Shortfall Fees in Factoring Pact

As financial circumstances become more difficult, it is expected that many businesses will turn to funding solutions such as factoring agreements to weather the storm. These agreements typically involve the advance of money from a financial institution to a business against proceeds from the business's outstanding accounts receivables.

In a recent decision, Judge Shira A. Scheindlin of the U.S. District Court for the Southern District of New York applied New Jersey law in ruling that a shortfall fee charged by a factoring company was enforceable, pursuant to an alternative fee structure under a certain factoring agreement.

In doing so, the court in Dessert Beauty, Inc. v. Platinum Funding Corp. 06 Civ. 2279 (SAS), Opinion and Order dated Oct. 1, 2007, rejected arguments that the fee in question constituted either an unenforceable penalty or an unreasonable liquidated damages clause, and in effect, reinforced the rights of the parties to freely chart the method of performance in the event of a certain potential contingency, which may not rise to the level of a contractual breach. [Note, at least two commentators have termed similar election of contractual performances 'embedded options.' See Robert E. Scott and George G. Triantis, 'EMBEDDED OPTIONS AND THE CASE AGAINST COMPENSATION IN CONTRACT LAW,' 104 Colum. L. Rev. 1428 (2004), for a much more in-depth analysis of contractual damages and embedded options.]

The alternative fee structure in question arose from a factoring agreement entered into by and between Platinum Funding Corp., a New York-based company, which provides, among other services, accounts receivable funding to companies with annual sales revenue between $1 million and $150 million, and Dessert Beauty Inc., a distributor of Jessica Simpson's line of edible cosmetics. [Note, Platinum Funding Corp. is one of the entities which operate under the umbrella of the Platinum Funding Group family of companies, all of which provide factoring services.]

As is commonplace in the factoring industry, the factoring agreement in question provided that Dessert Beauty Inc. sell a minimum amount of accounts receivable to Platinum Funding Corp., during the course of a defined term. Thus, a failure to provide the agreed-upon minimum amount of accounts receivable would lead to the imposition of an adjustment fee, which is commonly referred to as a 'shortfall fee' within the factoring industry.

During the course of the factoring agreement in question, the distributor did not deliver the agreed-upon minimum amount of accounts receivable, leading to the imposition of a shortfall fee through the withholding of funds. In an effort to recover these withheld funds, Dessert Beauty Inc. commenced an action, claiming, among other things, that the contractual provision providing for the shortfall fees in question constituted either an unenforceable liquidated damages clause or served as a penalty, and as such, was unenforceable. The court ultimately rejected these arguments and adopted the 'alternative performance' argument put forth by Platinum Funding Corp.

Alternative Performance

A brief nationwide search for comparable rulings bears out the fact that most similar cases end up turning on the question of the reasonableness of a liquidated damages clause, or at least a clause that comes to be judicially defined as a liquidated damages clause. See, e.g., First Call Friendly Note Buyers, Inc. v. McMenamy, 40 AD3d 1239, 837 NYS2d 363 (3d Dept. 2007); JMD Holding Corp. v. Congress Financial Corp., 4 NY3d 373, 828 NE2d 604 (2005); AP Propane, Inc. v. Sperbeck, 157 AD2d 57, 555 NYS2d 211 (3d Dept. 1990); Wasserman's Inc. v. Township of Middletown, 134 N.J. 478, 634 A.2d 525 (N.J. Supreme 1994); Monsen Engineering Co. v. Tami-Githens, Inc., 219 N.J.Super. 241, 530 A2d 313 (N.J. Super.A.D. 1987).

There can be a twofold explanation for this: First, liquidated damages are often only effectuated by a breach, which, in an of itself, becomes the subject of litigation; and, second, an analysis of the reasonableness of a supposed 'liquidated damages' clause takes courts down a less-convoluted path than that presented by alternative performance. By contrast, alternative performance is, after all, not a breach, but in fact, performance, despite appearances to the contrary. Such appearances often distort the intent of the parties to such an extent that it becomes simpler for courts to conjure up the label of 'liquidated damages.'

Most cases involving alternative performance are found within the realm of prepayment mortgage penalties, and, without delving deeper into the general question of contractual damages and/or freedom, as such an analysis is well beyond the scope of this article, provide a good basis for comparison to the relevant alternative fee structure in Dessert Beauty, Inc. v. Platinum Funding Corp. According to the Restatement (Third) of Property, 'The primary purpose of these [prepayment] clauses is to protect the mortgagee against the loss of a favorable interest yield. … Prepayment may also result in further losses, such as the administrative and legal costs of making a new loan … and in some cases additional tax liability.' In other words, as succinctly stated by the New Jersey Superior Court, Appellate Division, '[t]he lender has committed itself to leave its funds outstanding for a fixed period at a given interest yield, and to suffer the market rate risk inherent in this position. … From the lender's viewpoint, a prepayment is a derogation of the right to earn the agreed yield for the full term even if extrinsic rates drop. In other words, the borrower breaches its obligation to keep the loan in effect for its full term.' Westmark Commercial Mortg. Fund IV v. Teenform Associates, LP, 362 NJSuper 336, 344, 827 A2d 1154, 1158 (2003), citing Whitman, 'Mortgage Prepayment Clause: An Economic and Legal Analysis,' 40 UCLA L.Rev. 851, 871-72 (1993).

Thus, it becomes apparent that prepayment clauses serve to grant protection to lenders, in the face of changing markets. By embedding the costs of the borrower's prepayment in the loan agreement, the parties to the agreement have, in essence, granted the borrower two alternative methods of performance: The borrower could make payments as prescribed by the loan agreement, or the borrower could prepay the entire loan, along with the lender's costs arising from such a prepayment.

Late Fees Upheld As Alternative Performance

An illustrative case outside of the mortgage world involved the late fees charged by Blockbuster Video for rentals. In Pickens v. Blockbuster Inc., 2004 WL 339594 (Cal.App. 1 Dist. 2004), the plaintiff challenged the fees charged by Blockbuster for the late returns of videos as an unenforceable penalty. It is interesting to note that the plaintiff's challenge was based on her assertion that the late fee charged was actually an unlawful liquidated damages provision arising from a consumer transaction, which effectively made it an unenforceable penalty. In rejecting the plaintiff's arguments, the court found that the late fees constituted alternative performance; that is, 'rational people would be presented with a choice between keeping the video and watching it for a fee equal to or less than the initial rental fee, or returning it and making a second trip to re-rent it for an equal or higher price on a future occasion, or foregoing watching it altogether.' 2004
WL 339594 at *3. It is this 'choice' that is at the heart of the decision in Dessert Beauty, Inc. v. Platinum Funding Corp.

Adjustment Fee Structure and Factoring

The ruling provides a strong reaffirmation within the factoring industry, as well as within other financial industries, which often imposes unpopular and complex fees that are necessary to protect investments made in clients and customers. Although a traditional factor differs from a mortgagee in that a factor is not a lender but a purchaser of accounts receivable, the underlying principles behind the classification of mortgage prepayment fees as alternative performance are equally significant in the factoring world.

Within the realm of factoring, by advancing funds through the purchase of accounts receivable, factoring companies are undertaking many risks, with respect to both their clients and the customers of their clients, commonly referred to as account debtors. These risks are analyzed and ultimately undertaken in light of, among other things, the minimum amounts of accounts receivable that potential factoring clients undertake to provide, which affect the anticipated yield to the factor.

One very apparent risk is the failure by factoring clients to deliver the previously agreed-upon amounts of accounts receivable, during a defined time period. While such a nondelivery may not rise to the level of a contractual breach, the factor, nonetheless, still incurs losses from such shortages.

Under the adjustment fee structure, such as the one upheld by the Southern District of New York, nonperformance on the part of a client, not rising to the level of a contractual breach, grants the factor protection for the losses incurred, including coverage for manpower spent and the cost of the commitment to leave its funds outstanding for a given period of time. Furthermore, pursuant to the adjustment fee structure, a factored client is given a rational choice that may become relevant under shifting market and credit conditions. It may become preferable to the client to pay the adjustment fee, and to retain a certain amount of accounts receivable, instead of providing the entire promised amount of accounts receivable to the factor.

Conclusion

In today's credit-weary market, asset-based financing agreements, whether in the form of factoring agreements or otherwise, are becoming increasingly more common. As such, the decision in Dessert Beauty, Inc. v. Platinum Funding Corp., which found that the shortfall fee in question 'is unambiguous and sets out an alternate fee structure,' takes on added importance. 2007 WL 2852758, *7

With the likely increase of factoring arrangements and other asset-based financing arrangements, those providing funds under such arrangements are now further assured that their somewhat risky investments are adequately protected in the event of nondelivery by their contractual partners.

However, such fund providers must be cautioned that the decision in Dessert Beauty, Inc. v. Platinum Funding Corp. is far from a 'blank check' which allows for any alternative fee structure. It is likely that an unreasonable alternate fee structure will be struck down as a penalty. Just where that line in the sand is has yet to be determined by the courts, but, with the increasing importance of factoring, such a determination may come in the not-so-distant future.

This article is a modified version of one that originally appeared in the New York Law Journal, a sister publication of this newsletter.

Shlomit Ophir-Harel is the chief legal counsel for and Chaim Rybak serves as legal counsel to Platinum Funding Group.

As financial circumstances become more difficult, it is expected that many businesses will turn to funding solutions such as factoring agreements to weather the storm. These agreements typically involve the advance of money from a financial institution to a business against proceeds from the business's outstanding accounts receivables.

In a recent decision, Judge Shira A. Scheindlin of the U.S. District Court for the Southern District of New York applied New Jersey law in ruling that a shortfall fee charged by a factoring company was enforceable, pursuant to an alternative fee structure under a certain factoring agreement.

In doing so, the court in Dessert Beauty, Inc. v. Platinum Funding Corp. 06 Civ. 2279 (SAS), Opinion and Order dated Oct. 1, 2007, rejected arguments that the fee in question constituted either an unenforceable penalty or an unreasonable liquidated damages clause, and in effect, reinforced the rights of the parties to freely chart the method of performance in the event of a certain potential contingency, which may not rise to the level of a contractual breach. [Note, at least two commentators have termed similar election of contractual performances 'embedded options.' See Robert E. Scott and George G. Triantis, 'EMBEDDED OPTIONS AND THE CASE AGAINST COMPENSATION IN CONTRACT LAW,' 104 Colum. L. Rev. 1428 (2004), for a much more in-depth analysis of contractual damages and embedded options.]

The alternative fee structure in question arose from a factoring agreement entered into by and between Platinum Funding Corp., a New York-based company, which provides, among other services, accounts receivable funding to companies with annual sales revenue between $1 million and $150 million, and Dessert Beauty Inc., a distributor of Jessica Simpson's line of edible cosmetics. [Note, Platinum Funding Corp. is one of the entities which operate under the umbrella of the Platinum Funding Group family of companies, all of which provide factoring services.]

As is commonplace in the factoring industry, the factoring agreement in question provided that Dessert Beauty Inc. sell a minimum amount of accounts receivable to Platinum Funding Corp., during the course of a defined term. Thus, a failure to provide the agreed-upon minimum amount of accounts receivable would lead to the imposition of an adjustment fee, which is commonly referred to as a 'shortfall fee' within the factoring industry.

During the course of the factoring agreement in question, the distributor did not deliver the agreed-upon minimum amount of accounts receivable, leading to the imposition of a shortfall fee through the withholding of funds. In an effort to recover these withheld funds, Dessert Beauty Inc. commenced an action, claiming, among other things, that the contractual provision providing for the shortfall fees in question constituted either an unenforceable liquidated damages clause or served as a penalty, and as such, was unenforceable. The court ultimately rejected these arguments and adopted the 'alternative performance' argument put forth by Platinum Funding Corp.

Alternative Performance

A brief nationwide search for comparable rulings bears out the fact that most similar cases end up turning on the question of the reasonableness of a liquidated damages clause, or at least a clause that comes to be judicially defined as a liquidated damages clause. See, e.g., First Call Friendly Note Buyers, Inc. v. McMenamy, 40 AD3d 1239, 837 NYS2d 363 (3d Dept. 2007); JMD Holding Corp. v. Congress Financial Corp., 4 NY3d 373, 828 NE2d 604 (2005); AP Propane, Inc. v. Sperbeck , 157 AD2d 57, 555 NYS2d 211 (3d Dept. 1990); Wasserman's Inc. v. Township of Middletown , 134 N.J. 478, 634 A.2d 525 (N.J. Supreme 1994); Monsen Engineering Co. v. Tami-Githens, Inc., 219 N.J.Super. 241, 530 A2d 313 (N.J. Super.A.D. 1987).

There can be a twofold explanation for this: First, liquidated damages are often only effectuated by a breach, which, in an of itself, becomes the subject of litigation; and, second, an analysis of the reasonableness of a supposed 'liquidated damages' clause takes courts down a less-convoluted path than that presented by alternative performance. By contrast, alternative performance is, after all, not a breach, but in fact, performance, despite appearances to the contrary. Such appearances often distort the intent of the parties to such an extent that it becomes simpler for courts to conjure up the label of 'liquidated damages.'

Most cases involving alternative performance are found within the realm of prepayment mortgage penalties, and, without delving deeper into the general question of contractual damages and/or freedom, as such an analysis is well beyond the scope of this article, provide a good basis for comparison to the relevant alternative fee structure in Dessert Beauty, Inc. v. Platinum Funding Corp. According to the Restatement (Third) of Property, 'The primary purpose of these [prepayment] clauses is to protect the mortgagee against the loss of a favorable interest yield. … Prepayment may also result in further losses, such as the administrative and legal costs of making a new loan … and in some cases additional tax liability.' In other words, as succinctly stated by the New Jersey Superior Court, Appellate Division, '[t]he lender has committed itself to leave its funds outstanding for a fixed period at a given interest yield, and to suffer the market rate risk inherent in this position. … From the lender's viewpoint, a prepayment is a derogation of the right to earn the agreed yield for the full term even if extrinsic rates drop. In other words, the borrower breaches its obligation to keep the loan in effect for its full term.' Westmark Commercial Mortg. Fund IV v. Teenform Associates, LP, 362 NJSuper 336, 344, 827 A2d 1154, 1158 (2003), citing Whitman, 'Mortgage Prepayment Clause: An Economic and Legal Analysis,' 40 UCLA L.Rev. 851, 871-72 (1993).

Thus, it becomes apparent that prepayment clauses serve to grant protection to lenders, in the face of changing markets. By embedding the costs of the borrower's prepayment in the loan agreement, the parties to the agreement have, in essence, granted the borrower two alternative methods of performance: The borrower could make payments as prescribed by the loan agreement, or the borrower could prepay the entire loan, along with the lender's costs arising from such a prepayment.

Late Fees Upheld As Alternative Performance

An illustrative case outside of the mortgage world involved the late fees charged by Blockbuster Video for rentals. In Pickens v. Blockbuster Inc., 2004 WL 339594 (Cal.App. 1 Dist. 2004), the plaintiff challenged the fees charged by Blockbuster for the late returns of videos as an unenforceable penalty. It is interesting to note that the plaintiff's challenge was based on her assertion that the late fee charged was actually an unlawful liquidated damages provision arising from a consumer transaction, which effectively made it an unenforceable penalty. In rejecting the plaintiff's arguments, the court found that the late fees constituted alternative performance; that is, 'rational people would be presented with a choice between keeping the video and watching it for a fee equal to or less than the initial rental fee, or returning it and making a second trip to re-rent it for an equal or higher price on a future occasion, or foregoing watching it altogether.' 2004
WL 339594 at *3. It is this 'choice' that is at the heart of the decision in Dessert Beauty, Inc. v. Platinum Funding Corp.

Adjustment Fee Structure and Factoring

The ruling provides a strong reaffirmation within the factoring industry, as well as within other financial industries, which often imposes unpopular and complex fees that are necessary to protect investments made in clients and customers. Although a traditional factor differs from a mortgagee in that a factor is not a lender but a purchaser of accounts receivable, the underlying principles behind the classification of mortgage prepayment fees as alternative performance are equally significant in the factoring world.

Within the realm of factoring, by advancing funds through the purchase of accounts receivable, factoring companies are undertaking many risks, with respect to both their clients and the customers of their clients, commonly referred to as account debtors. These risks are analyzed and ultimately undertaken in light of, among other things, the minimum amounts of accounts receivable that potential factoring clients undertake to provide, which affect the anticipated yield to the factor.

One very apparent risk is the failure by factoring clients to deliver the previously agreed-upon amounts of accounts receivable, during a defined time period. While such a nondelivery may not rise to the level of a contractual breach, the factor, nonetheless, still incurs losses from such shortages.

Under the adjustment fee structure, such as the one upheld by the Southern District of New York, nonperformance on the part of a client, not rising to the level of a contractual breach, grants the factor protection for the losses incurred, including coverage for manpower spent and the cost of the commitment to leave its funds outstanding for a given period of time. Furthermore, pursuant to the adjustment fee structure, a factored client is given a rational choice that may become relevant under shifting market and credit conditions. It may become preferable to the client to pay the adjustment fee, and to retain a certain amount of accounts receivable, instead of providing the entire promised amount of accounts receivable to the factor.

Conclusion

In today's credit-weary market, asset-based financing agreements, whether in the form of factoring agreements or otherwise, are becoming increasingly more common. As such, the decision in Dessert Beauty, Inc. v. Platinum Funding Corp., which found that the shortfall fee in question 'is unambiguous and sets out an alternate fee structure,' takes on added importance. 2007 WL 2852758, *7

With the likely increase of factoring arrangements and other asset-based financing arrangements, those providing funds under such arrangements are now further assured that their somewhat risky investments are adequately protected in the event of nondelivery by their contractual partners.

However, such fund providers must be cautioned that the decision in Dessert Beauty, Inc. v. Platinum Funding Corp. is far from a 'blank check' which allows for any alternative fee structure. It is likely that an unreasonable alternate fee structure will be struck down as a penalty. Just where that line in the sand is has yet to be determined by the courts, but, with the increasing importance of factoring, such a determination may come in the not-so-distant future.

This article is a modified version of one that originally appeared in the New York Law Journal, a sister publication of this newsletter.

Shlomit Ophir-Harel is the chief legal counsel for and Chaim Rybak serves as legal counsel to Platinum Funding Group.