Merchant Cash Advances (“MCA”), which spawned from the 2008 financial crisis, offer an alternative method of short-term financing for cash-strapped small businesses who need a quick source of funds and may not qualify for a bank loan. MCA companies provide funds to struggling businesses in exchange for a percentage of the businesses’ revenue, which typically are repaid through daily or weekly automatic withdrawals from the business’s bank accounts.
Frequently referred to as payday lenders for businesses, MCA companies tend to use high pressure sales tactics to entice unsuspecting small business owners into signing contracts that can be the gateway to financial ruin. These contracts of adhesion contain one-sided terms in favor of the lender, default provisions that are so restrictive a business is certain to default before ever contemplating the protections of bankruptcy laws, broad security pledges that encumber every asset and potential revenue stream, allow the lender unfettered access to the borrower’s bank accounts to monitor the financial condition of the borrower, and include mandatory personal guarantees of both performance and payment that can be invoked at any time. MCA companies employ a network of independent sales organizations (“ISOs”) who use leads purchased from online paid lead generators whose websites promise to match the consumer with reputable lenders along with website inquiries. The ISOs receive a commission or referral fee paid by the borrower from the funding proceeds.
The MCA agreements mimic a traditional factoring transaction, but the reality is quite different. Factoring is a type of small business financing where a factoring company purchases accounts receivable at a discount from the invoice amount. In return for the right to collect on the invoice and retain the difference between the invoice amount and the discounted purchase price, the factoring company assumes the credit risk of the collectability of the accounts. As owner of the account, the factoring company is typically entitled to receive payment directly from the account debtor, and to undertake collection activities. In contrast, a loan is the exchange of a sum certain to a business, with a promise to repay the sum plus a rate of interest, presumably from the future operating revenues of the business. The lender does not assume the credit risk of any particular account or asset of the business and does not assume responsibility for the collection of any account. In New York, interest rates are capped at 25% and any lender who charges more than the statutory maximum will run afoul of the state’s usuary laws.
Although MCA agreements state that they purchase accounts receivable and display a percentage rate that is at or below the statutory maximum, the effective rate of interest is significantly higher. The agreements do not identify any particular account purchased and require payments on a set daily or weekly schedule. Despite reconciliation provisions in the agreements that purportedly require the lenders to adjust the payments at the request of the borrower, the lenders rarely disclose how the payments are determined or under what circumstances a borrower would be entitled to an adjustment. In many cases, these lenders don’t have a reconciliation department and recent court cases have shown that certain lenders never intended to make the adjustments. With sham provisions and virtually no likelihood of adjustment, the agreements bear the hallmarks of a loan transaction: certainty of payment and a finite term.
The characterization and type of the MCA transaction is critical and continues to be the subject of consternation of the New York Courts and the Bankruptcy Courts. MCA companies have a strong interest in ensuring that the agreements are interpreted as a sale of receivables and not a loan. If the agreements are said to be a loan, then the effective interest rates on the agreements, which can exceed 300% on an annualized basis, would exceed both civil and criminal usury laws and expose the lenders to the risk of criminal enterprise corruption statutes.
Courts have struggled to develop any test that will uncover the true nature of MCA transactions. Civil Courts have defaulted to a three-prong test that does little to consider the overarching purpose and character of the agreements. Bankruptcy Courts fair slightly better, having developed a more fact intensive inquiry, however even that falls short of full discovery of the true nature of the predatory lending scheme. The terms and conditions of these MCA agreements are intentionally designed and/or used by the MCA companies to try to deceive courts and law enforcement into believing the agreements do not contemplate a loan transaction and thus do not trigger the usury or racketeering laws. A central component of the scheme includes pushing cash poor businesses to the point that they cannot meet their obligations under existing MCA agreements, at which point the lender offers new advances with even more onerous terms, trapping their victims into a negative feedback loop before pushing businesses (and their individual owners)towards a financial cliff. Eventually, the terms become too oppressive, small businesses default, and the MCA companies aggressively pursue small businesses and their individual owners for repayment of the amounts due under the loans. MCA companies often employ threatening, deceptive, and illegal collection tactics, impose unconscionable fees, file lawsuits in New York against businesses out of state, use unreliable methods of service designed to ensure defendants fail to answer, which then allow the MCA lenders to file uncontested default judgments.
For nearly a decade, MCA companies have operated with impunity, unregulated and undeterred, compiling over tens of thousands of judgments against small businesses and their individual owners. In 2018, the tide began to slowly turn when Bloomberg News published a series of groundbreaking articles exposing the abuses of the MCA industry. The New York State Legislature enacted legislation extinguishing the lenders’ preferred weapon — the confession of judgment. On July 31, 2020, the Securities and Exchange Commission shut down an MCA company located in Philadelphia. On August 3, 2020, the Federal Trade Commission sued Yellowstone Capital, who paid more than $9.8 million to settle charges that it withdrew money from businesses’ bank accounts without permission and deceived them about the amount of financing and other features of its financing products. On December 23, 2020, New York Governor Andrew Cuomo signed into law the Small Business Truth in Lending Law, which is aimed at protecting small business owners and requires key financial terms to be disclosed at the time a credit provider or broker makes an offer of financing of $500,000 or less. In January 2023, the New Jersey Attorney General settled a case against an MCA company, awarding $27,375,000.00 in relief to its customers comprised of the forgiveness of all outstanding loan balances of those customers, as well as restitution, civil penalties, attorneys’ fees, and costs.
On September 25, 2023, the New York State Attorney General struck another blow to the MCA industry with a decision against a group of lenders which deemed the agreements to be “criminally usurious loans,” ordering the recission of all of the subject agreements, a full accounting, vacating confessions of judgment, terminating liens, and compelling the return of all amounts collected by the defendant MCA companies dating back to June 10, 2014. While legislation and court decisions have begun to clamp down on MCA companies, they have done little to alter the landscape. The MCA companies and their legal counsel closely monitor court decisions and with each adverse decision they evolve, redrafting their agreements to eliminate terms found to be unlawful and add illusory “protections” for borrowers. Without sweeping reform of the MCA industry, small businesses remain at risk of falling prey to the insidious tactics of these enterprises, and until then let the borrower beware.
Renee Segina Moore is an Associate in Underberg & Kessler LLP’s Litigation, Creditors’ Rights, and Tax Law Practice Groups. Drawing on her background as a CPA, Renee leverages her experience to provide clients with the unique perspective of an attorney who not only understands the legal side of disputes, but also any financial implications critical to achieving client objectives. She represents businesses and individuals in litigation, negotiation, and mediation. Renee can be reached at rmoore@underbergkessler.com.
Reprinted with permission from The Daily Record and available as a PDF file here.