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.

Once in awhile, however, a new prospect with a ‘rush’ closing comes along which can create tension and add stress between the sales and the credit departments within the factor’s business. This is normal.

What is not normal, however, is for a factor not to execute the verification process because of a rush situation or because of this added stress. Have you heard that other phrase about how stressful situations reveal character? That principle holds true here as well.

As many of you know, we all share stories after time has elapsed. These can be expensive lessons for those with the story to share, but they can also become learning opportunities for others. Over the past few years, I have come across a few stories that all focus on the same underlying issue: Bulk Verifications. (I really do not know that this is the correct wording; it’s just the wording we’ll use for today).

This occurs when a factor attempts to contact the debtors’ accounts payable departments to verify invoices. Instead, the debtor is only able to verify the balance owed (in bulk) or the checks to be written (i.e., $50,000 in outstanding receivables) – they cannot confirm the actual invoice numbers or details for that open balance.

In a rush situation, the factor may look at the invoices the prospective client provided for purchase, which total a little more than $75,000, and incorrectly assume (i) the $25,000 in additional invoices are probably just new invoices that are not in the accounts payable system yet and (ii) that the $50,000 in invoices have been verified. Yes, I did say incorrectly. This response should not be considered verification.

Why? Sometimes, in those rare situations, the prospective client could have sold the factor invoices that had already been paid and/or included some fraudulent invoices in their schedule or batch. When the $50,000 that the debtor has on the books later comes through the factor’s lockbox, that check may not include invoices that the factoring company purchased, meaning those funds will more than likely be processed as non-factored and returned to the client. Where does this leave the factoring company and the $75,000 they sent to the client?

There are other situations where bulk verifications may be the only way the debtor will confirm, and the factoring company may decide to accept this form of verification. Consideration for this may include the debtor’s concentration level, prior experiences with the debtor, copies of check remittances from prior payments received by the client, type of invoicing and backup, etc. The point, however, is to be aware of the potential for this risk and to ask yourself, “How do I know that the invoices I am factoring will be paid?” After all, that is the point of verifications.

So, next time you are in the middle of that rush closing and stress levels are on the rise… be sure to follow your process. Don’t take a shortcut or an easy way out hoping everything will turn out okay. Reveal your true character as a factor – “Trust, but Verify.”

Wishing you success. The Factor Guru.

Tax forfeitures affect an entity’s liability protection.  You are all familiar with the various entity forms.  You know that some entity forms provide limited liability for owners, shareholders and partners.  These include limited liability companies, S corporations, C corporations, limited liability partnerships, and professions corporations.  You also know that sole proprietorships, general partnerships, joint ventures and DBAs have no limit on liability.  Entities can lose their liability protection by failing to pay state franchise taxes.

Using Texas as an example, entities have three levels of standing.  They are (1) “Good Standing,” (2) “Not in Good Standing,” (3) and ‘Temporary Good Standing.”  Most states have the same or similar designations.  “Good Standing” means the entity has filed all franchise tax reports and paid its franchise taxes in full.  This allows the entity to continue doing business in the state.  “Temporary Good Standing” is really no reflection on the entity itself.  This simply means that the state has not yet processed the franchise tax reports. Until it does, all entities are granted temporary good standing.

“Not in Good Standing,” however, is very different. “Not in Good Standing” is a red flag for factors.  It means that the entity has not paid its state franchise taxes and has, therefore, forfeited its right to do business in Texas.  In practical terms, this means the entity is now operating as an assumed name or DBA so any shareholders, owners or partners are not protected personally from liability for debts incurred while the entity was “Not in Good Standing.”  Or, to be more direct, you are now factoring a sole proprietorship or general partnership.  My experience is that this not only can affect how you factor the client and perfect your security interest, but it is also a red flag that you may very well be factoring into a liquidation.

Because of the effect of failure to pay state franchise taxes, I recommend factors be vigilant in checking this.  Usually, the state comptroller’s office will have this information.  If you have a client whose account status changes for the worse, you should immediately contact the client to learn why this has happened and whether the client intends to correct the problem.  This may allow you to catch a failing business early on and take appropriate steps to protect yourself. Or, it may allow you to avoid factoring a business that just wants your money while intending to file for bankruptcy protection. The bottom line is factoring a client who is not paying its state franchise taxes can be a recipe for disaster.

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, including an upcoming teleconference on Issues to Consider when Litigating against Account Debtors.  He can be reached at 817/339-2474 or spierce@belaw.com.

This new service by the International Factoring Association where they announced the launch of an Attorney Locator Service is great. Do you realize the number of factoring companies that have clients in other states and markets? When a problem or concern arises in these other states, having an attorney that understands those state laws can be invaluable.

For example, I have had that fated call from a factor where they needed a local attorney (in that market)… they needed them to help but to also understand factoring. They called someone from the Internet. In fact, this one factor I spoke with spent several thousand dollars on the education process for the attorneys, only to find out the attorney they were using learned ‘a little too late.’ The attorney’s initial complaints did not address the proper arguments; they actually approached the suit as a ‘consumer’ suit… their reasoning had little to do with factoring or the sale of a receivable… let alone payment over notification. After all the legal fees and ‘education,’ the factoring company actually dropped the suit due to the legal fees (costs versus reward). A “pre-screened” attorney, endorsed by another factoring company, could have saved them money… and resolved their lawsuit.  I wish this service had been around several years ago.

Although it seems basic, factoring does require a special niche in the legal realm. Those attorneys who have experience in this segment of commercial finance can help, where others may spend your dollars educating themselves on our industry: factoring.

So, today, this new service through the IFA is designed to match factoring companies, asset based lenders and other receivables finance companies with the right attorney for their needs.  This free service can be accessed on the IFA’s website at Attorney Locator Service link and by selecting attorneys in the vendor category listing.  The IFA’s Attorney Locator Service is searchable by geography and practice area and provides a simple, reliable way to find a law firm which has been “pre-screened” by a peer.  Attorney specialty practice areas which are searchable include Bankruptcy, Collection/Litigation, Article 9, Contract Law, General Business, Litigation, Tax Law and Factoring.

Since these attorneys have been “pre-screened,” it makes it more efficient and more reliable for identifying an attorney who can help when the time comes… and it will.  So, yes, this seems like an advertisement… but it somewhat is. I do endorse it and wanted to be sure to share this link, as it adds value to us all.

Wishing you success. The Factor Guru.

Yes, factoring does go back over 4,000 years to the Mesopotamian King Hammurabi. He was the ruler who established the world’s first metropolis, Babylon, considered the bed of civilization. The Mesopotamians are accredited with being the first to implement notes/borrowings on clay tablets between two parties. These clay ‘contracts’ indicated promises to pay; they were promises for future payments. This concept expanded trade and increased economic power for that time, setting a foundation for certain alternative forms of finance today.

Since then, factoring has evolved becoming a critical financial tool for doing business in almost every civilization that followed, the Romans included, who were the first to sell discounted promissory notes. The first documented form of factoring in the American colonies, however, was prior to the revolution.

Merchant bankers in Europe gave the American colonists advances for materials, allowing the colonists the ability to harvest their lands. Raw materials like cotton, furs, tobacco and timber were shipped from the colonies to Europe. Factors during these colonial times advanced against the accounts receivable of these companies. This practice became very beneficial to the colonists, as they didn’t have to wait for the money to begin their harvesting again.

Later, during the economic revolution, factoring became more concentrated on the issue of credit, as factors began assuring payment for certain clients (today known more as non-recourse factoring). Before expanding to varied business types after the war, factoring specifically catered to the textile and garment industries in the United States.

By the 1960s and 1970s, an escalation of interest rates and tighter credit spawned a new interest in the factoring market, with a number of private factoring companies coming into existence. By the 1980s, further rate increases combined with new regulations within the banking industry caused many small businesses to seek alternative sources of funding outside of traditional banking. It was at this time, factoring became a more popular option for many of these companies.

As many of you know, factors make funds available even where banks cannot often do so; typically, factoring companies focus on the creditworthiness of the customer (debtor). In contrast, the fundamental emphasis in a bank lending relationship is on the creditworthiness of the company itself, not that of its customers.

Factoring is a financial transaction wherein a company sells its invoices/accounts receivable to a factor at a discount. In exchange for this, the company receives immediate working capital. Three parties are involved in the transaction: the factor, the company seeking financing and their customer (the account debtor). The sale of the accounts receivable transfers ownership of those invoices to the factor, at which time the factor obtains the right to receive the payments made by the customers.

Today’s factoring still focuses on advancing funds to small to mid-size, rapidly growing companies who sell to larger, creditworthy customers. Factoring is among one of the most effective and efficient forms of financing utilized by businesses. It immediately improves the cash flow of a business.

In addition, today’s factor offers other support services for their clients including providing credit checks on new and existing customers, sending monthly statements to customers for payment, performing collection calls, processing and maintaining history on invoices and customer payments, and providing reporting for this information, typically with online access for the client. Some factors even provide additional financing services for their client companies.

After all of that, the only history question from Factoring Jeopardy that this actually addressed and answered: Who is Hammurabi? I no longer remember the other questions… maybe some of you do and want to comment…

Wishing you success. The Factor Guru.

I have received some phone calls this past month from newer entrants to the factoring industry asking me about this conference and if it is worthwhile to attend.  I respond, with full disclosure that I am actively involved with supporting the IFA and say wholeheartedly “OF COURSE!  This conference is a must for any professional associated with receivables finance in any way.”  I say if you can only afford (both in terms of time or money) to attend one conference each year then this is the one.  Yes, you can probably purchase an audio CD after the event – but that’s only half of the draw.

The people that you will meet at this conference you are likely to develop relationships with that will serve you well over the course of your career or through the growth of your company.  I’ve watched alliances form over the years… folks that met each other for the first time who nine, ten, and even 12 years ago are now engaged in participations together, have bought and sold portfolios amongst each other, and have hired one or another in various roles.  I’ve met owners of factoring companies who started with nothing and have grown their portfolio to wild heights.  I’ve met others who have built up a portfolio, sold it, and are now in their second round.  Sad to say, I have seen folks come and go too.  I’ve met new business development people who have moved up the ranks to sales managers, account executives who have moved up to operations managers, operations managers who have moved up to portfolio managers – and many of those will go on to start their own companies.  The amazing thing is that almost all of them will take a moment to provide advice and share war stories, or in general, they are just pretty fun to be around.

It is important to note that it is not just other factors who attend this meeting; Vendors, service providers, attorneys, complimentary businesses also are in attendance – these too can be healthy contacts for you. For example, I really enjoy the folks over at 20/20 Tax Resolution, Ansonia Credit, MotherFund and First Corporate Solutions just to name a few. They know their business and the factoring industry well. Think about it: Where else can you interact with the likes of Mike Ullman, John Beckstead and Steve Kurtz? Even the face reader guy, Mac Fulfer, is scary “spot on” with his observations, and Brian Van Nevel (who must have been a game show host in a past life) will channel his inner Alex Trebek for a very educational round of Factoring Jeopardy.  The creator of the Factor Guru blog, Genevieve Merritt, will be there as well as all the other contributing writers such as myself, Scot Pierce and Rich Eitleberg.

So if you haven’t already signed up… I’d be thinking of doing that soon.  The room block ends this weekend – I hope to see you in Scottsdale! It’s sure to be an educational and productive event.

And yet, CIT’s other business segments combined with other nonbank, unregulated, newsworthy companies that failed in 2008 and 2009 have shed new light on something referred to as “Shadow Banking,” which many believe is to blame for the recent economic crisis.  What began by general comments during a speech in 2008 has evolved into a full out mission.

Unfortunately, this new light may ultimately and indirectly impact the factoring and asset based lending (ABL) communities at large, which would also adversely affect small businesses.

How so? As early as February 2010, rumblings in the marketplace have noted that staffers may begin preparing new legislation in the regulatory reform bill, which is intended to regulate the Shadow Banking segment. Some believe, including the American Factoring Association, an advocacy arm of the IFA, that both factoring and ABL companies could be inadvertently bundled under the category of Shadow Banking.

Note, however, that the majority of these factoring/ABL companies are nonbank, unregulated financial institutions that provide ongoing working capital to small businesses. These are predominantly independent financial institutions. Their sole purpose is to provide capital to companies that simply do not qualify for traditional bank lending; they do not engage in the trading of derivatives or collateralized debt obligations. They do devote their energies towards accurately valuing the most liquid assets of a business such as receivables and inventory.  Funding is not provided based upon past financial performance, time in business, or even future earnings or performance of a business. This alternative form of finance is very different, while often misunderstood.

In the January 8, 2010 publication for The Deal, one article noted final legislation should be made public near “the end of 2010 for 2012 implementation. This means uncertainty will prevail for the bulk, if not all, of next year.” This article focused on mortgage securitization and other forms of finance, however, and not specifically Shadow Banking. With that said, many of the items addressed may also be included in the next legislative bill.

What are possible inclusions for this new bill? For one, possible tightened capital requirements for banks that finance factors and/or ABLs, thereby potentially limiting financing resources, or raising the cost of financing for factors and ABLs. In the article mentioned in The Deal, one possibility would be not just to tighten capital requirements but to assess standards for “fixed capital requirements for various types of risk-weighted assets.” Knowing that many of the companies using factoring and ABL services are not considered bankable, what would their risk weighting be considered?

Moreover, the ramifications of this heightened awareness and legislation has the potential to greatly impact small businesses by then shutting off working capital to these companies that is now so readily available through such forms of alternative finance. The result for many small business owners: fewer available financing options… and that is just the beginning…

There are some finance companies who believe this type of legislation may never occur, or that this regulation would have little impact on their business. There appear to be more who believe that this regulation needs to be addressed now, as the effects of such regulatory reform and legislation would dramatically impact their individual business, as well as the factoring/ABL industries and small businesses alike. As Adam Smith said, “…by pursuing [our] own interest [we] frequently promote[s] that of the society more effectually…”

The AFA has already identified a lobbying firm in Washington, D.C. to not only create a preemptive effort for the benefit of the factoring and ABL communities but to also increase awareness on how critical our segment of the commercial finance industry is for the U.S. economy as a whole. If you have questions on this potential legislation or to find out what you can do to help, contact the American Factoring Association at (805) 773.0021 or visit their website at www.AmericanFactoring.org.

Wishing us all continued success. The Factor Guru.

BY RICHARD EITELBERG, CPA, FOUNDER-PRESIDENT OF HARTSKO FINANCIAL SERVICES, LLC, A SEVEN-YEAR-OLD PURCHASE ORDER FINANCE FIRM WHICH HANDLES ABOUT $150M IN ANNUAL TRANSACTIONS, BASED IN BAYSIDE, NEW YORK (WWW.HARTSKO.COM)

“The Great Recession” has left a lot of asset-based lenders and factors weak and lame.  Their inability during this period to access credit lines from banks, hedge funds, and equity investors often means they must restrict money to existing customers or refuse prospective clients.

Purchase Order Financing and Letters Of Credit generally looked upon as a last-resort bitter pill have seen increased acceptance as a way for a business owner to preserve a transaction opportunity.  With up front honesty, PF is expensive because of the very high risk issues involved and the intensive servicing requirements.  However, if a deal has the potential to yield a 30% profit or more—why should the business owner be concerned about sacrificing a few more percentage points over and above a traditional lender?  Is losing the opportunity to do the deal altogether, a better alternative?

Factors and asset-based lenders should realize that if they are at the end of their line with their client, referring the PF route can keep their relationship and income opportunity alive.  PF is a fast way for their client to secure funds needed to fulfill customer purchase orders and expand their business without giving up equity or trying to borrow additional funds (an option which no longer exists).

Here’s the process:

1.   The customer submits a purchase order to the client with all documents

2.   The client submits the customer purchase order to the PO financier for approval with all costs associated with transactions

3.   The PO financier will then will make direct payments to the client’s vendors so that the merchandise for the customer PO can be produced

4.   The client’s vendors deliver final product directly to the end customer or to a third party warehouse until shipped to end customer

5.   The seller then invoices the shipment and sends invoice and corresponding copy of customer PO to the factor

6.   The factor funds the invoice at his discount, paying the PO financier their loan plus fee

7.   The factor (or bank) collects from the end customer and pays the client their residual left from the advance

PF is taking a piece of equity in a client’s deal on a temporary basis, perhaps, thirty, sixty, ninety days, or 120 days.  A PF firm earns a fee on a precise part of the deal.  The PF firm doesn’t really “lend” a business money.  Most times, PF firms do not actually give a business any money or hard cash.  The PF firm’s money and equity backs up and supports the integrity of said purchase order.  It makes transactions work by opening up an LC usually overseas to procure merchandise, products, and materials for businesses.  (Or, wires are sent to domestic manufacturers to make purchases in behalf of businesses.)

PF is only transactional and temporary with the money going to fund the goods or merchandise in that specific transaction.  PF funds are not allocated to fund payroll, rents, cars, or any other business operations. Therefore, PF enables start-up companies to grow and troubled companies to survive.  Even bankrupt companies are generally able to access PF because the fees are guaranteed by the court.

Finally, in terms of the relationship, PF firms are not offended that a business owner may use this process one day, while returning to the factor or traditional lender the next day.  The PF community recognizes that PF is only going to be used when it is absolutely necessary and all other lender options have been exhausted.  The PF firm accepts that business owners and their lenders will only use it when they need it!

For more information on purchase order financing, feel free to visit www.Hartsko.com, or contact the IFA directly.

More about the author.

Richard Eitelberg is the Founder, President of Hartsko Financial Services, LLC., with offices in Bayside, New York and Deerfield, Illinois.  Mr. Eitelberg, was graduated from Michigan State University with a BA in Accounting.  He earned his license in certified public accounting (New York State).

Mr. Eitelberg has been the Chief Financial Officer for two garment industry companies: Adrian Landau Designs, and B. Lucid.  He was a Senior Auditor for Josephson, Luxemborg & Kantz, CPA’s, PC. He began Hartsko about seven years ago, assembling a group of private equity investors.  Today, Hartsko handles purchase order financing and letters of credit with some $150m in annual outstandings. (www.hartsko.com)

Mr. Eitelberg, a resident of Plainview, New York is a member of the Commercial Finance Association, the International Factoring Association (preferred vendor) and the Turnaround Management Association.

As a follow up to the Part I weblog from May, here are some other pokerisms (if that is even a word – probably not) that may be useful in your journey as  a factor… or they may just be entertaining. Either works.

Don’t be a “fish,” otherwise defined as a bad poker player. These fish never truly understand how to play the game; they just keep playing. In  factoring, if you fund enough bad deals or make too many exceptions to the rules that result in losses, you will eventually lose… you may even lose your  business. Good factors know the rules of the game, develop them, and execute them every day. If you are not sure where to seek assistance on the rules,  attend an IFA seminar or call the IFA, an industry consultant or even a friendly competitor for help.

Don’t throw good money after bad… sometimes, when you have a problem account, you may believe you need to continue providing working capital to the company so they stay in business. After all, if you are short on collateral, how else will you get your money back? This decision is not to be taken lightly. You cannot hope your way out of a deal that has gone bad, as they say.

Do your homework. What is really going on in the client’s business? How can it be corrected? Take your time to identify your exposure and other repayment or collateral options. Understand the inter-workings and financials of the business itself. Will putting more money into the pot really help get your money back?

Learn from your mistakes… it happens. We can all become complacent in our monitoring protocols with long time clients. We make exceptions to get deals done quickly, or we believe we have covered all of our bases (i.e., seen all the options on the river) during our due diligence… only to find we missed something extremely important (or misread our cards).

However, we can only get better if we actually learn from those mistakes. Go through your history of losses. Make a list and refer back to it. What were the reasons those losses occurred? What were the exceptions, if any, you made to get the deal done? What were the common characteristics between the various transactions? What have you learned from looking at this list?

What’s that song? “…Know when to fold ‘em. Know when to walk away. Know when to run…“

Did you see the July weblog “Understanding the Story… What If,” a guest blog by Darla Auchinachie? Once in awhile, there is a voice tapping you on the shoulder saying, “Um, perhaps it’s time to leave.” And, sometimes when you listen to this voice, you live to play another day.

One bad call in judgment can destroy ten good calls. How many deals does it take to make up for a loss on one bad deal? Do the math…

At some point, you will lose. You really can’t win them all. Some elements are out of your control. Structuring deals appropriately up front will however help mitigate losses significantly. Ask yourself on every transaction you review, “Can I get out tomorrow?” If not, why not? What can be done differently should you need to collect out of the deal?

Being aggressive can be a good thing. When a deal goes awry, it is better to act and act quickly. In factoring, the entire client receivable base can turn over in 45 days. The longer you wait, the further you may be from your collateral. And, don’t forget that the longer an invoice stays open, the harder it is to collect.

Good luck. Wishing You Success in the Game. The Factor Guru.

I recently became involved in underwriting an application for a factoring facility that brought me back to a session I co-instructed at the 2004 IFA Annual Factoring Conference. The title for that session: “Understanding the Paper you are Buying.” One of the ideas presented focused on how cutting corners in the due diligence process may lead to disastrous results. That was true five years ago, and it is even more so today.

It’s been said that it is very difficult to correct a bad underwriting decision, and anyone that has been tasked with a client “work-out” can echo that sentiment. The role of a factoring credit underwriter is to try to accurately predict that if a prospect is accepted for financing then that relationship will perform as expected – and to structure the facility in such a way that monitoring that performance can be effective. After the underwriter has recommended the prospect for financing, it becomes operation’s responsibility to employ the necessary procedures to protect and preserve the factor’s capital.

When you think about it, initial underwriting is a really tough job; even after you get past all the obstacles we understand academically, you still have to rely upon what your intuition tells you. And, after that, you have to determine if you are being too conservative or not conservative enough.

So, back to my original story about this application package, it was neat… too neat. Robust financials, plausible agings, strong guarantors, dare I say it – a factor’s dream. Of course there were issues a seasoned factor would spot such as the nature of the receivables having a “little hair on them” and the customers, while nicely spread out and quasi-governmental, still thin on the credit side. Of particular interest was the volume – it was substantial for the small non-traditional market. Who wouldn’t love funding a new prospect with a receivable base of several million, especially if it could be done for a desirable rate?

Personally, I wasn’t comfortable with the deal. It wasn’t necessarily the receivables themselves; it was more about the “Conditions” of the deal – Conditions is one of those “C’s” of credit we should never forget when underwriting. You see, the company had experienced tremendous growth in the past fiscal year, and by tremendous growth, I mean well over a 150% increase in revenues. But wait…

In this economy today, what industry could possibly support that kind of growth? I’m not talking about a startup company whose revenues might be expected to grow at a steep pace. This was a company that had been around for decades and had never experienced such a sharp increase in sales.

Another interesting Condition was that the prospect already had a factor funding their receivables. Usually this is not a cause for concern. In fact, it’s quite common to see an applicant who is already factoring. As part of the initial qualifying stage, the business development officer contacted the current factor and was given a glowing recommendation: the factor loved their client, had experienced zero dilution over the course of a multi-year relationship and wished they could keep funding the client. It was the client’s growth that had outstripped the factor’s ability to fund.

However, here is where the story becomes a little more interesting…

The prospect urged the incoming factor to “rush” funding. They needed the capital to continue operating during this explosive growth cycle. One should ask, “Why?”

Well, common sense and experience were telling me something was not quite right: the recent growth, the current factor volunteering there had never been any dilution over the course of a long funding relationship, and now the company needed to rush the initial funding for a payoff. Why was a participation arrangement not being considered or requested?

I know many factoring companies and believe that most have very capable and honest folks, but this factor in particular was relatively new to the industry and now had a several million dollar deal that had outgrown them. I’d never met this factor at any industry event; I even called other factors to see if they had any experience or knowledge of this financial source – no one did. Because of this, I recommended that my client (remember the one who originally engaged me to review the application) fully and strongly verify the receivable base before getting too far down the road. My client asked me, “Why shouldn’t we rely upon the existing factor’s story and records?”. And, this is what brought me back to that class in 2004…

It was after that session when a factor approached me stating they wished they would have attended this course before taking on a rather large client. They had relied upon another factor’s story, similar to the one described above. To their detriment, they funded the prospect’s receivables. You see, the incoming factor didn’t have a large enough staff to fully verify the invoices, and the payoff was also a “rush” situation. As it turned out, there was not enough true collateral. The incoming factor had wanted to appease the client and get the deal done. They had “assumed” the information received from the prior factor was accurate. Therefore, the incoming factor only made a few random calls instead of following their normal procedure of verifying a large percentage of the collateral.

I know several factors who would say they would never do such a thing: fund a large client without full verification – but what about those newer factoring companies? We’ve seen the number of factors steadily increasing over the years, and yet many of these businesses may not survive. I think this story provides a good reason why newer factoring companies tend to fail. They do not understand (or believe) that fraud exists, that there are people waiting for opportunities to intentionally defraud factors or lenders out of their capital. Further, they believe they can correct their cutting corners on the initial funding by performing post funding verifications. Really? I think if this is the plan, you will just know sooner that you have a fraud. Once the money is sent… it may really be gone.

Yes, it is important to talk to the prior factor and hear their story. However, you should not solely rely on what they say… especially where your interests are not the same. Perform your own due diligence.

Newer factors might not have experienced a fraud; they may assume the current factor has strong procedures in place that mirror their own. But, what if the current factor hasn’t figured out what they have on the books isn’t any good? Or, what if the current factor knows but is hoping someone takes them out of the deal? And then, what if the incoming factor just doesn’t have sufficient resources or time to verify the accounts? Well, that sounds like just too many “What if’s?”

Be aware of what your intuition tells you. Or as my friends in Texas say, “Go with your gut feel.” Business is tough for everyone, and we all want to fund new deals. But, just because you catch a nice fish on your line doesn’t mean you should take it home and fry it up – sometimes catch and release may be better off for the longevity of your factoring company.

Oh, and just in case you were wondering about that deal I was engaged to review… the factor did start calling to verify invoices before they funded even with the glowing recommendation from the prior factor. The result: Declined. While I won’t go into great detail, remember that a factor’s best friend can be the Internet and that searches and reverse phone number searches on customers can be easily checked.

Until the next time…