This article was written in response to questions from my factoring clients regarding whether factoring transactions constitute “true sales” of accounts receivable and, if not, why and what are the ramifications. A number of very good articles on this topic have been written over the years.1 What I have tried to do a little differently here is explain in some detail how factoring transactions work and then explain and apply true sale analysis to those details. As you will see, I take the position that factoring transactions in almost all instances would not withstand true sale scrutiny, but I also take the position that, in most cases, the lack of a true sale should not be an issue for factors.
I. Factoring Basics
To lay the groundwork for this article, I need to describe how factoring transactions work. I will do this by describing the two principal varieties of factoring transactions: Notification Factoring Without Advances and Notification Factoring With Advances.
A. Notification Factoring Without Advances
In this type of transaction, the factor purchases accounts receivable from the seller (sometimes called the “client” by the factor) with full notification to each account debtor (sometimes called the “customer” by the factor). In some transactions of this type the factor purchases all of a client’s accounts, and in others the factor purchases only the accounts a client offers for sale.
The typical “purchase price” of an account sold in this type of transaction is the net invoice amount (i.e., the gross invoice price less discounts for early pay and other amounts deducted by the seller), less the factoring “commission” on such account. The factor collects the factored accounts and “pays” the purchase price to the client by remitting those collections to the client on a periodic basis, less any obligations owing by the client to the factor and any reserves established by the factor.
A client’s main reason for entering into this kind of transaction is the factor’s assumption of the customer’s credit risk on approved accounts. Approved accounts (sometimes called “factor risk” or “warranted” accounts) are accounts on which the factor has assumed the risk that the customers will not pay due solely to their financial inability. If a customer does not pay an approved account by its due date solely due to financial inability, the factor “matures” the account - i.e., it pays the purchase price of the approved account to the client.
Approved accounts become unapproved accounts (sometimes called “client risk” accounts) if the client breaches any of the various reps, warranties and covenants contained in the factoring agreement regarding the approved accounts, including the representation and warranty that the accounts are upon purchase, and will continue to be, owing without “dilution” (i.e., customer disputes and deductions).
Factors charge a factoring “commission” on each factored account, the amount of which varies greatly but usually is in the neighborhood of 0.5% to 1.5% for customers with good credit. The factor deducts such commissions from collections on the factored accounts, but commissions are payable whether or not there are sufficient collections from which to deduct them.
Factors also charge interest on the client’s obligations owing to the factor, but since the amount of such obligations is relatively small in a transaction without advances, interest charges in such a transaction are usually small. Larger amounts of interest are more typical in Notification Factoring With Advances transactions as discussed below.
Factoring agreements typically contain few reps and warranties outside of the standard reps and warranties regarding a client’s existence, good standing and approval to enter into the transaction and standard reps and warranties regarding the factored accounts (e.g., the seller has good title free and clear of adverse claims, the accounts are not subject to disputes or other setoffs, the account represents a bona fide sale of goods or rendition of services, etc.).
In addition, factoring agreements typically have few covenants, either affirmative or negative, outside of basic covenants regarding the factored accounts (e.g., placing a notification of the sale and remittance instructions on the invoices; notifying the factor of all disputes; etc.) and covenants to provide financial information to the factor.
Factoring agreements typically contain events of default similar to those found in loan agreements (e.g., for non-payment of obligations owing to the factor, false representations and warranties, breach of covenants and insolvency events) but without the detail and breadth found in typical loan agreements.
Similarly, a factor’s remedies upon default are not as detailed and broad as those found in loan agreements for a secured lender but do mimic the basic structure of such remedies in that they typically provide for termination of the agreement and acceleration of the obligations following a default, as well as the rights of a secured party under the applicable UCC.
B. Notification Factoring With Advances
This type of transaction is similar in all respects to Notification Factoring Without Advances except that the factor makes an “advance” payment of the purchase price of the factored account to the client and applies collections on the factored accounts to pay down the advances.
Advances typically are funded upon the client’s request up to a client’s “availability”. Availability usually is calculated as the net amount of unpaid approved (and sometimes unapproved) accounts, multiplied by the applicable advance rate (something in the 80%-90% range is not unusual, but advance rates can vary widely), less the amount of unpaid obligations and reserves.
Reserves typically may be held in any amount and for any reason, and factors typically retain sole discretion whether or not to make advances, regardless of availability. Collections on factored accounts, as well the proceeds of approved accounts matured by the factor, are applied to reduce the unpaid balance of the advances and other amounts owing by the client to the factor. 2
Thus, as you can see, the advance rates and funding/paydown mechanics in these types of transactions closely mimic those found in asset-based lending transactions (except with respect to matured accounts, for which no counterpart exists in a lending transaction because lenders do not assume customer credit risk).
Factors may, and often do, obtain additional collateral in these types of transactions in the form of security interests on non-approved and even non-factored accounts receivable, inventory and other assets of a client. Factors also may make loans and advances against the value of such additional collateral as part of the overall credit facility to the client. When possible and required, factors also obtain unconditional payment guaranties by various persons and entities associated with the client. Such additional collateral and credit support may also be found from time to time in Notification Factoring Without Advances transactions but are more common in arrangements with advances.
II. Factoring and “True Sale”: Background
In a nutshell, a true sale of accounts receivable is a sale that is not subject to recharacterization as a secured loan. That’s simple enough, but getting one’s hands around just exactly why a sale is a “true sale” (and thus not subject to recharacterization) is not as simple.
A. Elements of True Sale
The various factors (no pun intended) evidencing a true sale are not found in any single source but rather have developed over time through case law, scholarly writings and industry practice. Not all such factors need be present in a given transfer for an attorney to opine - or a judge to determine - that a transfer is a true sale. However, the more undiluted true sale factors that are present in a given transaction, the more likely a law firm will opine - or a judge will determine - that such transaction is a true sale.
The following is a list of what I consider the principal true sale factors. Other practitioners’ and academics’ lists may differ but likely include many, if not most, of the following.
1. Recourse. Probably the most important true sale factor is the absence of recourse by the transferee to the transferor for non-payment of the transferred asset. As with any sale, however, recourse is permitted for the seller’s breach of standard reps, warranties and covenants regarding the transferred assets, including in the case of an accounts receivable transfer, the failure to keep the accounts free of dilution. Thus, the type of recourse that is not permitted in a true sale is recourse for non-payment due to the account debtor’s credit risk. This distinction between permissible and impermissible recourse is described at length in the classic Business Lawyer article, Rethinking the Role of Recourse. 3
2. Intent. The parties’ intention to accomplish a true sale, rather than a loan, must be expressed in the transaction documents and otherwise, including in communications between the parties and in each party’s records. The substance – rather than the form – of the transaction is what is important. Thus, documentation that describes a transfer as a sale but that also contains indicia of a loan will not be helpful to support a true sale. Neither will credit files and other records that refer to the transaction as something other than a sale.
3. Identification of the Transferred Assets; Administration as a Sale. You can’t sell what you can’t identify, and in the context of financial assets, that applies to proceeds as well. Thus, accounts receivable transferred in a true sale must be identified with specificity, and if a party other than the transferee is servicing the accounts receivable, the collections should be segregated in a special collection account rather than commingled with the servicer’s other funds. Notification of the transfer to the account debtors will also favor true sale.
4. Amount Paid to Seller in Relation to Fair Value. The purchase of any asset ostensibly reflects that asset’s fair value - otherwise, the seller would not be willing to part with it. As a result, payment of less than fair value for an asset could be evidence that something other than a true sale was intended. An approximate formula for the fair value of an account receivable might be (a) the net face amount of the invoice (i.e., the gross invoice amount less any adjustments or allowances given by the seller and less any discounts available to the account debtor for early payment), minus (b) the purchaser’s per annum cost of funds plus a reasonable margin, pro-rated over a reasonably expected number of days until payment of the account. To reflect the purchaser’s permissible recourse against the seller, a dilution reserve may be netted against the purchase price paid, but such reserve must be based on an identifiable formula that bears a reasonable relationship to historical dilution. In addition, any collections by the purchaser reflecting less dilution than what was reserved for must be remitted to the seller periodically. Purchase price reductions other than those set forth above or that are not identified with specificity could be viewed as both indicia of a loan and impermissible recourse.
5. Irrevocability. In a true sale, the risks and benefits of ownership must pass to the transferee upon closing, and those risks and benefits cannot then be reallocated. Lack of irrevocability may be evidenced, among other things, by an agreement that the transferee will receive a specified rate of return on its investment when in fact fluctuations in the dates on which accounts receivable are paid mean that a specified rate of return cannot be guaranteed. Lack of irrevocability may also be evidenced by an agreement to terminate a transaction at a given time and to reconvey any unpaid accounts to the seller in exchange for the outstanding balance of the accounts.
B. The Role of Accountants
Because true sale is a legal concept, accountants do not play a direct role in assessing whether a transfer is a true sale. However, their role in the sale process deserves a brief discussion since accounting principles determine whether a transfer of financial assets (including accounts receivable) will be accounted for as a sale.
The requirements for sale accounting of financial assets are found in FASB Statement No. 166.4 In general, the transfer of an entire financial asset will be accounted for as a sale if:
1. The transferred asset is legally isolated from the transferor and its creditors – even in a bankruptcy,
2. The transferee has the right to pledge or exchange the transferred asset, and
3. The transferor has no rights or obligations to reclaim the transferred asset (i.e., the transferor does not maintain effective control over the transferred assets).5
FAS 166 states that “a true sale opinion from an attorney is often required”6 to determine whether transferred accounts receivable have been legally isolated from the transferor and its creditors. While I have reviewed many factoring clients’ financial statements over the years that characterized factoring as a sale without a true sale opinion, an accounting determination that a transfer of accounts receivable is a sale can, and often does, turn on such an opinion – particularly for larger transactions with audited financial statements.
III. Factoring and “True Sale”: Analysis
A. Notification Factoring Without Advances
Based on the above discussion, there should not be much dispute that this type of transaction is not a true sale. This is certainly the case with respect to unapproved accounts; i.e., those on which the factor has not assumed the customer’s credit risk. Such accounts are merely being serviced by the factor for a fee - a worthy commercial endeavor, no doubt, but not a true sale.
Even with respect to approved accounts, I would argue that there has not been a true sale at the time of the sale as described in the factoring agreement; i.e., at the time such accounts arise. Because there has been no payment of any kind by the factor to the client at such time, the factor has not yet irrevocably taken on the risks and benefits of ownership of such account. The factor has promised to “mature” such receivables, but is such a promise without payment a true sale? In my opinion, the answer is no.
B. Notification Factoring With Advances
Because the factor pays the client an advance of the purchase price in this type of transaction, it looks more like a true sale transaction than does a Notification Factoring Without Advances transaction. However, for the following reasons (which track the true-sale factors discussed above), I believe this type of transaction is much more like a secured loan than a true sale.
1. Impermissible Recourse. In a Notification Factoring With Advances transaction, the concept of a non-recourse purchase is accounted for differently than in a structured, true sale transaction. In the latter, a purchase price is paid for an account (which price, as described above, may reflect a deduction for reasonably expected dilution) at the time of purchase or at a periodic settlement date, and if the account doesn’t pay due solely to customer credit risk, there are no further transactions between seller and purchaser with regard to that account. The sale was without recourse for credit risk, so the purchaser must turn to the account debtor to attempt to recover its investment.
In Notification Factoring With Advances, however, the factor’s payment to the client is typically described as an “advance” of the purchase price equal to a percentage of the net invoice amount, and the unpaid advances are described as an obligation of the client to the factor. If an approved account is not paid due to credit risk, then a factor typically matures the account as described above and credits the purchase price of the account against the outstanding advances.
In the sense that the deduction from the net invoice amount represented by the factor’s advance rates reflects a deduction solely for permissible dilution,7 then the advance rate should not create an impermissible recourse problem. However, factoring agreements rarely state that such deduction is specifically for permissible recourse or how such deduction was calculated in relation to historical dilution of the client’s accounts. Without a description of the calculation or a reference for historical dilution, there can be no determination whether such a deduction actually includes a deduction for credit risk.
There also is the issue of the “reserves” a factor may hold in connection with its agreement to make advances to a client. Such reserves reduce the amount available for advances to a factoring client and typically are created to address dilution (i.e., permissible recourse) greater than what is built into the advance rate. However, because the factoring agreement allows reserves to be instituted for any reason at the factor’s discretion, the factor could institute reserves for reasons other than permissible recourse.8
Finally, there is the issue of a factoring agreement explicitly excusing the factor from maturing an account for reasons that could be due to credit risk. This is most often expressed in a concept known as “extended default risk,” which arises when an account has not been paid within a certain amount of time after its due date, but no clear determination has been made that such non-payment is due solely to credit risk. Many factoring agreements provide that such accounts are no longer approved accounts. Factoring agreements also often excuse the factor from maturing accounts that are unpaid due to acts of God or force majeur. Since these provisions give the factor recourse to the client for reasons that may include credit risk, the factor may be considered to have impermissible recourse.
2. Intent. Almost all Notification Factoring With Advances agreements describe the transfer of accounts as a sale, and some even contain explicit statements of the parties’ intent to consummate a “true sale”. Nevertheless, I believe the substance of such a transaction is more like a loan than it is a sale.
As already described, the calculation and funding mechanics of a factor’s advances are very similar to those of an asset-based revolving line of credit. The payment of monthly interest on such advances also is very similar to a loan.
Another interesting similarity is the factor’s right to demand payment of all “obligations” (i.e., unpaid advances, interest and fees) owing from the client upon termination of the factoring agreement. It is true that most factoring agreements do not explicitly let the factor off the hook for customer credit risk on approved accounts just because a factoring agreement is terminated. However, assuming an agreement is terminated and factor is paid its obligations, the factor’s credit risk at that point is like its credit risk in the “without advances” transaction described above; i.e., it is merely a promise.9 One thus has to question whether such a transaction can constitute a true sale.
3. Identification of the Transferred Assets; Administration as a Sale. In both varieties of factoring transactions that have been described in this article, account debtors receive notice of the sale (either via a letter from the factor or the client or a notice on the client’s invoices or both), the seller’s invoices are submitted to the factor, the factor “ledgers” those invoices in its client accounting systems, and the factor collects the accounts. Thus, the administration of factored accounts looks more like a sale than a loan. However, as previously described, the factor’s administration of its advances to the client looks more like a loan than a sale.
4. Amount Paid to Seller in Relation to Fair Value. As already discussed, the calculation of both the purchase price deduction represented by the advance rate and the factor’s reserves is not described so that the amount thereof represented by permissible recourse can be determined. Furthermore, unlike a structured, true sale transaction in which collections in excess of the dilution reserve are remitted to the seller periodically, the factor in effect retains such amounts until all factored accounts are collected and all advances are repaid.
5. Irrevocability. Since factoring agreements typically provide for the payment by the client of periodic interest on the outstanding obligations (which are described in factoring agreements variously as “Funds Employed”, “Funds In Use”, etc.) at some per annum floating base rate plus a margin, factors are not taking the risk that accounts will not pay as predicted. Factors also reallocate risk by taking additional collateral from their clients in various forms, such as non-approved and non-factored accounts and inventory. In many cases, factors are providing additional liquidity against such assets, but nevertheless the equity in such collateral is available to pay the obligations owing in connection with the approved accounts.
C. Case Law
Case law on true sale in factoring transactions is spotty and, like case law on the issue of true sales of financial assets generally, provides no bright line tests for determining whether a transaction is a true sale. What cases there are, however, do tend to support the conclusions drawn in this article that most factoring transactions are not true sales for the reasons previously described.10
IV. Should Factors Care?
Before answering the question of whether factors should care if their deals are not true sales, let me be clear that I am not advocating that every factoring transaction is absolutely not a true sale. Some factoring transactions may be structured in ways so as to avoid the difficulties described above. However, as I hope I illustrated above, enough true sale factors are either absent from factoring transactions or present to such a diluted extent that many factoring transactions would be hard-pressed to qualify as true sales if tested. So, assuming a factoring transaction is not a true sale, let’s briefly examine the ramifications and then assess whether a factor should be concerned.
A. Recharacterization and Its Impact
As mentioned above, recharacterization changes a sale of accounts into a loan secured by the ostensibly transferred accounts. Thus, instead of the transferee simply continuing to collect the transferred accounts upon the transferor’s bankruptcy, the transferee is placed in the position of a pre-petition lender to the now bankrupt transferor with a security interest (duly perfected one would hope) in the ostensibly transferred accounts and their pre- and post-petition proceeds.
In bankruptcy (the venue in which a recharacterization challenge most likely would arise), such proceeds constitute cash collateral that the transferee can use to fund its cash needs, subject to court approval and adequate protection of the transferee’s/lender’s interest in the accounts.11 Adequate protection may be provided in the form of one or more of a replacement lien on post-petition accounts, the debtor’s maintenance of an equity cushion in the collateral, the payment of post-petition interest on the “loan”, or the requirement that the transferor/debtor hew to a rolling 13-week (or other suitable period) cash budget.12
B. The Factor’s Position
At the risk of stating the obvious, the recharacterization into a secured loan of a pre-petition transfer by parties intending a “true sale” would be an unexpected and highly undesirable event. But is that true for factors? While most factors will assert that their transactions are “sales” (and I am not suggesting they should do otherwise), I argue below that in most cases a factor should care very little if either type of factoring transaction described in this article is not a “true sale” and thus subject to recharacterization.13
1. Notification Factoring Without Advances. Because the factor is owed substantially less money in this type of transaction than in a Notification Factoring With Advances transaction, recharacterization would leave the factor with very little in the way of a “loan” to collect and, assuming proper documentation, such a loan would be vastly over-secured by the accounts recharacterized as property of the estate.
From the debtor’s point of view in this situation, there’s little to be gained from recharacterization because the factor is deducting only the above-described amounts from collections on the accounts before remitting them to the debtor. Likely for these reasons, I have never seen - and frankly do not expect ever to see - an attempted recharacterization of a transaction of this type.
2. Notification Factoring With Advances. In this type of transaction, the factor is owed substantially more than in a Notification Factoring Without Advances.14 Recharacterization thus is potentially more impactful on the factor because it will have a larger resulting loan and also potentially more beneficial to the debtor because more cash collateral will be released to the estate. Ironically, however, a factor is unlikely to face recharacterization in this situation for some of the same reasons that the factoring transaction is subject to recharacterization in the first place.
A factor with advances to a client is usually that client’s sole source of working capital and has factored all or most of the client’s accounts receivable (and may also have loans to the client secured by its inventory and other assets). Factors are also typically very well margined on their advances due to the visibility into and control over the collateral pool that factoring provides and the discretion factors have to make advances and establish reserves.
For these reasons, factors are much less likely to consider walking away from a newly-bankrupt client that has outstanding advances and attempting simply to collect the factored accounts and be done with the matter. Rather, factors typically will work with such a client to provide some level of post-petition liquidity to bridge the client to the next event in its post-petition life cycle. As a result, even though such a transaction may be highly susceptible to recharacterization as a secured loan, there typically is very little if any incentive for the debtor to attempt to do so.
The foregoing conclusion obviously does not apply if the factor desires simply to have its advances paid down through post-petition collections without any arrangement for post-petition liquidity. If a debtor in such a situation petitions the court for use of cash collateral, and the factor responds by saying there is no cash collateral because the accounts were sold to it in a true sale, the factor may find itself in a fight over the issue that will be difficult to win.
Based on an examination of true sale analysis applied to the two basic forms of factoring transactions – Notification Factoring Without Advances, and Notification Factoring With Advances - such transactions are hard-pressed to qualify as true sales and are thus highly susceptible to recharacterization as secured loans. However, Notification Factoring Without Advances transactions likely will not face recharacterization because there is not enough to be gained by a debtor from bringing such an action. Notification Factoring With Advances transactions, while potentially providing more benefit to a debtor if recharacterized, will likely not face recharacterization as long as the factor continues to work with the debtor to provide post-petition liquidity similar to what it would provide if it was a post-petition lender.
*This article is intended for educational and informational purposes only and does not constitute the rendering of legal advice. The views and opinions expressed in this article are solely those of the author and do not necessarily reflect the views, opinions or policies of Poyner Spruill LLP or its partners.
**Partner, Poyner Spruill LLP, Charlotte, North Carolina.
1See, e.g., Susan J. Klein, Factoring Accounts Receivable: True Sale Versus Secured Transaction, The Secured Lender (November/December 2006).
2The client accounting structure in most factoring agreements involves (a) debiting an accounts receivable account and crediting a reserve (or similarly named) account, in each case, for the purchase price of the accounts and (b) debiting the reserve account for advances. The net debit balance in the receivables account minus the net credit balance in the reserve account equals a number factors call “Funds Employed” or “Funds In Use” (or something similar), which number generally equates to the amount of unpaid advances owing by the client to the factor. Receivables collections are credited to the receivables account (after being matched with the invoice they are supposed to pay), which in turn reduces the net debit balance in the receivables account and Funds Employed. Thus, receivables collections do not pay down advances directly but the mathematical relationship between advances and collections is relatively obvious.
3Peter V. Pantaleo (Reporter), Herbert S. Edelman, Frederick L. Feldkamp, Jason Kravitt, Walter McNeill, Thomas E. Plank, Kenneth P. Morrison, Steven L. Schwartz, Paul Shupack and Barry Zetsky, Rethinking the Role of Recourse in the Sale of Financial Assets, 52 Bus. Law 159 (1996).
4Accounting for Transfers of Financial Assets, an amendment of FASB Statement No. 140, Statement of Financial Accounting Standards No. 166 (Fin. Accounting Standards Bd. 2009), available at www.fasb.org.
5Id. at 9-10.
6Id. at 31.
7See discussion supra part II.A.1.
8I am not saying factors routinely create such reserves but rather that the structure of a typical factoring agreement allows it.
9See discussion supra part III.A.
10See, e.g., Major’s Furniture Mart, Inc. v. Castle Credit Corp., 602 F.2d 538 (3d Cir. 1979) (holding that the factor did not take on the risks of a true sale as a result of, among other things, the factor’s high level of recourse to the seller and its description of its advances in a side letter as loans under a line of credit accruing interest); Reaves Brokerage Company, Inc. v. Sunbelt Fruit & Vegetable Company, Inc. et al., 336 F.3d 410 (5th Cir. 2003) (holding that the combination of a factor’s excessive recourse, discretionary advances and reserves, among other things, meant that its relationship with the seller was not a true sale) (the court’s holding in this case is expressly limited to the facts and arguments presented in the case).
1111 U.S.C. §363(a).
1211 U.S.C. §363(e). The requirements for adequate protection are set forth in 11 U.S.C. §361 and do not explicitly include a reference to a budget, but the use of a budget as part of the package of adequate protection provided to a lender secured by pre-petition accounts has become commonplace.
13Of course, the factor’s client that specifically desires sale accounting for the factoring transaction and cannot obtain it due to the transaction’s structure may care a great deal. Whether the transaction can be structured to satisfy the requirements of FAS 166 is beyond the scope of this article.
14See discussion supra part I.B.