FACTORING

A Powerful Tool in the World of Finance

Partho H. Chakraborty

&

Arvind Sonmale

Notion Press

Old No. 38, New No. 6,

McNichols Road, Chetpet,

Chennai - 600 031

First Published by Notion Press 2015

Copyright © Partho H Chakraborty & Arvind Sonmale 2015

All Rights Reserved.

ISBN: 978-93-52061-19-8

This book has been published in good faith that the work of the author is original. All efforts have been taken to make the material error-free. However, the author and the publisher disclaim the responsibility.

No part of this book may be used, reproduced in any manner whatsoever without written permission from the author, except in the case of brief quotations embodied in critical articles and reviews.

Partho

Partho has been involved in the Banking and Financial Services industry since 1990’s. He joined the Standard Bank London Ltd. in April 1996 as Representative looking after the entire bank’s business in India. He was subsequently appointed as the Honorary Advisor to The South African Trade Desk during his tenure with Standard Bank London Ltd.

He is an expert in Transaction Banking and Business development and has advised banks and corporates about business opportunities in India. He has extensively trained people in Trade Finance and Cash Management and has worked in Pioneering Forfaiting and Commodity Loans Transactions in India. He is currently The CEO of Annona IT Solutions Pvt. Ltd., which is a start-up in Supply Chain Finance.

His previous designation was Vice President - Product Marketing of Polaris Financial Technology Ltd. Prior to joining Polaris he has worked in various capacities in companies such as Standard Bank London Ltd., ICIC Bank, SAP, Intelligroup Asia Pvt. Ltd., etc.

Partho holds a Bachelor of Mathematics Degree from the University of Mumbai and an MBA Degree from University of Pondicherry with First Class. He is a member of International Consulting Companies such as Guidepoint Global and Equinoccio S.L.

Partho has gone as a speaker in prestigious events such as FICCI-IBA meet, Marcus Evans, Euromoney Seminars, etc.

He has written another book called Mathematical Model for Dependencies for Abstractions in Enterprises which will be published soon.

Arvind

Arvind Sonmale is a career Banker having been in the industry for over 34 years. Born in Pune, India in July 1950, he completed his Bachelor’s in Civil Engineering in 1971.He started his banking career as a Probationary Officer in State Bank of India in July 1975 after completing a four year stint as a civil engineer with an Architect’s firm and with the Maharashtra State Irrigation Department.

His 9 years with State Bank of India (SBI) took him through various areas of banking responsibilities including that of a Branch Manager of a SBI office in Panaji (Goa) and in SBI’s International Division at its apex Central Office in Mumbai. The latter was a stint of 4 years in the Export Finance Department.

1984 saw him joining the newly operationalised Export-Import Bank of India (Exim Bank) and over the next 20 years, his work responsibilities took him through various areas including Trade Finance, Project Finance, Forex Operations, Corporate Finance, Regional Office Head, Overseeing of Overseas Offices, and New Initiatives which included being a point person in bringing Forfaiting to India. He was the key person coordinating the start-up of two Joint Ventures spawned by Exim Bank, one- a Consultancy Organisation called Global Procurement Consultants Ltd in 1995 which coordinated procurement of Multilateral Funded Projects by Indian Companies and two-Global Trade Finance Ltd (GTF) In 2001 which catered to Factoring requirements of Indian SMEs.

Arvind Sonmale took over as Managing Director and CEO of Global Trade Finance Ltd. in December 2004 and by 2008,transformed it to one of India’s leading Factoring companies with a whopping 86% share in International Factoring. GTF won the first prize in Marketing in 2006 awarded by Factors Chain International (FCI) amongst it’s over 200 members spread over 60 countries. His association with GTF ended in April 2010. He has been a Speaker at various international forums on Factoring. He is currently heading a NBFC by the name of SAFL which is a first of its kind in retail agriculture finance in India.

Together We Can

Message from the Authors

My dear Readers,

Greetings.

This book was conceived way back in 2002 but due to various reasons I could not start writing it. Then I started work on my book and finished most of the work on Factoring in a couple of years. Even though the work was over, I was not too happy as I had concentrated only on the process of Factoring.

My aim was to not only on Factoring but also on all related subjects to it. In this quest I introduced Trade Finance, IFRS, BASEL II, etc. As I started working on it, the task got immense and one day I mentioned this to my good friend Arvind Sonmale. Arvind at that time was heading GTF and was very keen to contribute and both of us then in earnest worked to finish it. We would add chapters, discuss amongst ourselves, edit, modify, delete or keep it as it is.

As our aim was on Factoring, we did not dwell too much on topics such as Letters of Credit (L/C), UCP, Structured Trade Finance, etc. where we gave an overview and moved on. It is not decided but if we write a book on Trade Finance or Structured Trade Finance, we could probably go deep and dwell in many such topics, which we have not done here.

This book has tried to bring in concepts, such as Factoring and Warehouse Finance, Net Banking, etc. We have also brought under IT, SOA and Cloud Computing, where Cloud Computing is the latest buzz word in IT. A first of its kind is Carbon Credits and how Factoring can play a role to minimise carbon emissions.

We have provided a lot of diagrams, flowcharts and tried to explain the transactions with costings and event table, which is mapped to the flow chart.

We hope that readers will read and hopefully would not only like to keep a copy but also like to recommend it to others. We welcome criticism and look forward to our readers to tell us how to improve this book and make it better.

My special thanks to Apana B. Aparanda who designed and made out the Transfer Pricing in the book and also gave us the photograph of The Tiger.

I sincerely thank my wife Jayeeta, my late mother Usha and my daughter Riddhi for giving me unstinted support as I worked late at nights for many days to complete this book.

Partho H. Chakraborty

Bangalore, India

My dear Readers,

Greetings.

In the latter half of the year 2000, I was engaged in setting up a new Factoring company in India on behalf of Exim Bank of India. It was formally set up in 2001 and christened Global Trade Finance Ltd. (GTF) and during the course of the next 7 years, it went on to become the market leader in Factoring, in India.

It was during the formative stage that I looked for some single authoritative work on Factoring, as it was a relatively unknown product in India. To my surprise, I was unable to lay my hands on any such seminal or reference work. And that kept on haunting me at the back of my mind.

Hence, when good friend Partho queried me on my interest in co-authoring a book on Factoring, my response was quick and unhesitant. I did get in touch with Jeroen Kohnstamm, Secretary General of Factors Chain International for his thoughts on this idea. His response was even quicker in his famous cryptic style, Great Initiative. I am grateful for his unstinted support.

I believe that this book will be a welcome reference point to the many students, bankers, academics, and all those interested in Factoring. I would urge you, my dear Reader, to favour us with your critique and feedback. This will help us look at updating the book more comprehensively in later editions.

I dedicate this book to Ms.Tarjani Vakil,former Chairperson and Managing Director of Exim Bank of India, who has not only been an unswerving inspiration but egged me on during her tenure in Exim Bank to take up other skills as writing, as she saw potential in me, in that area. I shall be eternally grateful to her for the motivation and encouragement.

A special mention of Sunil George Kuruvilla, Asst. Manager, Corporate Communications, GTF who worked tirelessly with me in bringing out this work.

And last but not the least; I would like to thank my wife, Manorama, and daughters, Aditi, Aarti and Ashuti for having supported me with complete faith in this endeavour.

If this book goes even a little way in enlightening you, dear Reader, in the complex world of the product of Factoring, it would be a big step in rewarding us in our efforts in bringing this work to you.

Arvind Sonmale

Mumbai, India

Foreword

Factors Chain International

8 June 2015

Factoring a Powerful Tool in the World of Finance

Dear Mr. Chakraborty,

Factoring is big business and FCI is pleased and encouraged by the publication of a new book that explains the power of Factoring. Factoring a Powerful Tool in the World of Finance, is a timely publication and the authors, drawing from a rich background in Factoring and Trade Finance, have provided us with a comprehensive explanation of the history, development and innovative practices of Factoring. From concepts of Factoring and Warehouse Finance to Net Banking, the book also includes implications of prudential risk such as Basel rules as well as technological advances and uses in the world of Factoring . Written for Professionals in the Factoring industry as well as those new to the business, over 30 diagrams and flow charts are used to illustrate the mechanism of Factoring transactions in a clear and concise way.

As global markets march forward, trade barriers fall and businesses worldwide realise the advantages of Factoring; we will continue to see world Factoring numbers grow over the cunent US 3 Trillion dollars.

The authors have provided a tremendous service both for the Factoring industry and for those who one day will practice the time tested vehicle of Factoring .

With kind regards,

Mr. Peter MULROY

Secretary General

FACTORS CHAIN INTERNATIONAL

A worldwide network of factors

Preface

Factoring is an age old method of financing. It was called by different names in the past. Factoring can be broadly classified into Domestic Factoring and International Factoring and in turn International Factoring can be further sub-divided into Import Factoring and Export Factoring.

The Unidroit convention in 1988 gave a much needed stimulus to International Factoring, by applying the well tested domestic Factoring principles to International Trade. Factoring was considered relatively risky as the Seller exposed himself to supply goods or services on the assurance of a factor, who in turn would pay 80% of the value of the goods and the rest on realisation. The financing costs were also high.

Given this scenario it was obvious that Sellers preferred to have security by way of some bank instruments and the Letter of Credit (L/C) became the undisputed choice the world over – This was true even for domestic transactions. On the other hand, many Buyers did not wish to get their bank limits blocked and also spend additionally on L/Cs, so they began insisting on purchase on Open account terms. It was typically a stand-off to see who would blink first. But with the recession setting in and Buyers having wider array of choices over suppliers, business done on open accounts has far surpassed business done with bank instruments.

However, international Factoring still has a long way to go. What we see around us today is a typical mindset of Sellers who want L/Cs confirmed by the best banks in the world and payment at sight. This is chaning slowly. With banks now offering Factoring services directly or through their subsidiaries, a larger degree of trust and comfort is prevalent in accepting and doing business on open accounts.

As regards India, Domestic Factoring is a large opportunity in this country. Even now, a substantial portion of the Factoring business is contributed by the domestic market.

This is largely because India is primarily a consumption-led economy, driven by robust internal demand from a burgeoning middle class. On the other hand, India’s merchandise exports constitute around 15% of GDP, which indicates comparitively lower dependence on exports. With strong economic growth and the anticipated rationalisation of central and inter-state taxes in the years ahead, domestic trade is expected to flourish in larger measure, thus providing an ever growing market for domestic Factoring.

We have mentioned that a Factor pays only after Buyer’s Acceptance of Documents and also that Factoring gives instant cash. These statements should not create confusion as both the cases are true and it depends upon the relationship and comfort of the Factor to advance money, which is done on a case-to-case basis.

An important aspect is the need of education on Factoring. Recently there was the case of two senior bankers discussing Factoring and considered to be well versed in trade finance and now with a software company, who mentioned, as a general observation in the discussion that "Factoring Was Done Only In Politically Unstable Countries". With such poor levels of knowledge it is imperative that knowledge is disseminated to banks, companies, colleges and universities so that people know and understand what is Factoring and its relevance to business.

We hope that CII, FICCI and other trade bodies apart from banks and universities tie-up with Factors Chain International (FCI) to disseminate knowledge and take Factoring beyond the standard method of lending and do more of innovative and structured transactions.

Our sincere thanks to Mr. Jeroen Kohnstamm, Ex-Secretary General of Factors Chain International who over the past four decades has helped build one of the most successful global trade associations in the world today for having taken time out to read the manuscript and give valuable and critical suggestions, which we have incorporated to the best of our abilities.

We are very grateful to Mr. Peter Mulroy, Secretary General of Factors Chain International, who inspite of his busy schedule has, kindly written a Foreword to this book.

In this book, you will come across 8 Pictures, 2 Cartoons, 34 Tables, 14 Flowcharts, 19 Diagrams, 19 Graphs, 8 Business Process Flows, 4 Architecture, 3 Formulas, 3 Message Flows, 2 Images, 14 Photographs, 5 Hierarchy Diagrams, 1 Detailed Business Process Model, 1 Press Release, 1 Sample Form and 1 Factoring Bill published in The Gazette of India. The pictures, appearing in the book will be pleasant breaks and soothing to the eyes as they are topical informative texts. And a final word - We have included the last page with An Appeal to Save The Tiger and our special thanks go out to Apana for sharing with us such a wonderful picture of the tiger.

We are very grateful and extend our thanks to the Sparx Systems and especially Ken Harkin for helping us to generate the Business Process Models for Factoring through their proprietary software Unified Modelling Language tool called Enterprise Architect.

We sincerely hope that a lot of unasked questions of our readers are answered as they go through this book. Yet, we are also very eager to receive your feedback on the book and the improvements that we can do, perhaps, in the next edition of this book.

You can always write-back to us at:

Partho H. Chakraborty at: parthohc@gmail.com

Arvind Sonmale at: arvind.sonmale@gmail.com

Contents

Title

Copyright

Message From The Authors

Foreword

Preface

PART I

1. Introduction to Trade Finance

2. Concepts of Cash and Cash Flow

3. Development of Factoring

4. Concept of Factoring

5. Factoring Mechanism

6. Forms of Factoring

7. Framework of Factoring Arrangement

8. Factoring Associations

9. Factoring in India

10. Development of Factoring in India

11. Future of Factoring

PART II

1. Trade and Supply Chain Management

2. Trade Finance and Regulations

3. Information Technology and Trade Finance

4. Impact of Basel II on Trade Finance

5. Convergence with International Financial Reporting Standards (IFRS)

6. Carbon Credits

PART III

Appendix – I (Business Process Model for Factoring)

Appendix – II (Structured Trade Finance)

Appendix – III (Sample Application Form)

Appendix – IV (Factoring Figures)

Appendix V – (The Indian Factoring Regulation Bill)

Appendix VI – (The General Rules for International Factoring)

Appendix – VII (Acknowledgements)

Save The Tiger

Part I

¹

Amsterdam Stock Exchange – The World’s First Stock Exchange

Chapter 1

Introduction to Trade Finance

What is Trade Finance?

Whenever a trade transaction is financed or funded, it is called Financing the Trade or Trade Finance. This includes both Pre-Shipment and Post-Shipment Finance. Trade Finance is a catch-all term applied to the whole area of trading business, especially the part that involves finance provided directly by banks and financial institutions.

Trade was conducted amongst countries for ages and is nothing new. Typically, Trade was funded against personal sureties of the borrower and a guarantor. Trade finance, which was controlled by a coterie of merchants, was relatively risky and thus the cost of funds was high. Trade finance has come a long way since a early days to what it is today where cost of funds are low, risks can be mitigated and adequate profits can be earned.

The basic fundamentals of trade finance are:

 Assurance

 Finance

 Payment

 Risk Mitigation

A simple trade transaction has a Buyer and a Seller. Ideally the Buyer would like to purchase on credit and pay later whereas for the Seller they would like to get paid first and supply later as each looks at the transaction from their respective point of view.

In order to successfully complete such transactions banks and Factors play an important role by assuring both the Buyer and Seller in ensuring payments are done on time and as agreed upon in the contract between the two players. Banks and Factors help the Buyer and Seller by meeting their business objectives and mitigating their concerns on the lines listed below:

Letters of Credit

The ubiquitous Letter of Credit (L/C) is the generally accepted face of trade finance as it is the first choice for any Seller to receive the due payments against goods or services that he has supplied to the Buyer in any part of the word.

A L/C is an instrument issued by a bank, at the request of an applicant, in which the bank promises to pay a specified amount of money to the named beneficiary upon his presentation of non-discrepant documents as stipulated in the L/C. In a commercial transaction, the Buyer (importer) of merchandise becomes the L/C applicant and asks that the Seller (exporter) be named the beneficiary. The Buyer’s bank’s ‘promise to pay’ reduces the commercial risk incurred by the Seller because the Seller can receive his payment once he presents the required documents to the bank. These documents provide evidence that the desired goods have been shipped and the Buyer receives some (but not total) assurance that the Seller will comply with the agreed upon terms of sale before being paid.

There are 16 types of Letters of Credit. They are:

1. Irrevocable (As per UCP 600 all Letters of Credit are Irrevocable)

2. Confirmed and Unconfirmed

3. With Recourse Credits and Without Recourse Credits

4. Acceptance Credit

5. Transferable Credit

6. Assignable Letters of Credit

7. Divisible Letters of Credit

8. Back to Back Credits

9. Anticipatory Letters of Credit (Red Clause & Green Clause)

10. Revolving Letters of Credit

11. Installment Letters of Credit

12. Clean Letters of Credit

13. Transit Credit

14. Deferred Payment Letter of Credit

15. Standby Letters of Credit

16. Evergreen Letters of Credit

Process Flow of a typical Letter of Credit: Flow Chart

Event Table

Letters of Credit are the most preferred method of payments for trade as the bank has the onus of paying as per the obligation of the Buyer against receipt of non-discrepant documents.

Note: As per the latest UCP 600 guidelines, the word Revocable has been dropped and it is not mentioned anywhere. All letters of credit would be irrevocable, whether the word irrevocable is mentioned or not.

Also a point to note is that banks only deal in documents and not in goods. If the documents are in order, they will pay irrespective on the condition of goods, i.e. even if the actual goods are not in order in terms of quantity or quality or both.

Factoring - The Basics of Channel Financing

In order to build good relationship with their Suppliers, Buyers offer timely payments to the former. However, there are many occasions when a Buyer needs credit facility to pay the due amount to The Supplier. The Supplier may be able to offer credit facilities but that will mean blocking his credit limits with his banks. Similarly, the Buyer may also want credit facilities as he may not be able to pay up immediately as he may be selling the product to end users on credit terms. In order to cater to these requirements banks offer invoice discounting or Factoring.

Factoring provides services of assuming credit control / protection and collection functions for its client, purchasing his receivables with or without recourse, in a continuous arrangement which includes maintaining sales ledgers and attending to other book-keeping functions related to such accounts.

Invoice financing (Factoring) is simply the selling invoices or receivables to a Factor for immediate cash. The attendant interest charges can be borne by the Buyer or The Supplier or both in an agreed proposition.

Also, the Seller may require finance to purchase raw materials to process them to finished goods. Hence, in order to meet these financial needs, Banks finance the invoices of the Buyer as well as the Supplier and charge interest and fees for the same. Banks provide finance against invoices to speed up the company’s cash flow. This also saves time spent on chasing payments as far as the Supplier is concerned.

Channel Financing comes with two different structures. These structures are categorized based on the financed party – Supplier/Dealer. For a particular instrument (invoice) at one point of time, only one party can be financed. However, for the same invoice at different timings, two different entities can be financed. Thus, if both the Supplier and the Buyer are customers of the bank, both can avail the financing facility from the Bank at different timings. Once the Buyer avails the financing option, the exposure is transferred from the Supplier to the Buyer while the Bank settles the debit balance against the Supplier and marks a new Debit balance against the Buyer.

The core objective of Channel Finance is to provide integrated commercial and financial solutions to the supply and distribution channels of a given industry. This can occur either on the Buy side of a company where it buys components from his vendors or on the Sell side where it markets his finished goods through Distributors/Dealers. A typical example is an automobile manufacturing company. Channel Finance gives support to the commercial relationship between clients and their suppliers or clients and customers.

The commercial aim of Channel Finance is to add value to supply and distribution channels by providing unique solutions that meet customers’ demands.

By providing short term lending to clients utilizing qualified receivables as collateral, value is added to the client by working capital support, reduced accounts receivables and improved control of the sales/distribution channels. In addition, payables discounting serves to add value by improving supplier relationships and enhancing cash-flow management.

Buyers are now able to leverage their relationship with reputed companies in sourcing low cost funds with support from their counterparts. Channel Financing is an innovative product to extend working capital finance to dealers having business relationships with large companies in India. This may be in the form of either cash credit facilities or as a bill discounting line of credit.

Structured Trade Finance

Structured trade finance² is defined as cross-border trade finance in emerging markets where the intention is to get repaid by the liquidation of a flow of commodities. It is an increasingly important area of emerging-markets lending, but its potential pitfalls have given it a poor image among parts of the financial community. However, compared to any other form of lending or investing in the emerging markets, structured trade and commodity deals have demonstrated an enviable track record of survivability under extreme testing.

Structured trade finance is the art of transferring risks in trade financing from parties less able to bear those risks to those more equipped to bear them in a manner that ensures automatic reimbursement of advances from the underlying assets. Such assets include inventory and export receivables.

Structured commodity finance is particularly relevant for commodity companies in countries that are considered as risky by financiers. Structured commodity finance demands a lot from bankers in terms of imagination, in terms of their ability to structure the financing around the conditions of a company and the conditions of the country in which it operates. However, at the same time, structured financing is a very systematic process.

Counter Trade

Countertrade is one of the oldest methods of payment in international trade. According to some estimates, it is used for about one fifth of world trade, and this share is increasing. It generally involves the exchange of goods and/or services as a condition of purchase, or as financing of purchases.

Countertrade in its various forms has evolved as an important tool for doing business in difficult markets. It is particularly valuable in markets where there is a shortage of foreign exchange reserves, where the currency is not freely convertible, or where there is difficulty in obtaining export credits.

The different types of Counter Trade are given below:

 Barter

 Counter Purchase

 Compensation

 Tolling

 Switch Trading

 Buy Back

 Off Setting

 Ware House Financing

 Trust Receipts

3

Asia’s Oldest Stock Exchange – Mumbai Stock Exchange

Brokers traded under the shade of trees in front of The Old Town Hall before the Exchange was formally established in 1875.

Chapter 2

Concepts of Cash and Cash Flow

Cash

Before we proceed further in understanding the concepts and features of Factoring in detail, an important point to understand is Cash.

Cash is ready money in hand that can be immediately utilized for payment or procurement or for any other business activity. Assets however liquid, whether inventory or accounts receivables, are not cash. Assets can always be converted into cash later, but at the end of the day it takes cash (i) to pay suppliers, (ii) to pay for the day-to-day expenses and (iii) to pay the employees to name a few. A company can make profit only if it receives all its payments and dues in time and it keeps its expenses in check and evenly spread over a period in time. Though Profits and Cash are intricately related as profits generate cash and cash runs the business but it is cash that is a hard reality as it is needed on a day-to-day basis. Again it is the positive cash flow that is required to run a successful business or else the company’s profits are of no value. A company has little value if payments from customers have not