Factoring and the Uniform Commercial Code
Factoring is a business financing solution that gives access to capital based on the sale of invoices that have been issued by a business to their credit worthy business or government customers. Factoring works particularly well for smaller businesses since often their capital is tied up in their accounts receivable.
When small businesses are selling to creditworthy businesses or government agencies, substantial credit can be offered so they can take on larger projects than they otherwise could. Factoring gives them access to cash flow for timely payments to their employees, suppliers, contractors, etc., and their customers a level of assurance that the small business is capitalized sufficiently to excel at the contract.
In accounts receivable factoring the credit decision is focused on the accounts receivable since that is the collateral in the transaction. Factoring falls under the Uniform Commercial Code (UCC), which is the branch of law that has to do with business transactions including debts owed by one business party to another. All 50 states and Washington D.C. have adopted the UCC.
A key aspect of factoring is the Notification or Notice of Assignment. This is a letter issued by the factoring company to their client’s customer (the debtor of the invoices). The specifics of this letter are dictated by the Uniform Commercial Code. It instructs the debtor to remit payment to the accounts receivable factoring company for payment of all invoices that the client issues. When a debtor company has received a Notice of Assignment they are obligated by the UCC law to pay the factor all invoices issued by their client until they have been notified by the factor that the funding relationship has ended. Payment directly to their client instead of the factor does not remove their obligation under the UCC law to pay the factor. Most factors send the Notice of Assignment to a senior person in the general finance or accounts/payable organization of their client’s customer and they work with the A/P organization to set up correct remittance information.
When the entity providing the funding seeks security to assure repayment, it will complete a UCC-1 form and is referred to as the “Secured Party”. When this form is completed and registered with the state (or Washington DC), a lien is recorded which secures the collateral of the secured party. The collateral is whatever the secured party describes on the form and can include real estate, fixed assets, inventory, securities, accounts receivable, etc. This is authorized by the entity receiving the funds.
When the lien is filed, the information becomes public record. This provides information and protection for possible future lenders to be aware that the stated collateral is already “assigned” to a secured party. This prevents lenders from making decisions to loan against an asset that is already pledged.
In addition to providing access to capital for a small business, factors do a quality or verification of invoices to make sure that the product or service has been delivered acceptably. This is done very unobtrusively, typically verbal or online. The net result is a high level of customer satisfaction.
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