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Factoring Receivables in Construction

Brian R Gaudet


  • Factoring is not lending, but it looks somewhat similar.
  • Factoring can make a simple payment dispute on a construction project more complex.
  • Factoring rates generally range from 2 percent to 15 percent and may fluctuate.
Factoring Receivables in Construction
Nicolas Jehly on Unsplash

Step one in any potential piece of new litigation is understanding who the parties are, who has what claims and counterclaims, who might be potentially liable, and what a potential recovery might be. In the instance of a payment claim by an unpaid subcontractor or trade contractor, it is important to identify whether the subcontractor has assigned its receivables to a factoring company and to determine whether and to what extent the factoring company may have rights and what they are.

What Is Factoring?

Factoring is not lending, but it looks somewhat similar. The differences are important in the construction context. In a lending transaction, the lender gives the borrower money and secures its repayment by taking rights in collateral such as accounts receivable. In a factoring transaction, the factoring company (the factor) buys and owns the accounts receivable. The factor is not lending money per se; it is buying a debt and it expects to be principally repaid by the party who owes the debt, rather than the borrower (although the factor may have secured rights for repayment from the trade contractor in the event the original debtor does not pay). In the construction context, a factor may lend money to a trade contractor to give the trade contractor immediate cash for a pay application. When the pay application is paid by the general contractor, the factor expects to receive the payment from the general contractor. The factor charges a fee for doing this short-term “lending,” and depending on the length of time it takes for the pay application to be funded, the factor receives a greater share of the pay application. Factoring rates generally range from 2 percent to 15 percent and may fluctuate on the basis of how long it takes for the factor to be paid back.

What Is the Benefit of Factoring?

Why would a subcontractor factor its receivables and lose that money from a pay application it is about to receive? The quick answer is cash flow. To understand that concept more thoroughly in this context, let us examine the financial life of a trade contractor on a particular project. Trade contractors (heating, ventilation, and air-conditioning; mechanical; electrical; plumbing; etc.) make their money providing materials and installing them on a project. On day one, the trade contractor orders materials from one or more supply houses and has the materials shipped to the project site. On the day of delivery, the materials are typically invoiced by the supply house and the clock starts ticking. Payment terms will vary, but “net 30” terms are common. That means that payment is due within 30 days of invoicing. After receiving the materials, the trade contractor has to incur labor costs installing the materials. In construction, contractors typically work for a full month before they get to submit a pay application to be paid for that work.

When it comes time to submit a pay application, the general contractor has to assemble the pay applications of all of its trade contractors and roll those up into its own pay application. Once that process is complete, the general contractor will submit the pay application to the owner and architect/engineer for review. The architect/engineer will review the progress of the project and may return the pay application to the general contractor if it believes the general contractor is asking for more money than the progress on the project warrants. Some delay can occur while the pay application is adjusted. Once the pay application is approved, the owner will fund the pay application. There can be some delay in getting the approval of a lender and funding of the draw by the lender. After receiving the funds, the general contractor pays the trade contractors. The time for paying the trade contractors varies, but most common is a 7- to 10-day period. While it may take four to six weeks from getting started to receiving a payment, the trade contractor has to pay for its labor, its fixed overhead (vehicles, office, insurance, office supplies, etc.), and administrative assistance, and potentially must begin to pay back its materials suppliers during that time. For that reason, quite a bit of money leaves the trade contractor’s bank account before any money starts coming in.

The other thing to consider is the last project of the trade contractor and retainage. In most construction projects, trade contractors (subcontractors) have a portion of each pay application withheld until after the job is complete (retainage). Various state statutes may govern the amount of retainage that can be withheld. The most common amounts are 5 percent or 10 percent. Assuming there are no delays or disputes on a project, which can greatly affect the payment of retainage, the trade contractor will have some of its money tied up as retainage on previous projects it completed.

All of this “normal” activity has a real effect on cash flow. In the event there is a dispute or defective work that has to be redone, the cash flow crunch can get much worse.

How Factoring Works and Why It Complicates Matters

To generate some cash flow more quickly, a trade contractor may turn to a factoring company to have the factor buy the trade contractor’s receivables. The factor then takes an assignment of the right to be paid on the pay application. This transaction may be with or without recourse to the trade contractor if the factor is not paid by the general contractor.

In the scenario described above, proper notice is sent to inform the general contractor of the assignment. If the general contractor pays the trade contractor directly after it has received a proper notice of the assignment, that may not serve to discharge the debt owed to the factor. In an effort to avoid the situation in which a trade contractor factors its receivable, some general contractors may try to include provisions in their contracts that would seem to restrict a subcontractor’s ability to factor its receivables, through a limitation on assignments, including the assignment of the right to receive payment. This may not be enforceable. Section 9-406 of the Uniform Commercial Code addresses both the qualification for a proper notice and attempts to avoid the assignment of receivables.  The Uniform Commercial Code or portions thereof have been adopted by each of the states. Each state may have its own unique revisions to the code, and there is certainly a chance that in each state, common law and the state’s interpretations of the code might bring another element of uniqueness to the way in which these concepts are interpreted under an applicable state law. In addition, there can be interpretative challenges when there are multiple companies (factors, lenders, and others) contending that they have the right to be paid.

Accordingly, when you are dealing with a payment claim on a construction project and the name on the demand letter includes words like “financial” or “capital” and not “heating” and “cooling,” a factor may be involved. For that reason, it is important to investigate why that company is in the dispute and what rights the company and others may have. If your client asks whether it can ignore the factor and make payments directly to the trade contractor, please be cautious. If you are representing a trade contractor that has assigned its receivables and you are counting on having your attorney fees paid out of recovery of the receivables, that money may not go to the trade contractor. Check the applicable state law and proceed cautiously, regardless of the party you represent. In actuality, the dispute may be significantly different than it first appeared or was first presented by your client.