Factoring Agreements: What are they and how can they benefit your business?

By Brett Furr and Cameron Murray

In nearly every business, revenue is realized through the issuance of invoices for goods or services provided. For many businesses, the delay between providing the goods or services, issuing an invoice and receiving payment can place a significant strain on cash flow. Businesses in sectors such as trucking, construction, manufacturing, and oilfield services often issue invoices with payment terms of 60, 90 or even 120 days. As a result, payment may not arrive until months after the underlying costs for providing the goods or services are incurred. During this interim, businesses remain liable for payroll, funding operations, or purchasing materials to keep projects moving forward. Factoring is designed to address this gap between invoicing and payment. Factoring agreements convert unpaid invoices into immediate working capital, allowing business to maintain liquidity while invoices remain outstanding.  

2. The Structure of a Factoring Relationship.

A factoring agreement is a financing arrangement typically involving three key parties: (1) the vendor, providing goods and/or services to a customer; (2) the factor, purchasing those invoices and advancing funds against them; and (3) the account debtors, the vendor’s customers that are obligated to pay the underlying invoice. Through the factor’s purchase of the invoices, it acquires the right to collect payment directly from the account debtor. See U.C.C. § 9-109(a)(3).

For vendors, factoring provides immediate liquidity without the delay associated with ordinary invoice collection. For the factor, its returns are generated through the payment of the invoice it purchased at a discount. For account debtors, improved vendor cash flow may reduce the risk of work stoppages, supply interruptions, or other operational disruptions.

Factoring transactions are structured as a true sale of receivables similar to asset-based line of credit, which is secured by a security interest in the vendor’s accounts receivable. The significant structural difference is that in an asset-based line of credit, the vendor retains ownership of the invoices/accounts receivable. The legal characterization is not determined simply by how the transaction is labeled in the agreement. Courts conduct a fact-intensive inquiry and evaluate the economic realities of the transaction. Relevant considerations include the allocation of risk of nonpayment, the presence and scope of recourse of repurchase obligations, and which party controls collection of the receivables. See In re Shoot The Moon, LLC, 635 B.R. 797, 813 (Bankr. D. Mont. 2021).

The characterization of a factoring transaction as a true sale of receivables or a secured financing arrangement becomes particularly important if the vendor files bankruptcy. If the transaction is treated as a true sale, the receivables are generally not considered property of the vendor’s bankruptcy estate under 11 U.S.C. §541(a)(1) and the automatic stay of 11 U.S.C. § 362 does not prevent the factor from collecting them. If a court recharacterizes the transaction as a secured financing arrangement, the receivables may be considered property of the vendor’s bankruptcy estate under 11 U.S.C. §541(a)(1), the factor holds only a secured claim under 11 U.S.C. § 506(a), and proceeds collected post-petition constitute cash collateral under 11 U.S.C. §363(a). In re Carolina Utilities Supply Co., Inc., 118 B.R. 412, 417 (Bankr. D.S.C.1990). Under Section 363(c)(2) of the Bankruptcy Code, a debtor-in-possession may not use cash collateral without either the secured party’s consent or court authorization. Under 11 U.S.C. §363(e), the debtor may be required to provide adequate protection to the secured party for use of cash collateral. See In re Braniff Airways, Inc., 783 F.2d 1283, 1286 (5th Cir. 1986). The recharacterization question therefore has immediate, concrete consequences. Factors in a recharacterized transaction must seek relief from the automatic stay under § 362(d) to collect accounts, and vendors must obtain court approval before using account proceeds as operating funds.

3. Managing Collection and Priority Risks.

Even when carefully structured, factoring arrangements can generate disputes that disrupt the intended payment structure. Common issues include:

• An account debtor paying the vendor instead of the factor;
• Competing creditors asserting priority based on earlier or defective UCC-1 financing statement filings;
• Improper or incomplete perfection of the factor’s security interest;
• A party filing bankruptcy;
• Invoice disputes;
• Claims that good or services were defective or incomplete; and
• Asserted setoff, recoupment, or other payment defenses.

Any of these issues can delay or prevent collection. These risks underscore the necessity of a properly drafted factoring agreement that establishes clear rights and procedures before disputes arise. Without those protections, routine payment issues can escalate into costly litigation.

Key documentation often includes a notice of assignment directed to the account debtor, which informs the account debtor that the receivable has been assigned and that payment may only be made directly to the factor. Under Article 9 of the Uniform Commercial Code, after receipt of proper notice of assignment, the account debtor generally may only discharge its obligation by paying the factor. See U.C.C. § 9-406(a). An agreement between the vendor and the account debtor may include a clause wherein the account debtor agrees not to raise certain claims or defenses against assignees of receivables. U.C.C. §9-403(a) allows the factor, as an assignee of the receivables, to enforce such a waiver of defenses and claims if it takes the assignment for value, in good faith, and without notice of any defenses or claims. If those requirements are met, the factor is generally entitled to collect receivables free of claims and defenses. An invoice acknowledgment, typically signed before an invoice is purchased, can provide an additional layer of protection by requiring the account debtor to confirm that the invoice is valid, due, payable, and not subject to known defenses, offsets, or disputes. Together, these tools help reduce the risk of nonpayment and support enforcement if disputes arise.

Factoring agreements may also include provisions that shift collection risk back to the vendor. These provisions may include recourse obligations requiring the vendor to repurchase uncollected invoices, personal guaranties, default provisions, acceleration clauses, indemnities, and remedies tied to misdirected payments or disputed receivables. These provisions should be drafted clearly to ensure enforceability and practical effectiveness.

4. Practical Considerations.

The success of a factoring arrangement depends on careful structuring at the outset. When disputes arise, prompt action is necessary to protect rights and limit financial loss. Our firm regularly advises factors and businesses in structuring, negotiating, and enforcing factoring arrangements. For more information, contact our banking and finance group at brett.furr@taylorporter.com and cameron.murray@taylorporter.com.