Factoring and Forfeiting

Factoring, as a fund based financial service, provides resources to finance receivables as well as facilitates the collection of receivables. Although such services constitute a critical segment of the financial services scenario in the developed countries, they appeared in the Indian financial scene only in the early nineties as a result of RBI initiatives. The theoretical framework of factoring services and the salient features of such services currently in operation in the country is divided into three Sections. The theoretical/conceptual framework is examined in this article.

Theoretical Framework:

This section describes the theoretical framework of factoring services with reference to aspects such as its concept and mechanism, types, functions of a factor, legal aspect of favoring its relationship with bills discounting and forfeiting its advantages and evaluation and so on.

Definition and Mechanism:

In the absence of any uniform codified law, the term ‘factoring’ has been defined in various countries in different ways. Many efforts have been made to arrive at a consensus regarding uniform meaning and to define a well laid scope for such type of service contract. The study group appointed by the International Institute for the Unification of Private Law (UNIDROIT), Rome, during 1988, recommended in general terms, the definition of factoring as under:

Factoring means an arrangement between a factor and his client which includes at least two of the following services to be provided by the factor:

1. Finance
2. Maintenance of accounts
3. Collection of debts
4. Protection against credit risk.

However, the above definition applies only to factoring in relation to supply of goods and services: (1) across national boundaries; (2) to trade for professional debtors (3) when notice of assignment has been given to the debtors. Domestic factoring is not yet defined concept and it has been left to the discretion of legal framework as well as trade usage and convention of the individual country.

Nevertheless, following the development of factoring concept in various developed countries of the world some broad agreement has been arrived at towards defining the term. Factoring can broadly be defined as an agreement in which receivables arising out of sale of goods/ services are sold by a firm (client) to the factor (a financial intermediary) as a result of which the title to the goods/services represented by the said receivables passes on to the factor. Henceforth, the factor becomes responsible for all credit control, sales accounting and debt collection from the buyer(s). In a full service factoring concept (without recourse facility), if any of the debtors fails to pay the dues as a result of his financial inability / insolvency / bankruptcy, the factor has to absorb the losses.

Mechanism: Credit sales generate the factoring business in ordinary course of business dealings. Realization of credit sales is the main function of factoring services. Once a sale transaction is completed the factor steps in to realize the sale. Thus, the factor works between the seller and the buyer and sometimes with the seller’s banks together.

A schematic view of factoring mechanism explaining the interaction between the different parties and flow of information between them is summarized as follows:

The Buyer:

(a) Buyer negotiates terms of purchasing the materials with seller;
(b) Buyer receives delivery of goods with invoice and instruction by the seller to make payment to the factor on due date;
(c) Buyer makes payment to factor in time or gets extension of time or in the case of default is subject to legal process at the hands of factor.

The seller:

(a) Memorandum of Understanding (MOU) with the buyer in the form of letter exchanged between them or agreement entered into between them;
(b) Sells goods to the buyer as per MOU;
(c) Delivers copies of invoice delivery challan, MOU instructions to make payment to the factor given to the buyer;
(d) The seller receives 80 per cent or more payment in advance from the factor on selling the receivables from the buyer to him;
(e) The seller receives balance payment from the factor after the deduction of factor’s service charges etc.