Invoice “factoring” is a financing arrangement in which a subcontractor sells outstanding invoices to a factoring company. Here’s how it works. After the contractor signs a “verification” (or “estoppel”) letter admitting that the invoiced amount is owed, the factor pays the subcontractor a percentage, usually between 70-85%, of the invoice. After the contractor pays the factor, the factor pays the subcontractor the remainder of the invoice less a financing fee.

Most contractors do not appreciate the risk factoring poses when an invoice is confirmed. In a recent Indiana case, Sterling Commercial Credit – Michigan, LLC v. Hammert’s Iron Works, Inc., a contractor subcontracted with a steel erector. The steel erector then entered into a factoring agreement that gave the factor the right to purchase invoices for a fee.

Before purchasing a particular invoice, the factor asked the contractor to sign a “verification letter” to “confirm that the work, product or service has been completed and accepted and that there are no joint checks requests, offsets, credits, debits for counterclaims of any kind, and that this job is not subject to any payment bonds, contractors bonds, performance bonds, or other bonded obligations.” The verification letter also stated that the factor was “reliant upon this verification in order to provide financing to” the steel erector.

The factor purchased invoices from the steel erector for 85% of the invoice amount, waiting to receive payment of the full invoice amount from the contractor. In total, the factor purchased three of the steel erector’s invoices, each of which was conditioned on receiving a signed verification letter from the contractor.

Before the project was completed, the steel erector went out of business. The contractor completed the steel erector’s work and paid the steel erector’s lower-tier subcontractors and suppliers. When the contractor failed to pay the factor, the factor sued.

The court ruled for the factor, holding that the factor had paid the steel erector only after relying upon the contractor’s verification letter, which assured the factor that the invoice was not subject to any backcharges or other offsets. As a result, full payment was due, even though the contractor would have been able to backcharge the steel erector for payments made to the steel erector’s subcontractors.

A contractor should be cautious about cooperating with a subcontractor who desires to factor its invoices, and a contractor would be wise to decline any request that it provide a verification letter to the factor. That is unless the contractor is confident that it will not need to assess a backcharge for any reason.