Businesses must pay supply and labor costs to produce goods for sale today; however, they typically won’t get paid for those goods for at least 30 days. Factoring agreements help solve the cash-flow problem by enabling businesses to convert their account receivables into working capital.

Black’s Law Dictionary defines (traditional) factoring as “[t]he buying of accounts receivable at a discount. The price is discounted because the factor (who buys them) assumes the risk of delay in collection and loss on the accounts receivable.” Black’s Law Dictionary (11th ed. 2019).

In traditional or “old line” factoring, a factoring company (or “factor”) buys accounts receivable at a discount; the factor’s seller company obtains immediate operating cash, and the factor profits when the face value of the account is collected.

Courts interpreting factoring agreements generally have considered the hallmark of such a true sale to be the assumption, by the factor as purchaser, of the risk that the receivables become uncollectible due to the financial insolvency of the customers in whose names the receivables are drawn.

Traditional factoring agreements are called “non-recourse” because the factor has no recourse against the selling company in the event the receivables become uncollectible due to financial insolvency of the customers.

Another indicator of a true sale is notification by the seller company to its customers that a factor has purchased their receivables and that payment should be remitted directly to the factor. Accordingly, traditional factoring has been described as, “the discounting of acceptable accounts receivable on a non-recourse, notification basis.” Woelfel, Charles J., Encyclopedia of Banking & Finance, at 370 (10th ed. 1994) (emphasis added).

These days, very few factors offer accounts receivable financing solutions that are truly on a non-recourse, notification basis, except to multinational corporations with a roster of large customer-debtors with solid credit. Most companies are more likely to be offered only partial or so-called “full-recourse” factoring products.

Factoring agreements underlying such products may, on their surface, state that they are purchase agreements with a seller and buyer of receivables. On closer inspection, however, such agreements typically contain terms that are viewed by courts as incompatible with a true sale. The clear majority rule in American jurisprudence is that full-recourse factoring is simply a disguised, secured loan.

UCC implications

Whether a factoring agreement is construed as consummating a sale or a loan can have significant implications for how the transaction is treated under the Uniform Commercial Code.

Additionally, the distinction can be important in determining whether a transaction is subject to statutes that prohibit usury. See, e.g., Funding Metrics, LLC v. D&V Hospitality, Inc., 91 N.Y.S.3d 678, 683 (N.Y. Sup. Ct. 2019) (“given [the factor’s] refusal to [even] contemplate . . . the possibility of not being repaid . . . the financial arrangement cannot be deemed to be anything short of a loan, and based upon mathematical calculations, a criminally usurious loan”).

The distinction becomes especially critical when a company whose invoices are factored goes bankrupt, and competing creditors vie over whatever valuable property may remain within the bankrupt estate.

A case in point is Nickey Gregory Co., LLC v. AgriCap, LLC, 597 F.3d 591 (4th Cir. 2010). Robison, a produce distributor, bought produce from an agricultural trust of growers on short-term credit. Robison then distributed the produce to restaurants and school systems on credit so as to generate accounts receivable. After experiencing financial difficulties, Robison sought a line of credit from factoring company, AgriCap, and assigned the receivables to AgriCap.

Robison filed for bankruptcy without paying the growers the outstanding balance owed to them. The growers brought suit against Robison, arguing that because the factoring agreement was a loan, not a sale, the underlying accounts receivable at issue remained in the Robison bankrupt estate, over which the growers’ trust had a priority lien that was senior to AgriCap’s.

In affirming the district court on appeal, the Fourth Circuit agreed that the factoring agreement at issue represented a loan. Robison had not transferred risk of non-collection of accounts receivable to AgriCap; documents related to the transaction referred to the receivables as collateral; and AgriCap filed a UCC-1 Financing Statement for the transaction.

The court concluded that the substantive aspects of the transaction were inconsistent with a sale of assets, and that the transaction was in “essence a loan in the form of a revolving line of credit secured by accounts receivable.”

Accordingly, the accounts receivable and their proceeds never left the growers’ trust, and their proceeds had to be made available for payment of the claims of unpaid grower-creditors, first.

Full-recourse factoring agreements, as secured loans, can be replete with complexities and parties entering into them are best advised to seek appropriate counsel on the issues involved.

Arie Michelsohn, Ph.D., Esq. is special counsel at Steiner Law Group, LLC. He focuses his practice on bankruptcy and commercial litigation, as well as contracts, licensing, and intellectual property.