Is Factoring Going Out of Fashion II?

(an updated version of the previous article based on recent events)
Provided by Doug Hand 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?

Unfortunately, yes.

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. In mid-July, CIT received $3 billion of funding from certain of its bondholders allowing it to barely avert a bankruptcy filing. In early August, CIT invested $1 billion of such funding in its factoring business the “Factoring Business”). Currently, CIT is soliciting the approval by debt holders for a Prepackaged Plan of Reorganization (the “Plan”) under Chapter 11 of the U.S. Bankruptcy Code (the “Code”).

What might a bankruptcy mean to designers for whom CIT factors receivables?

The Plan does not include the Factoring Business in CIT’s bankruptcy proceedings. If the Plan is not approved, CIT has stated that it will liquidate its assets, including the Factoring Business, under Chapter 7 of the Code. In either event, analysts are predicting that the Factoring Business will remain intact, but may not have access to sufficient capital to meet its then-current funding obligations or to enter into new factoring arrangements.

Are other factors subject to risk?

Today it is 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 the Factoring Business, under the stewardship of a post-Plan CIT or a purchaser in liquidation, 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 fact, the Factoring Business has been quite profitable – in the estimation of financial analysts, it is CIT’s other businesses and the lack of available credit that is forcing CIT into bankruptcy.

In the end, the best case scenario for the industry is for CIT to (i) keep the Factoring Business outside of the Plan and continue to dedicate sufficient resources to it or (ii) sell the Factoring Business in liquidation to a more financially healthy institution. However, as this might not be what the future has in store for the Factoring Business, 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 or are seeking legal advice, contact Hand Baldachin & Amburgey LLP at 212.956.9500 or via email at info@hballp.com.

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