Article

By King-tak Fung

Both factoring and forfaiting are trade finance products. Both involve the transfer of rights to receive payment from the seller to the buyer by way of sale and purchase. ICC is in the process of producing a new set of rules, the Uniform Rules for Forfaiting. Factoring is also a popular receivable finance product.

Assignment - purchase or security?

Under English and Hong Kong laws, there are two common ways for a buyer to acquire the rights to receive payment:

(1) assignment by way of purchase and

(2) assignment by way of security.

By way of purchase

This takes the form of a true sale and purchase transaction between the assignor and the assignee. In effect, the assignee is purchasing the debt (e.g,. receivables under a sales contract or under an L/C) from the assignor. As a result, the receivables, after assignment, are no longer the property of the assignor, but the property of the assignee. This explains why no registration of the assignment is required.

By way of security

This takes the form of collateral for an advance. The assignee advances funds to the seller and takes the receivables as security backing the advances. Under this arrangement, the receivables remain the property of the seller, but are subject to the security interest of the assignee. It follows that a registration requirement will apply. The consequence of failing to register a registerable assignment will render the assignment void against the liquidator and creditors of the assignor.

These differences demonstrate that the legal classification of an assignment is of critical importance to the financier. Unfortunately, it is neither a straightforward nor an easy task to determine whether an assignment constitutes a true sale or a security.

What constitutes a "true sale"?

In a recent Hong Kong case, Hallmark Cards Incorporated v Yun Choy Ltd (in compulsory liquidation) & Another [2011] 5 HKC 453, the High Court tested the legal nature of a receivable purchase assignment and shed light on this complicated area of law.

The salient facts of this court case are as follows:

1. Before its liquidation, Yun Choy (a Hong Kong limited company) entered into a receivables purchase agreement ("RPA") with Standard Chartered Bank Hong Kong Limited (the "Bank") in which Yun Choy agreed to sell to the Bank all of its receivables of Hallmark Cards Incorporated ("Hallmark") for its sale of goods owing by Hallmark.

2. The net sum payable on the invoices for the goods sold was paid into court by Hallmark, as both the Bank and the liquidators alleged that it was the legitimate owners of the money. This was an interpleader1 application.

3. The Bank alleged that it had purchased the receivables based on the RPA, so it was entitled to such receivables.

4. The liquidators, however, contended that the ownership of the receivables had not been obtained by the Bank by virtue of the RPA based on the following two grounds:

First ground

Notwithstanding that the RPA expressed the transaction as a sale and purchase of the debts due from Yun Choy's customers, the liquidators argued that it was not an out-and-out sale of book debt. They said that it was, in substance, an assignment by way of security, creating a fixed charge for the book debts. In the absence of registration, the charge was claimed to be void against the liquidators. Some of the arguments put forward by the liquidators are summarized below:

i. The commercial purpose of selling book debts is to pass the title of the debts, as well as the risk of nonpayment, to the Bank. However, the RPA gave the Bank the sole discretion to reject and re-assign the debt. Therefore, the claim was that the risk of non-payment of a debt remained with Yun Choy, so the RPA was not a true sale;

ii. Yun Choy was obligated to repay the Bank if an approved debt became an unapproved debt, or when the debts exceeded the respective limits set outin the RPA;

iii. The discounting charge accrued on the amount of funds in use at the specified rate on a daily basis was, in fact, interest on an outstanding loan. The Bank could, on or after a termination event, require Yun Choy to purchase all the outstanding debts and the sum of the funds in use, which was essentially the repayment of the outstanding loan;

iv. The Bank had to account to Yun Choy for any surplus collected from the debtors and was entitled to recover any shortfall from Yun Choy;

v. There was no fixed price for the purchase of a debt, and the prepayment was merely a loan.

The liquidators submitted that all of these protections to the Bank refuted categorizing the transaction under the RPA as a true sale, and that the purported sale of receivables was only, in substance, a revolving credit facility granted by the Bank to Yun Choy and secured by a fixed charge over Yun Choy's book debts.

Second ground

The liquidators argued that the Bank had not provided consideration for some of the debts (involving nine invoices) which constituted the sum paid by Hallmark into court, namely:

i. Yun Choy notified the Bank of the six invoices but had not requested any prepayment. The request for prepayment of one notified invoice was rejected by the Bank, while for two other invoices Yun Choy did not even notify the Bank;

ii. The liquidators did not accept that the RPA was a deed; consequently, consideration was required for the purchase of debts;

iii. The RPA was not a whole turnover agreement, but a facultative agreement whereby the purchase by the Bank of any debt was at the Bank's option, and there could be no purchase if the Bank did not exercise the option.

The liquidators argued that since there was no prepayment for the nine invoices, there was no consideration for the purchase of these invoices and the Bank had not purchased them. Accordingly, the liquidators claimed to be entitled to the net sum receivable from these invoices.

General legal principles

It is well established that a court must look at the provisions of an agreement as a whole to decide whether, in substance, it amounts to an agreement for the sale of receivables or only a mortgage or charge over the receivables and their proceeds. Only by thoroughly reviewing the entire language of the agreement can the substance of a transaction be ascertained.

The legal classification of a transaction is not what the transaction is, but whether it is what it purports to be. Unless the documents taken as a whole compel a different conclusion, the transaction which they embody should be categorized in conformity with the intention the parties have expressed in the documents.

(Writer's note: this demonstrates the importance of good drafting skills in a document; the provisions must clearly and accurately reflect the actual operations of the financier.)

Decision of the court

One can start from the position that statute law in general refers to the legal nature of a transaction and not to its economic effects.

The court decided that the terms of the RPA stated clearly that the arrangement was a sale. The liquidators' contentions were all concerned with the economic effects of the RPA; however, all indications were that the arrangement was, in fact, a revolving loan secured by a fixed charge on book debts (as alleged by the liquidators), which is permissible in a sale of debts arrangement.

Courts have treated that right of recourse, discounting based on current interest rates, as allowing the assignor to collect the proceeds of the debts "sold" and to keep any surplus money, etc. as being entirely consistent with the sale of receivables. Courts have consistently looked to the legal rather than the economic substance of the transaction and have upheld freedom of contract. The judge therefore held that the RPA was a sale transaction and not a charge.

The judge also agreed with the Bank's reply that no separate consideration needed to be provided for each of the debts. The RPA was a deed (for which no consideration was required). Further, the RPA was a whole turnover agreement to the effect the beneficial interest in the future debts vested in the Bank as and when the debts came into existence.

Consequently, the court ordered the payment to the Bank of the sum plus interest paid in by Hallmark. The liquidators were also liable to pay for the legal costs incurred by Hallmark and the Bank in the interpleader proceedings.

Implications

This case demonstrates and explains why a properly drafted receivable purchase agreement or forfaiting document must fully reflect the parties' intentions. Since the legal classification depends on the interpretation of the language used in the agreement, it is advisable to avoid using ambiguous terms. In order to demonstrate that there has been a true sale, wording such as "prepayment" instead of "loan", "discount price" instead of "interest" and "repurchase" instead of "repayment" is preferred in order to minimize the possibility that any unnecessary disputes or arguments will arise. Poor drafting, as in a provision that allows the assignor to redeem the assigned debts upon full repayment (i.e., a right of redemption) will probably render the agreement a fixed charge instead of a true sale.

King-tak FUNG is a Banking Partner of Eversheds Hong Kong, a member of the ICC Consulting Groups on the UCP 500 revision and Forfaiting and author of Leading Court Cases on Letters of Credit (www.iccbooks.com) and UCP 600 - Legal Analysis and Case Studies (www.peer.com.hk). His e-mail is ktfung@eversheds.com

1 A procedure used to decide how conflicting claims against the same person should be dealt with.