Invoice Factoring and the Associated Receivables Funding v. Classic Case
We covered invoice factoring – the good, the bad, and the predatory – in a previous blog. Below, we’ll look at one of the rare cases involving invoice factoring to make it to the high courts, the 2024 South Carolina Court of Appeals case Associated Receivables Funding, Inc. vs. Classic Industrial Services, Inc. (find it here, PDF).
Businesses who work with factors should be aware of this case because it answered two questions:
- Does an invoice have to be paid once it’s certified? and
- Is the customer bound by all the terms of the factoring agreement between the factor and the vendor?
Let’s dive in.
Background: The Associated Receivables Funding Case
As a quick reminder, in invoice factoring, there are three parties:
- The customer who obtains products or services from the vendor
- The vendor who provides products or services to the customer and creates an invoice, which it then sells to the factor
- The factor who buys the unpaid invoice (receivable) from the vendor and collects payment from the customer
In this case, the parties are:
- The customer: Classic Industrial Services (Classic)
- The vendor: Dunlap, Inc. (Dunlap)
- The factor: Associated Receivables Funding, Inc. (ARF)
ARF had an agreement (the Factoring Agreement) executed under South Carolina law with Dunlap in which ARF would provide Dunlap funding in exchange for receivables. Starting in spring 2014, ARF began purchasing receivables in which Classic, who had hired Dunlap as a subcontractor, was the customer.
For the next two years, the arrangement worked as it should. Classic paid ARF on at least 40 Dunlap invoices totaling over $1 million without issue. When Classic received a Dunlap invoice, it completed ARF’s “Work Completion Form” and certified the invoices with language indicating the work had been complete and the invoice was ready to be paid.
Then Classic Stopped Paying
But Classic stopped paying the Dunlap invoices starting in March 2016, believing Dunlap had not paid some of its suppliers. Classic was rightly concerned, because Dunlap’s failure to pay its own subcontractors or suppliers could lead to a mechanic’s lien that could become a big problem for Classic.
Despite knowing this was going on, Classic continued to assure ARF that everything was fine, so ARF continued advancing funds to Dunlap on new receivables. Classic also continued to certify the Dunlap invoices as before.
ARF finally learned in July 2016 that Classic was not going to pay the remaining Dunlap invoices. By the time of the trial, ARF’s outstanding invoices totaled $323,718.31.
ARF sued for repayment.
Yes, Certified Invoices Must Be Paid
In a nonjury trial, the circuit court agreed with ARF, finding Classic liable for payment under three theories:
- Under South Carolina Code § 36-9-607 and § 36-9-404, an “account debtor” (Classic) must pay the “assignee/secured party” (ARF) once it receives notice that the “assignor/debtor” (Dunlap) has assigned the right to payment. Classic had an obligation to pay the amount owed under its contract with Dunlap – not under the terms of the Factoring Agreement between Dunlap and ARF. And because Classic certified the invoices as valid and payable, it could not then withhold payment, even for a valid reason.
- Under the common law theory of negligent misrepresentation, the court found Classic liable because it knowingly made false statements to ARF, representing that the Dunlap invoices were valid and payable, and ARF relied on this information to continue advancing money to Dunlap.
- Similarly, under the theory of promissory estoppel, ARF relied on the false information Classic provided to continue advancing funds to Dunlap.
The appeals court agreed with the circuit court on the first and second points, declining to discuss the issue of promissory estoppel because it was not necessary.
No, the Customer Is Not Bound by All the Terms of the Factoring Agreement
Importantly, the appeals court disagreed with the circuit court on one issue: the rate of interest applied to the outstanding amount.
The circuit court had imposed a rate of 24.64%, as specified in the Factoring Agreement – but Classic was not a party to that agreement. While Classic was bound to the assignment of the right to pay in the Factoring Agreement, it was not bound to the rest of its terms. The appeals court directed the lower court to calculate the money owed with the statutory interest rate of 8.75%, rather than the higher rate of 24.64% that Classic was not bound to.
After the decision, both the Respondent (ARF) and the Appellant (Classic) requested a rehearing but were denied by the South Carolina Court of Appeals in September 2024.
A Sidebar: “Should” You Pay the Invoice?
The appeals court takes a moment to discuss the meaning of the word “should” in the context of contract language. When Classic certified the Dunlap invoices, it stated that “complete payment should be processed.” (Emphasis added)
Does “should” carry the connotation of obligation or discretion in this context? Classic argued that there was disagreement over whether the word “carries the force of a mandate.”
South Carolina courts have not yet ruled on this, notes the appeals court, but cites the Fourth Circuit’s interpretation that “should” on its own “can express the notion of requirement or obligation.”
“We find it problematic to construe ‘should’ as discretionary in the context of processing a payment for work certified to be complete and payable in the course of an ongoing business relationship,” writes the appeals court. “Instead, it seems logical to construe ‘should’ as a requirement or obligation in such a contractual context.”
For Strategic Business Advice to Help Grow and Protect Your Business, Call Gem McDowell
For help with contracts, corporate governance documents, buying and selling businesses, and much more, contact business attorney Gem McDowell. Gem and his team at the Gem McDowell Law Group, with offices in Myrtle Beach and Mt. Pleasant, SC, provide legal services and strategic business advice to help you protect and grow your business.
Schedule your no-obligation consultation today by calling Gem’s office at 843-284-1021 and let us know how we can help.
What is Invoice Factoring? The Good, The Bad, and The Predatory
When a company needs cash fast, one option is to sell its receivables in the form of unpaid invoices at a discount to a third-party business called a factor. The factor collects payment for a fee, and the business gets cash in hand without having to take on debt or put up collateral.
Sounds great, right? Factoring, or invoice factoring, can be a convenient solution to temporary cash flow issues, and many businesses have benefitted from the arrangement. But invoice factoring comes with downsides, even in the best-case scenario, and in the worst case, it can lock businesses into a predatory cycle of low high-interest borrowing and repayment. This is the hidden side of invoice factoring that doesn’t get discussed much.
Below, we’ll briefly look at how factoring works, the benefits and hidden downsides of it, and what to do before working with a factor.
Factors and Factoring: How Invoice Factoring Works
In factoring, there are three parties:
- The customer who obtains products or services from the vendor
- The vendor who provides products or services to the customer and creates an invoice, which it then sells to the factor
- The factor who buys the unpaid invoice (receivable) from the vendor and collects payment from the customer
Here’s how it usually goes. The factor buys the receivable and pays the vendor an “advance” of ~70-95% of the value of the invoice. The factor then gets the payment from the customer. After the customer pays, the factor remits the remaining “reserve” to the vendor, minus a “discount fee,” which is typically 1-5%.
Is Factoring a Standard Business Service or Predatory Loan Practice? Benefits and Risks for Businesses Using a Factor
It can be either, depending on the terms of the agreement and integrity of the factor. We advise businesses we work with to be very cautious before entering into any agreement with a factor. What first seems like a convenient business service can turn out very badly.
Let’s look at the Good, the Bad, and the Ugly of invoice factoring.
The Good: Benefits of Invoice Factoring to Businesses
Factoring as a service has been around for hundreds of years, and many businesses have benefitted from it to maintain cash flow without taking on any debt. It can be especially helpful for businesses with high upfront expenses and long payment cycles (e.g., 60 to 90 days), as it provides cash quick for a relatively low fee when all goes well.
Invoice factoring is also an alternative to traditional financing like a bank loan, which requires collateral. This makes it an attractive option to companies that cannot, for whatever reason, secure a traditional loan.
The Bad: Downsides of Invoice Factoring
Even when all goes well, and the factor is ethical, there can be some downsides for a business working with a factor.
The most obvious downside is the discount fee, which reduces profit margins. Working with a factor can damage customer relations, too, as it can be seen as a sign that the business is struggling. This is an even bigger problem if the factor is rude and aggressive when pursuing payment from the customer. It can deter potential investors or buyers, who may view factoring as a sign the company is struggling to maintain consistent cash flow, or because the agreement between the business and the factor is an impediment to a sale.
Factoring agreements can include restrictive terms, such as guaranteeing exclusivity (not to work with another factor) or requiring the business to sell all of its invoices from a certain customer or within a certain timeframe to the factor. Some agreements include a recourse provision for customer non-payment, which requires the business to buy the invoice back, or replace it with another, if the customer doesn’t pay. Recourse factoring can entail stricter terms, lower advances, and/or higher fees, all of which is bad for the business. It also shifts the risk back onto the business, eliminating one of the benefits of factoring.
The Ugly: The Predatory Side of Invoice Factoring
If you do an internet search for “pros and cons of invoice factoring,” you’ll find many articles and lists with the same benefits and downsides listed above. You are less likely to read about how invoice factoring can damage or destroy a business if it turns predatory. That’s why we’re writing this article; we want more businesses to know the hidden dark side of working with a factor.
Not all factors engage in these kinds of business practices. But some of them do. This is why you should be extremely cautious before signing an agreement with a factor.
Unethical factors often advertise low discount rates (1-2% or so) but charge many high fees on top, such as application fees, early termination fees, wire/ACH transfer fees, invoice processing fees, monthly maintenance fees, service fees, attorneys’ fees, and more. All these fees add up and can drastically reduce profit margins. For example, unethical factors often impose excessively high late fees for customer late payments that increase quickly with time. It’s not uncommon to see late fees that reach an effective APR of 30-50%.
Unethical factors can lock businesses in long term through restrictive terms and high termination penalties that make it difficult for the business to end its relationship with the factor. Businesses just trying to stay afloat can get caught in a cycle of predatory lending and repayment, similar to the way an individual can get caught in a cycle of debt and repayment with payday loans.
Using complex legal language to obfuscate the true terms of the agreement is another tactic we’ve seen used by unscrupulous factors. The agreements leave certain procedures and fees vague, giving the factor an advantage. For example, an agreement that doesn’t provide clear procedures and timelines on calculating a payoff amount can create a situation where the factor intentionally takes a long time to come up with the figure. By the time the business is given a payoff amount, it’s already out of date, as more fees and interest have accrued in the meantime. This is just one example of a tactic that’s technically legal, as it adheres to the terms of the agreement, but highly unethical.
Here’s the bottom line: Ethical factors want to make money by providing great service and maintaining good customer relations. Unethical factors want to make money by locking customers in no matter what it takes. They benefit more by keeping customers in a perpetual borrow-and-payback cycle with high interest rates and hidden fees rather than by providing excellent service.
Is Invoice Factoring Subject to Governmental Oversight and Regulation?
How can a factor get away with some of the business practices above?
In part, it’s because invoice factoring is a self-regulating industry. Factors are not subject to the same regulations and oversight by federal and state government bodies that banks and other loan-making financial institutions are because they are not technically making loans. Instead, the industry has various private associations that set standards and best practices. But those standards are not legal requirements, and membership is voluntary.
Factoring transactions are governed by laws at the state level, specifically Article 9 of the Uniform Commercial Code (UCC), a set of laws that regulates commercial transactions in all 50 states and Washington, D.C. In South Carolina, Title 36, Chapter 9 of the SC Code is based on the UCC Title 9. These laws provide limited protection to businesses that work with factors and to factors themselves.
Before You Try Invoice Factoring
Know what you are doing before entering into an agreement with a factor.
- Plan for invoice factoring to be temporary. Do not get trapped long term. Think of invoice factoring as a convenient but temporary solution for cash flow. It’s not a viable alternative to building cash reserves in your business for long-term growth and sustainability.
- Research the factor. If possible, get a positive referral from someone you know and trust whose business has similar needs.
- Read the terms closely before signing. Look for recourse provisions, extra fees like those listed above, restrictive terms, interest rates, and so on. (Having said this, even a close reading may not be enough to know what working with the factor will be like.)
- Speak to an attorney first on invoice factoring. Get advice from a business attorney who has advised businesses working with unethical factors. He or she can help you understand a factoring agreement before signing and/or discuss alternatives to keep your business going. Find someone in your state; if you’re in South Carolina, call Gem McDowell (see below).
- Seek alternative financing through traditional and/or private lenders. If you are in need of a temporary solution for cash flow, consider alternatives to invoice factoring like reducing expenses, selling assets, or securing a traditional loan from an institution with more oversight and regulations that protect you.
For Contracts, Business Law, and Strategic Advice to Grow and Protect Your Business, Call Gem McDowell
Contracts are often easy to sign but hard to get out of. Do you know exactly what you’re agreeing to?
Before entering into a contract with a factor, or any other contract, have it looked at by an experienced business attorney like Gem McDowell. With nearly 35 years of experiencing helping South Carolina business owners and professionals, he knows how to protect your interests and avoid mistakes so your business can grow and thrive.
For everything from contracts and corporate governance documents, to buying and selling businesses, to strategic advice to avoid mistakes and help your business thrive, Gem is here for you. Gem and his team at the Gem McDowell Law Group with offices in Myrtle Beach and Mt. Pleasant, SC are here for you – call 843-284-1021 today to schedule your free consultation.
