Understanding Invoice Discounting: Legal Framework, Transaction Dynamics, and Implications under the IBC, 2016

[By Nakshatra Gujrati]

The author is a student of National Law University Odisha.

 

Introduction

In the dynamic realm of financial transactions, invoice discounting has emerged as a pivotal tool for businesses seeking to optimize their working capital. Invoice Discounting, also known as Bill Discounting, entails three key participants: the seller, the customer (who is also the debtor to the financier), and the financier, commonly referred to as the factor. The financier provides this short-term relief in exchange for a predetermined commission and discount rate, forming the core dynamics of the transaction. 

This article explores the complexities of invoice discounting and its intersection with the Insolvency and Bankruptcy Code, 2016 (“Code”). Governed by the Factoring Regulation Act, 2011, (“Act”) the examination commences by delineating the fundamental process of invoice discounting and elucidating the roles assumed by the seller, customer, and financier. The article examines the dynamics of transactions between the financer and the customer, as well as between the financer and the seller. It scrutinizes the decisions rendered by tribunals, offering insights into the classification of customers as financial debtors and classification of sellers as operational debtors. 

What is Invoice Discounting  

Invoice Discounting, also known as Bill Discounting in trade circles, is a process where an entity can transfer its invoices (receivables) to a third-party financier, such as a bank or another financial institution. This financial entity, referred to as the “financer”, offers a bank discounting facility, providing short-term assistance in fulfilling the working capital needs of the entity that sold the outstanding bill. In return, the financer levies a designated commission and discount rate for their services. 

The Factoring Regulation Act, 2011 (“Act”) regulates the practice of invoice discounting, and businesses engaged in this activity are referred to as “factoring businesses”. This Act aims to validate contracts related to the assignment of receivables. The party to whom the receivable is transferred is known as the assignee, while the entity owning the receivable is termed the assignor. 

Invoice discounting typically involves three participants; the seller (sold goods and services to customer), the customer (also debtor of the financer) and the financier (commonly referred to as the factor). In this process the business sells its invoices to the financier, who provides cash. Afterwards when it comes time, for payment the customer pays the amount, to the financier. 

Invoice Discounting and Insolvency and Bankruptcy Code, 2016 

The section 5(8) of the Insolvency and Bankruptcy Code, 2016 (“Code”) defines financial debt as “debt along with interest, if any, which is disbursed against the consideration for the time value of money”, including “receivables sold or discounted other than any receivables sold on non-recourse basis” as per section 5(8)(e) of the Code.  

Nature of transaction between the Financer and the Customer. 

The customer enlists the services of a financer to enhance their cash flow, facilitating timely bill payments with reduced risk and increased flexibility, given that such arrangements don’t necessitate collateral. However, a dilemma arises when the customer fails to fulfil payment obligations to the financer. The tribunal is confronted with the inquiry of categorizing the customer as either a financial creditor or an operational creditor of the financer. 

In the case of M/s Shree Jaya Laboratories Private Limited,(“Jaya Laboratories”)  it was ruled that “an application under section 7 of the code may be maintained against the customer”.  

In the instant case the financer extended its services to the customer on a recourse basis. The Master Direction- Reserve Bank of India (Financial Services provided by Banks) Directions, 2016 classifies the factoring services into three categories. These include (i) non-recourse factoring, where the financer has no recourse against the customer except in cases of fraud, misrepresentation, or failure to fulfill obligations; (ii) recourse factoring, wherein the customer remains liable to the financer; and (iii) limited recourse factoring, allowing the customer and financer to establish conditions for recourse through a contractual agreement. As per section 5(8)(e) of the code, financial debt includes receivables sold or discounted other than non-recourse basis. Hence, the relationship between the financer and customer is of financial creditor and financial debtor and thus an application u/s 7 of the code is maintainable against customer.  

Nature of Transaction between the Financer and the Seller 

In the recent judgment of NCLAT in Minions Ventures Pvt Ltd vs Tdt Copper Limited (“Minions Ventures”) it was held that “while discounting the invoice of sellers the financers enter into shoes of seller to become operational creditors”. It was observed that in this transaction, no funds were disbursed, let alone for the time value as a financial debt to the seller. Instead, it constituted an operational debt, as the seller provided goods and services to the customer, defining the nature of the debt between the two as operational.  

Similarly, this view was taken in Jaya Laboratories while dismissing application of financer against seller under section 7 of the code. 

Conclusion 

The practice of Invoice Discounting, also known as Bill Discounting, plays a crucial role in facilitating working capital needs for businesses by allowing them to convert their receivables into immediate cash through third-party financiers. The Factoring Regulation Act of 2011 regulates this financial activity, defining the roles of factoring businesses, assignors, and assignees in the process. 

Examining the intersection of Invoice Discounting with the Insolvency and Bankruptcy Code of 2016, it becomes evident that the nature of the transaction between the financer and the customer is one of a financial creditor and financial debtor. This is especially true when the services are provided on a recourse basis, as outlined in the Master Direction of the Reserve Bank of India. The application of Section 7 of the Insolvency and Bankruptcy Code against the customer is deemed maintainable under these circumstances. 

In the context of the relationship between the financer and the seller, recent judgments, such as the one in Minions Ventures, suggest that when discounting invoices, financers assume the role of operational creditors. In these cases, where no funds are disbursed as financial debt, but rather the transaction revolves around goods and services provided by the seller to the customer, the debt is classified as operational. This view is consistent with the dismissal of applications against the seller under Section 7 of the Code in cases like Jaya Laboratories. 

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