How is a Subordination Used in Invoice Factoring?

In most cases, setting up a factoring account is relatively simple. Once the factoring contracts are signed, the factor files a UCC lien to secure its position against the accounts receivable, sends notices of assignment, and starts funding the account. Usually, this process is done fairly quickly.

One of the most common reasons to delay funding a factoring account is that there is an existing UCC lien that claims account receivable – your invoices – as collateral. In this scenario, the factor cannot claim first position against the accounts receivable it’s financing because another party already has first position. The factoring company won’t be able to finance the account until the issue is resolved.

Issue #1: Is there another lender involved?

Most business loans are secured by filing a lien against the assets of business. This lien often includes accounts receivable and is typically noted using terms such as “all accounts,” “accounts receivable,” or simply “all assets.” Keep in mind that notations vary, so consult an attorney or your lender if you need clarification.

Having a pre-existing lien is the reason you cannot use a line of credit and factoring at the same time – both finance companies need to be in first position.

Issue #2: Does the IRS or another taxing authority have a lien?

The IRS and local taxing authorities can place a tax lien against the assets of a business if the company does not pay taxes. This lien encumbers your assets and puts the taxing authorities in first position. Placing tax liens is one of the ways they collect taxes owed to them.

Use a subordination agreement

You can handle a lien by closing the financing line or paying the tax liability to the authorities. However, this measure isn’t always practical – or even possible. For example, you may need the financing line to operate your business, or you may not have enough money to pay the tax liability outright.

In if you cannot get the lien closed, the only alternative is to get a subordination from the lien holder. A subordination is often secured through an inter-creditor agreement. In the agreement, the existing lien holder subordinates its position to the factoring company: they give the factor “first position” against the accounts receivable, while they take a lower (subordinate) position.

Why would a lien holder subordinate its position?

Getting a lien subordination from another lender is extremely difficult. The only way you can convince a lien holder to subordinate its position is if you can show how the subordination benefits them. Generally, the argument is that the factoring financing line will help your company grow, thereby making the lender’s position on their other collateral presumably more secure. Most lenders will not agree with this argument unless they hold a strong position in other collateral that is liquid and valuable.

On the other hand, getting a lien subordination from taxing authorities is easier. The argument, however, is the same. You show them how using factoring improves your cash flow, which, in turn, allows you to pay them. This argument makes sense if you have cash flow problems and if those problems are preventing you from growing. Taxing authorities often insist on implementing a payment plan that you must follow. As part of that payment plan, they may ask that the factor remit a portion of your monies directly to them.

Consult an attorney

This article is for informational purposes only as it oversimplifies what can be a complex matter. If there is a lien against your company, consider retaining an attorney to help you determine the best course of action.

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