Receivables financing - don't overlook the basics 

Receivables financing is one of the oldest form of financing and dates all the way back ancient Mesopotamia. Rules relating to receivables financing are recorded in the Code of Hammurabi - a well-preserved Babylonian law code of ancient Mesopotamia (c. 1750 BC)¹.

These days, innovative technology has transformed receivables financing into one of the most commonly used forms of financing. The surge in popularity has been led by the increase in fintech companies (in particular, tech start-ups) entering the receivables financing sector. A number of these fintechs offer borrowers the option to finance receivables on their platform speedily and with minimal fuss.

The size of the global receivables financing market in 2016 amounted to EUR 2,355 billion², with Asia contributing almost a quarter of this market. Not surprisingly, China leads the trade finance volumes in Asia and is the world’s second largest market after the United Kingdom³.

In this article, we outline some of the basic concepts and risks in receivables financing. In our next article, we will look at how blockchain is transforming receivables financing⁴ and examine how and if the technology can address some of the risks inherent in such financing.

Why is Due Diligence of Receivables still important?

The principle of caveat emptor or “buyer beware” applies equally to the purchase of receivables in the same way as it would with the purchase of any other asset. Given the risk of fraud and the resulting serious consequences that could arise, proper due diligence on the underlying receivables is essential to any factoring transaction.

In February 2014, Citi Group's Mexican subsidiary, Banamex, was the victim of a massive US$400 million factoring fraud involving Oceanografia, an oil services firm in Mexico. Citi Group found that, of the USD585 million in invoices that had been provided by Oceanografia, only USD185 million were documented.

Some practitioners feel that a fraud of this scale may be the result of the lack proper controls and protocols in the bank’s due diligence process. Receivables financing is particularly susceptible to fraud as it is traditionally paper based and arises from what a supplier expects to receive in the future.

It is possible for financiers to mitigate such risks, by ensuring that they have robust risk control measures to procure information or evidence that the receivables exist and have not been previously financed. This is what most practitioners refer to as the due diligence process.

Due diligence is particularly important in today’s digital world. Given the technological advances in the sector, customers now expect their financing requests to be approved within a shorter time frame. Faced with increasing time pressures to approve transactions, it is important for financiers to remember the following three key legal principles and how they apply to the relevant transaction.

Prohibitions or restrictions on transfer and/or assignment

A sales contract may state that the rights held by the supplier may not be transferred or assigned to any other party or may not be transferred or assigned without the consent of the buyer. 

If the supplier purports to transfer and assign the receivable to the financier in breach of such a restriction, the transfer or assignment will generally not be valid against the buyer.

The buyer can, in those circumstances, choose to ignore the fact the transfer or assignment has occurred and continue to discharge its obligations by paying the supplier instead of the financier.

If consent is required, it is equally important to follow the procedure required for consent carefully. Failure to do so may also mean that the transfer or assignment may not be valid against the buyer.

In the case of Barbados TrustCompany Ltd -v- (1) Bank of Zambia (2) Bank of America N.A,⁷ there was the requirement to obtain prior written consent. However, consent would be deemed given if the buyer failed to reply to a request for consent within 15 days. 

In this case, the procedure required for consent was not followed and the Court of Appeal found that the purported legal assignment was invalid on the basis that deemed consent was not obtained. 

This case is a good reminder for financiers to obtain consent before the transfer or assignment is made where required.

Are there provisions which dilute or diminish the quality of the receivable?

It is important to check if the receivables are subject to any set-off rights, rebates, discounts, or penalties – as such provisions may dilute the receivables which the financier is purchasing.

A dilution of a receivable refers to any portion of a purchased receivable which a financier is not able to collect. If a financier purchased a receivable, it would typically be on the basis that the face value of the invoice will be paid in full on the maturity date – ie. free of dilution.

To address this issue, most financiers undertake a stringent payment history analysis based on past payments between the supplier and buyer, to determine if any of the prior payments have been diluted.

If such dilutive rights exist, the buyer should be required to expressly agree not to exercise any of its these rights while the financing is in place.

Merely notifying a buyer that it is not allowed to exercise any right of set-off or counterclaim pursuant to a notice of assignment will usually not be sufficient. A buyer must contractually bind itself to the prohibition by (for example) signing the acknowledgement to the relevant notice.

Requiring the buyer to expressly consent to waive its rights under the supply contract also addresses a long-standing question of why it is important for a debtor to sign the acknowledgement to a notice, even though (under certain laws) it is not one of the legal requirements for perfection of a legal assignment.

Last word

The points set out in this article are by no means exhaustive. The underlying facts of each transaction will often differ from case to case. It is therefore important to obtain sound legal advice early, so that the relevant risks can be identified and suitably considered when structuring a receivables financing transaction.

_{1 Article on Factoring and Accounts Receivable Discounting. An Evidence from the Egyptian Market dated September 2013 by Ibrahim Ahmed Farag} 

_{2 Statistics from FCI - the Global Representative Body for Factoring and Financing of Open Account Domestic and International Trade Receivables} 

_{3 World Factoring Yearbook 2017 Edition - The most authoritative work of reference on the global factoring industry. Edited by Michael Bickers Introduction by Peter Mulroy}

_{4 In the context of this article, references to receivables financing relate to factoring/invoice discounting style the arrangements whereby a supplier sells its future account receivables to a financier for ready cash (and not a loan backed by security over receivables).}

_{5 Blockchain}

_{6 The Uniform Commercial Code provides that a contract for the sale of goods may be made in any manner sufficient to show agreement, and that "an order or other offer to buy goods for prompt or current shipment shall be construed as inviting acceptance either by a prompt promise to ship or by the prompt or current shipment of conforming or non-conforming goods."}

_{7 Barbados Trust Company Ltd -v- (1) Bank of Zambia (2) Bank of America N.A. [2007] EWCA Civ 148}