Navigating Financial Regulation - Understanding the Legal Framework for Factoring

Josef Bergt
2023

Introduction

Factoring, an increasingly vital financial service, encompasses the continuous purchase of receivables from deliveries or services of the factoring client (known as "associated customers" or "sellers") by the factor ("buyer"), according to a framework contract. The nature of this contractual relationship can be multifaceted, extending to complete delegation of accounts receivable management, including collections, dunning, and legal enforcement of claims. Factoring serves multiple functions, depending on the contractual setup:

• Financing Function: Purchase and crediting of receivables.
• Service Function: Management of debtor accounts.
• Delcredere Function: Assumption of default risks.

The framework contract may stipulate that the associated customer is obliged to offer all receivables to the factor for purchase, meeting specific criteria. The contract governs the conditions under which the factor can reject a purchase offer. The associated customer guarantees the veracity, or legal validity, of each sold receivable.

In "true factoring" (non-recourse factoring), the factor irrevocably purchases the customer's receivables, assuming the debtor's insolvency risk upon contract conclusion (delcredere function). The customer retains the paid value for the purchased receivables without the possibility of a chargeback. This arrangement allows the customer to satisfy their suppliers as if they had collected the receivables themselves. The customer is only liable for the veracity of the claim. True factoring adheres to the typical risk distribution of sales law, hence, legally considered a sales contract. As the counterparty risk is taken over, there is no financing business and true factoring therefore also does not constitute a lending business reserved for credit institutions.

The delcredere function distinguishes true factoring from loan agreements, thereby excluding it from the credit transaction definition. This applies even with limited service functions, such as when the debtor accounting, including collection and dunning processes, remains with the associated company (known as self-service or in-house factoring, in contrast to standard factoring).

In "recourse factoring", the factor reserves the right to recharge the receivable to the customer in case of the debtor's insolvency. Legally, the receivable is transferred to the factor only on a provisional basis, and such contracts are deemed loans rather than sales. Due to the financing function, they may constitute a lending business reserved for licensed banks.

Legal Definition of Factoring

The financial service "factoring" requires:

• The "purchase" of receivables;
• Continuously, based on framework contracts;
• Financing function.

Purchase of Receivables

• Factoring typically involves money claims. However, the legal definition does not restrict the type of receivable. Any monetarily valuable claim within the scope of framework contracts is viable. The claim can arise from legal transactions or other legal bases, like damages or unjust enrichment. The law remains deliberately open in this respect.
• "Purchase" refers to any contractual agreement, irrespective of whether it's governed by national law or a foreign legal statute, aimed at acquiring the claim. In true factoring, the seller (cedent/associated customer) is responsible only for the legal validity of the claim, not the debtor's creditworthiness; the buyer bears the default risk. In recourse factoring, where the buyer reserves the right to recourse for poor debtor creditworthiness, the contract is legally considered a loan. 

“Continuously, Based on Framework Contracts"

• Not every "purchase" of receivables constitutes factoring. There must be an ongoing business relationship between the buyer and seller, where the buyer (factor) repeatedly purchases receivables. A one-time purchase of a receivables portfolio only constitutes factoring if further such transactions are planned. This is usually presumed if the parties have contractually agreed to this.
• Moreover, these transactions must be based on a framework agreement, which need not necessarily be in writing. An implicit framework agreement with validity beyond the single receivables purchase is sufficient.

Financing Function

• The sale of receivables provides the associated customer, often a small or medium-sized enterprise with significant receivables on their balance sheet, with cash flow before the receivables' due date, avoiding the need for bank loans. 

Only in the non-recourse purchase of due receivables, legally a sales contract, is the financing function absent, justifying its exclusion from the proximity of banking transactions. 

Delineation Issues and Relationship with Credit Business

The "purchase" of receivables without assuming delcredere risk (recourse factoring) is typically a loan under civil law and thus primarily classified as a credit transaction under supervisory law which is reserved for regulated credit institution, i.e., banks. 

Banking services are considered commercially operated if intended for a certain duration and aimed at profit-making, regardless of whether the scope of these activities objectively requires a commercially organized business operation.

Source: BaFin Factsheet on Factoring

Executive Summary:

• Factoring Defined: Factoring involves the continuous purchase of receivables from a client (associated customer or seller) by a factor (buyer) under a framework contract. Factoring can serve multiple functions, including financing, service, and delcredere (default risk assumption).
• True Factoring (non-recourse-factoring) vs. Recourse Factoring: In true (non-recourse) factoring, the factor irrevocably purchases receivables and assumes the risk of debtor insolvency. In recourse factoring, the factor can recharge the receivable to the customer in case of debtor insolvency, and such contracts are typically treated as loans putting them in the proximity of lending business reserved for licensed credit institutions.
• Factoring and Legal Implications: Factoring, depending on its nature (true or recourse), has different legal implications affecting its classification under sales or loan agreements.
• Distinction from Credit Business: To differentiate factoring from credit transactions, the acquisition of receivables without assuming the delcredere risk is generally categorized under loan agreements and thus classified as a credit transaction.