FACTORING ACCOUNTS RECEIVABLE: TRUE SALE VERSUS SECURED TRANSACTION

Secured Lender, The, Nov/Dec 2006 by Klein, Susan J

Factoring is the sale of a seller's accounts to its factor at a discount. Factoring differs from asset-based lending because the factor relies on the creditworthiness of the account debtor, not its seller, in deciding whether to purchase the accounts. Upon the purchase of the accounts receivable, the factor advances to its seller, a stated percentage of the face amount of the accounts (typically 75 percent-85 percent). The account debtors are required to pay the factor directly, so that the factor maintains dominion and control over the accounts.

Whether a sale of accounts represents a true sale or a disguised secured transaction is particularly important in the context of a seller's bankruptcy. If the transaction is determined by the bankruptcy court to be a true sale, and the factor is the owner of the accounts receivable, then the accounts will not be part of the bankruptcy proceeding. However, if the bankruptcy court determines that the "sale" of accounts is in fact a disguised secured transaction, then the accounts and proceeds are property of the estate under 11 U.S.C. §541, and subject to use, sale or lease by a debtor-in-possession under 11 U.S.C. §363(b)(1) in a Chapter 11 case, and a bankruptcy trustee in a Chapter 7 case.

This article will examine what elements are analyzed in determining whether an assignment of accounts, absolute on its face, may be recharacterized as a secured loan rather than a true sale.

Uniform Commercial Code (UCC) Article 9

Article 9 of the UCC governs, among other things, outright sales of accounts and loans secured by accounts. A purchaser of accounts is a "secured party" under UCC 9-102(a)(72)(D). Since Article 9 covers outright sales of accounts, by definition a factor has a security interest in the accounts it purchases.1 Therefore, regardless of whether the transaction is a sale of accounts by the seller to the factor, or a loan secured by accounts receivable, the factor must file a financing statement covering accounts and proceeds in order to protect and perfect its interest. UCC 9-§310; see also §9-102 Cmt. 5 ("Many categories of rights to payment that were classified as general intangibles under former Article 9 are accounts under this Article. Thus, if they are sold, a financing statement must be filed to perfect the buyer's interest in them.")

The fact that Article 9 of the UCC is applicable to sales of accounts is not relevant to determining whether in fact the transaction is a "true sale" or a secured loan transaction. That determination has generally been left to the courts.

Chapter 11 bankruptcy v. Chapter 7 bankruptcy

Issues relating to recharacterization of a sale of accounts to a secured transaction most often occur in bankruptcy cases. The type of bankruptcy case may affect the court's characterization of the transaction. In a Chapter 11 reorganization case, characterizing the transaction as a sale would permit the factor to cut off funds or control what is paid to the bankruptcy estate. In a Chapter 11 reorganization, where the goal is rehabilitation of the debtor, a court may be less willing to find a true sale of accounts. For example, in denying a creditor's emergency motion to modify an interim cash collateral order, without an evidentiary hearing, based on the creditor's claim that the accounts were actually sold to the factor, the bankruptcy court in In re LTV Steel Co., Inc., 274 B.R. 278, 285 (Bankr. N.D. Ohio 2001). stated: "To suggest that Debtor lacks some ownership interest in products that it creates with its own labor, as well as the proceeds to be derived from that labor, is difficult to accept. Accordingly, the Court concludes that Debtor has at least some equitable interest in the inventory and receivables, and that this interest is property of the Debtor's estate. This equitable interest is sufficient to support the entry of the interim cash collateral order." The court noted that to grant the emergency motion would cause the shutdown of the debtor, loss of jobs and retirees' benefits and negative consequences to the debtor's other creditors.

If the factor has a security interest in the accounts receivable, rather than owning the accounts receivable, the debtor may use the cash from accounts receivables in its operations, subject to a bankruptcy court order providing adequate protection of the factor's interest in the accounts receivable. "Adequate protection" under 11 U.S.C. §361 may be cash payments, "an additional or replacement lien," an "administrative expense" claim or the "indubitable equivalent" of the factor's interest in the property. Adequate protection may not provide the factor with the cash it thought it bargained for when purchasing the accounts.

In a Chapter 7 liquidation, it is less likely that the Chapter 7 trustee will require any cash flow since the business is often not operating at the time of the bankruptcy filing. The Chapter 7 trustee may not contest the characterization as a true purchase of accounts since, provided the factor filed a financing statement covering accounts and proceeds, and there is no equity in the accounts for the bankruptcy estate, the factor would be entitled to relief from the automatic stay of 11 U.S.C. §362 to collect the accounts.