With the enactment of the Factoring Regulation Act, 2011 (“Factoring Act”), for the first time a consolidated legal framework governing all aspects of and codifying the law applicable to factoring transactions was introduced in India. The Factoring Act was introduced primarily with the laudable objective to address the delay in payment and liquidity problems faced by micro, small and medium enterprises (“MSMEs”) and to introduce a framework which would enable greater access to working capital finance. The Factoring Act also dispensed with stamp duty on factoring transactions to incentivize increased transactions without the burden of heavy duties which would have otherwise been applicable to assignment of movable property.

While the Factoring Act is an important enactment, its achilles heel has always been the limitations it introduced on the types of entities which could engage in the factoring business, in particular, its peculiar treatment of non-banking financial company(ies) (“NBFC(s)”), an important class of lenders in India. To elaborate, while NBFCs are covered within the definition of the term ‘factor’ under the Factoring Act, they are required to obtain a separate certificate of registration from the Reserve Bank of India (“RBI”) to commence or carry on the factoring business under the Factoring Act. Furthermore, a NBFC can be granted registration only if its ‘principal business’ is the factoring business viz. only NBFCs whose financial assets in the factoring business exceed 50% of its total assets and whose income from the factoring business exceeds 50% of its gross income can be authorized by the RBI to carry on the factoring business. Pursuant to the provisions of the Factoring Act, the RBI introduced a new category of NBFCs viz. NBFC–Factors (“NBFC-Factor(s)”) and effectively stipulated a time period within which existing NBFCs could either meet the ‘principal business’ criteria[1] or wind down their factoring business.

In light of these provisions many NBFCs, who prior to the enactment were engaged in the factoring business as part of a larger lending business, were compelled to wind down this element of their business. This is also borne out from the fact that despite almost a decade having passed from the date of enactment of the Factoring Act, only 7 entities have registered as NBFC Factors[2].

The limited impact which the Factoring Act has had on increasing factoring as a means of financing in India was also noted in the RBI Concept Paper on Trade Receivables and Credit Exchange for Financing of Micro, Small and Medium Enterprises published in March 2014 which stressed the need to build a suitable institutional infrastructure to enable an efficient and cost effective factoring/ reverse factoring process and ensuring sufficient liquidity is created for all stakeholders through an active secondary market. With this avowed objective, the RBI issued the Guidelines for setting up of and operating the Trade Receivables Discounting System (“TReDS”) in 2014 providing for a scheme for setting up and operating an institutional mechanism for facilitating the financing of trade receivables of MSMEs from corporate and other buyers through multiple financiers. However, the ambit of entities which could be financiers on the TReDS platform was again limited to banks and NBFC-Factors, thereby limiting the access of MSMEs to a wider set of financiers on the platform. This debilitation has been noted by the recent Report of the Expert Committee on MSMEs of June 2019 which acknowledged that MSMEs find it difficult to discount invoices on the TReDS platform and has recommended widening the scope of financiers by permitting NBFCs other than NBFC-Factors and for necessary amendments in the Factoring Act to be considered by Government.

The Honourable Minister of Finance has in her speech on July 5, 2019 when presenting Budget 2019-2020 as well as in her more recent speech on February 1, 2020 when presenting Budget 2020-2021 referred to the proposal to make necessary amendments to the Factoring Act particularly to enable NBFCs to extend invoice financing to the MSMEs through TReDS, thereby enhancing their economic and financial sustainability.

While this issue is not new and several calls for action have already been sounded and taken on board, the need to amend the Factoring Act has taken on a new sense of urgency in light of the COVID-19 pandemic. One of the pressing issues which the Government is focused on in tackling the COVID-19 pandemic is measures which can be taken to encourage the provision of finance to and to generally boost the MSME sector – the amendment of the Factoring Act to widen the scope of lenders who can engage in the factoring business is low hanging fruit and now would be the perfect time to implement the same. Considering the constraints the original wording of the Factoring Act placed, ideally any amendment introduced should provide flexibility for new classes of lenders to be permitted to undertake the factoring business, from time to time, through government/ RBI notifications without necessitating further legislative amendments.

Authors:
Gautam Ganjawala, Partner
Bhargavy Ramesh, Senior Associate

Footnotes:

[1] The RBI vide the Non-Banking Financial Company –Factors (Reserve Bank) Directions, 2012 dated July 23, 2012 at first in exercise of its enabling powers under the Factoring Act stipulated a principal business criteria over and above the 50% critieria set out in the Factoring Act viz. a requirement to ensure that its financial assets in the factoring business constitute at least 75% of its total assets and its income derived from factoring business is not less than 75% of its gross income. However, based on industry representation and also to encourage the factoring sector in India, the RBI vide the circular dated November 10, 2014 subsequently aligned the threshold to the 50/50 threshold set out in the Factoring Act.
[2] List of NBFC-Factors registered with RBI (As on February 29, 2020) accessible at https://www.rbi.org.in/Scripts/BS_NBFCList.aspx