Accounting for invoice factoring30 April 2018
You enter into a contract for supplies or services on behalf of the Commonwealth and under the contract you agree to pay the contractor on a milestone or recurring basis for work performed. The arrangement is going well, until the contractor (or an unknown third party) asks if you could pay amounts due under the contract to someone else instead. Wait a minute—is this allowed?
In this scenario, it's possible the contractor is seeking to enter into an arrangement known as invoice factoring. We will explain this arrangement, why government contracts are popular targets and what to consider when a contractor wants to assign its right to payment.
What is invoice factoring?
Invoice factoring (or receivables financing) is a legitimate form of financing that allows a company to sell its accounts receivable (i.e. unpaid invoices) to a third party financial institution or investor (known as a factor) for a lump sum amount, to improve the company's working capital. This provides the company with immediate funds that can be used to alleviate cash flow pressures and pay expenses.
Traditionally used as a short-term solution for companies under financial stress, invoice factoring is also appealing to companies wanting to grow their business, as it allows for working capital to flow more consistently and provides access to funds that would otherwise be tied up in ledgers. It is particularly attractive for companies with slow paying customers and/or extended payment cycles, and offers an alternative to traditional finance.
Why are Commonwealth contracts appealing for invoice factoring?
Commonwealth contracts can attract invoice factoring for two main reasons:
- Large government contracts (particularly major projects or construction contracts) are often slow-paying with long payment cycles, but many have key milestones at generally pre-determined intervals. This helps generally stabilise a contractor's accounts while attracting a need for quicker payment.
- Financiers usually assess the contractor's customer's ability to pay an invoice, so having a credit-worthy organisation such as the Commonwealth as a debtor is likely to result in the contractor receiving more favourable terms for any invoice factoring.
What to consider when approving invoice factoring
These are the types of issues that should be considered by the Commonwealth when faced with invoice factoring:
- Underlying reasons for the arrangement—while factoring could indicate the contractor is in financial distress, it may also be that a significant and time-critical opportunity has arisen to grow the contractor's business, hence the (otherwise financially sound) contractor is seeking additional liquidity. Understanding the strategic business reasons for the arrangement is important as the Commonwealth generally has a vested interest in successful contractors—it is not generally in the Commonwealth's interest for contractors to enter external administration.
- Continued contractor performance—if payment is assigned to a factor, will the contractor be sufficiently motivated to perform obligations on time or to the contract standards, given it is not receiving 100% of the invoice amount? Will the relationship or the contractor's desire to protect its reputation be sufficient motivation? Although invoice factoring can be structured so that contractors receive an amount upon an invoice being paid in full to the factor, this amount is usually nominal and may be insufficient to address performance issues.
- Factor disputes—many Commonwealth contracts (especially for major projects) contain complicated payment arrangements affecting how much and when a contractor is entitled to receive payment—e.g. the contract may include stop payment milestones, withholding provisions, milestone criteria that must be met, or a performance management framework that places profit at risk. A factor is unlikely to be familiar with Commonwealth contract terms, so there could be an increased likelihood of disputes around payment owed. Additionally, since factors will not be subject to the same relationship incentive as contractors, factors could be more likely to aggressively pursue payment.
- Recovery of debts—the contractor could owe amounts to the Commonwealth (e.g. liquidated damages, royalties, or refundable non-recurring engineering costs) and many Commonwealth contracts contain provisions allowing a reduction in contract price commensurate with debts due by the contractor. Assigning invoices to the factor may prevent the Commonwealth from exercising any right to "set off". The Commonwealth may need to pursue payment of contractor debts through more traditional means, which may lead to other issues should the contractor enter external administration.
- Reputation—consideration should be given to potential reputational damage for the Commonwealth arising from the arrangement—e.g. if the contractor is subject to financial difficulties and enters external administration, any assignment of invoice rights to the factor may place those funds beyond the reach of controllers or creditors.
- Confidentiality and security—the factor will usually want to see the contractual terms (at least those regarding payment) to satisfy itself of the Commonwealth's obligations to make payments. However, Commonwealth contracts often contain confidential and other sensitive information, making it inappropriate to disclose the entire contract to the factor. This may mean the factor is only aware of invoices being issued, rather than whether those invoices were properly rendered and actually payable.
- The Personal Property Securities Act 2009 (Cth) (PPSA)—the PPSA has played a significant role in the evolution of invoice factoring. A contractor's accounts receivable will generally be subject to the provisions of the PPSA in lieu of, or separate to, the law governing assignments. This means that invoice factoring may need to comply with PPSA provisions concerning registration, attachment, and the like, and may give rise to disputes concerning competing priorities. Terms of a contract that prohibit a contractor from assigning an account to a third party may also be unenforceable against that third party. While the Commonwealth may retain any claim against the contractor for breach of contract, this may be difficult to enforce if the contractor enters external administration.
Invoice factoring is gaining popularity for companies that require enhanced cash flow to strategically grow their business or avoid financial distress, so it looks like it's here to stay. While it bears some similarity to traditional financing by securing accounts through general security agreements, the outright transfer of the receivables attracts its own unique issues.
Though unlikely to offer complete protection, the Commonwealth would be well-advised to retain the "no assignment without consent" provisions in contracts, so the contractor remains obliged to seek approval of any factoring arrangement. It would also be prudent to ensure regular searches of the PPSA register are undertaken (in conjunction with any audit powers concerning the financial information of the contractor) to get a better picture of a contractor's financial position. Other notice and negative covenant clauses may also be appropriate depending on the particular circumstances.
In all cases, the Commonwealth should seek to understand the underlying reasons for the factoring and if financial issues exist, consider whether there are:
- other impacted agreements with the contractor
- implications for the marketplace, and
- other ways to address cash flow concerns (e.g. though progress milestones or mobilisation payments).