Factoring, as a form of commercial finance, has a long established history. It is, essentially, the business of buying accounts receivable at a discount—a discount provided because the factor (the party who buys the receivables) assumes the risk of delay in collection and loss on the accounts receivable. Under a factoring agreement, the factor purchases a client’s billing invoices at a discount in exchange for a security interest in the receivables owed by third-parties in payment of these invoices. The factor (or the factor’s client) notifies the third-party, thereby securing the factor’s right to payment. Through this transaction, the client gains short-term working capital and the factor manages the receivables and collections. On payment, the factor generally remits a portion of the payment to its client, retaining the remainder for service fees.
Factoring is often viewed as a source of financing of last resort, preferred by companies often on the brink of insolvency that are unable to benefit from other forms of traditional financing. Factoring is common in the construction industry—and there has been a recent uptick in factoring activity. For the unwary and underprepared contractor, this comes with significant risk, such as paying on an invoice twice or having to pay even when contractual protections otherwise would allow the withholding of contract funds. There are steps that every prudent contractor should take to protect itself from added costs arising from downstream factoring.
Know who you are dealing with: Factors often do not plainly identify themselves as such. Depending on other aspects of their respective businesses, they may refer to themselves as a bank, financial institution, lender, capital resource, asset solution, or some other financially related term. If a contractor receives a notice interjecting a new party in the payment process with a subcontractor/supplier, a factor may be involved—regardless of the name of the entity or the type of business it claims to be.
Carefully evaluate subcontractors/suppliers who factor invoices: At a minimum, there are a number of inconveniences for a contractor when its subcontractors/suppliers have factored their invoices. Procedures for payment processing must be modified as a new party is now involved, and special steps may need to be taken to keep contractual protections in place. Such events and activities involve additional time and a potentially disruptive change from standard practices. The fact that a subcontractor/supplier is factoring its invoices certainly could be an indication of serious financial issues. A contractor should carefully evaluate any subcontractor/supplier who is factoring its invoices and determine whether or not the added burden and risk is worth the value that the subcontractor/supplier otherwise provides, and, where appropriate, limit the opportunities to work on future projects with the contractor.
Know the limits of your contract terms: Contracts often contain clauses by which one party (or both parties) are prohibited from assigning any contract rights or obligations to a third-party without the consent of the other party to the contract. The goal of such clauses is to ensure that contracting parties know who they will be working with. However, by statute, such clauses are ineffective to the extent that they prohibit or restrict assignment or require the consent of the person required to pay. While anti-assignment clauses can be a useful tool in order to provide continuity during and after completion of a project, they have their limits.
Understand the risks of paying the wrong party: Once a contractor has received proper notification that a right to payment has been assigned and that payment is to be made to the factor, the contractor may only discharge its obligation by paying the factor. These notices need to be taken seriously, as once it is received, paying the subcontractor/supplier will not discharge the debt—only paying the factor will. A contractor who overlooks the significance of this notice may find itself paying a debt twice, and trying to collect the overpayment from the subcontractor/supplier.
Understand your rights and the implications of your statements: Generally, a factor’s rights are subject to all terms of the agreement between the contractor and the subcontractor/supplier (e.g., withholding rights, conditions to payment, etc.) and any defense or claim in recoupment (e.g., offset). However, this is not the case where a subcontractor/supplier has made an enforceable agreement not to assert defenses or claims. There is no requirement that such an agreement be made in writing, and factors have been known to seek to obtain an agreement during a telephone call (which the factor may be recording). Carefully read any document that a subcontractor/supplier or factor provides to ensure that no rights or defenses are inadvertently waived by any action or inaction. Similarly, be careful what is said on the telephone to a factor’s representative.
Remove your business from the factoring arrangement: If a subcontractor/supplier has factored its invoices, consider working with the subcontractor/supplier to see if there are any opportunities to be removed from the factoring arrangement. The subcontractor/supplier may be receptive (or persuaded), and the factor might agree to a satisfactory resolution—but be sure to get any such agreement in writing. If removal is not a viable option, work to secure an agreement with the factor where it agrees that the vendors of the subcontractor/supplier should be paid before the factor is paid the remainder. These solutions are really a function of leverage and the openness of the parties involved. What may work in one instance may not work in another.
This provides a very general overview of tricks and traps associated with factoring. If possible, a contractor may wish to avoid subcontractors/suppliers who factor their invoices altogether. If that is not feasible, a contractor should be very diligent in protecting itself to avoid the risks that arise when a factor takes on the right to payment of a subcontractor/supplier. ■
About The Author R. Carson Fisk is a construction attorney and shareholder in the Austin, Texas, office of Ford Nassen & Baldwin P.C. (www.fordnassen.com), which is nationally recognized in the construction industry and is one of the largest construction law firms in Texas. He focuses his practice on commercial construction disputes, as well as other construction-related matters. He is also a mediator and arbitrator. Mr. Fisk can be reached at rcfisk@fordnassen.com or 512.275.1783.
Modern Contractor Solutions, September 2014
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