will assign to the factor receivables arising from contracts of sale of goods made between the supplier and its customers (debtors) other than those for the sale of goods bought for their personal, family or household use:

(b) the factor is to perform at least two of the following functions:

 finance for the seller, including loans and advance payments;

 maintenance of accounts (ledger keeping) relating to the A/R;

 collection of receivables;

 protection against default in payment by the buyers;

writing to the debtors

1.3 In this Convention references to “goods" and "sale of goods"

shall include services and the supply of services.”

Different terminology Note that the Convention talks about “suppliers”, “debtors” and

“receivables”, whereas FCI has standardised on the words “sellers”,

“buyers” and “accounts receivable”

The Convention refers to the “assignment” of the accounts receivable and we should spend a little time studying this concept before looking

in detail at the four functions mentioned in the Convention

Assignment of Accounts Receivable

What Is an

assignment? An assignment is an agreement by a creditor (or assignor) to transfer his

rights to an A/R to a third party (the assignee - in our case, a factor) and the assignee’s agreement to accept those rights without necessarily the

consent of the buyer (Per F R Salinger in Factoring Law and

Practice)

This means in factoring that the agreement is the Factoring Agreement (or Contract) and the seller agrees to sell his rights to the A/R to the factor The purchase price is the value of the A/R transferred less the factor’s charges and any deductions (such as, cash settlement discounts) made by the buyer The factor becomes the owner of the A/R Usually, but not always, the buyers are notified of this transfer of ownership (See below)

The procedures for perfecting an assignment, so that it will be fully enforceable at law against all parties, vary greatly from country to

country

As this is such a fundamental issue in factoring, you should research the requirements of your country’s legal system

Why have an

assignment? Factoring in its simplest form is the financing of the seller without

providing any other service and is in effect no different from lending money against the security of the A/R As such, no ownership of the A/R is really necessary Indeed in some countries even when he is providing other factoring services, a factor does not obtain ownership

of the A/R or at least not at the beginning The reason for this is usually to avoid some complex legal procedure or the payment of some form of tax An assignment of an A/R will be taken in these situations only when the factor needs to enforce his rights to the A/R by taking legal action

In most cases, however, the factor does take an assignment of each A/R

at the moment that it is created This procedure is administratively cheaper and more practical and the factor can more easily and quickly enforce his rights to collect payment from the buyer, using, if necessary, legal proceedings to do so

Notifying the buyer of

the assignment One common requirement in domestic and international factoring is

that the buyer is informed or (to use the technical term) notified by the

seller that all present or future A/R will be assigned to the factor This notification of the assignment is important for two main reasons:-

1 To prevent the buyer from making payment to the seller and obtaining a valid discharge Upon receipt of the notice of assignment the buyer must treat the factor as his creditor as far as the assigned A/R is concerned If the buyer ignores the notice and pays the seller, the factor may legally compel the buyer to pay a second time You should be aware that commercially this might not be so simple If an important buyer is involved, this experience may cause him to put pressure on his other suppliers not to factor their A/R;

2 To stop the buyer from using any claims or defences which he may have from other contracts An example of this is where the buyer is owed money for goods that he has supplied to the seller and wishes

to offset his debt against the one owed by the seller This would clearly reduce the value of the factor’s security

The procedure for giving notice normally consists of two steps:

Introductory letter This is sent to all the buyers at the start of the factoring agreement by

the factor but in the name of the seller It will advise buyers that all their accounts payable arising from their purchases from the seller have been and will be assigned to the factor until further notice This subject

is examined in more detail in Chapter 5 of the Communication Manual together with an example of the text of a letter

You should make yourself familiar with the text of your company’s introductory letter

Notice of assignment

on the invoice This is usually printed on the invoice by the computer at the time of

raising the invoice Labels printed with the text of the notice of assignment (sometimes known as “stickers”) can be used but care must

be taken to avoid omitting them by mistake

In some countries the notice of assignment is a legal requirement and without it the assignment is not valid in respect of the buyer In all countries it is a necessary administrative procedure to assist in the collection of the A/R See also Chapter 6 of the Communication Manual for an example of a notice of assignment

It is important to note that the notice of assignment to the buyers under Article 1.2 (c) of the UNIDROIT Convention is not optional and therefore, the convention is not applicable to any type of non-notification international factoring

United Nations Commission on International

Trade Law (“UNCITRAL”)

The role of UNCITRAL You can see from the previous section that the legally enforceable

assignment of an A/R is a key issue in factoring In domestic factoring

as long as the factor understands and follows the requirements of his own country’s legal system, there should not be a problem The assignor (the seller), the assignee (the factor) and the buyer are all subject to that system

In international factoring this is, of course, not the case Throughout the world there are a number of different legal systems and the requirements for a valid assignment may differ to the extent that it may

be unenforceable against the buyer or challenged by the assignor’s (seller’s) creditors

In 1995 UNCITRAL set up a working group whose task it was to produce a convention with rules to regulate the assignment of A/R in international trade The principal aim of the convention is to increase the availability of credit and reduce its cost This can be achieved only

if it can reduce the risks and administrative problems for those such as factors who provide that credit

Naturally this is an important issue for the members of FCI and since

1997 FCI has been represented by a very experienced observer who is able to speak for the interests of the factoring industry as a whole

Draft Convention In 1999 the draft convention was produced and the following is a

summary of the most important rules that relate to factoring:

 The effectiveness of bulk assignments and the assignment of future A/R

 The effectiveness of an assignment in spite of a prohibition against

it in the contract between seller and buyer This may be subject to

an exclusion for government contracts

 Notification to the buyer

 Discharge of the buyer by payment (before and after notification of the assignment and after multiple assignments)

 The buyer’s defences and rights as regard set-off and changes to the

original contract

 The priority of the assignee (1) against another assignee and (2) against the assignor’s creditors and in the insolvency of the assignor

The draft also includes provisions by which a subsequent assignment (as, for example, from EF to IF) is treated in the same way as the original assignment (from seller to EF) The only difference is that the notice of assignment to the subsequent assignee (the IF) will be deemed

to include notice of the original assignment

Relationship with the

The other rules in the draft convention as they affect factors are likely

to be similar to those in UNIDROIT and so FCI members will benefit if the UNCITRAL convention overtakes UNIDROIT

When will the

The Four Main Functions of Factoring

As we have seen from the definition of factoring in the UNIDROIT Convention there are four main functions or services provided by factoring

Finance One of the key elements in the need for additional working capital is

the growth in the A/R In the factoring contract the factor agrees to pay the seller a substantial proportion (commonly 80%) of the value of the qualifying* A/R as soon as they come into existence The seller will receive the balance when the factor has collected from the buyer

The seller no longer has to wait until the end of the credit period (and often much longer) to receive his money A substantial part of his A/R becomes active working capital which, if he uses it properly, will contribute significantly to the growth in the seller’s company

 What is meant by “qualifying A/R” will depend on the type of factoring used: for full service factoring it will be the credit covered A/R and for recourse factoring it will be the A/R that meet certain control criteria

Advantages The main advantages of factoring finance may be summarised as

follows:

 Injection of working capital to finance expansion

 More finance available than from conventional bank borrowing: it is geared specifically to the A/R and therefore to the growth in the seller’s sales

 more turnover = more A/R = more finance

 Suppliers can be paid promptly and so the seller can doubly benefit from reducing costs by taking advantage of prompt payment discounts and improving his credit standing with suppliers

 No loss of equity - the seller should not need to seek additional capital from outside shareholders and thereby lose some control of the company

 No formal funding limit - the funding automatically keeps pace with growth

A/R Ledger

Administration

The factor takes the seller’s buyer accounts onto his books and updates these accounts with all transactions - invoices, credit notes, payments etc Where appropriate, the factor sends statements to the buyers showing what should be paid to the factor and how this amount is made

up The seller receives regular report on the status of the ledger and so

is able to keep fully informed about the performance of his buyers Advantages  Savings in personnel costs: this is most applicable to those companies

which are growing strongly The increased volumes would mean more staff and the factoring services can help to keep this to a minimum

 Reduction in administrative overheads such as postage, telephone, fax stationery etc

 Savings in management time

Collection of

the A/R

One of the problems with the open account payment is that there is no automatic means of initiating payment from a buyer as one would find with an accepted Bill of Exchange, for example The factor’s administration system, therefore, is designed to prompt the buyers for payment systematically by letter and to give the collection staff the necessary information to seek payment from the buyer by telephone when necessary

In cases of serious delay legal action will have to be taken If the A/R

is credit covered, the cost of this legal action will usually be borne by the factor However this is not always the case and you should study

the Legal Manual for a more detailed explanation of the criteria which determine who must pay the legal costs

Advantages  The seller will be able to focus on the key tasks of production and

sales rather than spending time on getting paid for what has happened

 The seller will be able to "hide" behind the factor when problems over payment arise It is often difficult to be both debt collector and salesman

 Better collection management means faster payments which in turn means lower financing costs

 The seller can use the factor’s high quality collection staff It is unlikely that he has employees of a similar standard in his own company

Credit Cover If the buyer defaults in his payment, the factor will pay the seller

normally 100% of the credit covered A/R when:

 the buyer is insolvent (as defined in the contract); or

 the A/R is (are) 90 days past the due date on the invoice This period may vary in a domestic contract - some factors do not have a guarantee period in their contracts but simply pay if and when the buyer becomes insolvent, as defined in the factoring contract

You must check in your company’s contract for the precise definition of

“insolvent”

Non-recourse This arrangement is often referred to as “without recourse” or

“non-recourse” - in other words, the factor cannot seek payment from the seller if the buyer is unable to pay but must suffer the loss himself The opposite of this is, of course, “with recourse” where no credit cover is provided and the seller must bear any bad debt losses himself

Credit covered A/R A credit covered A/R is one which falls within the current line cover

agreed by the factor for that buyer and which is not subject to dispute The granting of a line cover does not restrict the seller from trading above that line but the excess will be at his risk

Not all buyers may be credit covered for 100% of the A/R As soon as the seller starts to negotiate with a prospective buyer, he should apply for a line cover The credit department will then carry out their assessment of the buyer risk Their decision may be to grant the line requested in full or in the light of the information received to approve a lesser amount or even to refuse cover altogether

Advantages  Certainty of payment at least 90 days past due date for undisputed and

credit covered A/R

 Elimination of losses through bad debts

 Expert evaluation of buyer credit standing

Cost Components of Factoring

Having studied the four functions described above, you will realise that factoring can be divided into two elements: financing and service (sales ledger administration, collection, credit cover and credit assessment) When we consider the pricing of factoring it is convenient to break it down into these two elements

Finance

Charge

This is also known as “interest charge” This charge is normally calculated on a day-to-day basis at a rate per cent per annum on the amount of finance provided The actual rate will be a margin over the cost of funds to the factor The cost of the funds at any given time will depend on the political/economic situation in the country The margin

is a matter decided by the factor’s business policy

Factoring

Commission

This covers the service element and is generally charged as a flat rate per cent of the total gross factored turnover (that is, disregarding credit notes) Some factors charge a flat rate plus a fixed amount per invoice/credit note, for example: 0.85% plus EUR 10 per invoice/credit note This is more common in international factoring when the import factor cannot be certain of the workload

Some factors will include a minimum charge or even a fixed amount per month to guard against the possibility that the factored turnover is less than an acceptable minimum

Costing systems There are a number of costing systems in use for calculating the exact

price of the factoring commission and generally these will take into account the following:

 Workload - the number of invoices, credit notes and buyers

 Volume (sales turnover) - generally the greater the volume, the

more attractive the business and the lower the percentage rate But

if there are many buyers and many small value invoices, this could make the price too high and the business unattractive both to factor and seller Conversely the volume must be adequate Most factors set a minimum volume below which it would be unprofitable to do business

 Buyer Credit Risk - the credit department will assess the portfolio

of buyers and set a price (a percentage of turnover) which will cover the expected credit losses plus a margin for administration costs This assessment is based on the industry sector, the strength of the buyers and their spread If the factor uses credit insurance (see

below) then the premium charged for this cover will be built into the commission

 Profit Margin - the need for this should be self-evident!

Some Varieties of Factoring

The following are the more common varieties of factoring in use at this time You will find more varieties of international factoring covered in detail in Chapter 12 of the Communication Manual

Full Service What you have been studying so far in the course is what is known as

“Full Service” factoring or as it is sometimes called "standard" or

"old-line" factoring As the title suggests, it is made up of all the factoring services - finance, sales ledger administration, collection, credit risk cover - and the arrangement is fully notified to the buyers The factor takes over the A/R ledger of a seller and the seller in effect has only one debtor - the factor Although in principle this is a non-recourse service, in practice, certain A/R will be " with recourse" to the seller The factor only carries the credit risk for approved accounts that are not disputed Depending on the agreement with the seller the factor keeps any non credit covered and disputed A/R on his books on a

"collection only" basis or if collection is not possible, re-assigns such items to the seller

From the factor’s point of view the full factoring service is demanding

in terms of the administrative resources and know-how that it requires but it does give him good control over risk

Who can benefit? This comprehensive form of factoring is best suited to small to medium

sized companies which are growing quickly and which need not only additional finance but also the administrative support and protection It

is also particularly appropriate for larger companies moving into new export markets

International

Factoring

This is usually based on the full service model We shall be concentrating our studies on this service as practised within FCI later in the course

Recourse

Factoring

In essence this type is the same as full service without the credit risk cover A number of factors do not offer full service factoring at all and recourse factoring is the main part of their business Despite this, in certain countries recourse factoring is regarded as the lending of money against the security of A/R (Account Receivable financing) – though in other countries it is still treated as the purchase of the A/R

notwithstanding the recourse element

It is important to remember that credit assessment of the buyers is still carried out by the factor even though he is not taking the buyer credit risk “Credit limits" on buyers in recourse factoring are concerned with the level of advance payments that can be made to the seller Such levels will primarily be based on the total value of the A/R’s at any one time It may be, however, that the A/R on a particular buyer exceed what the factor considers to be a prudent level of credit - the “credit limit” In that case the maximum value of the A/R for that buyer which the factor includes in his calculation of the advance payments is the credit limit

In his contract with the factor the seller in effect "guarantees" that the buyers will pay and at the request of the factor agrees to re-purchase the A/R from the factor if a buyer does not make payment in full after an agreed period beyond the due date

The difference in cost to a seller between recourse and non-recourse factoring is usually not great Pure risk is only a part of the credit service costing The administration costs and the profit element will be present in both types Certainly the difference will nearly always be less than the cost of a credit insurance policy

Maturity

Factoring

This form is sometimes known as collection factoring, though neither

"maturity" nor "collection" fully describes this variety It can best be seen as the full service without finance Because finance is not offered the security requirements of the factor are quite different The risk lies only in the credit cover provided on the underlying buyers There is no seller risk For the same reason there is no finance charge and the factor takes his remuneration only from the commission fee

The factor pays the seller for the A/R in one of two ways:

1 After an agreed period from invoice date, for example 60 days This

is known as the "maturity period" The benefit of this method is that the seller knows exactly when he will be paid and so can plan his cash flow accordingly; or

2 On receipt of payment from each buyer or on the insolvency of the buyer provided that the buyer is credit covered This is known as the

"pay when paid" method

Who can benefit? To benefit from this service the seller will have adequate sources of

finance elsewhere and is looking to the factor to strengthen a weak administration or maybe reduce overheads and provide protection