Factoring and Forfaiting

1. Factoring and Forfaiting

2. Factoring Services - Concept • Factoring services started in US in early 1920s and were introduced to other parts in 1960s • Factoring is a financial service covering the financing and collection of accounts receivables in domestic as well as in international trade • Basically, factoring is an arrangement in which receivables on account of sale of goods or services are sold to the factor at a certain discount. As the factor gets the title to the receivables on account of the factoring contract, factor becomes responsible for all credit control, sales ledger administration and debt collection from the customers

3. Factoring Services - Concept • A study group appointed by International Institute for the Unification of Private Law (UNIDROIT), Rome 1988 defines • “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; • i) finance, • (ii) maintenance of accounts, • (iii) collection of debts and • (iv) protection against credit risk

4. Factoring Services - Concept Deliver of goods Client Customer Order placed Client submits invoice Customer pays Factor-Prepayment Monthly statements Factor

5. Factoring Services - Mechanism • Buyer • Buyer negotiates terms of purchasing the material with the seller • Buyer receives delivery of goods with invoice and instructions by the seller to make payment to factor on due date • 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 the factor

6. Factoring Services - Mechanism • Seller • MoU with the buyer in the form of letter exchanged between them or agreement • Sells goods to the buyer as per MoU/agreement • Delvers copies of invoice, delivery challan, MoU, instructions to make payment to factor given to buyer • Seller receives 80 percent or more payment in advance from factor on selling the receivables from buyer to factor • Seller receives balance payment from factor after deduction of facto’s service charges etc.

7. Factoring Services - Mechanism • Factor • Factor enters into agreement with seller for rendering factoring services • On receipt of copies of sale documents as referred to above makes payment to seller of the 80 percent of the price of the debt • Factor receives payment from the buyer on due dates and remits money to seller after usual deductions • Factor also ensures that the following conditions met to give full effect to factoring arrangements • Invoice, bills or other documents drawn by the seller should contain a clause that these payments arising out of transaction as referred to or mentioned in might be factored • Seller should confirm in writing to the factor that all the payments arising out of these bills are free from any encumbrances, charge lien, pledge, hypothecation or mortgage or right of set-off or counter claim from another • Seller should execute a deed of assignment in favor of the factor to enable him to recover the payment at the time or after default • Seller should confirm that all conditions to sell-buy contract between him and the buyer have been complied with and the transactions complete • Seller should procure a letter of waiver from a bank in favor of factor in case the bank has a charge over the assets sold to buyer and the sale proceeds are to be deposited in the account of the bank

8. Factoring Services - Concept • Parties to factoring – client, customer and factor • Cost of factoring • Service fee (for administrating the sales ledger as well as protection against bad debts – as a percentage of invoice value or number of invoices) • Discount charges (advance provided by factor and is interest which is PLR plus or minus)

9. Types of Factoring Services • Recourse and Non-recourse Factoring • A brief discussion • Advance and Maturity Factoring • Advance paid against invoice where as in maturity factoring payment is made against guarantee or collection of receivables • Full Factoring • Disclosed and Undisclosed Factoring • Name of the factor is disclosed in the invoice by the supplier/client asking the customer to make payment to the factor

10. Factoring Vs Bills Discounting • Similarities – many • Differences • Bill discounting is always with recourse, factoring can be either with or without recourse • In bill discounting drawer undertakes the responsibility of collecting the bills and remitting the proceeds to financing agency, whereas a factor usually undertakes to collect the bills of the client • Bill discounting facility implies only provision of finance but a factor also provides other services like sales ledger maintenance and advisory services • Discounted bills may be rediscounted several times before they mature for payment. Debts purchased for factoring cannot be rediscounted, they can be refinanced • Factoring implies the provision of bulk finance against several unpaid trade generated invoices in batches, bill financing is individual transaction-oriented – each bill is separately assessed and discounted • Factoring is an off-balance mode of financing • Bill discounting does not involve assignment of debts as is the case with factoring

11. Two-Factor System of Factoring • There are usually four parties to a cross-border factoring transactions • Exporter (client) • Importer (customer) • Export Factor • Import Factor • Two factor system results in two separate but inter-linked agreements • Between exporter and export factor • Between export factor import factor

12. Two-Factor System of Factoring • Usually export and import factors belong to a formal chain of factors with well-defined rules governing the conduct of business. • Import factor provides a link between export factor and the importer and serves to solve the international barriers like language problem, legal formalities and so on. He also underwrites customer trade credit risks, collects receivables and transfers funds to the export factor in the currency of the invoice • Functions of factors are divided between export factor and import factor

13. Two-Factor System of Factoring • Steps • Exporter informs the export factor about the export of goods to a particular import-client domiciled in a specified country. • Export factor writes to import factor (domiciled in the country of the importer) enquiring about the credit-worthiness, reputation and so on of the importer • On getting satisfactory information from the import factor, exporter delivers the goods to the importer and the relevant invoices, bills of lading and other supporting documents are delivered to the export factor. Export receivables on a non-recourse basis are factored • Export factor does credit checking, sales ledgering and collection to the import factor • Import factor collects the payment from the importer and effects payments to the export factor on assignment/maturity/collection as per the terms of assignment in the currency of the invoice • Finally, the export factor makes payment to the exporter upon assignment or maturity or collection depending upon the factoring agreement between them

14. Country A Country B Exporter Importer Goods and invoices – Stage I Payments Stage VI Copy Invoice Stage II Prepayments Stage III Statements Stage V Export Factor Import Factor Copy Invoices Stage IV Payments Stage VII Payment of Commission Stage VIII

15. Forfaiting • Forfaiting is a form of financing of (export) receivables pertaining to international trade. It denotes the purchase of trade bills/promissory notes by a bank/financial institution without recourse to the seller. The purchase is in the form of discounting the documents covering the entire risk of non-payment in collection. All risks and collection problems are fully the responsibility of the purchaser (Forfaiter) who pays cash to seller after discounting the bills/notes.

16. Forfaiting • Steps • In pursuance of a commercial contract between an exporter and importer, the exporter sells and delivers the goods to the importer on a deferred payment basis • Importer draws a series of promissory notes in favour of the exporter for payment including interest charge. Alternatively, the exporter draws a series of bills which are accepted by the importer. Bills/notes are sent to the expoerter. The promissory notes/bills are guaranteed by a bank which may not necessarily be the importer’s bank. The guarantee by the bank is referred to as an AVAL defined as an endorsement by a bank guaranteeing payment by the buyer (importer)

17. Forfaiting • Steps • Exporter enters into a fortaiting arrangement with a forfaiter which is usually a reputed bank including exporter’s bank. Exporter sells the availed notes/bills to the bank (forfaiter) at a discount without recourse. The agreement provides for the basic terms of the arrangement such as cost of forfaiting, margin to cover risk, commitment charges, days of grace, fee to compensate the forfaiter for loss of interest due to transfer and payment delays, period of forfaiting contract, installment of repayment, usually bi-annual instalment, rate of interest and so on. The rate of interest or discount charged by the forfaiter depends upon the terms of the note/bill, the currency in which it is determined, credit rating of the avalling bank, country risk of the importer etc • Payment to forfaiter to the exporter of the face value of the bill/note less discount • Forfaiter may hold these notes/bills till maturity for payment by the importer’s bank. Alternatively, he can securitize them and sell the short-term paper in the secondary market as high-yielding unsecured paper

18. Forfaiting • Summary • Specific form of export trade finance • Export receivables discounted – full value of export bill considered • Debt instruments most commonly used are bills of exchange and promissory notes • Payment in respect of export receivables which is further evidenced by bills of exchange/promissory notes must be guaranteed by importers bank. Usual form of guarantee is an Aval • Forefaiting is always without recourse • Source of trade finance which enables exporters to get funds from the institution called forfaiter on transferring the right to recover the debts from the importer

19. Factoring Vs Forfaiting • Forfaiter discounts the entire value – 100 % finance where as a Factor – 75-80% • Avalling bank provides unconditional and irrevocable guarantee – critical factor in forfaiting – in factoring decision is based on credit rating of the exporter (non-recourse) • Forfaiting is pure financial arrangement – Factoring includes ledger administration, collection, advise etc • Factoring is short-term finance whereas forfaiting finances notes/bills arising out of deferred credit transactions spread over 3 years • A factor does not guard against exchange rate fluctuations, whereas forfaiter charges a premium for such risk