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A REPORT ON

BILL OF FACTORING
Submitted To PROF. (DR.) J. D. JADEJA Offg. Dean

Submitted By Ami D. Thakkar ROLL NO. 33

M. S. PATEL INSTITUTE OF MANAGEMENT STUDIES Faculty of Management Studies The Maharaja Sayajirao University of Baroda

INTRODUCTION
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. Around the world, factoring is the dominant form of asset-based finance and an important source of external financing for corporations and small and medium-size enterprises (SMEs). Under asset based finance the credit provided by a lender is explicitly linked on a formula basis to the value of a borrowers underlying (working capital) assets, not the borrowers overall creditworthiness. This explicit link is continuously managed so that the value of the underlying assets always exceeds the amount of the credit. In factoring the underlying assets are the borrowers accounts receivablethat is, sale payments due from customerswhich the factor (lender) purchases at a discount. For example, a seller (borrower) might receive from a factor 70 percent of the value of an account receivable, and the remaining 30 percent (less interest and service fees) upon receiving payment from the customer.

The three parties directly involved are: the one who sells the receivable, the debtor (the account debtor, or customer of the seller), and the factor. The receivable is essentially a financial asset associated with the debtor's liability to pay money owed to the seller (usually for work performed or goods sold). The seller then sells one or more of its invoices (the receivables) at a discount to the third party, the specialized financial organization (aka the factor), often, in advance factoring, to obtain cash. The sale of the receivables essentially transfers ownership of the receivables to the factor, indicating the factor obtains all of the rights associated with the receivables. Accordingly, the factor obtains the right to receive the payments made by the debtor for the invoice amount and, in nonrecourse factoring, must bear the loss if the account debtor does not pay the invoice amount due solely to his or its financial inability to pay.

Usually, the account debtor is notified of the sale of the receivable, and the factor bills the debtor and makes all collections; however, nonnotification factoring, where the client (seller) collects the accounts sold to the factor, as agent of the factor, also occurs. There are three principal parts to "advance" factoring transaction; (a) The advance, a percentage of the invoice face value that is paid to the seller at the time of sale, (b) The reserve, the remainder of the purchase price held until the payment by the account debtor is made and (c) The discount fee, the cost associated with the transaction which is deducted from the reserve, along with other expenses, upon collection, before the reserve is disbursed to the factor's client.

The History of Factoring Factoring is one of the oldest forms of commercial finance. Some scholars trace its origins to the Roman Empire and some even further back to the Hammurabi, four thousand years ago. The term factor comes from the Latin verb facio, which means he who does things. As the Latin verb suggests, the history of factoring is the history of agents doing things for others. For example, factoring was a well-developed activity in England in the 14th century, where it evolved with the growth of the wool industry. The job of factors centred on their functions as sales agents, or commission merchants, for textile mills. The distances between customers and manufacturers made commerce problematicgiven the primitive forms of transportation and communicationso factors assumed complementary functions to address the business challenges that arose because of these distances. At the centre of these functions was the factors role as the sales force for the textile mills. As a by-product of this activity, factors assumed other marketing and distribution functions, including offering advice on customer tastes, product demand, and warehousing services -so that mills could ship merchandise to the factors, who would then ship to the final customers.

Factors also assumed some critical financial functions on behalf of the mills. They offered credit advice on how much to sell on account to potential customers. They also guaranteed payments to the mills, assuming full responsibility for the creditworthiness of the mills customers. To protect themselves, factors established reserves to cover claims for defective merchandise and any disputes that arose out of those claims. Finally, and equally important from an historical perspective, factors advanced funding to the mills based on the value of the merchandise sold. Thus, in essence, factoring was fully reflected economically in the financial component of the factoring business as it existed 600 years ago. The difference between today and 600 years ago is that the sales, or agenting, component has been purged from the factoring relationship. But factoring as it is typically practiced in both developed and developing economies can still be viewed as a bundle of activities. In addition to financing, factors typically provide their clients with two other services: credit and collections. In developing countries factoring offers several advantages over other types of lending. First, factoring may be particularly useful in countries with weak secured lending laws, inefficient bankruptcy systems, and imperfect records of upholding seniority claims, because factored receivables are not part of the estate of a bankrupt SME. Second, in a factoring relationship the credit is primarily based on quality of the underlying accountsnot the quality of the borrower. Thus factoring may be especially attractive to high-risk SMEs.

How factoring works? Characteristics of factoring Usually the period for factoring is 90 to 150 days. Some factoring companies allow even more than 150 days. Factoring is considered to be a costly source of finance compared to other sources of short term borrowings. Factoring receivables is an ideal financial solution for new and emerging firms without strong financials. This is because credit worthiness is evaluated based on the financial strength of the customer (debtor). Hence these companies can leverage on the financial strength of their customers. Bad debts will not be considered for factoring. Credit rating is not mandatory. But the factoring companies usually carry out credit risk analysis before entering into the agreement. Factoring is a method of off balance sheet financing. Cost of factoring=finance cost + operating cost. Factoring cost vary according to the transaction size, financial strength of the customer etc. The costs of factoring vary from 1.5% to 3% per month depending upon the financial strength of the client's customer. Indian firms offer factoring for invoices as low as 1000Rs

For delayed payments beyond the approved credit period, penal charge of around 1-2% per month over and above the normal cost is charged (it varies like 1% for the first month and 2% afterwards). The flexibility of factoring is a likely reason that factoring has existed for so long and is so widely used. A company may have various business services included as part of the arrangement with their factor. In many of the situations listed below, the company is outsourcing its accounts receivable, reporting and collections to the factor. This can benefit the company by helping them keep staff and systems overhead low.

Non-recourse factoring. The factor provides the bookkeeping, accounts receivable posting and the reporting and collection services. The factor may provide advances or loans against the purchased accounts receivable, inventory or other assets. The factor assumes credit risk of an account debtors inability to pay the outstanding accounts receivable. Recourse factoring. The factor provides the bookkeeping, accounts receivable posting and the reporting and collection services. But, similar to an asset-based lending situation, the factor does not assume credit risk of a customers inability to pay the outstanding accounts receivable. The risk is borne by the client. Collection factoring. The factor provides the bookkeeping, accounts receivable posting and the reporting and collection services. But, the factor does not offer loan or advance privileges. The factor assumes credit risk of an account debtors inability to pay the outstanding accounts receivable. Money or funds in use factoring. The factor provides the bookkeeping, accounts receivable posting and the reporting and collection services. The factor does offer advances and/or loans against the purchased accounts receivable, inventory or other assets. This can be done on a non-recourse or recourse basis. Non-notification factoring. The client is responsible for collecting the invoice payments from its own customers. Generally, the client is required to direct its customers to remit payment to the factors lockbox.

Domestic and International Factoring in 2010

Total Factoring Volume by Country in the Last 7 Years

Total factoring volume

The overall results illustrate that exporters and importers, around the world, are becoming more and more familiar with the advantages to be derived from a factoring arrangement: working capital, credit risk protection and collection service for the exporter. India has shown a notable increase in factoring volumes since 2005. In 2007 factoring volumes were Euro 5.20 billion in comparison to Euro 1.99 billion in 2005. So we can say that factoring is moving upward in India, and soon factoring will spread its wings across the length and breadth of the country. It is quite implied now that factoring is a very easy and fast method. Still, its implementation is not so good. There are certain hiccups that have come up in the way of releasing the full potential of factoring in India. One of the main reasons for it was the legal framework of India, which has now been put in place by passing The Factoring Regulation Bill,2011. Generally factoring companies need legal protection as all advances are uncollateralized. The benefits of factoring The most obvious benefit of working with a factor is the ability to quickly get working capital. The accelerated cash flow a factor can provide may help the success of a start-up, a company experiencing high growth or a seasonal sales spike, or even a business in a turnaround situation. Factors typically offer favourable advance rates for accounts receivable, inventory or other assets. A factor can also provide credit protection against customer bad debt losses. An established factor can offer the ability for a client to outsource credit, accounts receivable bookkeeping and collections functions. This typically speeds accounts receivable collections and can free-up additional working capital for a company. It also converts accounts receivable management costs from fixed to variable, and they may be eligible for off balance sheet treatment. Disadvantages The basic disadvantage of factoring is that it may lead to ruined relations with the customers especially if factor engages in aggressive or unprofessional practices when collecting accounts

Cost is another disadvantage, cost involved in factoring agreement may be more than the cost of other methods of financing available in the business

Factoring in India Indias factoring turnover in 2009 was around Euros 2500 Million in domestic and Euros 2650 million in total as compared to a total of Euros 1,283,559 million worldwide1 and the turnover over the last 7 years has seen a tremendous growth and steep downfall as well; while that of Asia has risen 219% from 2004 to 2010 and is valued at $637 billion. Some of the challenges faced by the factoring companies in India are a) There was no specific law for assignment of debt, b) There was no recovery forum available to the factoring NBFCs such as DRT or under Sarfaesi Act, c) Lack of access to information on credit worthiness and d) Assignment of debt involves heavy stamp duty cost. Factoring service in India is of recent origin. It owes its genesis to the recommendations of the Kalyanasundaram Study Group appointed by the RBI in 1989. Pursuant to the acceptance of these recommendations, the RBI issued guidelines for factoring services in 1990. The first factoring company SBI Factors and Commercial Ltd (SBI FACS) started operation in April 1991. The main recommendations of the Committee/Group are listed as follows: (1) Taking all the relevant facts into account, there is sufficient scope for introduction factoring services in India which would be complementary to the services provided by banks. (2) The introduction of export factoring services would provide additional facility to exporters. (3) While quantification of the demand for factoring services has not been possible, it is assessed that it would grow sufficiently so as to make factoring business a commercially viable proposition within a period of two/three years. (4) On the export front, there would be a fairly good availment of various services offered by export factors. (5) With a view to attaining a balanced dispersal of risks, factors should offer their services to all industries and all sectors in the economy. (6) The pricing of various services by factors would essentially depend upon the cost of funds. Factors should attempt a mix from among the various sources of funds to keep the cost of funds as low as possible, in any case not exceeding 13.5 percent per annum, so that a reasonable spread is available. (7) The RBI could consider allowing factoring organizations to raise

funds from the Discount and Finance House of India Ltd, as also from other approved financial institutions, against their usance promissory notes covering receivables factored by them, on the liens of revised procedure under bills discounting scheme. (8) The price for financing services would be around 16 per cent per annum and the aggregate price for all other services may not exceed 2.5 percent to 3 percent of the debts services. (9) In the beginning only select promoter institutions/groups of individuals with good track record in financial services and competent management should be permitted to meter into this new field. (10) Initially the organizations may be promoted on a zonal basis. (11) There are distinct advantages in the banks being associated with handling of factoring business. The subsidiaries or associates of banks are ideally suited for undertaking this business; initially, it would be desirable to have only four or five organizations which could be promoted either individually by the leading banks or jointly by a few major banks having a large network of branches. (12) Factoring activities could perhaps be taken up by the Small Industries Development Bank of India, preferably in association with one or more commercial banks. (13) The business community should first be educated through bank branches about the nature and scope of these services and the benefits accruing there from. (14) Factors cannot extend their services efficiently, effectively and economically without the support of computers, as quick and dependable means of communication. Concurrent with consideration of various aspects relating to commencement of factoring operations the promoters should initiate measures for organizing network of computers /dedicated lines the branches/agents in different parts of the country for accounting follow up remittance and other activities involved in factoring business. (15) The Central Government ad RBI should initiate appropriate measures immediately for setting up specialized agencies for credit investigations; until such agencies become fully operative, factors may have to rely on such information about clients/customers as could be collected through banks or other sources. (16) Since the suppliers would be able to obtain financial services from both banks and factors, it is necessary to provide for proper linkage between banks and factoring organizations.

(17) The factoring of Small Scale Industrial (SSI) units could to be mutually beneficial to both factors and SSI units and the factors should make every effort to orient their strategy to crystallize, the potential demand for this sector. Obstacles According to World Bank, various taxes, legal and regulatory obstructions will block factoring services. "Factoring generally requires good historical credit information on all buyers; if unavailable, the factor takes on a large credit risk." It also points out that fraud represents another big problem in this industry (e.g. bogus receivables and nonexistent customers). Mr. Laxman N. Sankade, Managing Director, Canbank Factors Ltd, said: "For factoring to develop, it is imperative that an enabling legal environment be created and the Factoring Bill be passed in Parliament. (It has now been passed). It is also seen that a lot of weak companies would actually be able to tide over their liquidity problems if the receivables are acceptable to the factoring companies and which could be factored. According to Mr. Basab Majumdar, Head-Factoring and Receivables Finance, India, HSBC, "Assignment of debt is still a cumbersome process and involves stamp duty which again is a State level subject and there is no uniformity in the rates of stamp duty across States. Moreover, every time a debt has to be assigned to the factor and stamp duty paid on the transaction, which has the potential of making the proposition expensive for the client. Most of the developed countries have implemented clear laws related to assignment/transfer of debt, bankruptcy, debt recovery, etc. Additionally in India, access to information on companies, their repayment performance with the banking system, etc is thinly available, which results in lack of information to decide on credit."

THE FACTORING REGULATION BILL, 2011 The Parliament recently passed the Factoring Regulation Bill 2011 (Factoring Bill or Bill). Given the fact that several other important bills have taken years to ascend into the statute book, the Factoring Bill has really been commendably quick to progress. No one would perhaps know what the urgency was for the Bill it is not as if factoring business was a mushrooming business which needed regulation.

On the contrary, factoring is an idea that the RBI has been meaning to promote over decades, and there has not been any substantial pick up in factoring volumes over the years. If at all factoring business needed anything it was support and promotion. But the tone of the Bill is far from promotion it is full of a regulatory slant. This is exactly the model that RBI used when passing the Securitisation Act with the idea to promote securitisation, and it ended up in regulating securitisation to the extent that no securitisation transaction has ever happened so far under the Act. The regulatory tone of the Bill apart, the Bill seeks to enact the provisions of the UNCITRAL model law on assignment of trade receivables1, which itself, 11 years after its proposition, has been affirmed only by 4 countries in the world. Factoring has obviously not been something to attract the fascination of either the banks or the NBFCs. The factoring volumes in India have not been significant enough, and unlike other facets of NBFC activity, factoring business has not drawn foreign players to any appreciable extent, except recently when some foreign banks seem to have begun factoring services. Receivables financing: While factoring might have picked up much, receivables financing has continued to grow with the growth of the NBFC sector. The NBFC sector today views receivables as much as a part of assetbased financing as other tangible assets. And lot of investments in happening today in the infrastructure as well as IT sector where the basis

of investment is receivables. To give instances a PSU/ government department goes for a massive system upgradation where equipment and services are provided by an aggregator, who in turn finances himself based on the receivables committed by the client. Receivables discounting is also common as a mode of sales-aid financing several software and hardware vendors provide the facility of instalment or deferred payments to their clients and in turn sell the receivables to finance companies. None of this is factoring in the real sense, because none of the so-called receivables financiers are going anywhere beyond pure financing. First of all, was there a case at all that a factoring company was not covered by the regulatory ambit prior to the enactment of the new law? If the factoring activity was being carried out as a true acquisition of receivables by the factor, it is possible to argue that what is a purchase of receivables cannot be a financing transaction, and hence, a factor is not a non-banking finance company under existing definition in the RBI Act. However, most factors actually carry out full recourse factoring with features that hardly imply intent of purchase of receivables hence, such activities nothing but lending on the security of receivables, and hence, would still amount to a financial business for being regulated as an NBFC. Therefore, if the law is based on the premise that factors were not regulated so far, and the idea is to regulate them, the basis is misplaced. As regards receivables financing - admittedly, this is a financing activity and hence, the business is a financial business, bringing the business under RBI supervision. However, the key feature of the existing NBFC regulation is that financial business needs to be the principal business to bring an entity into NBFC domain. If a non-banking, non-financial entity carries financial business, it may still retain its status as a non-financial business as long as the business remains non-principal. The RBI has been using a percentage of assets and income as the criteria for determining principality. If the idea of the Bill is to bring entities engaged in factoring business into the regulatory ambit, let us examine to what extent does the law go in meeting this objective.

First of all, the Bill defines factoring business to include both acquisitions of receivables as well as receivables financing. That is to say, any financial transaction where receivables are accepted as a security. Clearly, the definition is thoughtlessly inserted and can be stretched to completely unintended extent. For example, if someone gives a loan against a machine, and accepts receivables as a collateral security, it is certainly not a transaction of financing of receivables, but looking the way the definition is worded, the transaction will amount to factoring business. The biggest problem lies in the language of sec. 3 which says no factor shall commence or carry on the business of factoring without RBI registration. The word factor is defined in sec. 2 (i) as a non-banking financial company, a body corporate, or any other company. Sec 3 (2) and its proviso pertain to an NBFC presently carrying out, as its principal business, on the date of commencement of the Act. However, sec 3 (1) nowhere says that the provision will be applicable only where the factor carries on factoring as its principal business. That is to say, if the language of sec. 3 is taken as it is, every company carrying on factoring business, whether as a principal business or not, needs to apply for RBI registration. The only exception to this will be banks, and statutory corporations, in term of sec 5 of the Bill. This brings a completely over-stretched arm of the Bill which requires mandatory registration, and RBI supervision, in case of non-financial companies which may be engaged in acquisition or security interest over receivables as a non-principal activity. Several manufacturing/trading companies do so. Several IT companies may also be doing the same. There is an exception specifically made in case of securitisation transaction, further reinforcing the assumption that whether or not the business of factoring is the main business, registration under the Bill becomes mandatory. Thus, NBFCs will need registration under the law only if their principal business in factoring, but other companies, excluding banks, will come under the registration requirements irrespective of whether factoring business is principal business or not. If it is a business, it will come under the law.

Substantive provisions: The substantive provisions of the law inclusively pertain to giving effect to an assignment agreement. Section 7 provides that an assignment shall be effective between assignor and assignee on the execution of the agreement, and section 8 provides that no right shall exist against the debtor unless the debtor has been served with the notice of assignment. This is exactly the common law position understood through more than a century. Sec 130 of the Transfer of Property Act provides for the same thing and common law jurisdictions all over the world work on the same principle. This was the law before; this remains the law after the Bill. To put the point in perspective, several assignment of receivables are silent assignments meaning, the fact of the assignment is not notified to the debtor. This is the universal practice in case of securitisation transactions. In case of financing transactions also, the lender typically does not need to, and hence does not, notify the obligor.

However, section 17 of the Bill makes silent assignments completely fragile and almost impossible. This section says that in case of silent transfers, the assignee will be bound by any such modification of the original contract that the assignor may make with the debtor. It is only after the notification of the assignment that such modifications become ineffective. That is to say, unless the assignee gives immediate notice of the assignment to the debtor, the assignee is virtually at the mercy of the assignor. This provision is borrowed from UNCITRAL model law on international assignment of trade receivables, but will certainly give major jolt, particularly those who lend money against receivables. By way of saving grace, the provisions of the Bill have been excluded in case of securitisation transactions, but what is a securitisation transaction itself will remain queer.

Registration provisions The Bill mandates registration of all assignment transactions, and also satisfaction of claims of the assignee. Non-registration does not affect the validity of the assignment; registration does not amount to a notice to the debtor. However, non-registration is punishable with a fine up to Rs 5000 per day. The registry office is the Central Registry under the SARFAESI Act, currently being run by NHB. The way the language of the law is, filing notice of satisfaction or realisation of a debt may, in case of instalment or partial payments, notifying innumerable events. In case of trade receivables, factoring transactions involve revolving lines of credit, with numerous receivables getting assigned in succession. Hence, the mandatory registration requirement, with no advantage as to validity or deemed notice to the obligor, only impose an added administrative burden. Among other provisions, the bill proposes to ban financial institutions from directly entering the factor business.

The regulation of factor (Assignment of Receivables) Bill 2011 provides... for empowering the RBI to issue directions, call for information from the factor and prohibit financial institutions from undertaking factoring business, if the factor fails to comply with the directions given by the RBI," says the Bill's statement of Objects and Reasons. If any factor fails to comply with a direction issued by the Reserve Bank of India, the factor and every officer in default may be punished with a fine of up to 5 lakh rupees and an additional fine of Rs 10,000 for each day the default continues. Other Salient features The Bill also provides for establishment of a Central Registry which would maintain details regarding all transactions carried out by factors. It makes registration of all factor transactions mandatory. Besides, factors would be entitled to take legal recourse for recovering assigned debt and receivables from buyers of goods and services. 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. Factors are barred from disclosing personal information obtained from any assignor, its present and future customers, its commercial and business activities, and the terms of sale between the assignor and any debtor. The bill allows factors to take legal recourse to recover assigned debt and receivables from buyers of goods and services. After the assignment of receivables takes place, the payment instruction issued to the debtor may modify whom payment is to be rendered to, but not (a) the amount of debt specified in the original contract, (b) the place where payment is to be made, and (c) the date on which payment is to be made. The Bill refers to the factor as the assignee, the industry selling the receivable to the factor as the assignor, and the person liable to the industry as the debtor. Future Prospects As per IFCI Factors, India accounts for a meagre 2.2 percent of the global factor business worth 1.325 trillion euros. Potential clients of the factor

business include SMEs that account for 45 per cent of Indias industrial output and 40 per cent of exports. In 2013, these SMEs will account for 22 per cent of GDP. Dun & Bradstreet, an independent consultancy, has estimated that the factoring business could be worth Rs 2, 45,000 crore in four years.

CONCLUSION Growth of factoring will solve the liquidity and working capital problems of numerous small and medium scale industries, which supply spare parts and operate as ancillary units of large manufacturing units and other business entities. Traditionally, banks take lending decisions based on the borrower's capacity to pay and other securities. Factoring will be undertaken considering the capacity, standing and status of debtors. The new law is a major step in financial sector reforms, and needs to be appreciated. There is only one direction in which factoring can go in India: upwards. As the awareness level about the benefits of factoring increases, factoring will spread its wings across the length and breadth of the country.

REFERENCES
1. URL: http://www.indianexpress.com/news/lok-sabha-approves-factoring-bill-to-help-msmesector/890430/2 2. URL:http://articles.economictimes.indiatimes.com/2012-02-01/news/31012822_1_receivablesfactoring-services-business-activity 3. URL:http://www.prsindia.org/billtrack/the-regulation-of-factor-assignment-of-receivables-bill2011-1602/ 4. URL: http://www.citeman.com/4934-factoring-in-india.html 5. Factors Chain International, Annual Review, 2011 6. SAMPADA Factoring Bill: Blow to receivables financing: Article by Vinod Kothari

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