Factoring is a form of business financing under which a business entity sells its receivables to a third party (or factor) at a discount and receives immediate payment to finance its business. It is a useful financial tool for micro and small enterprises and helps such entities manage resource constraints, delayed payments and receivables management. However, in the absence of a consolidated legal framework regulating factoring in India, it has so far played a limited role in business financing.
The Factoring Regulation Act 2011 provides for and regulates the assignment of receivables and is intended to provide a much-needed legal framework for factoring in India. The act came into force in February 2012, except for Section 19 (registration of assignment of receivables transactions), Section 20 (public inspection of the central registry's records), Section 21 (penalties for non registration) and Section 32 (central government powers to make rules under the act), which came into force as of April 2 2012.
The central government has also notified the Registration of Assignment of Receivables Rules 2012. These rules set out in detail the procedure that must be followed by a factor when registering an assignment with the central registry.
Definition of 'factoring business'
The act defines 'factoring business' to mean:
"the business of acquisition of receivables of assignor by accepting assignment of such receivables or financing, whether by way of making loans or advances or otherwise against the security interest over any receivables but does not include –
(i) Credit facilities provided by a bank in its ordinary course of business against security of receivables;
(ii) Any activity as commission agent or otherwise for sale of agricultural produce or goods of any kind whatsoever or any activity relating to the production, storage, supply, distribution, acquisition or control of such produce or goods or provision of any services..."
'Factoring business' can thus be defined as the business of acquiring receivables by accepting the assignment of receivables or financing against the security interest over receivables; it does not include lending by banks in the ordinary course of business. The word 'receivables' has been widely defined to include, among other things, future receivables and toll or other charges linked to the use of infrastructure facilities.
Registration of factors
A 'factor', as defined under the act, includes:
- a non-banking financial company (NBFC) that has been granted a certificate of registration under the act;
- a body corporate established under an act of Parliament or any state legislature; or
- a bank or a company registered under the Companies Act 1956 engaged in factoring business.
In order to commence or carry out the business of factoring, a factor (other than a bank, a corporation established under an act of Parliament or state legislature or a government company) must obtain a certificate of registration from the Reserve Bank of India (RBI). A company that is registered as an NBFC with the RBI and is engaged in factoring business as its principal business(1) must apply for registration as a factor within six months of the date on which the act came into force. Such entities may continue to carry on their factoring business until a certificate is issued (or refused).
Procedure for assignment of receivables
The act stipulates that the assignment of receivables will be effected by an agreement in writing. On the execution of this agreement, all rights, remedies and security interests in respect of such receivables shall vest in the assignee (ie, the factor), which shall then have the right to recover such receivables and exercise all rights and remedies of the assignor. A debtor that has received notice of assignment will be discharged from liability on making payment to the assignee. However, if notice of assignment has not been given to the debtor and it makes payment to the assignor, the assignor must hold the money in trust for the benefit of the assignee and such payment shall discharge the debtor. The act seeks to protect the interests of the debtor by giving it the right to retain all defences and rights of set-off arising from the original contract with the assignor in case of a claim made by the assignee against the debtor for payment of the assigned receivable, provided that these are disclosed to the assignee at the time of assignment.
Assignment of receivables constituting security in favour of bank/creditor
A common problem faced by factors was that, in almost all cases, the receivables proposed to be assigned by the relevant enterprise were charged in favour of existing working capital lenders. The act provides for a practical solution to resolve this situation of intersecting rights, stating that where receivables that constitute security for repayment of a loan advanced by a bank or creditor are assigned, the assignee (or factor) must pay the consideration directly to such bank or creditor, provided that it has received notice of such encumbrance.
Registration of assignments
In order to minimise the possibility of fraud-related risks, the act requires details of every transaction of assignment of receivables to be filed with the Central Registry (set up under the Securitisation Reconstruction of Financial Assets and Enforcement of Security Interest Act 2002) within 30 days of the assignment date or of the establishment date of such registry. On realisation of the assigned receivables or settlement of the claim, the factor must file satisfaction of the assignment of receivables in its favour. The lack of a centralised source of information was a practical difficulty that many factors in India faced when undertaking their customary due diligence checks on borrowers (and in particular, on the receivables proposed to be assigned). The creation of a central registry is thus a key step towards addressing this problem.
Exclusions under the act
Assignments of receivables that are not subject to the provisions of the act include, among other things, those under:
- a merger, acquisition or amalgamation of business activities;
- a change in the ownership or legal status of a business;
- a letter of credit or independent guarantee;
- loan sell-down transactions between banks or NBFCs; and
- securitisation transactions.
Significant amendments to other statutes
The single largest impediment to the growth of the factoring business in India is the high rate of stamp duty payable on an agreement for the assignment of receivables (which, although different for each state, can be as high as 3% of the market value of the receivables). The act aims to overcome this by inserting a new Section 8D into the Stamp Act 1899, thereby granting an exemption from stamp duty on agreements for the assignment of receivables in favour of a factor. Further, the act has amended the Code of Civil Procedure 1908 to extend the law relating to summary suits to claims of factors, in order to facilitate speedy recovery of receivables.
The act is a significant step towards furthering the growth of factoring in India. It seeks to:
- provide a well-defined legal framework for the assignment of receivables;
- clearly define the rights of a factor with respect to the debtor;
- provide for a central registry to record the assignment of receivables; and
- amend stamp duty laws so as to exempt the stamp duty payable on agreements for assignment of receivables.
The above changes considerably reduce transaction costs of factoring arrangements and should make factoring a more popular means of trade finance in India.
For further information please contact Shilpa Mankar Ahluwalia at Amarchand & Mangaldas & Suresh A Shroff & Co by telephone (+91 11 4159 0700), fax (+91 11 2692 4900) or email ([email protected]).
(1) An NBFC shall be treated as engaged in factoring business as its principal business if its financial assets in the business of factoring are more than 50% of its total assets (or such percentage as may be stipulated by the RBI), and if its income from factoring is more than 50% of its gross income (or such percentage as may be stipulated by the RBI).