Explained | What is Factoring Regulation (Amendment) Bill, 2020?

The new law is expected to improve the availability of credit to MSMEs

The Parliament this week passed into law the Factoring Regulation (Amendment) Bill, 2020, which is an amended version of the Factoring Regulation Act, 2011. The new law is expected to improve the availability of credit to micro, small and medium scale enterprises (MSMEs) since more non-banking financial companies (NBFCs) will now be eligible to offer factoring services to MSMEs.

What is factoring?

Factoring is an arrangement where a business sells its receivables (outstanding bills of sale against which it is yet to collect cash) to an interested buyer. The buyer who purchases the receivables from the business later collects cash from the party that owes these bills. The buyer makes a profit in the process since he usually purchases the outstanding receivables at a discounted price from the seller. So, for example, a business may have sold goods worth ₹1 lakh to a third party and may expect the outstanding amount to be paid within six months. Its capital, however, will be stuck in the business until it receives cash from the third party. So the business may decide to sell the receivable worth ₹1 lakh to a buyer at a discounted price of ₹90,000. The buyer of the receivable in this case can make a profit of ₹10,000 if he manages to collect the entire receivable amount of ₹1 lakh from the third party.

What are the benefits of the new law?

When financial institutions such as NBFCs are willing to assume the risk of collecting pending receivables, it leads to greater choice for businessmen in the MSME sector. For instance, many MSME owners may not want to wait to receive payments and may be willing to sell their receivables at a discount. Further, the risk associated with collecting receivables can prevent many who are risk-averse from entering the MSME space at all. Greater availability of factoring services can thus pave the way for the entry of new businessmen.

MSMEs at the moment do have access to overdraft facilities offered by banks for which their receivables are sometimes used as collateral. However, banks can hold overdraft borrowers accountable in case a receivable submitted as collateral turns out to be uncollectible. In the case of factoring, however, the entire risk of collecting the receivable is usually transferred to the NBFC or bank.

According to Finance Minister Nirmala Sitharaman who spoke in Parliament, the new law will bring in over 9,000 NBFCs into the factoring business. Earlier, the Reserve Bank of India (RBI) allowed only NBFCs whose primary business was factoring receivables, meaning that more than 50% of their balance sheet consisted of factoring-related assets, to offer factoring services. This meant that only a total of seven large NBFCs were deemed as eligible to engage in factoring through the Trade Receivables and Discounting (TReDS), an online factoring platform set up by the government.

What lies ahead?

While the new law may make it more likely that MSMEs will gain better access to factoring services, its success is by no means assured. The primary issue is likely to be India’s weak legal system which is plagued with inordinate delays and corruption. Even large creditors find it very hard to make successful recoveries under the current system. So it may not be easy for NBFCs to recover uncollectible accounts through legal means. In turn, this may affect their willingness to invest in the factoring business.

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