Micro, Small, and Medium Enterprises ("MSMEs") play a vital role in India's economy, contributing nearly 30% to the GDP1. However, they often struggle to secure the working capital needed for their operations. Traditional banks impose stringent lending criteria, which MSMEs frequently cannot meet due to their lack of credit history, lower credit ratings, and inability to provide collateral.
Factoring bridges this gap by facilitating access to much-needed working capital finance for MSMEs, who may be unable to obtain sufficient bank financing.
What is Factoring?
Factoring is a form of "account receivables financing" that involves a business selling its receivables (money owed by customers) to a financial intermediary known as a "factor" or "factoring company".
The sale or assignment of receivables is made on a discount. Upon the transfer of ownership of receivables, the responsibility of collecting the invoice payments shifts from the seller to the factor, allowing the seller to receive upfront funds from the factor.
The Factoring process usually involves the following steps:
- A seller provides goods or services to a buyer on credit.
- Instead of waiting for the payment period to end, the seller assigns the receivables to a factor to get immediate financing, mitigating cash flow issues and the risks of payment delays.
- The factor releases funds to the seller (assignor) at a discount.
- When the payment period in the invoice expires, the factor (instead of the seller) will receive the full payment from the buyer.
Regulatory Framework for Factoring in India
In India, Factoring is subject to The Factoring Regulation Act 20112 ("Act"), enacted to regulate the assignment of receivables to factors, provide for registration for carrying out factoring business and establish the rights and obligations of parties to factoring contracts.
Registration Requirements for NBFCs:
As per Section 3 of the Act, any factor intending to carry on a factoring business must obtain registration from the Reserve Bank of India ("RBI").
Currently, the factoring business can be carried out by either banks or NBFC-Factors. Banks can undertake factoring business without the prior approval of RBI.3 However, Non-Banking Financial Companies ("NBFCs") intending to carry out factoring business as their principal business are required to obtain prior approval from RBI.
Eligibility Conditions for NBFCs:
Earlier, the Act, along with NBFC-Factoring (Reserve Bank Directions), 20124, provided stringent eligibility requirements for starting a factoring business and receiving NBFC-factor registration.
Following the 2021 amendment to the Factoring Regulation Act ("2021 Amendment")5, the RBI issued the Registration of Factors (Reserve Bank) Regulations 20226 ("Factors Regulations").
As per a clubbed reading of the amended Act and the RBI's Factors Regulations, any company has to fulfil the following eligibility conditions7 to seek NBFC-Factor registration:
- Net Owned Fund ("NOF"): Every company seeking registration as NBFC-Factor shall have a minimum Net Owned Fund of ₹5 crore, or as specified by the Reserve Bank from time to time.
- Principal Business Criteria ("PBC"): An NBFC-Factor shall ensure that its financial assets in the factoring business constitute at least fifty percent of its total assets and its income derived from the factoring business is not less than fifty percent of its gross income.
Investment and Credit Companies: The Factors Regulations also make NBFCs classified as investment and credit companies ("NBFC-ICCs") eligible to engage in the factoring business.
An existing NBFC-ICC can apply to the RBI for registration as an NBFC-Factor if8:
- it does not hold or accept public deposits;
- it has an asset size of INR 1000 crore or above (as per its last audited financial statements);
- it meets the NOF requirements prescribed by the RBI.
Registration of Assignment of Receivables:
The Act also mandates the 'factors' to register details of every transaction related to the assignment of receivables in their favour with the Central Registry of Securitisation Asset Reconstruction and Security Interest of India ("CERSAI") created under the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest ("SARFAESI") Act, 2002.
Trade Receivables Discounting System ("TreDS"): TreDS is an electronic platform for facilitating financing or discounting trade receivables of MSMEs via multiple financiers, which involves creation of a Factoring Unit ("FU"), representing invoices or bills of exchange, documenting the sale of goods or services by MSME sellers to buyers.
The 2021 Amendment added provisions regarding TreDS to the Act, mandating the relevant TreDS platform to register the assignment transactions financed through their platform with the CERSAI within the time period prescribed by RBI9.
Conclusion:
The factoring service market is projected to grow at a CAGR of 11.6% from 2024 to 203210. However, the current regulatory framework may still need adjustments to fully support industry growth and better serve the needs of MSMEs in India.
While the Factoring Regulation Act amendments aimed to encourage more NBFCs to enter the factoring business, reinstating the Principal Business Criteria through RBI Factors Regulations raises questions about achieving this goal.
Footnotes
1 Contribution of MSME Sector in GDP, PIB - https://pib.gov.in/PressReleaseIframePage.aspx?PRID=2003871.
2 The Factoring Regulation Act 2011, Act No. 12 of 2012 - https://www.indiacode.nic.in/bitstream/123456789/2116/4/a2012-12.pdf.
3 Section 5 of The Factoring Regulation Act 2011.
4 RBI Notification DNBS. PD.No. 247 /CGM(US)-2012, The Non-Banking Financial Company –Factors (Reserve Bank) Directions, July 23 2012 - https://rbi.org.in/scripts/NotificationUser.aspx?Id=7462&Mode=0#AN.
5 The Factoring Regulation (Amendment) Act, 2021 - https://prsindia.org/files/bills_acts/acts_parliament/2021/The%20Factoring%20Regulation%20(Amendment)%20Act,%202021.pdf.
6 RBI Notification No. DOR.FIN.080/CGM(JPS) – 2022 - Registration of Factors (Reserve Bank) Regulations, January 14 2022 - https://rbi.org.in/Scripts/NotificationUser.aspx?Id=12222&Mode=0.
7 Regulation 3 and 4 of Registration of Factors (Reserve Bank) Regulations, 2022.
8 Regulation 5 of Registration of Factors (Reserve Bank) Regulations, 2022.
9 RBI Notification No. DOR.FIN.081/CGM(JPS) – 2022, Registration of Assignment of Receivables (Reserve Bank) Regulations, January 14, 2022 - https://rbi.org.in/Scripts/NotificationUser.aspx?Id=12223&Mode=0.
10 India Factoring Services Market Research 2032, Allied Market Research - https://www.alliedmarketresearch.com/india-factoring-services-market-A21885.
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