If a funder is pulling money out of your account every day or every week, it is natural to wonder whether filing bankruptcy will make it stop. The honest answer is that it depends less on the filing itself than on how the MCA agreement is structured. If the advance is treated as a loan by the bankruptcy court, the court can void the agreement, throw out the funder’s claim, and claw back payments the funder already received. If the advance is a true sale, most of those bankruptcy tools don’t apply.
MCAs are an aggressive form of non-bank financing. In MCA transactions, a funder will give a small business cash in exchange for a percentage of the business’ future receivables. MCAs charge extraordinarily high effective interest rates. Payments are typically taken on a daily or weekly basis, which means the frequency of payments is far higher than with a typical bank loan. The language of MCAs typically describe these transactions as a sale of a percentage of future receivables, not as a loan. Unfortunately for funders, bankruptcy courts often recharacterize MCAs as disguised loans. A recharacterized MCA is a different animal. For one, the agreement could be voided under state usury laws. Second, the funder’s claim could be disallowed entirely. Third, the payments made pre-bankruptcy could be clawed back as preference transfers or as fraudulent transfers.
Three Recent Cases
So what does bankruptcy do to your MCA? To find out, let’s look at three recent cases: In re JPR Mechanical, In re Williams Land Clearing, and In re Global Energy Services. All three agreements were governed by New York law, so each court used the same three-part test. The test comes from LG Funding v. United Senior Properties of Olathe, a New York appellate decision.
The first is the reconciliation clause. In plain English, this asks whether the payments could be adjusted to match how much the business actually collects. Because the payments are tied to the receipt of collections, the funder is assuming the credit risk of the receivables. A reconciliation clause can be illusory though, and the courts don’t take it seriously in that case.
The second factor is the repayment schedule. If the agreement has a definite, set end date for repayment, it looks more like a loan. In other words, it doesn’t matter whether the receivables generate enough money to support the payments through the life of the agreement, or not. That risk is left with the business.
The third factor is recourse. If the funder has the right to get their money back from the debtor personally, or from a guarantor, if the business fails or files for bankruptcy, then the transaction is probably a loan. Personal guaranties, security interests and the ability to file a proof of claim in the bankruptcy all point the same way.
In JPR and Williams Land, the courts found that reconciliation was illusory. The agreements were subject to a de facto fixed term. And the agreements included personal guaranties. JPR and Williams Land were loans. In Global Energy, by contrast, the court found that reconciliation was real and tied to the amount the funder collected. The agreement did not include a fixed term. And the funder assumed the risk of insolvency. The debtor did not default on the agreement by filing bankruptcy. Global Energy was a true sale.
Underneath all three factors sits one question: who bears the risk of non-payment? In a true sale, the funder accepts the risk that it may not recover all it advanced. In a loan, the funder looks for repayment no matter what happens to the business.
Criminal Usury Rate
Why does the label matter so much? Because of what comes after a court says loan. In New York, the criminal usury rate is capped at 25% per year. The court found that in In re Williams Land, the advance had an effective interest rate of 101.1%. As such, the agreement was void from the beginning. The debtor was then able to recover the payments made to the funder and object to the funder’s claim. In In re JPR, the court avoided over $3 million in transfers as preferences. However, In re Global Energy was deemed a true sale and all usury claims were dismissed. The state matters, too. There is no similar usury law in Illinois for corporate borrowers.
Your Own Agreement
If you want to know where your own agreement falls, pull it out and read it with these three factors in mind. Start with the reconciliation clause. Is it real, or is it illusory? Is there a set payment schedule? Who has recourse? And then if you think your deal may be a loan and not a true sale, alert your bankruptcy attorney.
Global Energy is the case to keep in mind before you assume bankruptcy will rescue you. The funder there kept its true sale, and the usury claims were thrown out. The bankruptcy might not even help you. Still, the value of bankruptcy in restructuring your debt is that it can tilt the balance of power between you and the funder. You, the debtor, or a trustee should review your agreement with an eye toward claim objections, avoidance actions and usury defenses.
