Understanding UCC 9-404: how it pertains to claims and the right to offset

If you've ever worked with/for a factoring company at any capacity, you may have heard a hot headed portfolio manager throw out the term "UCC 9-404 - No right to offset." All to often this portion of the Uniform Commercial Code is loosely interpreted incorrectly, and used to protect poor verification and lazy due diligence on the part of the accounts receivable factoring company.

Usually, 9-404 is wrongly interpreted to mean that if a factor verifies an invoice with a debtor and specifically inquires about any exisiting claims regarding this specific invoice - anything that could potentially offset the payment back to the factor - and they are told there are no claims, then the invoice verified is free and clear of any claims that the debtor may have on file. This is close - but also dangerously far away.

Here is the actual UCC 9-404.

9-404. RIGHTS ACQUIRED BY ASSIGNEE; CLAIMS AND DEFENSES AGAINST ASSIGNEE.

(a) [Assignee's rights subject to terms, claims, and defenses; exceptions.]

Unless an account debtor has made an enforceable agreement not to assert defenses or claims, and subject to subsections (b) through (e), the rights of an assignee are subject to:

(1) all terms of the agreement between the account debtor and assignor and any defense or claim in recoupment arising from the transaction that gave rise to the contract; and

(2) any other defense or claim of the account debtor against the assignor which accrues before the account debtor receives a notification of the assignment authenticated by the assignor or the assignee.

The portion that most concerns us in this case is section (a). The attourney for my
former factoring company explained this to me to mean that the verification regarding claims must be done at the time the debtor is first notified of the assignment. This means that unless during the first call the factor makes to the debtor, he asks an authorized employee regarding any existing claims, that debtor will always have the right to offset factored invoices for any previously existing claims. Whether the claims pertain to factored invoices or not.

Currently Reading: The Law of Contracts and the Uniform Commercial Code 

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Buyout Process - What Each Factor is Up To

Once you've notified your current factoring that are planning to leave for another factor, a new and sudden game plan shifts into gear. We'll start by going over what actions your current factor is going to take. 

After they receive your written notice to terminate - either 90 Days or Early Termination - your current factor will probably be interested in finding out why you want to leave. Possibly, they may try to negotiate new terms with you or meet any needs that weren't previously being met. Assuming they fail, they will begin calculating the buyout figure.

You may have to provide the current factor with a letter authorizing them to release details about your account (i.e. aging reports) to the new factor. With a fresh accounts receivable aging report in their hands, the new factor will begin verifying all the open invoices on your account. Typically, this is done by physically calling the accounts payable department for each of your customers to check each and every invoice. Along with this, they will also contact the buyers, brokers, claims departments, etc. This will help verify that there is no fraud or history/ongoing issues with claims and your business.

I have worked through many buyouts on both sides of the business and can tell you that it is extremely important for the above steps to be taken by the new factor. I once had a factoring company request an aging report that had at least 30 different debtors (your customers) and 5 to 10 open invoices each. By the next morning, they were already wiring us the buyout money. Over the year that followed, I was constantly being contacted by my old client, the new factor, and the customers, who were all so confused about who to pay, where did check number such-and-such go, and how come I didn't get any reserve after the buyout?

Be sure to follow up with the new factor to be sure they are doing their DUE DILIGENCE. In the next post, we'll explain just where this buyout money comes from and just how much you should pay in early termination fees.

Buyout Process - how to calculate the buyout figure

Are you moving from factoring company to another? If so, you may find you and your business may be caught up in the tedious process of a Buyout. A buyout occurs whenever one company has a balance owed on accounts receivables they purchased and are the current UCC-1 lien holder on the business in question. There are many steps involved and over the next few weeks, we'll take a look at them all. This week, we'll discuss how to calculate the buyout figure.

Simply put, the buyout figure is the total amount owed to the UCC-1 lien holder. Here's how that is reached:

Unpaid Invoices + Fees Owed - Reserves = Buyout Figure

Still unclear? Understandably so. Let's work it out with an assumed fee structure and totals.

Lets say that your fee structure is a 90% advance with a flat 5% fee for invoices factored month to month. Your current outstanding balance in accounts receivables factored for the month total $85,000.

1. Total A/R - $85,000

5% of  $85,000 is $4,250. This would be your fees owed. If you did not give written notice prior to leaving, you may also owe Early Termination fees, so check with your factor.

2. Total Fees Owed - $4,250

Your reserves - which should be roughly 5% of your total open balance depending on how your factor releases reserves - can vary greatly based on many variables, lets just say you have $5,000 in reserves.

3. Total Reserves $5,000

The final result would look something like this:

$85,000 A/R
$4,250 Fees
(5,000) Reserves

Buyout Figure = 84,250.00

In the next week of this series, we'll look at how the new factoring company verifies the already outstanding invoices and reach this buyout figure for your business.

Financial wisdom. . . for free!

While reading Free Money Finance this morning, I came across this post that shared some samples of great advice regarding investments an loans from CNNMoney.com. While these are geared toward personal finance, you can easily apply them to your business and its relationship with a factoring company.

While reading Free Money Finance this morning, I came across this post that shared some samples of great advice regarding investments an loans from CNNMoney.com. While these are geared toward personal finance, you can easily apply them to your business and its relationship with a factoring company.

My favorite comes from Elizabeth Gilbert - author of, "Eat, Pray, Love: One Woman's Search for Everything Across Italy, India and Indonesia"

"Borrowing money is like wetting your bed in the middle of the night. At first all you feel is warmth and release. But very, very quickly comes the awful, cold discomfort of reality."

Click here for the rest of this resourceful post. 

How to ask for early reserve release

Remember the old adage, "It's not what you ask, but how you ask it?" This also applies to requests you make to your factoring company. Most likely, the payment you get for the invoices you sell to your factor are being advanced to you in part. Anywhere from 85 to 97 percent would be typical. The remaining amount is held in a reserve account until the invoice is paid. Some factoring companies may release reserves as invoices are paid, but release reserves only once monthly.

In the event that you find yourself  in need of funds and do not yet have any new invoices ready to send in to your factoring company, all is not lost. The two most common reasons I was given for needing an early reserve release were fuel for the trucks or needing to meet payroll. When we got pleas such as is, we almost  always gave in.  much more went into the decision to hold or release those funds early. Try to keep in mind that factor relies solely on this reserve as a safety net should any of your customers not pony up the dough. So before you make your request, here is the information you will want to have at the ready:

1. Total outstanding A/R compared to total A/R over 60 days - Many factors have a 90 day recourse rule. If an invoice is not paid back within 90 days by your customer, you buy it back with that reserve. If your portfolio is upside down (more over 60 than current) they may hold that reserve indefinately.
2. On average, are most  of your customers paying in a timely manner and do they have a good relationship established with your factoring company?
3. Do you have any upcoming orders that you will be planning to factor? If so, your factoring company may be take that into consideration when making their decision.

In my old office, the Portflio Manager often based his decisions on whatever his mood was for the day. If you encounter this type of personality, keeping your cool and having a better understanding of not only the best explanations to give to backup your request, but also the information as to why would not put the factor in jeapordy of eating the costs of any unpaid fees for invoices.

How to create a 'factor friendly' invoice to your customer

You've probably been in business for quite awhile, your current invoicing system is working smoothly, and feel that you are not in need of any education on how to properly invoice your customers. Factoring companies are very cautious and particular about the accounts receivables they purchase. It was not often that I had a client who invoiced exactly the way we needed, but an invoice that is "factor friendly" will ensure easy verification and quicker turn around for funding and payment by your customer to your factor.


 You've probably been in business for quite awhile, your current invoicing system is working smoothly, and feel that you are not in need of any education on how to properly invoice your customers. Factoring companies are very cautious and particular about the accounts receivables they purchase. It was not often that I had a client who invoiced exactly the way we needed, but an invoice that is "factor friendly" will ensure easy verification and quicker turn around for funding and payment by your customer to your factor.

The first page of your billing should be the Invoice. This sheet contains your company name and address, a complete billing address to your customer in the upper left hand corner, detailed charges with a total below, and any payment terms and important remit to information. Your business will increase its professionalism and impression on your factoring company ten fold with a sleek and neatly typed up invoice. Bills that are look sloppy or handwritten on poor quality paper speak volumes to your account executive about your organizational skills and attention details, although they may not communicate this to you, it is a red flag for any factor to be extra careful when verifying. There were several instances where I had to return bills to my clients to enforce a more neatly created invoice. I have attached a sample template that you are welcome to make use of for no charge.

The rest of the paper work is comprised of what is usually called the Back Up. The original purchase order signed by your customer shows your factor that the service or product was in fact requested and serves as a confirmation of the agreed rate. This should always be the original version of this document with exceptions given only in the case that the order is a blanket or ongoing PO. In those cases, copies will suffice but will almost always require verification with your customer.

Equally as important as the signed Purchase Order is an original signed Proof of Delivery. Depending on the factoring company, delivery trackers from an overnight courier may be allowed here as well. This document show that your accounts receivable invoice is billing for product delivered or services rendered. Any invoice that does not contain a signed proof of delivery will surely not be funded until has verified thoroughly.

There are many website available for invoice help that are of no cost at all, The Invoice Machine,
 Microsoft Office Templates, and  Office-Kit.

Finally, leave any questions or concerns you've encountered with invoicing or problems you've experienced with your factoring company funding your invoices, and I will personally address each every one in a new article.

Accounting for factored invoices with Quickbooks

On occasion, I would get asked questions regarding Quickbooks and how to account for factored invoices, released reserve, or invoices that were charged back against the reserve. I was never able to help as I had no experience with that software. I did a little research and found some helpful info available at the Quickbooks official site user forum.



On occasion, I would get asked questions regarding Quickbooks and how to account for factored invoices, released reserve, or invoices that were charged back against the reserve. I was never able to help as I had no experience with that software. I did a little research and found some helpful info available at the Quickbooks official site user forum. So if you currently find yourself wonder how to use Quickbooks with an accounts receivable funding company,  here is how Chuck Vigeant, an Advanced Certified Pro Advisor, has handled factoring for his clients over the years:

"First remember that you typically will have two new accounts in a factoring situation: one for escrow (which is a portion of the total amount held back by the factoring company), and an operating account - which will show the actual money made available to you for the receivables purchase.

Sometimes the operating account will actually be your own account, and not two separate accounts. Depends upon the factoring company and your arrangement with them.

Once the factoring company purchases the receivables, receive payment against the invoices Your invoices will now show that they are paid in full and if sales taxes are involved they will correctly show as being paid.

Now you will need to create a deposit to represent the amount received in the operating account; while using the cash back window to create a debit to the escrow account. (You could also receive the payments directly to the operating account, and then create a j/e for the escrow amounts, but this is an easy shortcut)

Once the factoring company receives the money from the client, it will then send you a notice for their fees. Create a journal entry to debit the fees, and credit the escrow account.

I have found that this method allows you to reconcile your operating and escrow accounts like any other bank accounts - although I have typically setup the escrow account as an other current asset because the funds are not readily available to me as a true bank account - unless the factoring company tells me I have the minimum necessary escrow amount.

If the factoring company is unable to collect on the account, they will credit back against your escrow account, and your entry will debit A/R for that customer again. What you need to track here is that you do NOT want to pay your sales tax twice, so you will need to make an adjustment to your sales tax report for that period. This is the only part of this operation that does not flow properly through QB using my methods.

I have attached a simple t-account spreadsheet so you can see the flow of dollars.

Another thing to remember, is that the factoring company generally sends the statements, because they are the new owner of the "paper". In some cases you can work with the factoring company on collections operations. Your clients may take a raised eye to someone else collecting money for services you have provided.

Lastly, be very, very cautious of factoring companies. I have seen companies get caught in a vicious circle - because if the clients don't pay on time, the escrow requirements get higher and higher; and when you sell new invoices, you might find out that most of the purchased invoices go towards escrow - instead of your pocket."

Before you sign up with a factor, have an exit strategy!

If you are looking to sign up with a factoring company, I strongly recommend that you do so with a clear exit strategy. Ideally, you are planning on using invoice factoring in order maintain some positive cash flow during your business' current rapid growth. At some point, your growth rate will slow and when that happens, you do not want to be stuck in the vicious factoring cycle.


If you are looking to sign up with a factoring company, I strongly recommend that you do so with a clear exit strategy. Ideally, you are planning on using invoice factoring in order maintain some positive cash flow during your business' current rapid growth. At some point, your growth rate will slow and when that happens, you do not want to be stuck in the vicious factoring cycle. Please understand that this post is not a cookie cutter solution for every business. With that in mind, take comfort that the relationship with your accounts receivable factoring company may be a short one.

Most factoring companies lock in their clients with an automatically renewing contract. When I worked for Acme Factoring, we had verbiage in our security agreement that any client who wished to terminate the contract agreed to an early termination fee whenever we did not receive a written 90 day notice. That fee was equal to your average monthly fees paid over the next three months. Depending on your volume, that could be an astronomical amount of cheese.

My first tip in this series is to submit your written 90 day notice immediately after your first funding. Doing so will ensure that in three months, you will have the option available to you to end the contract without ensuing any fees. If you need longer that 90 days, just submit your written notice to rescind the notice to terminate the week of your last day. Be sure to carefully read over your security agreement for any language that suggests your factor will not releases due during that 90 day period. The portfolio at my company always used our security agreement as a deterrent to this tactic. We reserved the right to release or hold reserves at our discretion and he would claim that during the 90 days there was too much uncertainty for us to be able to release any reserves held that were due.

If you are still in the negotiating stage with your sales rep for the factoring company you've chosen, try to land a fee structure with a flat rate and fee rebates based on volume and the average days your A/R turns. Having a flat fee rate (90/10 advance 5% flat) would mean that on average, you will little to no reserves due each month anyways. More on that in a later post.

I had a client present written 90 day notices every three months for this same reason when I was with Acme Factoring. As an Account Executive, I can say that I found thoroughly frustratingghhg and finally confronted my client. Once I understand the reason, I realized it was really just a sound business move to give them an opportune exit strategy every 90 days.

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