“Factoring” in the Risk of Selling Construction Receivables
Austin Principal Shelly Masters wrote the following article for the May edition of Construction News magazine. Shelly discusses how to “factor” in the risk of selling construction receivables.
When times get tough, more construction companies turn to alternative financing solutions, such as factoring. Factoring is the practice of selling unpaid accounts receivable to a third-party company or “factor” in exchange for short-term liquidity. Factoring agreements are not a loan but a cash advance against unpaid invoices. However, contractors should tread carefully when deciding to factor invoices.
Factoring agreements often contain onerous terms, excessive fees, long-term obligations and recourse against other assets, projects and parties which may conflict with Texas laws that seek to protect contractors’ rights to payment (e.g., Texas Construction Trust Fund Act and Mechanic’s Lien statute).
The following cases serve as cautionary tales which illustrate the hidden risks factoring agreements pose to contractors.
Dakota Util. Contractors, Inc. v. Sterling Com. Credit, LLC, 583 S.W.3d 199, 201 (Tex. App.—Corpus Christi 2018, pet. denied):
- A general contractor (“GC”) entered into a construction contract on several Texas pipeline projects. To get short-term cash flow, the GC entered into a factoring agreement. The GC defaulted and filed for bankruptcy. The bankruptcy court approved 1) the GC’s payment to the factor for $400,000, and 2) the owner’s payment to the GC for $900,000. The GC issued a partial payment to its subcontractor.
- The sub sued the factor claiming it misapplied construction trust funds in violation of the Texas Trust Fund Act. The Texas appellate court held in favor of the factor, finding the factor was not the GC’s “agent” and could not be held liable under the Texas Trust Fund Act. Thus, the factor did not have to pay the sub for its work.
- The Court acknowledged “that the presence of factoring agreements in construction cases may frustrate the intent of the [Texas Trust Fund Act] to protect subcontractors and materialmen from the risk of nonpayment.” The Court concluded that “[t]his is not a case where our interpretation of the statutory language creates an absurd result, but rather . . . at most demonstrates ‘a gap or oversight in the statute that, if true, must be corrected by the legislature, not the courts.’”
Sterling Com. Credit–Michigan, LLC v. Hammert’s Iron Works, Inc., 998 N.E.2d 752 (Ind. Ct. App. 2013, no pet.):
- A steel erector entered into a subcontract requiring its subcontractor to submit lien waivers with payment requests. To bridge cash flow gaps, the sub contracted with a factor. The factoring agreement required the steel erector to verify the sub’s invoice amounts. The factor paid subcontractor 85% of the invoice amounts up-front for three verified payment requests. The project experienced financial troubles. When the steel erector paid the second invoice to the factor, it attempted to condition the payment on the factor paying the subcontractor’s unpaid workers. The factor ignored the request and deposited the check. The steel erector did not pay the third invoice to the factor. When the steel erector’s sub went out of business, the steel erector incurred the costs to complete its sub’s work.
- The factor sued the steel erector for the third payment claiming the steel erector breached its subcontract by not paying the factor on the subcontractor’s behalf.
- The Court of Appeals held for the factor. Because the factor paid the subcontractor up-front in reliance on the steel erector’s verifications, the third invoice was not subject to back charges or offsets.
To protect against unwittingly being exposed to contractors who may engage in factoring, some of the risk may be avoided or mitigated by including specific contract language that requires immediate notification of executed factoring agreements or prohibits contractual assignment of receivables or other interests in the contract. Notices from factoring companies should be reviewed carefully with legal counsel.
Shelly Masters is a Principal in the Austin office of Cokinos Young. She represents clients in the areas of construction, labor and employment, commercial and products liability law. Cokinos Young has been representing the construction industry for over 30 years. She can be reached by e-mail at smasters@cokinoslaw.com or by phone at (512) 615-1139.
About Cokinos | Young
Cokinos | Young has led Texas construction and real estate law for over three decades. And today, our 100+ dedicated professionals operate coast to coast and proudly handle all aspects of construction law for owner/developers, project managers, general contractors, design professionals, subcontractors, sureties, and lenders. We provide both dispute resolution and transactional services to clients through all phases of commercial, industrial, pipeline, offshore, civil, and residential construction. Our reputation was built on relentless commitment to client service and the industries we serve, and that remains our primary driver. Dedicated. Resilient. Expertise. That’s Cokinos | Young. Learn more at cokinoslaw.com.