Factoring is a widely used mechanism in the business world. This article discusses the law in relation to factoring and practical tips to be adopted by companies when it comes to factoring and set off rights.
What is factoring?
Factoring is a form of financing by which a company sells debts that are due to be collected from a customer to a third party (the Factor) at a discounted price, and in turn assigns its rights to collect the debts from the customer or customers to the Factor.
After the factoring arrangement is entered into between the company and the Factor, it is the usual practice for the Factor to send out to the relevant customers a letter giving notice that from the date of the letter and until further notice, all debts owed by the customers to the company are automatically assigned and become payable to the Factor. This letter is usually known as an introductory letter.
Law on factoring and its effect on set off rights
Under Hong Kong law, the assignment of debts is governed by both statute and common law principles. Section 9 of the Law Amendment and Reform (Consolidation) Ordinance (Cap. 23) (the Ordinance) provides that:-
“Any absolute assignment, by writing under the hand of the assignor (not purporting to be by way of charge only), of any debt or other legal chose in action, of which express notice in writing has been given to the debtor, trustee or other person from whom the assignor would have been entitled to receive or claim such debt or chose in action, shall be and be deemed to have been effectual in law (subject to all equities which would have been entitled to priority over the right of the assignee…) to pass and transfer the legal right to such debt or chose in action from the date of such notice, and all legal and other remedies for the same, and the power to give a good discharge for the same, without the concurrence of the assignor.”
This means that when a customer receives (and/or acknowledges) a written notice of assignment (including an introductory letter) from the Factor, the assignment of debt to the Factor becomes effective in law.
Section 9 of the Ordinance provides that the Factor takes the assignment of debt subject to all equities which would have been entitled to priority over the rights of the Factor. Cases have interpreted this wording to mean that:-
(a) the Factor takes subject to the customer’s right of set off against the assignor; but
(b) if the set off does not arise out of or is not closely connected with the same contract or the subject-matter of the assignment, the customer can only claim a set off against the Factor if the right of set off arose before the notice of assignment is given.
Where there is a prior contractual set off agreement in place between the company and the customer, the law is not as clear cut when it comes to deciding whether such an agreement will also be effective against the Factor where the transaction out of which the cross-claim sought to be set off arose was entered into after the notice of assignment is given. There are two competing views arising from the case law on this issue:-
(a) One view is that the assignee (i.e. the Factor) takes the same interest and is subject to the same liabilities as the assignor (i.e. the company) at the date of the notice of assignment, and the prior agreement will allow the debtor (i.e. the customer) to set off cross-claims, both present and future, including claims which arise out of new transactions.
(b) The competing view is that when the debtor receives notice, the debtor should regulate its conduct accordingly and should not rely on debts arising out of new transactions to diminish the rights of the assignee as they stood at the time of notice: in other words, set off is not available in respect of new transactions.
A set-off agreement entered into by the company and customer after the customer has notice of the assignment will not ordinarily be effective as against the Factor.
In summary, set off rights will continue to apply after assignment where:
(a) the relevant cross-claim arose before the assignment;
(b) the relevant cross-claim arose out of the same contract or is closely connected with it;
(c) the factor expressly (or, depending on the facts, by implication) agrees to the continuation of a contractual set off right.
Below are various measures which can be taken by a company to strengthen its position when it comes to factoring and set off rights:-
- It is prudent for a company to include a clause in their terms and conditions with the supplier providing that the set off rights which the company has under the contract will continue to be enforceable against the supplier and their assignees regardless of (a) any existing or future agreements entered into between the supplier and a third party assigning the right to the third party to collect its receivables or (b) any future notice of assignment of debt which may be received by the company in relation to the supplier’s debt. Again, it is also prudent to get an acknowledgement from the Factor and the supplier that they will adhere to these terms.
- Set up measures to ensure that Factors are kept up to date with the set off arrangements which the company has in place with their customers e.g. by periodically sending letters to Factors (especially if the Factor is involved in a long term trading relationship) reminding them that the company’s set off rights against the customer and Factor will continue to apply to future assigned debts of the customer; and
- In the event the company’s right to set off crystallises (e.g. default by the supplier), the company should put the supplier and Factor on immediate notice that the company will exercise their set off rights against any assigned debts which are the subject of any existing or future invoices which may be issued by the supplier.