Some tips for guarding against legal risks in commercial factoring

Factoring is a comprehensive financial product that contains trade financing, commercial credit investigation and accounts receivable management in one entity. Since the Bank of China pioneered factoring in the PRC in 1992, the factoring business in China has grown at a rapid clip. According to incomplete statistics, factoring turnover – including bank factoring and commercial factoring, but excluding third-party payment type, electronic commerce type and supply chain financing type – in China in 2012 was probably greater than RMB10 billion (US$1.6 billion).

Economic significance

Factoring is a comprehensive credit service where the true transaction background of the buyer and seller serves as the support, and the creditor transfers the accounts receivable that have arisen with the debtor to the factor, and the factor provides such service functions as financing – usually the amount of the financing will not exceed 80% of the total amount of the accounts receivable – sales ledger maintenance, collection of accounts receivable, credit risk control and bad debt security. Factoring includes bank factoring provided by banks and other such financial institutions, and commercial factoring provided by non-financial institutions. As factoring answers the needs of enhancing domestic and foreign trade competitiveness, it has become a new trade financing instrument which, together with letter of credit business and credit insurance, forms the troika for assuring trade receivables.

Proof of establishment

Commencing in 2004, a number of commercial factoring companies in China have received approval to engage in factoring business, and in May 2006 the State Council issued the Opinions on Issues Relevant to Promoting the Development and Liberalisation of Tianjin Binhai New Area encouraging the area to take the lead in certain financial areas. Subsequently, Tianjin municipality submitted the “Plan of Tianjin Binhai New Area for Comprehensive Complementing of Reform, Experimentation and Financial Innovation”, listing factoring as one of the innovations, and the plan was approved in October 2009. With this, commercial factoring companies finally obtained formal recognition, and commercial factoring firms could now register in Tianjin.

Major business types

Depending on whether the debtor is notified, factoring can be divided into disclosed factoring and undisclosed factoring. In undisclosed factoring, the seller – i.e. the party with financing needs – does not notify the debtor about the participation of the factor for commercial strategy or other such reason, and when the amount falls due, the seller collects and repays the financing proceeds to the factor. In disclosed factoring, the creditor notifies the debtor of the fact of the transfer of the claims from the outset, and the debtor directly repays the financing proceeds to the factor.

Factoring may also be divided into recourse factoring and non-recourse factoring. In recourse factoring, if, after the factor has purchased the debtor’s accounts receivable, the debtor fails to effect repayment once they fall due or fails to effect repayment in full, making it impossible for the factor to recover the financing on the date it falls due, the seller will bear liability for unconditionally repurchasing the outstanding accounts payable. In non-recourse factoring, the risk of failure by the debtor to effect payment upon the accounts receivable falling due is borne solely by the factor, and it has no right of recourse against the seller.

Factoring can also be divided into pooled factoring and one-off factoring. The term “pooled factoring” refers to the business model where once the accounts receivable are recovered, and provided that certain conditions are satisfied, the seller is permitted to use the proceeds of the recovered accounts receivable (i.e. repeated financing). The term “one-off factoring” refers to the business model where once the proceeds of the one-off accounts receivable transfer financing have been recovered, the factoring terminates.

Guarding against legal risks

The principle legal relationship involved in commercial factoring is the “claim assignment” specified in the Contract Law, and the risks that it may involve include: 1) risk of a change in the credit standing of the debtor – if the credit standing of the debtor as the final payer deteriorates, it will cause a loss in the factor’s claim; 2) risk of the lawfulness of the claim – if one of the violations of the law specified in the Contract Law applies to the underlying contract for the claim, the claim will be unlawful; 3) risk of the transferability of the claim – whether the claim is transferable is mainly determined by the law or the provisions of the seller and buyer on the transferability of the claim in the underlying contract; and 4) claim transfer notice risk – pursuant to the Contract Law, when a creditor transfers a right, it is required to notify the debtor, and in the absence of such a notice the transfer is not binding on the debtor.

To guard against these risks, the following measures can be taken:

Strengthening of credit investigation. The credit investigation conducted by the factor should target the contractual parties, including the status of the performance of the underlying contract, the debtor’s repayment capacity, and whether any disputes have arisen in connection with the underlying contract. Additionally, the capacity and intention of the party with financing needs to perform the factoring contract should be investigated.

Enhanced review of the claim to be acquired. Types of claims that should not be acquired include: debts arising from a sale carried out by a method more flexible than that approved by the factor; a claim that, as specified in the underlying contract, may not be transferred; and a claim where the invoice amount and the amount specified in the underlying contract are not consistent, or over which a pledge has been created.

Sound factoring contract. We recommend that the following provisions be specified in a factoring contract: undertaking of the party with financing needs in respect of the validity, transferability and integrity of the claim and a security clause; a valid notification provision, i.e. notification of the debtor of matters relating to the transfer of the claim; active assistance provision, i.e. if the debtor refuses to pay, the party with financing needs is required to assist the factor in seeking recourse; right to recourse provision, i.e. if the debtor refuses to pay or other such circumstance arises, the party with financing needs is required to perform the repurchase obligation, and the factor has the right to recover the factoring proceeds that the party with financing needs has received, and other relevant charges; a provision providing for the provision of security by the party with financing needs or a third party.

Zhen Qinggui is a partner and Zou Wen is a legal assistant at Zhonglun W&D Law Firm in Beijing