There is a considerable amount of confusion regarding the difference between a lien and a levy.  A lien is a charge or an encumbrance that a person has on the property of another as security for a debt or obligation.  The most common is a home mortgage.  Generally, the lien determines priority.  Internal Revenue Code Sec. 6323(c) grants creditors limited priority over the federal tax lien to the extent that the loan or purchase is made within 45 days of the filing of the notice of federal tax lien (NFTL) or made before the lender or purchaser had actual knowledge of the filing, if earlier.  This is known as the “45-day rule.”

An NFTL does not divest the taxpayer of his or her property or rights to transfer property.  A levy does the divesting.  A levy transfers constructive ownership to the government.  There is no difference between a levy and seizure, other than the type of asset involved.  Before the IRS can issue a levy, the Service must issue a Final Notice of Intent to Levy (Final Notice; IRS letter 1058 or LT11).  If no appeal is filed within the 30 day window from the date the notice is issued, the IRS can begin levying bank accounts and accounts receivable.

Wrongful Levy

Contrary to popular belief, the IRS does not have to record an NFTL before it can levy bank accounts or receivables.  Once the Final Notice has been issued and 30 days have passed, the IRS can levy bank accounts and / or accounts receivable.  The IRS does not perform a lien search prior to issuing a levy.  As such, the Service has no idea whether the assets on which it is about to levy are secured by another entity, e.g., a lender.

Let’s assume the IRS issues a levy to a receivable, but there is no NFTL.  Let’s also assume that the receivable is collateral for which the lender has a perfected security interest.  As long as the IRS follows its internal procedures (issues the Final Notice then waits the appropriate timeframe or for the appeals process to run its course), there is nothing incorrect about the levy.  The IRS did not make a mistake.

In our example, the levy is “wrongful” because the IRS’s levy attached to property belonging to a third-party, the lender.  Internal Revenue Manual section 5.11.2.2.2(2) (08-24-2010) indicates “A ‘wrongful levy’ is one that improperly attaches property belonging to a third party in which the taxpayer has no rights.”  Therefore, the IRS can levy on the receivable, but the levy is “wrongful” in that the lender has a security interest with priority over the IRS, who does not have a secured interest at all.

The question becomes:  “how can I get my money back from the IRS?”  Generally, there are two options – (1) ask the IRS for the money or (2) file a suit in federal district court.  In the past few months, the number of “wrongful” levies brought to Tax Guard’s attention has increased dramatically.  This is likely a result of, at least in part, the IRS’s new “Fresh Start” program instituted in February 2011.

The Fresh Start program furthered a trend of pushing risk to the private sector by reducing the number of NTFLs.  The program increased the threshold for filing a lien to $9,999.  The IRS will not file (and in some cases may release) federal tax liens if taxpayers enter into Direct Debit Installment Agreements.  The DDIA provisions apply to individuals (sole proprietorships) that owe less than $50,000 and businesses that owe $25,000.  If these agreements default, the IRS can levy bank accounts and receivables despite the fact there is no NFTL.

There are two divisions within the Collections System of the IRS – the Automated Collection System (ACS) and the field (Revenue Officers).  Theoretically, ACS is designed to work liabilities less than $25,000.  However, ACS has control over many cases where the liability is greater than $25,000, but a Revenue Officer in the field has yet to be assigned.  ACS is a computer system and phone bank.  Call 800-829-3903 and a different person answers the phone each time – it is impossible to speak with the same person more than once.  ACS has a tremendous amount of power – it can file liens and issue levies.  There is little oversight – if one asks to speak with a manager, a return call from the manager will never come.  Without a conference with a manager, the IRS cannot entertain an administrative appeal of a “wrongful” levy.

Generally, it is a nightmare to work with ACS.  Moreover, most “wrongful” levies are issued by ACS.  Because of the administrative problems within ACS, it is highly unlikely that a “wrongful” levy can be resolved by ACS.  The representatives within ACS know nothing of lien priority, the 45-day rule, factoring, etc.  The response is typically – “the Service issued the Final Notice, there was no appeal, and we issued a levy.  Oh yeah, your client should have paid its taxes.”  Whereas ACS cannot typically resolve the “wrongful” levy it issued, the alternative is to file a lawsuit in federal district court.  In most cases, this is not feasible or justifiable from a cost-benefit analysis perspective.

The majority of “wrongful levies” issued by the IRS will be on liabilities of less than $25,000.  However, so long as ACS retains authority over cases in excess of $25,000, the possibility of a wrongful levy of $50,000, $100,000, $250,000, etc., still exists.  This is especially worrisome since the GAO indicated in a July 2008 report that an NFTL has not been filed for sixty percent of all unpaid payroll tax liabilities currently in the Service’s inventory.

In the case of the “wrongful” levy, an ounce of prevention really is worth a pound of cure. Tax Guard provides an integrated solution to this problem.  Initially, lenders should use our Initial Report prior to funding to determine whether the IRS is in a position to levy receivables.  Ongoing monthly monitoring will alert factors to liabilities and when Final Notices are issued that can threaten lenders’ collateral.  Finally, the IRS cannot levy while there is an Installment Agreement in good standing.  Tax Guard can negotiate a reasonable Installment Agreement and subordination of federal tax lien, which protects lenders’ clients as well as the lender.

For additional information on this topic or Tax Guard, please contact Jason Peckham, Director of Business Development, 303-953-6325, Email: jpeckham@tax-guard.com. Visit their website at www.tax-guard.com.

Wishing you continued success. The Factor Guru.

Predicting the trends for tomorrow is not always as easy as it may appear. Today, we live in an environment where companies are working on predictive models for how we shop, what we buy, where we buy, how businesses can gain a marketing advantage, and of course which companies will prevail where others may fail. Historical patterns can drive these trends. Further, when evaluating debtor credit, these trends can be helpful. Staying on top of the current data and statistics still remains essential though.

I would equate this to the underwriting versus the ongoing credit monitoring process. They are both necessary to appropriately set and manage credit risk and exposure. Debtor credit begins on the front end but never ends. Successfully reviewing the risks up front is part of a factor’s business model, even more so in today’s economic environment. As Tolbert Marks, owner of Dallas based Landry Marks Partners, LP, noted, “This is no different than any other business cycle experienced – good or bad. I believe that diversification and diligent underwriting can overcome any of the conditions that exist today.”

As we discussed last year, staying on top of debtor credit more frequently is necessary. The days of evaluating debtor credit are no longer limited to an annual or semi-annual review. Many factors are and continue to identify new methods to receive and review data almost instantly. Factoring companies are looking to broaden their available data resources and credit tools. They are not just relying on one credit reporting resource, or even one type of credit resource. For example, we are looking at credit reports from multiple credit reporting agencies (i.e., Ansonia, Cortera, Dunn & Bradstreet, Experian, and Smyyth just to name a few) in addition to credit insurance recommendations and credit rating agency briefings. More credit tools equates to more data availability.

This is one of the reasons more and more commercial finance companies are also reporting their own data to credit providers. These credit reporting companies will provide email updates on customer credits and offer discounted costs for those factors who report their own information. It also adds value to understand where the actual data stems from when reviewing credit reports. Some credit companies allow debtors to self report credit and trade information. Others do not. In a time when we are all looking to gain access to more data while also looking to reduce our costs, understanding the reporting and gaining access to more information more often can be invaluable.

Factors have also been seeking new ways to create trend models, not just for clients but also for debtors. How are debtors paying now compared to how they historically paid, are we seeing changes in their payment patterns, are they requiring longer payment terms, etc.?

Gaining access to more resources and getting this data faster, especially in today’s technology-driven environment, will continue to help credit departments better manage their portfolios. And, fully understanding the data is critical. These trends will continue in 2012. More tools. More data. More monitoring. More of the time.

Finding more efficient ways to review debtor credit and predict trends seems to be becoming the norm, as many factors and lenders continue to streamline their administrative functions to reduce costs as price compression occurs within the marketplace.

What else have we been seeing and what do we expect to see in the next year? Well, in my discussions with other factors out there, we all have seen a general slowdown in payments over the past year. Mr. Marks shared these remarks, “We were fortunate during 2011 that we did not have to deal with any significant debtor bankruptcies. The challenge we did experience, however, was a general, across the board, slowdown in payments. We spent more time chasing payments than any year I can recall. From a risk management perspective, a slow paying debtor does not always indicate a credit problem, but it can, and often does, alter the yield on a factoring relationship and it almost always increases the factor’s capital needs. We dealt with both of these issues last year.”

Stewart Chesters, Managing Member and COO of Louisiana based Republic Business Credit, also saw a slowdown in debtor payments over the past year but did note that the last few months of 2011 remained steady. One of the challenges they faced, as many of us, was evaluating the outcome for certain household names such as American Airlines, Hostess, and the continuing review and determination on Sears. As credit became more rigid and scarce for these types of credits, more vigilance was needed in evaluating the overall risk associated with the debtors and the clients. Chesters went on to say, “For each of these [situations], we saw the usual facilities with high concentrations being presented… Catching these debtor credits at underwriting and protecting our portfolio has been the key.”

As we have all seen more of these concentrations within our portfolios overall or within individual debtors for a particular client, this has prompted an increase in participations as well as credit insurance requests or reliance. Sometimes, this information from the credit insurance company is utilized just to help evaluate the credit being extended. However, when these insurance companies hit capacity levels for certain debtors, there are still puts and other credit guarantees that can be purchased from third parties to help mitigate credit or concentration exposure.

Yet, the economy is expected to improve. With this slight recovery, many believe credit demand is sure to increase as well, making monitoring just as important if not more for this next year. Rob Flowers, Partner at New York based Atalaya Capital Management, LP, noted this same trend stating, “… Overall, credit quality has held although credit demand has been muted. We believe debtor credit will be relatively stable, but we would not be surprised to see credit demand pickup to the extent that the economy becomes more robust. Businesses have mostly gone through the deleveraging process. Once the economy and sales pickup, loan demand should follow.”

As noted above, though the economy is expected to improve, many feel that it will be at a gradual pace and not much better than 2011. However, even with this minor improvement, many also believe that the payment patterns will not reduce back to prior levels. Debtors will continue to pay more slowly than years’ past, as they look to utilize their own capital more efficiently. As Chesters said (and I liked the analogy), “The psyche of ‘cash is king’ and credit lines being protected like a hoard of Mayan treasure will not recede quickly…”

So, what are the takeaways for what we should expect to see for 2012?

• Concentrations are still a big deal.
• More tools and resources will be critical to stay on top of debtor credit management.
• We need to review credit more often and using technology can help.
• We are all looking for more ways to improve our capital positions, reduce costs and get more ‘bang for our buck’ essentially – factors and debtors alike.
• The slowdown in debtor payments we saw in 2011 is not likely to reverse as the economy only somewhat improves in 2012.

We are all trying to do more with a variety tools and resources but for less money, all in an effort to reduce risk while maximizing revenue.

Of course, not many of us can truly predict where we will be or what we will see. Uncertainty still exists which is one of the causes for the slower recovery. Part of this may be political since it is an election year as well. In any case, predicting trends for the next year is much like evaluating credit itself. It is based on reviewing our own historical data and trends and trying to stay on top of new information as it arises.

Welcome to 2012. The year for more.

Jason Peckham with Tax Guard recently published an article (below) outlining these risks for factors. And, yes, these offsets on purchased accounts receivables have occurred within the factoring community, possibly to someone you know. The government has the ability and has been short paying invoices for amounts owed to them for past due taxes.  The risk really is real…

The federal government can offset / setoff payments to businesses that owe money to the IRS.  In 2011, important and significant changes were made to the system.  These changes went into effect as of January 15, 2012.  Since January 15, 2012, Tax Guard has directly and indirectly seen an increased occurrence of offsets of federal government receivables.

The offsets occur through a program called the Federal Payment Levy Program.  In short, the IRS sends the deficiency information to the Financial Management Service (FMS).  When FMS gets an invoice to pay your client, it checks to see whether it needs to offset the payment for some reason, e.g., an IRS liability.  If FMS matches the invoice with the business (your client) and the IRS liability, it will send some of or the entire invoiced amount to the IRS rather than the business / taxpayer.

In 2004, Congress authorized FMS to offset 100 percent of the invoice as opposed to 15 percent.  Due to what amounts to IRS bureaucratic red-tape, the program was used only on a limited basis until recently.  In 2011, Congress gave the IRS permission to offset without first issuing a final notice of intent to levy and providing appeal rights.  This new rule went into effect on January 15, 2012.  Now, the IRS and FMS can offset proceeds regardless of whether (1) the final notice of intent to levy was issued or (2) a federal tax lien was filed.  Since January, we have seen a substantial increase in the number of offsets.  Some offsets have been at a rate of 15 percent.  Others have been 100 percent.  It is not clear what criteria the IRS and FMS are using to determine the amount of the offset.

In circumstances where a federal tax lien has not been filed, lenders may be able to argue that because the IRS does not have a secured interest in the receivables the offset constitutes a “wrongful levy” and the lender should be entitled to equitable relief.  However, the lender will likely have to file a lawsuit to make this point.  There’s not enough precedent at the moment to make an accurate prediction as to the outcome.

The best solution for avoiding offsets of federal government receivables is the following:

1. Continue to monitor your clients through Tax Guard (we let you know about issues when they arise, which is well before the filing of the federal tax lien).
2. When federal government receivables are involved, it is imperative that an Installment Agreement with the IRS be secured as soon as possible.

• Tax Guard can remove taxpayers from the Federal Payment Levy Program so no offset / set off occurs.
• Further, once Tax Guard has negotiated an Installment Agreement, the IRS / FMS will not offset payments so long as the agreement remains in good standing.

For additional information on this topic or Tax Guard, please contact Jason Peckham, Director of Business Development, 303-953-6325, Email: jpeckham@tax-guard.com. Visit their website at www.tax-guard.com.

Wishing you continued success. The Factor Guru.

Factors will find that there is ample opportunity to work with contractors engaged in public works construction, considering that there are nearly 400 major “shovel-ready” projects where designs are complete and a combination of Federal/state funding is in the pipeline.  Expectations have been greatly elevated because the President has made high profile policy speeches about “putting construction and building trade people back to work”.  He even identifies independent contractors and subs, a number of them family-owned small enterprises, for the public works opportunities.

Factors on the firing line of finance know that the President has been creating a serious disconnect because many of the contractors and subs in question lack working capital. Their financial capacity is weak or non-existent, their credit scores are problematic due to the challenges they confront during this current economic downturn, and their financial statements are distressed. (The most recent government regulations, like Dodd-Frank, make it prohibitively difficult for banks to put loans to these business owners on their books!) Furthermore, for the same reasons this contractor is not able to qualify for the surety bonds required to participate in most publicly funded projects.

(I get questioned: “Where is the evidence to back up my assertion?”  No bank will confess that they are unwilling to finance these contractors and subs.  Typically, they go through an application exercise with these prospective customers to act politically correct.  This is today’s  “HIV of financing” where everyone is afraid to confront it because of stigma and embarrassment.)

Factors which have typically rejected opportunities for deals in public works construction should now examine the potential, especially when they can partner up with another factor which already has the technical knowledge and invested capabilities to monitor such a project and handle disbursements through a funds control program.

For a glimpse at the contractor’s capacity, a comprehensive examination of budgets, estimates, and costs should be conducted by the factor to determine that the contractor can handle the project’s terms to completion.

The factor must confirm the ability of the contractor to pass through significant increases in the cost of materials sold or manage escalation clauses.  The factor’s receivable is diminished in value if the contractor is unable to satisfy their responsibilities under the contract for whatever reason.

Establishing the size of a factoring facility created for a contractor is a key ingredient in this program. The factor will set the bar on the credit line extended to their contractor client.  It should be more than the maximum amount the contractor anticipates having outstanding at any given time in a six-to-eight week period, depending on the average turn time of their receivables.  It should take into account the line limits for projects which are anticipated will fall under the line extended or the anticipated approved projects.

Knowing the contract’s payment terms, how invoicing will be executed, the payment schedule of the owner or General Contractor (GC) and the amount which the contractor is contractually able to progressively invoice at each step in the process will determine the line limit.  It is also important that the factor checks for change orders in the contract.  Typically, factors who specialize in working with construction contractors will only allow invoices for change orders that are approved by the owner and/or GC to be included for factoring.

After this start-up work, the factor must implement proper financial and performance monitoring via disbursement procedures set up for each project.  The review inherent with the disbursement system will organize the project over its time-span to ensure compliance with the contract and the schedule of values.  Most contractors do not have in-house depth when it comes to financial or project administration.  Normally, these abilities require significant investment in staff and software, which can eat up a lot of time and expense.

Factors specializing in working with construction contractors realize that their advancing of funds to a contractor based on the purchase of a progressively billed project receivable falls within the trust laws of the state requiring those funds to pay project expenses before they can be used for any other expenses.  These laws are designed to prevent funds from Project A paying expenses associated with Project B or general overhead.

If the re-directed funds deny the rightful recipients of those funds, (i.e.: subs and suppliers) a lien could be placed on the project.  The factor is then unable to collect on the receivable until the lien holder’s claim is satisfied. Thus the requirement for a funds control program for the disbursing of project advances and proceeds.  This process not only lowers the risk associated with construction factoring, it also saves the contractor money that comes with the overhead expenses.  It brings meaningful experience to the transaction which may be able to help minor capacity issues.

To give a construction executive a sense of funds disbursement by factors:

—payroll must only be issued for hours, days, or units of work completed on the project for which invoices are being factored.

—checks are written by the disbursing agent from a segregated account in the name of the contractor for payroll, benefits, subs, suppliers, and taxes (including 940/941, Social Security, FICA, Worker’s Compensation, and related withholdings).

—job specific overhead and expenses such as equipment, materials, and project overhead personnel must be allocated and tracked against the schedule of values and project budget.

With the Miller Act (and similar laws in different states), most public works projects must have bonding from a Treasury Listed surety, rated by A.M. Best.  While the involvement of a surety implies their first position on the project receivables, the factor who performs good funds control, should not have any problem with this perfection.  The factor has already paid the statutory lien holders on the project.  The factor is therefore, perfecting the payment side of the bond which complements the surety’s agenda.

On the other hand, if contractors (because they lack the working capital) are unable to qualify for the required bonding—the factor may be able to help the contractor by providing the working capital so that they can become bonded, resulting in a win-win circumstance for all parties.  The contractor is capitalized and bonded, the surety is relieved that the factor is providing working capital and funds disbursement and the factor is pleased to get their money “working on the street” with limited credit risk.

Granted, this underwriting process often requires more time and effort than the typical deal which the factor is used to putting on their books.  However, if this is executed correctly, especially given the latest abundance of opportunity and enormous need right now—the factor can see substantial profits.

With the current administration’s commitment here, the factors should consider the excellent revenue potential in the role of a catalyst.   Factors should reach out to pro-actively educate contractors about how they can gain access to capital through non-traditional means and the growing acceptance of these forms of financing throughout the public works construction sector.

By Earl Harper, Senior Vice President, RMP Capital Corporation (WWW.RMPCAPITAL.COM), a ten-year old national factor focused on public works construction, with headquarters in Islandia, New York, with additional offices in Massachusetts, Texas and South Dakota.

As the end of the year nears and a new one begins, here are some tips that some of you have provided to share with our readers, all of which relate to fraud prevention. Thank you for your comments and emails.

What if you suspect a fraud? Have you ever considered taking a portion of the verbiage on an invoice and entering that into a search engine on the internet? This may sound really crazy, but recently someone I know did this as the items being billed for on the invoice looked “off” and the descriptions were extremely long. As it turned out, the exact verbiage was found on the marketing products page for a completely different company.  The prospective client had copied and pasted the verbiage from a site in their haste to prepare invoices. What did the factor say, “Plagiarism is not limited to college or high school term papers anymore.”

With technology today, it has become increasingly easy to create, edit and submit invoices, purchase orders, and even billing documentation. You can find a lot on the Internet, and there are several tools that allow for editing PDF files and other documents that now exist. Just think of all the tools you have access to in your daily work.

Even more so, what about those prospective clients or clients who have also created account debtors? Yes, this can be done and is done. You can check credit agencies, secretary of state websites, and perform Internet searches on the customers. Sometimes a simple credit report is not sufficient. Plus, it is important to know which credit reporting agencies take reporting from the company being reported on (self reporting) versus accepting credit reporting only by third parties. If you are not sure, find out before you rely on simply one credit agency.

All of this is time consuming for the prospective client and for the factor to research, but it can be done. More importantly, it has been done and is being done today. When money is involved, people looking to initiate a fraud will go to great lengths to convince you to send them money. Creating the story and covering their tracks is what they do all day, every day.

When someone who commits fraud goes so far as to set up fraudulent debtors with websites and state registered companies, even if you cross check a phone number or address on the Internet, your independent research will reveal matching results with what your prospective client has provided to you, the factor.

One way to attempt to catch this is to check out the domain name for the debtor; this also works on email addresses as well. Watch for discreet domain ownership as this type of service can be used to hide a potential fraud.

On another note but along the same lines, have you ever had verification calls that went too smoothly? This with forwarded phone calls, Internet phone services, prepaid cell phones and other methods of hiding the true person you are contacting will also help a company commit fraud. If the company is valid, there should be a land line that can be identified with that company.

Well, that should be enough fraud facts for now. Thank you for your comments and tips. Please keep them coming.

Wishing you continued success. The Factor Guru.

Did you know that you can reverse search debtor websites or even debtor email addresses by looking up the owners of those domain names? These are helpful to be sure you are receiving an independent verification from the debtor. After all, who owns the website where you are verifying the receivables? Where did that confirmation email come from? Was it from the debtor, or could it be from the client? I typically use Go Daddy to research this information.

On their home page, there is a domain search field where you can enter domain names or even try email address extensions (i.e., factoring.org). The site will tell you if that name is already registered. Then, you can just click on the link that says “Get Info” to see details on who owns that domain.

Why do we use the term ‘rely’ when we send out those written verification letters or when we pre-verify receivables? If you tell the debtor you are relying on the information they are providing to fund an invoice, then they know you only funded based on their response. This helps when pre-verifying invoices to ensure that the proper message has been conveyed. And, as a side note, if you verify an invoice after the fact, then you would not be relying on their information. That is why these post-funding calls are typically considered confirmation calls only.

What are some early warning signs and red flags to watch for during the verification or collection process?

• Credit memos, disputes, offsets start to increase
• Quality issues arise more frequently (i.e., incorrect product, damages)
• Debtor responses for verifications / collections decrease
• Key personnel changes at the debtor or client
• Clients picking up checks or changing factor remittance
• Average days to pay increases
• Payment patterns change
• Invoice receipt delays by accounts payable
• Billing errors increase
• Invoice dates vary (invoice date on invoice versus the date on the debtor’s check)
• Name changes on invoices or remittance (ABC Mfg Co now says ABC Company)
• Skipped invoice payments

Until the next time… Wishing you continued success. The Factor Guru.

The issue was whether to interpret certain contract clauses as eliminating a claim for fraudulent inducement. The facts are bad. The Plaintiff signed a lease with the Defendant to open a restaurant in Dallas. The Plaintiff signed a lease with the following clauses:

Representations. Tenant acknowledges that neither Landlord nor Landlord’s agents, employees or contractors have made any representation or promises with respect to the Site, the Shopping center or this Lease except as expressly set forth herein.

Entire Agreement. This lease constitutes the entire agreement between the parties hereto with respect to the subject matter hereof, and no subsequent amendment or agreement shall be binding upon either party unless it is signed by each party…

After opening the restaurant, the Plaintiff became aware of a foul odor that turned out to be sewer gas. The odor greatly affected Plaintiff’s business. Plaintiff was unable to remedy the problem, and had to close. Plaintiff then sued Defendant for a number of causes of action including fraudulently inducing them into signing the lease.

Before signing the lease, Defendant had made statements to Plaintiff that it was not aware of any problems with the space and that the space was in perfect condition. Plaintiff presented extensive evidence showing that Defendant was aware of the odor problem, but had concealed it from Plaintiff.  After considering the evidence, the trial court concluded that Defendant had lied and rendered judgment for the Plaintiff. The appellate court, however, reversed and found that the above clauses negated any reliance for fraudulent inducement. Plaintiff appealed to the Texas Supreme Court. The issue was whether the contract clauses prevented Plaintiff from being able to rely on Defendant’s untrue statements as a basis for a fraudulent inducement claim.

The dissent pointed out that the clauses explicitly state that there were no representations other than in the contract. There can be no statements for Plaintiff to rely on if the parties agreed in the contract that there were no other representations. If Plaintiff, who was represented by counsel, did not like the clauses, then it should not have agreed to them. As a result, Plaintiff should lose on its fraudulent inducement claim.

The majority of the Court, however, disagreed. They reasoned that the clauses did not expressly disclaim reliance. They just state that no representations were made other than are in the contract. Since the clauses did not disclaim reliance, Plaintiff wins.

The Italian Cowboy Partners opinion is a classic example of where the facts were so bad, that the Court felt compelled to find a remedy. Now, unfortunately, the law is less clear. The lesson is to be careful what you put in contracts when you are relying on someone else’s statements or someone is relying on your statements. Many of you negotiate your own intercreditor agreements. Be especially careful of the clauses in these agreements.

This article is not intended to render legal advice for any specific matters or situations. It is merely intended for informational purposes. You should contact your attorney for advice about any specific matters.

About the author: Scot Pierce is a partner with the lawfirm of Bracket & Ellis, P.C. located in Fort Worth, Texas.  He has represented a number of factors with commercial litigation and bankruptcy issues.  He also regularly writes articles and presents speeches on creditor issues.  He can be reached at 817/339-2474 or spierce@belaw.com.

Wishing you continued success. The Factor Guru.

A few weeks ago, an underwriter contacted me about her process in reviewing a new deal. She also wanted to share some Red Flags that arose in her process.

The prospect had been owned by one party, but all correspondence had been through another individual. We’ll call him Joe. The underwriter on the deal felt that Joe, although stating he was forthcoming, continued to omit pieces of information. She went through her six C’s of credit ultimately concluding to decline the deal.

But, let’s start at the beginning, the credit.

The debtor credit was insufficient for the amount being requested; the credit department was looking for additional history to support the request. In the interim, the underwriter requested copies of invoices. Joe said they did not invoice the debtor. Instead, they provided handwritten backup to the debtor and the debtor invoiced the client. The underwriter never did receive a report or copy of these debtor invoices.

Speaking of credit, the application noted another person owning the business, not Joe. The owner’s personal credit and background appeared good. However, the documentation on who actually owned the company legally did not link back to this person. Moreover, Joe had been the one to provide all correspondence, since he was who was running the daily operations. Since Joe did not own the business, he also would not sign an application for credit or background checks, nor would he sign any type of guaranty. After all, he was just helping out the owner to start the business.

The underwriter then decided to start searching – the Internet – there were just too many pieces that did not add up in the story. After trying different search phrases, there it was… Joe was no stranger to factoring. In fact, he had defrauded other factors in other states using the same strategy. Unfortunately for him, one of those times, he had the business in his name.

But, it was the Common Sense part of the underwriting process that led the underwriter to search a little bit more on the Internet, where she ultimately found these articles. Afterwards, she prepared some Red Flags to think about when going through this process:

Red Flag # 1:

“This prospect was almost overly friendly, likable, and eager to help. Fraudsters know that they need to become your friend first in order to drop the wall of skepticism between you. Typically prospects will get exasperated with the front end factoring process at some point in time, but this prospect was always making reassuring statements such as ‘we will get whatever report you need, and I will make sure that it has every piece of information you need is on it’.  He also didn’t even hesitate when I asked to speak directly to the debtor at an early stage in the underwriting process which would typically be a good sign.”

Please note that the reports were never received; the conversation with the debtor was never had.

Red Flag # 2:

“Double Talk. After going through a few questions on the underwriting call, specifically Joe’s background and experience, I felt as though we had talked for over 20 minutes regarding his background yet I couldn’t tell you one thing about him. Keep in mind that he wasn’t the owner of the business, but was acting more as an advisor and therefore we didn’t have any information on him (application info, background/credit information, driver’s license, financials, etc.). I pressed a bit further and nicely let him know that I still really didn’t understand what his experience or background was and that this is an important piece given the fact that it is a start-up operation. At this point, he finally realized he would have to give something concrete and told me that he used to work in the sporting goods industry (still not much). As we know, when answers are vague, that is when you need to keep pressing for better answers.”

This is another tactic fraudsters will use (see How to Smell a Rat).

Red Flag # 3:

“Physical signs of discomfort. When pressing the individual for a background report, I not only got an excuse as to why that wouldn’t be necessary, but he also mentioned his age along with the a reference as to his great character accompanied by a sort of numerous small coughs that had not been there previously. When attending the IFA’s fraud seminar this past year, a former FBI agent spoke to the group regarding various physical signs of distress. This was clearly a sign of distress as he had never done that in our previous conversations, going back to what the agent called ‘knowing your prospect’s baseline’.”

Thank you for sharing your experience with our readers.

Wishing you all continued success. The Factor Guru.

The amount that can be advanced to a client is generally expressed as a percentage, called the Advance Rate. Typically, this is calculated as a function of Dilution (which is the percentage of an invoice that is not returned or paid). Dilution includes discounts, returns, allowances or any reason an invoice is not paid in full. Many factors will use a multiple of Dilution (3x or 4x) to establish the Advance Rate; other factors typically just add 10% to the dilution.

Tip: You may hear or see on factoring reports the words Chargeback, Recourse, or Adjustment… these are all dilutive items.

For illustration purposes, if a client sells $10,000 in widgets to their customer and a factor advances 80%, the client would receive $8,000. Then, when the customer (debtor) pays for the products, let’s assume they only pay $7,500 claiming they had a credit on file for $2,500. Therefore, they do not pay the full amount of the invoice. The portion that is not paid is considered dilutive, or Dilution. Of the $8,000 the factor sent to the client, only $7,500 was received. The factor would still be owed $500 plus any factoring fees.

It is because of this that setting an appropriate Advance Rate is important, as well as monitoring the client’s ongoing Dilution. This also highlights why during verifications and collections factors will inquire as to open credits, other potential offsets, discounts, disputes, etc.

Chargebacks / Dilution:

Did you know that many recourse factors may ignore chargebacks after recourse to a client. For example, if an invoice hits 90 days, they may just charge it back to the client without wondering or asking Why? Since the invoices purchased should include services that are completed or goods that have been delivered, why are there chargebacks?

• Was it a discount that was pre-approved in the client’s terms if the debtor paid quickly?
• Were the goods damaged or of poor quality? Is this an ongoing issue with the client that should be watched in the future?
• Was the account debtor a bad credit risk and didn’t have the ability to pay?
• Did the debtor request a credit and rebill for a reason? Do we know the reason? Does it make sense? And, did the invoice date stay the same or did they re-date the invoice?
• What was the ultimate outcome of the chargeback? Did the invoice pay later? If so, who did the money go to? If not, why was the invoice never paid?
• Did the client ‘pre-bill’ the invoice and not finish the work?
• Are there offsets that the debtor took against the invoice that we did not know about (i.e., contra account, deposit, other open credit memo, volume rebates, year end rebates, restocking fees, co-op charges, etc)?
• Was the invoice even real?

Remember that a factor purchases (buys) an invoice from a client and gives the client money against that invoice. For example, ABC client sends in an invoice for $50,000; the factor reviews the paperwork or verifies the invoice to ensure the work is completed. They should also review the debtor’s credit to be sure they have the ability to pay the invoice. The factor then buys the invoice, advancing typically 80% against the invoice amount. In this case, on the $50,000 invoice, the client would have received $40,000. If the invoice is later not paid, then how does the factor get repaid on the $40,000?

This is the reason that reviewing invoice documentation, verifying invoices and checking debtor (customer) credit are so important to a factor. Good factors know why these chargebacks occur and manage that risk.

Wishing You Continued Success. The Factor Guru.

Facts of the Case

In 2002, Jersey Tractor Trailer Training, Inc. entered into a loan agreement with Wawel Savings Bank for $315,000.  To secure the loan, Wawel took a blanket security agreement against all assets including inventory, equipment, accounts, instruments, documents, chattel paper and other rights to payment including general intangibles.  Wawel filed a UCC-1 on May 24, 2002.  Wawel put no restrictions on Jersey’s use of its accounts and the proceeds unless there was a default on the loan.

In 2003, Jersey entered into an agreement to factor its receivables with Yale Factors NJ, LLC.  According to the court, Yale never asked Jersey about any prior encumbrances and never reviewed Jersey’s books or records.  Dun and Bradstreet ran a lien search for Yale, but instead of using Jersey’s exact legal name, they left off “Inc.”  Because of this, Dun and Bradstreet did not find Wawel’s senior lien.  And, of course, the client concealed Wawel’s loan from Yale and concealed Yale’s factoring agreement from Wawel.  Yale filed their UCC-1 against all present and after acquired accounts in 2003.

Jersey continued having cash flow problems.  In December 2005, Wawel and Yale finally learned about each other and began litigation.  By April 2006, Jersey Tractor declared bankruptcy.  Yale and Wawel promptly filed an adversary proceeding in the bankruptcy court to determine who is entitled to the proceeds of all of Jersey’s accounts.  Yale argued that this case was an exception to first to file priority rule and that it should win over Wawel.

2007 Opinion

In 2007, after a two day trial, the bankruptcy court held that Wawel wins.  Yale argued that under New Jersey’s version of UCC 3-302, 9-330 and 9-331, it should have priority over Wawel to the proceeds because it was a holder in due course and purchaser for value of invoices.  For Yale to qualify for protection under either of these statutes, the court must find that the invoices are “instruments.”  The court must also find that Yale took the instruments in “good faith” which means that Yale observed “reasonable commercial standards of fair dealing.”  Although the court held that the invoices are instruments, the court denied Yale relief because Yale did not observe “reasonable commercial standards of fair dealing” when it entered into the factoring agreement because its due diligence was lacking and because it did not run the lien search using the exact corporate name of the debtor.

2008 Opinion

Yale appealed to the district court.  In 2008, the district court issued an opinion upholding the lower court’s ruling.  Wawel wins again.

2009 Opinion

Yale then appealed to the Third Circuit Court of Appeals.  In 2009, the Third Circuit affirmed most of the district court’s decision, but found that the bankruptcy court could not conclude that Yale’s lien search was commercially unreasonable as a matter of law just because it omitted “Inc.” from the name.  In fact, the Third Circuit Court seems to believe Yale’s search was commercially reasonable.  But instead of reversing the bankruptcy court, the Third Circuit sent the case back to the bankruptcy court to redetermine commercial reasonableness.  No one wins, but Yale gets another chance.

2010 Opinion

This year, the bankruptcy court issued a ruling in favor of Wawel . . . but for a different reason.  The bankruptcy court reconsidered the issue of whether an invoice is an “instrument” for purposes of 3-302, 9-330 and 9-331.  The court concluded that an invoice is merely a record of a transaction and not an instrument.  Yale Factors, therefore, cannot avail itself of any of the holder in due course or purchaser for value protections regardless of whether it acted with commercial reasonableness.  Yale attempts to argue that it was not just invoices, but also checks from account debtors that it purchased, therefore, the court should analyze whether these checks are instruments.  At trial, however, Yale never introduced any checks into evidence.  Without these checks, the bankruptcy court held that it cannot even begin to consider this issue.  Wawel wins again.

So what should we learn?  There are lots of lessons, but I want you to consider how much time and money these parties have spent litigating this issue.  Better due diligence and lien searches could have saved everyone a lot of time and money.  Or, to say it another way, an ounce of prevention is worth a pound of cure.

About the author:

Scot Pierce is a partner with the lawfirm of Bracket & Ellis, P.C. located in Fort Worth, Texas.  He has represented a number of factors with commercial litigation and bankruptcy issues.  He also regularly writes articles and presents speeches on creditor issues and has been a speaker with the International Factoring Association.  He can be reached at 817/339-2474 or spierce@belaw.com.

Wishing you continued success. The Factor Guru.