Factoring: A better alternative to L/C

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Factoring: A better alternative to L/C
« on: August 31, 2014, 11:10:50 PM »
Posted : 23 Aug, 2014 , Saturday

Factoring: A better alternative to L/C

M S Siddiqui

Payment for international trade is an issue that usually poses difficulties to businesspersons and other stakeholders. In international trade, both the buyer and the seller are concerned with the completion of the deal. The buyer wants to be sure that he receives the goods of the quantity and quality as agreed. On the other hand, the seller is eager to receive payments on time once he has sent the goods. In order to meet these demands, various methods of payment have been developed.

There are basically four methods of making payment in international transactions. These are: i) cash in advance, ii) open account, iii) documentary collection and iv) documentary credit.

Under the cash in advance payment terms, the exporter receives payment before the ownership of goods is transferred. An open account transaction is a sale where the goods are shipped and delivered before payment is due, as per agreement for payment after a certain period of time, which is usually 30 to 90 days. A documentary collection on account of letters of credit (LC) is a transaction whereby the exporter receives the payment after sending all shipping documents (Invoice, Packing List, etc.) through his bank to the importer's bank. A documentary credit is a commitment by a bank to a bank of the seller on behalf of the buyer that payment will be made to the exporter provided that the terms and conditions stated in the L.C. have been met, through the presentation of all required documents. In addition to these, another option, Factoring, is being used by the businesses of different parts of the world for settlement of trade transactions.

L/C is useful when reliable credit information about a foreign buyer is difficult to obtain, but the exporter is satisfied with the creditworthiness of the buyer's foreign bank.  L/C is a commitment by a bank on behalf of the buyer that payment will be made to the exporter's bank provided that the terms and conditions stated in the L/C have been met. In Bangladesh, about 90 per cent (both in terms of the number of cases and amount) import payments from the country is made through L/C and 75 per cent (in volume) of export payments are obtained through L/C and the other methods such as documentary collection which accounts for about 32.50 per cent and advance payments for an insignificant 0.5 per cent. The other two methods -- cash in advance and documentary collection -- are less used methods for international trade payments.

L/C is a contractual agreement between the importer's and exporter's bank, whereby acting on behalf of their customers banks make payment to the exporters against receipt of stipulated documents. L/C is a separate contract from the sales contract on which it is based; therefore, the bank is not concerned whether each party fulfils the terms of the sales contract. The bank's obligation to pay is solely conditioned upon the seller's compliance with the terms and conditions of the L/C. In L/C transactions, banks deal with documents only, not goods. Due to the condition of security and margin requirements, the importers face serious time constraints and other problems for opening an L/C.

The importer may face the risk of non-delivery, short shipment, late shipment and failure of banks during the period of settlement, although some of the risks can be minimised by having a well-formulated international sales and purchase contract. The importer's bank may also face the insolvency of the importer.

The conference of International Institute for Unification of Private Laws (UNIDROIT) on Factoring held in May 1988 defines that Factoring is an arrangement between a Factor and his client which includes at least two of the services as: (a) finance, (b) maintenance of accounts, (c) collection of debts and (d) protection against credit risks. Usually, the Factor pays the client about 80 per cent of the value of the receivable and the remaining amount is paid by collecting from the debtor after the deduction of charges.

There are different institutions currently at work to support and strengthen the mechanism. Among these, the prominent ones are the International Factors Group (IFG) and the Factors Chain International (FCI). These are associations of Factoring organisations or Factors from all over the world. IFG was founded in 1963 as the first international association of Factoring companies. The original mission of IFG was to help Factoring companies to conduct cross-border business acting as correspondents for each other.

Factoring can be classified as Domestic Factoring and International Factoring. Domestic factoring can be: (1) Bulk factoring, (b) Maturity factoring, (c) Agency Factoring, (d) Invoice discounting and (e) Undisclosed factoring. It can be again of two types such as: (a) Factoring without recourse and (b) Factoring with recourse.

The International Institute for the Unification of Private Law (UNIDROIT) convention defines international Factoring as "an agreement between an exporter and factor whereby the factor purchases the trade debt from the exporter and provides the services such as finance, maintenance of sales ledger, collection of debts, and protection against credit risks". There are various forms of international factoring. It basically depends on the exporters' needs and cost bearing capacity, and security to the Factors. These are: "Two factor system", "Direct export Factoring", "Direct Import Factoring" and "Back to Back Factoring". Among these types, the Two Factor System gives some added benefits.

The Two Factor System requires completing the payment settlement under the two Factor system where the Factors are situated in different countries. The Factors communicate with each other through IFG and FCI for credit checking and assignment of invoices which facilitates fund transfer.

The system involves four agreements, one between the exporter and the importer, one between the export Factor (Bank) and the exporter and one between importer and his Factor (Bank), one between the Factors themselves. It is important to bear in mind that the import Factor's obligations are to the export Factor alone and they include determining the importer's credit rating and the actual collection of the debts. The import Factor assumes the credit risk in relation to approved debts and is responsible for the transfer of funds to the export Factor. On the other hand, the export Factor is responsible to the import Factor for the acceptance of any recourse.

Factoring supports the exporter to predict the cash flow with its flexible form of finance and guaranteed payment on time. The export Factors immediately finance up to a certain percentage of the eligible export receivables. The export Factor checks information about the debtors in the importing country from its own database and if the information is absent in the database, the Factor collects information about the Factor with the help of the counterparts in the importing country. Thus the exporter knows about his clients in detail which helps him to have a healthy portfolio. Factors use different hedge strategies to protect the clients from the risk of currency fluctuation. In Factoring, the banks of importer and exporter became part of the three contracts and work together to execute the deal with less risk and hassle of breach of contracts.

Factoring is gaining popularity in international trade as a better alternative to Letter of Credit. The disadvantage of the system is the expense involved but considering the risk in other options and lengthy procedures, it is considered a better choice for both importers and exporters.

In Bangladesh, Factoring is practised by different NBFIs (non-bank financial institutions) like IDLC, United Leasing, Lanka Bangla Finance and others at domestic level. Among commercial banks, the Eastern bank Ltd. and Trust Bank Ltd. are practising Factoring on a very small scale. This has become possible in Bangladesh due to the publication of a guideline on domestic Factoring by the central bank. Bangladesh can go for international Factoring through enacting a law as done by other countries.

The writer is a legal economist.