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Copyright © International Chamber of Commerce (ICC). All rights reserved. ( Source of the document: ICC Digital Library )
by Guillermo C. Jimenez
Exporters who grant open account terms (or accept deferred payment) may find that potential working capital is sitting in accounts receivable (invoices awaiting payment): this is the classic “cash flow” predicament. However, when exporters’ customers are creditworthy, intermediaries known as “factors” are willing to provide advance financing against the exporters’ receivables.
Factoring companies not only advance funds against receivables, they also offer a range of payment, credit, accounting and collection services.
“Forfaiting” has a number of similarities to factoring, but there are also important differences, e.g. as to the degree of recourse to the exporter and the number of receivables that can be forfaited in a single transaction.
With forfaiting an exporter obtains immediate payment by discounting an importer’s payment obligation (usually a bill of exchange or promissory note). In essence, the exporter “discounts” or sells the bill of exchange or promissory note to the forfaiter.
Forfaiting usually involves a single transaction, whereas factoring arrangements are usually ongoing and tend to cover a stream of receivables.
In today’s competitive global markets, exporters are often forced to grant open account terms. With open account, payment is received long after delivery (e.g. 30, 60, 90 or even 180-day terms). Improved credit reporting and financial information have driven the continued expansion of open account trading at the international level.
The prevalence of open account arrangements can create severe cash-flow problems for exporters. Worse, it can be costly to pursue buyers who pay late or go bankrupt.
One option is for the exporter to rely on overdrafts or credit lines from its bank. However, this is relatively expensive and can tie up credit lines that the exporter would like to use for other purposes. An alternative — set forth in this chapter — is to raise financing on the strength of the exporter’s “receivables”, i.e. the invoices the buyer has agreed to pay, or the bills of exchange the buyer has accepted.
With “factoring” the exporter sells its accounts receivable (invoices) to a third party (called a factor) at a discount. Commonly, the factor provides financing in the form of a cash advance, often 70-85% of the purchase price of the accounts. The remaining balance of the purchase price is paid (net of the factor’s charges) upon collection.
International factors not only advance funds against receivables, they also offer a range of ledger management and collection services. An exporter can outsource most of its international payments and collections operations to an international factor.
Forfaiting also involves applying a discount to receivables, but transactions tend to relate to a single, larger, receivable, while factoring applies to all (or a portion) of the exporter’s invoices. With forfaiting, the exporter sells, for example, a bill of exchange or promissory note to the forfaiter at a discount. Because the risk of non–payment is low[Page152:]with these types of negotiable instruments, the percentage advanced (before finance costs) is usually 100%. Payment will be made directly to the forfaiter, and as a result it is not necessary to provide ledger management or collection services.
Factoring is now widely recognized as vital to the financial needs of small- and medium-sized exporters, who will often have large volumes of small value receivables. Forfaiting, on the other hand, is generally reserved for larger contracts (US$ 50,000- 100,000 and above). Because of the large number of individual invoices involved in a typical factoring relationship, factoring companies offer a range of financing and risk management services to exporters, which would not be necessary in a forfaiting transaction.
At its simplest, factoring is the purchase of an exporter’s receivables by a factor. In addition to the purchase of receivables, factors may also offer credit risk assessment and protection, collection of overdue accounts and administration of accounting ledgers. UNIDROIT (International Institute for the Unification of Private Trade Law) has stated that any arrangement that contains at least two of the above services can be considered international factoring.
Factoring and related ancillary services are also known as “invoice financing”, “invoice discounting”, “receivables discounting” or “sales financing”.
Since factoring allows exporters to grant open account terms without fear of overseas collection problems, many international traders are switching to factoring as a means of moving away from letter of credit or documentary collection terms. Some exporters resort to factors when other means of short–term trade finance are perceived as inappropriate. Thus, an exporter may be faced with cash–flow problems but find that the services offered by banks are too expensive or are based only on negotiable instruments (i.e. bills of exchange), which do not cover a large part of that exporter’s accounts receivable.
Some factors’ services include overall management of the export accounting process. Thus, just as small exporters can subcontract most of their transport management to freight forwarders, they can also turn over the management of foreign credit and payment operations to factors.
Sometimes, the exporter will not wish importers to know that it is making use of a factor’s services and will require “undisclosed” or “silent” factoring, i.e. factoring that is not revealed to the customer. Such exporters may be concerned that customers might make negative assumptions about the financial status of a company that needs to rely on factoring. One form of undisclosed factoring is “invoice discounting”: the factor provides financing against the exporter’s invoices, but does not provide credit management or accountancy services.
World growth in international factoring services has been very strong in recent years, reaching a total value of EUR 246 billion in 2010, representing a year–on–year increase of 48% (Factors Chain International). Over the past decade, compounded annual growth exceeded 15%.
These figures illustrate that exporters and importers worldwide are becoming more familiar with factoring. While the practice has been historically strong in specific market sectors such as garments and fabrics, it has now spread to many other manufacturing and service sectors. Among the key reasons for growth are:
> Greater familiarization in individual markets with the flexible and service-oriented nature of factoring, leading to a healthy increase in demand;
> Introduction of factoring to countries where the practice was previously unknown or rare, e.g. Peru, Colombia, Egypt, the former Yugoslav republics, Ukraine, the United Arab Emirates and Vietnam.
[Page153:]
> Basic procedure
The exporter sells goods to a foreign buyer on open account terms (e.g. “net 90”). In order to raise working capital and eliminate credit risk, the exporter assigns its invoices (receivables) to a factoring organisation. Immediately upon shipment, the factor advances a percentage of the invoice amount, normally up to 70-85% to the exporter, and collects the sums due from the importer on the agreed payment dates. Exporters may choose to purchase different factoring services (finance, collection and credit cover). As a general rule, exporters get the best deal when they agree to assign the whole or a specified part of their receivables flow to the factor.
Commonly, the exporter signs a factoring contract assigning all agreed future receivables to the export factor. The factor then becomes responsible for all aspects of the payment operation. It can acquire receivables on either recourse or non–recourse terms.
Recourse factoring has traditionally been more common. With recourse factoring the factor has recourse to the exporter if the buyer fails to pay. With non-recourse factoring the factor buying the credit receivables makes the credit evaluation in advance and assumes all credit risk of non–payment. The distinction between recourse and non-recourse finance can be extremely important to the exporter. With nonrecourse finance, the exporter does not have to worry that it will have to reimburse an advance from the factor (e.g. in the event of the bankruptcy of a major client). Recourse finance, in contrast, puts all the credit risk back on the exporter, so exporters should understand the risk associated with recourse factoring. Recourse factoring offers advantages that are associated with the lower risk profile for the factor — coverage is easier to obtain and at a lower fee.
Typically, the factor charges the exporter a fee, usually a percentage of the face value of the receivables, for its credit cover and collection services. It also charges interest on the amounts advanced to the seller. Factoring firms usually require the opening of a factoring account. It normally takes five to seven business days to open the account and begin factoring. Once the account is open, the exporter may begin to receive funding for receivables within 24 hours. Credit must be established for the customers whose invoices will be factored, and a limit is established for each customer. Internally, factors also evaluate the creditworthiness of the buyers and fix limits on them up to which such invoices can be factored. This can be done directly or through their correspondent factor, also known as import factor, in the country of the buyer.
The exporter completes the business transaction as usual and generates an invoice for products or services. The exporter sends copies of invoices to the factor. Usually, the original invoices are sent directly to the importer, while the factoring company may ask for additional proof of product/service delivery, e.g. a copy of the transport document.
Sometimes the factoring company will wish to verify that the products were received and/or services rendered by requiring evidence of the delivery of the merchandise (as by a “delivery note”). Upon satisfying itself as to the documentation, the factoring company remits the factored sum to the account of the exporter by wire or by crediting the exporter’s account.
It is typical for the exporter to receive an immediate advance payment, usually between 70% and 85% of the original invoice amount. This eases cash–flow problems. When payment is received in full from the exporter’s customer, the exporter receives the remaining percentage from the factor (wired to its account). The factor’s fees are normally billed separately per month, but in appropriate circumstances can also be charged “up front”.
> Fee structure and funding
The exporter normally pays:
> a service charge of approximately 1% of the invoice amount (this covers the credit risk protection, the collection service, the reporting, etc.);[Page154:]
> if the exporter wants to draw funds as advances against the assigned receivables, he normally pays an interest charge calculated on funds in use per day, similar to what he would pay a bank for overdraft advances.
> Single factor and two-factor schemes
Factoring arrangements can be divided into two–factor and single factor schemes. Under a two-factor system, the exporter enters into a contract with a factor in the exporter’s country, called the export factor. The export factor, in turn, will establish an agreement with a correspondent factor in the importer’s country, called the import factor. The two factors may belong to the same company, or may simply establish a contractual relationship. Once the agreement is in place, the receivables are then reassigned to the import factor. At the same time, the import factor investigates the credit standing of the buyer of the exporter’s goods and establishes lines of credit.
When the goods have been shipped, the export factor advances up to 85% of the invoice value to the exporter. The import factor collects the full invoice value at maturity and is responsible for the swift transmission of funds to the export factor, which then pays the exporter the outstanding balance. If an approved invoice remains unpaid, the import factor will pay 100% of the invoice value under guarantee and follow up with the importer for recovery. By ensuring risk-free export sales, factoring allows exporters to offer more attractive terms to overseas customers. Both the exporter and the importer benefit by spending less time and money on administration and documentation.
Frequently, international trade requires the use of a two-factor system. When the exporter has delivered the goods or otherwise performed under the contract, the import factor issues an invoice to the importer with a copy to the export factor. Working together, the two factors take over the remaining financial and administrative responsibilities. The import factor will follow up on any overdue accounts and even resort to legal action if necessary. The import factor’s knowledge of the importer’s local language and customs can make the factor very effective in pursuing defaulting buyers.
Factors having a well-established network of branches can handle their clients’ business without involving factors in the buyer’s country. Single factor or “direct export” factoring is also well recognized in international trade and is particularly common in the European Union, where national boundaries are diminishing in importance. Moreover, with well-written factoring contracts, which are easily enforceable in such jurisdictions, and with adequate factoring documentation available, it is easier for single factors to initiate legal proceedings, if required. In cases where there are long or well-established relationships between the exporter and importer, an import factor’s expertise in credit checking or collections may not be perceived as necessary. Single factor systems tend to be cheaper, but they may also be exposed to additional risks.
> Multi-factor schemes and credit insurers
When the exporter is considering making use of the factor’s credit protection services, the question arises as to the distinction between factoring and credit insurance. Factors and credit insurers provide different benefits depending on the characteristics of the exporter and the transactions concerned. The factor will often provide a higher level of credit protection (e.g. 100% as opposed to 90%), but will be slower and more exhaustive in conducting its credit evaluation of the prospective customer. The factor’s fees are correspondingly higher than those of the credit insurer. In general, new exporters may prefer to rely on factors, because of the additional level of service; experienced exporters with a good understanding of the risks inherent in particular transactions may prefer the lower cost of credit insurance premiums.[Page155:]
Factoring is useful when importers are not prepared to pay in advance or accept payment through a letter of credit. In such situations, the exporter has no choice but to forego the sale or offer open account terms, which are risky and may constrain cash flow. Factoring helps mitigate the risks and also supplies needed working capital.
Factors can provide other important export services to local SMEs. For example, an obstacle for firms in emerging markets wishing to sell into export markets is overseas customers’ reluctance to use letters of credit. Firms in developed countries often refuse to pay on receipt to firms in emerging markets, since they prefer to have time to confirm the quality of the goods. They also know that it could be very difficult to receive a refund on returned or damaged goods from firms in countries with slow judicial systems. Factors provide both sides with the security and convenience they need to enter into the deal.
As a financial service, factoring is often highly regulated. In France, for example, all factors must obtain a licence from the Banque de France and are required to provide the bank with specific and regular reports. In Germany, the law does not permit a typical whole-turnover agreement, which allows the sale of present and future invoicing. Therefore, a factor needs to have two transactions per client: the first to purchase the existing outstanding invoicing, and the second consisting of a new legal transaction for each future invoice to prove that it actually purchased this specific invoice from its client. In India, a stamp duty has acted to constrain the development of factoring.
> Forfaiting is a “medium term” solution
Forfaiting is similar to factoring in that it provides exporters with a source of trade finance. It allows exporters to provide short- to medium-term credit to importers, and then to obtain immediate payment from a bank to which the exporter transfers the debt asset on a discounted non-recourse basis. Forfaiting has been defined as “a form of export trade finance involving the discount of trade–related debt obligations due to mature at a future date without recourse to the exporter/endorser”.
Forfaiting is typically medium-term finance (one to five years) concluded at a fixed or floating interest rate. Traditionally, forfaiting has been used most often to finance exports such as capital goods. More recently, there has been some diversification into other uses, such as providing working capital for trade-related business.
> Forfaiting compared to factoring
There are several important distinctions between factoring and forfaiting. First, while factoring deals primarily with low-value, short-term accounts receivable (e.g. usually less than a US$ 100,000 invoice on 60- to 90-day payment terms), forfaiting tends to involve higher value and medium- and long-term obligations (e.g. more than US$ 100,000, up to and above 180–day payment terms). Thus, while factoring contracts tend to involve coverage of a stream of invoices, forfaiting generally involves a single, independent transaction. Forfaiters will, however, often enter into uncommitted master agreements under which they will be prepared to consider the purchase of receivables satisfying certain characteristics set out in the agreement.
Since forfaiting involves purchasing the entire risk in an individual transaction, there is no need to offer the credit protection and accounting services available with factoring, as the forfaiter will replace the customer as the creditor of the underlying obligor and thereby assume all of these risks and duties for its own account. Finance terms and costs are different as well. In forfaiting, payment is usually made on the full value of the invoice price minus the charge for discounting the bill of exchange. In comparison, although there is no discounting under factoring, the exporter will only receive a partial advance payment (e.g. 80%) prior to settlement by the customer, and will pay interest on the advanced sum.[Page156:]
Legally, forfaiting is the purchase by the forfaiter of an exporter’s receivables, often but not always, negotiable instruments such as bills of exchange. Since there will be a ready and liquid market for these bills if they are “avalized” or guaranteed by a bank, such as the importer’s bank, forfaiting will be easier when supported by an aval or bank guarantee, although direct and unsupported corporate exposure can also be considered in the right circumstances. In addition, forfaiters will be prepared to discount obligations arising under letters of credit, typically where bills have been drawn under acceptance letters of credit or where a deferred payment undertaking has been incurred by the issuing bank or confirming bank. The nature of the forfaiting industry is such, however, that numerous structures and obligations can be considered, provided only that they make financial and legal sense.
> Key features of forfaiting
In summary, the main characteristics are:
To take one example, an importer accepts bills of exchange (drafts) or signs promissory notes which are guaranteed or “avalized” by a bank in the importer’s country.
The exporter then endorses the drafts or notes and hands them over to the forfaiting bank, which negotiates (i.e. pays) them without recourse to the exporter. If the documents are drawn under a letter of credit, the issuing bank or the confirming bank accepts the documents or incurs a deferred payment undertaking to mature for payment on a certain due date. The forfaiting bank then discounts the acceptance or the deferred payment undertaking. The discounted payment to the exporter is on a “without recourse” basis, meaning that the forfaiter (or any subsequent holder) takes the payment risk at maturity, and the seller-beneficiary is under no obligation to refund the amount received by it in case payment is not made by the obligor.
Forfaiters often distinguish between Supplier Credit structures and Buyer Credit structures. In the first, funds are advanced directly to the exporter who will, for example, draw a bill of exchange on the buyer which will then be accepted by it and, if required, avalized by the buyer’s bank. In the second, the buyer will typically issue a promissory note and receive funds directly, or the buyer’s bank may re-finance a sight letter of credit by issuing a promissory note itself. The differences between the two structures relate, not just to the nature of the instruments, but also to the commercial characteristics of what can be expected from the forfaiter’s counterparty. For example, in a Buyer Credit structure it may be harder to obtain shipping documents, and there may be concerns that the funds advanced will not be used to pay for the goods being imported.
Both cases, however, are viable and can give rise to varied structures.
In a typical forfaiting transaction, the sequence is as follows:
The exporter approaches a forfaiter, which confirms that it is willing to quote on a prospective deal, covering the export in x months’ time, bearing the aval of ABC Bank or its acceptance or deferred payment undertaking under a letter of credit.[Page157:]
If the transaction is worth US$ one million, the forfaiter will calculate the amount of the bills/notes, so that after discounting the exporter will receive US$ one million and will quote a discount rate of “n”%. It will also charge for “x” days grace and a fee for committing itself to the deal, worth “y” % per annum, computed only on the actual number of days between commitment and discounting.
The forfaiter will stipulate an expiry or “availability” date for its commitment (that is, when the paper should be in its hands).This period will allow the exporter to ship its goods and get its bills/notes avalized and to present them for discounting.
The exporter gets immediate cash on presentation of relevant documents, and the importer is then liable for the cost of the contract and receives credit for “z” years at “n”% interest.
> Documents required in forfaiting
Specific documents are required by the forfaiter from the exporter, usually at a minimum:
> Forfaiting fee structure
The principal fee charged by forfaiters is the discount fee, which can vary between 0.25% p.a. to 4% p.a. depending on country risk on top of finance costs (i.e. fixed rate or floating rate to be fixed before discounting). Sometimes a forfaiting agreement includes a commitment fee if there is a long run-in to the export, and the exporter wishes to reserve a line of credit and a cancellation fee (or “break up” fee), depending on the size of the deal.
The fee is made up of:
> A charge for the money received by the seller, which covers the forfaiter’s interest rate risk. This procedure is to cover the forfaiter’s refinancing costs and is invariably based on the cost of funds in the Euromarket. Forfaiters calculate this charge on the LIBOR (London Interbank Offer Rate) rate applicable to the average life of the transaction.
> A charge for covering the political, commercial and transfer risks attached to the importer/avalizing bank/guarantor. This is referred to as the margin, and it varies from country to country, and guarantor to guarantor.
> Additional costs (that are also included in the forfaiter’s calculations) include a “days of grace” charge and, when necessary, a commitment fee. Days of grace are an additional number of days’ interest charged by the forfaiter, which reflect the number of days’ delay normally experienced with payments made from the debtor country. These range from none to, say, ten days in some countries.[Page158:]
Many exporters prefer to work with forfaiting brokers that can assure the exporter of competitive rates. Such brokers typically charge a nominal 0.25% to 1% fee to arrange the commitment. This is a one-time fee on the principal amount and frequently is added to the selling price by the exporter.
13.3.3 Key advantages of forfaiting
One key benefit for the exporter is that the forfaiter purchases the bills on a non– recourse basis. Thus, even if the importer or his bank defaults on payment of the bill, the forfaiter cannot recover the payment from the exporter. The forfaiter, therefore, assumes both commercial and political risk. Should war break out or should the importer’s government suddenly impose exchange controls, the forfaiter may not be able to recover payment from the importer or the importer’s bank. The forfaiter assumes such risks, as well as any interest and currency rate risks.
Another advantage is that the exporter is quoted a fixed rate for payment against the bill. The discount rate will depend on a variety of elements, including the date of maturity and other risk factors. However, the size of the discount may make the forfaiting option appear relatively expensive (the exporter should remember how much risk is being assumed by the forfaiter). In any event, the cost calculations related to a forfaiting deal can be quite complex, and exporters considering forfaiting should seek expert advice.
A potential disadvantage of forfaiting is that strict documentary requirements must be adhered to, which requires the importer’s participation in obtaining the necessary bank guarantee or aval. In some cases, the importer may be reluctant, for example, to instruct its bank to grant an aval which will count against the importer’s credit lines, or to pay a fee for obtaining the aval. But it should be noted that an aval is not always a requirement.
In 2009, ICC and the International Forfaiting Association (IFA) created a joint drafting group to prepare new global forfaiting rules under the auspices the ICC Banking Commission. The group was created following a request to review existing IFA guidelines for the Forfaiting Primary Market. These rules are now published (publication 800). I think this sentence should be reworded with something like: “In effect since 1 January 2013, the ICC Uniform Rules for Forfaiting (URF 800) provide a standard set of rules that reflect a broad consensus among bankers, users and all members of the forfaiting community worldwide. The use of global rules and standards helps avoid misunderstandings, harmonizes best practice around the globe and facilitates dispute settlement. Clear definitions and practical model agreements, also included in this edition, will help further understand and efficiently apply the present rules.
IFA is the worldwide trade association for commercial companies, financial institutions and intermediaries engaged in forfaiting. Founded in 1999 and with more than 120 members, IFA aims to foster business relationships and enable best practice among those engaged in the global forfaiting community. IFA’s Market Practice Committee has prepared guidelines and advised on a code of conduct for the international forfaiting market.
The ICC Banking Commission is the leading global rule–making body for the commercial banking industry, as well as a worldwide forum of trade finance experts whose common aim is to facilitate international trade finance across the globe. The Banking Commission is known for producing universally accepted rules and guidelines for documentary credits, documentary collections, bank-to-bank reimbursements and bank guarantees. It is expected that the URF will bring greater standardization and recognition to the rapidly-expanding global forfaiting market.
Neither factoring nor forfaiting is exempt from the risk of fraud and money laundering. As such, the various anti-money laundering (AML) standards apply.[Page159:]
The Financial Action Task Force (FATF) is an intergovernmental body whose purpose is the development and promotion of national and international policies to combat money laundering and terrorist financing. The FATF has produced policy documents known as the “40 Recommendations” on money laundering and the “9 Special Recommendations on Terrorist Financing”. These guidelines set forth an enhanced, comprehensive and consistent framework of measures for combating money laundering and terrorist financing. Forfaiting is covered under the FATF recommendations, as are most categories of designated businesses and forms of lending by financial institutions involving the transfer of funds.
It is important to distinguish between the primary and secondary markets when dealing with the risk of money laundering. In the primary forfaiting market, the forfaiter will usually be dealing directly with an exporter (usually its customer). The exporter should undergo due diligence review in accordance with the existing rules and requirements of the forfaiting company. As part of its risk-based approach, the forfaiting firm should also scrutinize the other party to the underlying commercial transaction, as well as the transaction itself, to satisfy itself of the validity of the transaction. The extent of the scrutiny will depend on the firm’s risk assessment of the client and transaction.
In the secondary forfaiting market, the firm’s customer will be the person from whom it buys the debt instrument. However, if it holds the instrument to maturity, it will receive funds from the guarantor bank, and thus it should perform due diligence here as well. Using a risk-based approach, forfaiting firms should also consider conducting due diligence on the underlying parties to the transaction, as well as on the transaction itself. This will depend on a risk assessment of the countries and types of clients or products involved. As a general rule, the further away from the original transaction is the purchaser of a forfaiting asset, the harder it will be to undertake meaningful due diligence.
Test Your Knowledge: Factoring and Forfaiting
True/False
Answers: 1. T 2. F 3. T 4. T 5. F