As a method of lending, factoring is unique in that it’s collateral for advances of cash is simple an invoice. Though an invoice is simply a piece of paper, that paper represent a pending cash payment so it’s important to understand how a factor insures that it receives that payment. To better understand a factor’s collateral and how it insures payment on invoice purchases, you need to know a little about the concept of collateral for a financing and the importance of the UCC or Uniform Commercial Code.
Factors, as you know, are members of the asset-based finance (ABF) community of lenders and as a group, all asset-based financiers operate based on the concept of collateral. What really sets this group apart from traditional “financial statement” lenders, such as most banks, who gauge loan approval primarily on a borrower’s financial strength, is that asset-based financiers focus more heavily on collateral assets and the ability to quickly liquidate a particular collateral in the event a financed party defaults on its obligations. For example, an equipment leasing company depends on its ability to repossess a piece of equipment and sell or re-lease it to recover or protect its invested capital if the lessee fails to make its timely lease payment.
Put simply, collateral is just a pledge of an asset which secures a borrower’s repayment of a loan or similar financial accommodation. Anyone who has ever purchased a home is familiar with this concept with the mortgage lender having the right to foreclose on the real property if monthly payments are missed. The same is true for any business asset which is used to secure a commercial loan. In business finance, such lending is termed “secured lending”, since the loan is secured or backed up by a collateral which can be liquidated in the event of default.
For factors, collateral is the accounts receivable of their clients, even though true factoring is never a loan. As you know, factors actually purchase the accounts of a business at a discount and contractually, the business accounts (and rights to collection thereon) are assigned to the factor by the business owner at the time of purchase. The accounts are pledged as collateral for the factoring arrangement at the time of contracting. The factor then becomes sole owner of the accounts and when due, will receive payment directly from the seller’s customer, the account debtor.
You should also know that in almost all instances, the pledge of accounts as collateral for a factoring facility includes both purchased and non-purchased invoices. In an event of default by the client, the factor has the right to collect on all invoices, purchased or not.
Although the factor’s purchase of the invoices through payment and assignment provides rights to collection, there exists another problem. What is to prevent a business owner from securing a loan from a bank or traditional lender, pledging its accounts to the bank as collateral, and then subsequently applying for a factoring arrangement and pledging the same accounts a second time to the factor? If done, the collateral would be financed twice and in theory, shared equally by both the factor and the bank. A battle surely would ensue to see who gets paid first in the event of default by the borrower. To prevent such a problem and enjoy a truly secure transaction, factors and lenders file a document called a Uniform Commercial Code Financing Statement.
The Uniform Commercial Code (UCC) is a body of business related law that governs commercial transactions in all 50 states and especially those transactions involving the sale of goods, their transportation and delivery, and the payments upon such goods. The UCC is comprised of a series of articles or sections which, among their many focuses, define certain transactions and rights regarding those transactions. Included among these are sales, leases, deposit transactions, letters of credit, negotiable instruments, etc. Most important to factors and the asset-based finance community, is something called “Article 9”, which deals with the laws and rules involving secured transactions.
When financing a company based on an asset or assets, a lender will file a “security interest” in the assets as collateral for the loan or financing. This filing document, called a UCC-1 Financing Statement, is said to “perfect” the lender’s security interest in the collateral. In layman’s terms, the UCC-1 filing:
When filed, a UCC-1 is time stamped and in the world of UCCs, first to file wins. The first filer (lender) is said to be senior lender, and is entitled to collect upon the collateral first in the event of default. Second or lower position filers are junior lenders. In the event of default, a junior lender is only entitled to proceeds from the collateral after the senior lender is satisfied fully. In factoring financings, the factor must always be senior lender on accounts.
When underwriting a new client, one of the very first tasks a factor or any lender will perform is to search the appropriate UCC database to determine if the collateral for a loan is available or is already pledged and subject to lien by some previous lender or factor. The UCC requires that a UCC-1 security interest filing be:
Such a standardized filing and database system makes determining the availability of any collateral a relatively simple process. Lenders can search confidently for current active UCC filings on most business collaterals.
So as you now know, factors must have a senior 1st position lien on accounts in order to provide financing. If a search of the UCC filing database evidences a current active filing upon a prospective client where the client’s accounts receivable are pledged, the ability to finance the prospect through factoring is prohibited unless:
Even prior to the final contracts with a client being signed, it is not unusual for the factor to file a UCC-1 financing statement to secure its first lien position in accounts. In some instances of fraud, a borrower will apply to multiple lenders at the same time, attempting to quickly secure financing more than once on the same asset and thus defrauding the lender.
In the event the contracting with the new client is not finalized and does not occur, the factor will simply release its lien. Such a lien release is performed by filing a UCC-3 amendment statement which is used to extend, modify or to terminate an existing, related UCC-1 financing statement.