Provided for CFDA “From the Experts”
What is a Factoring Agreement?
Many designers enter into factoring agreements with financial institutions (which we will refer to in this Q and A as “factors”). In simple terms, a typical factoring agreement allows a designer to sell its accounts receivable to a factor that collects such receivables and remits them (minus a discount that the factor keeps) to the designer. Factors that regularly serve the fashion industry are usually quite able to make these collections, as such factors have an experienced network set up to deal with collecting from retailers both on your behalf and on behalf of other designers.
A factor also assumes the credit risk with respect to receivables that have been granted prior credit approval. Factors are able to do this because they have the ability to perform the sophisticated financial analysis necessary to determine the creditworthiness of the retailers you sell to.
Factors may also provide an advance on factored receivables. Such an advance provides many designers with the working capital necessary to pay for the manufacture of goods well in advance of the payment by its customers for such goods.
So far, so good. Is there any downside?
First, everything comes at a price. The assumption of credit risk and the advance of receivables both take a bite out of the amount invoiced to your retailers in the form of a percentage fee.
Second, payments to you by the factor for collected receivables or as an advance on outstanding receivables are subject to the factor’s ability to make good on such obligations. The risk of the creditworthiness of a factor has historically been viewed as quite remote, but recent events involving CIT Group have certainly heightened the awareness of such risk.
What is happening with CIT?
CIT is the preeminent factor within the fashion industry. CIT received $3 billion of funding from certain of its bondholders allowing it to barely avert a bankruptcy filing in mid-July. Many analysts covering CIT believe that this financing will only serve to postpone a bankruptcy for weeks or a few months. In early August, CIT invested $1 billion of such funding in its factoring business. This would seem to indicate that CIT either expects such business to survive a restructuring intact or to be sold intact in event of liquidation.
What happens in bankruptcy?
In bankruptcy, a trustee is appointed to liquidate (in a typical Chapter 7 filing) or maintain and restructure the assets (in a typical Chapter 11 filing) of the bankrupt company for the benefit of that company’s creditors, both secured and unsecured. Once the company files for bankruptcy, it is protected under federal law from the claims of its creditors (this period of protection is known as the “automatic stay”).
What might a bankruptcy mean to designers for whom CIT factors receivables?
First, advances against future receivables might become unavailable as CIT determines its ability and willingness to advance cash. Since the automatic stay would be in effect, the designer would likely not be able to enforce their contractual rights to receive this advance.
Second, as designers are typically – under the terms of most factoring agreements –unsecured creditors of CIT, and secured creditors likely have a security interest in the cash accounts of CIT into which collected receivables are deposited, it is possible that such collected receivables will never be paid to the designer on behalf of which such receivables were factored.
Third, and perhaps worst of all, until the designer is entitled to terminate its factoring agreement with CIT (which termination is often only permitted during a short window that appears once a year), CIT will likely own all receivables generated by invoices issued even after it enters bankruptcy.
Are other factors subject to risk?
Recently it has been CIT, but it is certainly possible that the future may find other factors – particularly those affiliated with troubled financial institutions – faced with potential bankruptcy. In addition, certain factors (if so permitted by the factoring agreement with the designer), “re-factor” through CIT. So you may find that your factoring arrangement still exposes you to CIT risk, even though CIT is not a direct party to it.
What does the future hold and what should we do?
The fashion industry will likely continue to need factors as much as it needs sewing machines. They provide an essential service, especially for small and midsized designers. If CIT were to fail and not honor its obligations under its factoring agreements, the fallout could be devastating. But we would not expect such a failure to mean the end of the availability of factors, as factoring is often a valuable and profitable business.
In the end, the best case scenario for the industry is for CIT to pull out of their financial situation unscathed by avoiding bankruptcy and restructuring their business outside of court or for CIT to successfully sell their entire factoring business to a more financially healthy institution. However, as this might not be what the future has in store for CIT and the industry, designers factoring their receivables with CIT must not only monitor their exposure to CIT, but must also seriously evaluate available means to mitigate the risk of exposure to CIT.
As the factoring agreement governing a designer’s receivables, as well as the myriad of ancillary facts and circumstances surrounding that relationship, are different in each case, it is important for designers to consult with an attorney in order to evaluate all applicable risk mitigation strategies. Alternative arrangements to be considered include moving to a deferred purchase agreement with your existing factor or exploring the possibility or obtaining an insurance product for your receivables.
If you have any further questions, contact Hand Baldachin & Amburgey LLP at 212.956.9500 or via email at firstname.lastname@example.org.
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