Treatment of Invoice Factoring under The Code
Sriram Venkatavaradan & Saai Sudharsan Sathiyamoorthy
Advocates
Introduction
A typical factoring agreement involves a company legally assigning its outstanding invoices (i.e., book debts or other receivables) to a financial company or a factor at a discount in exchange for immediate cash. The factor, in turn, charges a fee and interest on the advance. Usually, these factoring arrangements are entered into when a company needs immediate working capital.
In India, factoring is subject to the Factoring Regulation Act, 2011 (“Act”) and the RBI Non-Banking Financial Company – Factors (Reserve Bank) Directions, 2012. ‘Factoring Business’ is defined under the Act as “the business of acquisition of receivables of assignor by accepting assignment of such receivables of financing, whether by way of making loans or advances or in any other manner against the security interest over any receivables.” [See, S. 2(j) of the Factoring Act, 2011].
The present article seeks to examine the law relating to factoring agreements in India and its corresponding treatment as ‘financial debt’ under the Insolvency & Bankruptcy Code, 2016 (“Code”).
Factoring agreements
In every factoring transaction, there are at least three parties involved and sometimes four if there is a surety or a guarantor. They are the assignor i.e., the principal borrower, the assignee i.e., the factor, the approved debtor i.e., the purchaser of the goods or services; and optionally, a surety or a guarantor. The factor typically pays the assignor a percentage of the invoice’s value immediately after checking that the same are valid, and after collection of the entire invoice value from the debtor, the factor pays the company the remainder of the invoice’s value minus an agreed fee. Further, through such agreements, the collection of amounts is contracted out, thereby reducing the cost, inconvenience and manpower employed in recovering dues, maintenance of accounts related to the same, management of the risks associated with the debts etc. [See, IFCI Factors Limited v. Ramsarup Industries Ltd., 2019 SCC OnLine Del 9457].
It may be noted that factoring and invoice discounting are well recognized forms of invoice financing. They both involve selling unpaid invoices to a financial provider, who will then give the company a cash advance on the majority of the unpaid balance. However, there are some key differences between factoring and invoice discounting. One of the main differences between invoice discounting and factoring pertains to who has control over the sales ledger. With invoice discounting, the company is typically in control of the sales ledger, and it remains the company’s responsibility to chase invoices. But with invoice factoring, the company signs over control of the sales ledger to the finance provider, who takes on the responsibility for chasing invoices and the customers will settle their invoices directly with the finance provider, rather than with the company.
The Factoring Regulation Act, 2011 defines the term “factor” in section 2(i) as “a non-banking financial company as defined in clause (f) of Section 45-I of the RBI Act, 1934 which has been granted a certificate of registration under sub-section (1) of Section 3 or any body corporate established under an Act of Parliament or any State Legislature or any Bank or any company registered under the Companies Act, 1956 engaged in the factoring business.” In terms of section 3(1) of the said Act “no factor shall commence or carry on the factoring business unless it obtains a certificate of registration from the Reserve Bank to commence or carry on the factoring business under this Act.”
The RBI, in its circular titled “Provision of Factoring Services by banks- Review,” DBR. No. FSD. BC. 32/24.01.007/2015-16 dated July 30, 2015, recognizes three types of factoring services:
- Factoring without recourse, where banks will have no recourse against the assignor, except in the case of misrepresentation or non-performance of obligations by the assignor;
- Factoring with recourse, where the sale of the receivables by the assignor to the banks would not amount to a true sale on the books of the assignor and the assignor would remain liable for any amount not paid by the purchaser of goods to the bank, and;
- Factoring with limited recourse, where the conditions of recourse may be contractually agreed between the bank and the assignor. [See, Canbank Factors Ltd. v. Shree Jaya Laboratories Pvt. Ltd., (2022) iblaw.in 712 NCLT].
In the said circular, the RBI also prescribes the prudential and exposure norms in relation to the different types of factoring and makes it abundantly clear that in the case of factoring with recourse, the exposure is to be reckoned on the assignor and in the case of factoring without recourse, the exposure is to be reckoned on the debtor (i.e., person liable to pay the receivable). In other words, in a case of factoring with recourse, it is the assignor, who will be the borrower and in cases of factoring without recourse, it will be the debtor (i.e., purchaser of invoiced goods or person liable to pay the receivable) who will be treated as the borrower.
Treatment of ‘factoring with recourse’
Under the Code, transactions involving invoice factoring would be covered within the definition of ‘financial debt’ contained under section 5(8)(e) of the Code, which provides as follows: “receivables sold or discounted other than receivables sold on non-recourse basis”.
In Mr. Ritesh Kumar Agarwal v. M/s. India Factoring and Finance Solutions Pvt. Ltd., (2023) ibclaw.in 426 NCLAT noted that the factoring agreement entered into between the parties clearly indicated that the factoring arrangement was on a recourse basis and consequently, the said arrangement was covered within the definition of financial debt contained under SS. 5(8)(e) of the Code. Similarly, in Drip Capital Inc. v. Concord Creations (India) Pvt. Ltd., CA (AT)(CH)(Ins.) No. 167 of 2021 and Drip Capital Inc. v. Vibrant Fab Pvt. Ltd., C.P.(IB) No. 174/NCLT/AHM/2020 it was observed that the financial creditor was entitled to exercise the recourse available under the ‘Receivables Purchasing Agreement’ and the advances made by the financial creditor would fall within the definition of financial debt contained under section 5(8)(e) of the Code.
Although the factoring agreement was executed on a recourse basis, the Appellate Authority in Canbank Factors Ltd. v. Dharmendra Kumar, [2019] 7 Comp Cas-OL 30 (NCLAT – New Delhi) remarked that the financial creditor was precluded from recovering its dues from the receivables of the corporate debtor during the subsistence of moratorium.
Treatment of ‘factoring without recourse’
In Canbank Factors Ltd. v. Shree Jaya Laboratories Pvt. Ltd., (2022) iblaw.in 712 NCLT (“Shree Jaya Laboratories”), the NCLT, Hyderabad Bench, while referring to the above-mentioned RBI Circular, held that only those factoring transactions in respect of “receivables other than on non-recourse basis” fall within the scope of section 5(8)(e) of the Code. It observed:
“In the background of the RBI Circular “Provision of Factoring Services by Banks — Review“, dated 30 July 2015, when we refer the definition of Financial Debt in section 5(8) of the Code, more particularly the clause (e) thereof, it becomes immediately clear that only the factoring transactions in respect of “receivables other than on non-recourse basis” are included therein. In other words, factoring transactions on recourse basis only will fall within the mischief of Section 5(8)(e) of the Code. The reason to restrict the mischief of Section 5(8)(e) to debt arising from discounting of bills otherwise than on non-recourse basis only fits perfectly into the concept of Financial Debt under the Code having the two intrinsic ingredients of ‘disbursal” of funds for “time value of money” which would obtain in the case of an Assignor only.
…
In any case, we have referred earlier to the RBI guidelines which provide for recognizing the debt in the hands of the customer/ debtor only if the factoring has been done on non-recourse basis which clearly and admittedly is not the case before us. We also hasten to observe here that even if such an event would have occurred, i.e., the factoring transaction was on “non-recourse” basis, the Factor/ Assignee may have a right to reckon the debt in the hands of the Customer/ debtor and may have legal remedies to recover the debt but will have no eligibility to file an Application U/ s 7 of the Code against the Customer/ debtor / purchaser of goods as Section 5(8)(e) shall not be applicable in such factoring “with non-recourse” cases.”
Ultimately, in Shree Jaya Laboratories, the NCLT, Hyderabad Bench concluded that there was no disbursal of funds to the customer/corporate debtor to claim the existence of a financial debt. Moreover, it held that there was no jural relationship of creditor and borrower between the applicant and respondent therein and, consequently, the applicant could not claim to be a financial creditor qua the respondent so as to maintain the application under section 7 of the Code.
Similarly, in Mudraksh Investfin Pvt. Ltd. v. Brijesh Singh Bhaduriya RP, (2024) ibclaw.in 12 NCLAT (“Mudraksh Investfin”) and SBI Global Factors Limited v. Aks Electricals and Electronics Limited, IB/638/ND/2022 (“SBI Global Factors”) the Appellate Authority and NCLT, Delhi Bench remarked that the section 7 application would not be maintainable against the respondent therein since there was no ‘disbursal’ of any amount by the applicant for ‘time value of money’. At this juncture, it is necessary to clarify that the factoring agreement under consideration in SBI Global Factors was ‘ON RECOURSE’ basis and consequently, the Adjudicating Authority had opined that the section 7 application would be maintainable only against the assignor and not the respondent therein.
Conclusion
It can be observed that factoring transactions, by their very nature, involve the underlying transaction being one for sale of goods and services, i.e., the nature of transactions that the assignor seeks to discount with the factor, in most cases, involves invoices emanating from the sale of goods or services to the customer. Consequently, the nature of debt owed under the underlying transaction typically qualifies as an operational debt under Section 5(21) of the Code. Moreover, factoring transactions without recourse basis, by their very nature, also contemplate an assignment of debt by the assignor in favour of the factor/lender. In such instances, when the factor steps into shoes of the assignor, it would be impossible to interpret that the relationship between the factor/lender and the customer would be that of a financial creditor and a borrower. At best, their relationship could be categorized as that of an operational creditor and debtor respectively, as rightly observed in Mudraksh Investfin and Minion Ventures Pvt. Ltd. v. TDT Cooper Ltd., (2023) ibclaw.in 209 NCLAT.
While the legal position in relation to the treatment of factoring with recourse basis is well settled, the obiter in Shree Jaya Laboratories and the ratio in Mudraksh Investfin, pertaining to the treatment of ‘factoring without recourse’, provided a much-needed clarity as to why factoring without recourse basis ought not be treated as a financial debt under Code. As rightly observed in Mudraksh Investfin, there is no disbursal of funds for time value of money between the factor and the customer/debtor either in transactions involving factoring with recourse or without recourse basis. This is precisely why the legislative intent has been to clearly treat only factoring with recourse basis as a financial debt and that too, as against the assignor alone.
