Promulgation of Factoring Regulations
Written by: Marija Nicksic, Esq., Associate, Krieg Devault LLP
The factoring industry is currently undergoing significant regulatory upheaval. Despite the long history of factoring transactions, states are now subjecting the factoring industry to new regulatory systems. Why now? The simple answer is that certain industries have taken advantage of the lack of regulation surrounding commercial financing transactions, to the detriment of small businesses. Regardless of the cause, factoring transactions are now subject to complex regulations and navigating these various state regulatory schemes can be daunting. This article discusses (i) the general requirements of these regulations; and (ii) the impact of said regulations going forward.
1. Regulations
At this point, seven states have instituted regulations that apply to factoring transactions: California, New York, Virginia, Connecticut, Utah, Florida and Georgia. Most of these regulations require certain disclosures. Before entering factoring transactions in these states, it is important to review these regulations and to be aware that these are not plain language statutes. In order to further analyze the types of regulations that currently apply or will apply to factoring transactions, this article will discuss California’s regulatory system.
Of all the states that have instituted regulations on factoring transactions, California has, by far, the most comprehensive and complex system. In order to engage in commercial financing transactions in California, commercial lenders (including factors) and brokers are first required to be licensed under the California Finance Lenders Law and apply directly to the Department of Business Oversight. The Requirements for this license include: having and maintaining a $25,000 net worth; obtaining and maintaining a $25,000 surety bond; no criminal history or history of sanctions by any regulatory agency resulting from dishonesty, fraud or deceit; and having a plan of business consistent with the business of finance lender.
California has used this licensing system to monitor commercial lenders since 1995. Currently, if a factoring transaction takes place in California, the factor must be licensed. There are limited exceptions, including a “de minis exemption” that exempts commercial lenders who make not more than one commercial loan in a twelve-month period. The licensing provisions developed separately from the factoring-specific regulations but are a prerequisite for entering into factoring transactions in California and therefore being subject to the California regulations on factors.
The promulgation of disclosure specific regulations began with the California Commercial Financing Disclosure Law (CCFDL), effective since December 9, 2022. The CCFDL resembles the federal Truth in Lending Act (TILA) and applies to all commercial financing transactions offering $500,000 or less to “recipients whose business is principally directed or managed from California,” specifically applying to factoring transactions. Certain lenders who are already subject to other regulatory systems are exempt from the CCFDL, including depository institutions.
Lenders must complete either transaction specific disclosures or example disclosures. Transaction specific disclosures must include: (i) the total amount of funds provided; (ii) total dollar cost of the financing; (iii) term or estimated term; (iv) the method, frequency, and amount of payments; and (v) description of prepayment policies.
Those who are familiar with factoring transactions will note that all these requirements, with the exception of point (v), are not readily calculable under most factoring agreements. The total amount of funds and total dollar amount of financing varies as invoices are submitted and accounts are purchased. Likewise, the term of a factoring transaction is dependent on the payment of accounts by an account debtor. Therefore, example disclosures may be the better option for factors.
Example disclosures are calculations of hypothetical transactions that could occur under the factoring agreement and must include: (a) amount financed; (b) total dollar cost; (c) term or estimated term; (d) method, frequency, and amount of payments; (e) description of prepayment policies; and (f) total cost of the financing expressed as an annualized rate.
Notably, many terms used in the disclosure requirements are defined, and the same term may have different definitions depending on the disclosure. For example, “Amount Financed” in the transaction specific disclosures includes the original advance amount, minus any prepaid finance charge. However, in the example disclosures “Amounts Financed” includes the approved advance limit, minus any prepaid finance charge. Careful attention must be paid to each requirement to comply with these regulations. Whichever disclosure is used, it must be provided to the client at the time of extending a commercial financing offer and the client must sign the disclosure.
Taking effect at the beginning of this year, California passed Bill 666, which restricts fees that can be charged in factoring transactions funding less than $500,000.00 total. Factors may comply with this regulation by adding a statement to the underlying agreement that, in good faith, the total funding under such agreement will be more than $500,000.00. Under this regulation, fees cannot be charged by the factor for accepting or processing a payment by automated clearing house, producing a statement for amount due to pay off debt, any fee other than an origination fee that does not have a corresponding service, a fee for monitoring collateral if the business is less than 60 days delinquent on an account, or a fee in excess of 150% of the cost of filing or termination for filing or terminating a UCC lien. To comply with this regulation, factors may choose to define any upfront fees as origination fees and keep record of the cost of all service fees charged.
New York followed California and also adopted a regulatory scheme, with some key differences from the California regulations. Under New York Commercial Finance Disclosure Law (CFDL), the factor must disclose (i) the receivables purchase price paid to the recipient less any prepaid finance charges; (ii) the finance charge; (iii) the total payment amount, which is the purchase amount plus the finance charge; (iv) a description of all other potential fees and charges that can be avoided by the recipient; and (v) a description of the receivables purchased and any additional collateral requirements or security interests. The finance charge is a defined term that includes all charges that would be included under 12 C.F.R. part 1026.4 as if the transaction were subject to 12 C.F.R. part 1026. However, in factoring transactions, the finance charge is calculated based on the difference between the face value on the invoice and the amount paid directly to the recipient upon assignment of the legally enforceable claim to the financer, inclusive of any factoring fee. Therefore, it’s important to acknowledge that, although the New York system adopted a regulatory scheme following the California regulations, they are not the same and require separate analyses to meet all disclosure requirements.
2. Regulations Going Forward
Other states are following California’s regulatory lead, and the factoring industry can expect further regulation across the country. Multiple complex regulatory regimes may be forthcoming, especially if the states are left to promulgate unique systems.
The Capital Access for Small Business Harmonization Act (Cash Act) was proposed to and approved by the American Factoring Association (AFA) in 2023. The purpose of the Cash Act is to standardize disclosures for factoring transactions across the country. Under the Cash Act, issues like the discrepancy between the definition of “finance charge” under New York law versus California law would be remedied. Factors would only need to meet one set of disclosure requirements as opposed to complying with various unique regulatory systems. The AFA is moving to build coalitions of small businesses and finance trade associations to work to pass the Cash Act at the federal level.
In conclusion, when factoring in a state subject to these requirements, the factor must comply with all licensing and disclosure requirements. The regulations are not intuitive. Even where regulations specifically apply to factoring transactions, the regulations are not drafted within a true sale framework and are instead made to restrict predatory lending. Factors can no longer depend solely on transactional knowledge because the regulations are not congruent with true-sale factoring transactions. Going forward, factoring transactions will require familiarity with regulatory laws. It is important that every factor have procedure in place to ensure compliance with the licensing and disclosure requirements, and for keeping current on the various states regulatory schemes.