Can a merchant cash advance be treated as a loan in bankruptcy?

The Impact of Dodd-Frank on Small Businesses

After the 2008 crisis, Congress passed Dodd-Frank in 2010, which was designed to rein in the excessive risk-taking that had led to the collapse in the first place. The new rules created the Consumer Financial Protection Bureau, which was designed to stop mortgage companies and payday lenders from exploiting people. The reform did help to make the lending business less dangerous. But it shares some of the blame. The government had good intentions, but a side effect of the new regulation was it created opportunities for a new sort of exploitation.

Big corporations take out loans to help fund big projects and expenses. They get these commercial and industrial (C&I) loans from banks and heavily regulated lenders. Unlike large corporations, many small businesses can’t just walk into a large bank and take out a big loan to fund their costs. This got some researchers interested in why small-business lending has decreased so much. In April 2018, NBER researchers Bord and Duca published a working paper. The paper looked at the impact of Dodd-Frank on small businesses.

Dodd-Frank hurt small businesses indirectly. It raised the fixed costs of making business loans and operating as a bank. Small banks devote far more of their C&I lending to small businesses than large banks do. The share of C&I loans that were “small” fell nine percentage points at large banks and banks with more than $300 million in assets since 2010. This same measure dropped twice as much at small banks. Once controlling for the business cycle and bank size, nearly all of the decline can be explained by the effect of the rule. Other Fed surveys found that credit standards for small firms tightened more than for large firms.

Despite the government’s good intentions, the effects of Dodd-Frank created a hole that can be seen in small business loans. Compliance costs for small banks pushed them away from small-dollar term loans (short-term business debt). Big banks didn’t want those loans. In the end, small firms lost fair, equitable funding.

Merchant Cash Advance Lenders

Of course, such short-term debt exists in all businesses, even technology behemoths like Amazon and Microsoft. Demand did not vanish with access. Because demand was already there, new firms entered the market to satisfy it. That’s where merchant cash advance lenders came into the picture. They operate outside Dodd-Frank regulations, taking advantage of loopholes. The lenders are unscrupulous outfits that saw desperate owners shut out by banks after the recession, and so built a product designed to slip past the rules. It’s a risky product.

An MCA is the purchase of a business’s future receivables for a lump sum cash payment. You, the merchant, use the cash like a short-term loan. Legally, it’s a sale, not a loan, so the merchant may not be able to write off the debt in Chapter 11 bankruptcy. That’s a risk the merchant may not know they’re taking on.

Think of a payday loan, but for business. With a payday loan, you get a lump sum of money that’s paid back with your next paycheck. With an MCA, you also get a lump sum of money, but you pay it back by having money taken from your bank account each day, whether you like it or not.

Daily withdrawals are quite painful if your income fluctuates day-to-day. Say you’re a contractor. You do a job and you have to wait 30 to 60 days to get paid by your client. But meanwhile, your lender is taking money from your account. Every single business day. So while you’re waiting to get paid, the lender is eating away at the rest of your income. It doesn’t matter to the lender that your client hasn’t paid. Payments that happen every day can harm even the healthiest of businesses. Miss one day and you’re in default and the whole balance is typically due immediately. Lenders show little sympathy.

CapCall V. Foster

A groundbreaking ruling came down in September 2021, from the federal bankruptcy court in Montana, in the 9th Circuit, in CapCall v. Foster. The debtor in the case was a business called Shoot the Moon, LLC.

CapCall, a New York MCA lender, filed an application for a declaratory judgment that $228,449.93 in segregated funds was CapCall’s to take from the bankruptcy estate. Foster had sold virtually all of the business assets, and the net proceeds were far below the claims of the senior secured creditors. What matters here is that if CapCall prevailed, that money would be tapped ahead of the other secured creditors, who would already be shorted. Everyone here is trying to cut in line, it seems.

The key question is whether the transactions in question were sales or loans. On one hand, CapCall argued the transactions in question were sales of receivables, and that, if they were, CapCall would have ownership of the receivables before other creditors. On the other hand, Foster argued that the transactions were loans, and therefore CapCall had a subordinate interest in the assets, such that, under section 506(d) of the Bankruptcy Code, when the assets were worth less than the liens on it, CapCall had only an unsecured claim, with no lien interest, in the assets. Hence, Foster concluded, CapCall would recover nothing. In plain language, the label determined who went first in line. If sale, then CapCall went first. If loan, then CapCall got none of the proceeds of the sale.

Think of the old “duck test” - that is, if it walks like a duck and quacks like a duck, it’s probably a duck.

What the court did, therefore, was compare how CapCall tried to characterize these transactions in the applicable documents with how those transactions actually worked in practice. If the transaction functioned as a loan, the court said, it was a loan. The old view has been that MCA’s are sales and not loans. In this CapCall case, the court disagreed, finding that because the terms of the contract were shown not to match the way the transaction actually worked, the deal should be treated like a loan - even if the contract said it wasn’t a loan.

The holding is where you get some clarity on the subject. Judge Whitman L. Holt declared CapCall’s merchant agreement to be not a true sale, found CapCall to be in violation of Montana usury laws against predatory interest rates, and found CapCall to have no interest in the bankrupt estate’s assets.

Does this mean you can declare an MCA a loan in bankruptcy? Yes, if the court agrees with you. Labels don’t help. So what to take from this groundbreaking ruling is that if you have an MCA and wind up in bankruptcy, the Court may look to how the transaction actually operates rather than the labels on the contract. A first-round victory for MCA victims, but don’t look for a sea change from one court, in one case. Watch as the recession pushes more businesses to MCA lenders.