Running a business is hard enough, but when you’re short on working capital or cash flow, owners are often looking for creative funding options. The COVID-19 pandemic has slowed many small businesses down to a crawl. Owners are doing their best to stay true to their word with employees, and are hoping that things will improve soon. Now, some are finding that the best option is to close their doors, but will they be able to handle the merchant cash advances they have on hand? When it comes to options, it is essential to consider every avenue and the risks involved before taking action.
A merchant cash advance is like a payday loan for a business. You sell your future receivables for an immediate lump sum, and you’ll usually pay it back between six to twelve months. That repayment plus a fee comes in the form of a set percentage of holdback from daily or weekly credit card transactions, or a fixed daily or weekly ACH withdrawal from your business bank account.
Merchant cash advances charge fees that are often much higher than traditional financing. Those fees are based on the risk the MCA company calculates to your business. The factor rate on these deals are often 1.2 to 1.5, which can end up being an annual percentage rate as high as 200 percent. Many businesses get trapped in cycles of debt where they take out new advances to pay off old ones.
A True Sale of Future Receivables or Simply a Disguised Loan
How do you close your business if you have unpaid merchant cash advances? That’s the question you need to be able to answer. It all hinges on whether the advance was a true sale of future receivables or simply a disguised loan. That distinction controls whether usury laws apply, whether the MCA provider gets secured status, and whether the payments can be clawed back in a bankruptcy for being preferential or fraudulent.
The real pain I’ve heard from businesses trying to avoid paying their MCA debt is some of them will claim, “Hey, this isn’t a purchase of receivables, this is a disguised usurious loan!” There have been a bunch of these cases in court recently, mostly out of New York state trial courts. It’s telling that many MCA companies are putting New York choice of law clauses in their agreements, since New York trial courts have mostly ruled the MCAs are purchases of receivables and not loans.
When it comes down to it, courts are going to look at a few things to decide if your deal is a sale or a loan. Is there a reconciliation provision that allows you to change the daily payment to equal your actual daily receipts? Is the contract indefinite? Does the provider have any recourse if you go out of business or declare bankruptcy? If you’re closing, the last one is the biggest thing to look out for.
Why does recourse matter so much? One federal bankruptcy appeals court, Qualia Clinical Services, 8th Circuit, held that the recourse provisions in the MCA invoice purchase agreement put the risk of non-collection on the debtor, and so the court ruled it was not a true sale, but a disguised loan. Reconciliation cuts the other way: if your sales slow while you wind down, a reconciliation clause allows your daily payment to come down to match.
But two other factors also come into play. First, does the provider require a UCC-1 financing statement to be filed to give them a security interest in your receivables? And second, do they require a personal guaranty? In the end, the question of which is a loan and which is a sale boils down to this: Is the repayment absolute or contingent on the merchant earning future income?
If the provider must bear the risk of not getting repaid, that is, if the repayment is contingent and the provider takes the risk of not getting paid, the court will likely rule that this is a true sale. Not even a UCC-1 filing or personal guaranty defeats a true sale, provided the guaranty is not broader than the merchant’s own obligations, i.e. it does not require the guarantor to pay even if the merchant ceases to have future income. If you are closing your business, read the recourse and guaranty language carefully.
But some California courts take a harder look. If the transaction is essentially a loan dressed up to avoid usury laws, a judge might call it a loan anyway, no matter what the document says. There’s not a ton of case law yet at the state or federal level to tell us exactly how they’d rule, but they’d probably apply the same kind of factor analysis. In other words, don’t bank on getting off the hook with usury or predatory lending arguments if the MCA company takes you to court.
Preferential Transfers
What happens if your business closes, only to land in bankruptcy court? The big question in the MCA world is whether the payments to your MCA provider were preferential transfers or whether they fall under the ordinary course of business exception in section 547(c)(2) of the Bankruptcy Code. It comes down to the relationship between the parties. If the debtor has a history of taking out MCAs and has made regular payments, the payments are more likely to be treated as ordinary course.
In In re Hill, a 2018 Illinois bankruptcy case, the debtor had racked up so many MCAs that they had become an ordinary part of its business, and therefore the trustee could not get the payments back as preferences. The takeaway here is clear: If you are an owner who has taken one advance after another, you should not expect bankruptcy to get your payments back.
One bankruptcy court in Nebraska decided against an MCA provider: The debtor and the provider had only been in business together two and a half months. There was no established routine and the advances were all made only when the debtor was in financial trouble. On the other hand, the bankruptcy trustees generally have not fared well with their claims against MCA providers.
Consider All Your Options - and the Risks
Please consider all your options - and the risks - if you’re shutting down a business with MCAs outstanding. Remember the extreme fees, the drain on future receivables, and that usury defenses will probably fail in a collection suit. Read your agreement for reconciliation, recourse and guaranty terms before you close down shop.
