How can a factor use DIP financing in Subchapter V to clear merchant cash advance debt?

The slogan “DIP em and dump em” comes to us from Lewis Merrifield of 1st Commercial Credit. You’re looking for Debtor-in-Possession financing if you want to lend to a factoring client in bankruptcy. In a bankruptcy filing under Sub-Chapter V, your client can propose a plan under which the MCA lender gets back bankruptcy dollars, often a fraction of what is owed. If you’re a factor whose client’s drowning in a swamp of stacked MCA debt, or an owner of a business that wants to stay in business, read on to learn about a different way to use DIP funding.

Sub-Chapter V

Why Sub-Chapter V exists

Sub-Chapter V was a necessary step in fixing a broken system. Congress passed it in 2019 because most business Chapter 11 cases had failed. Back when there was such thing as an old-style Chapter 11, the debtor had to deal with a creditors’ committee, a U.S. Trustee, a disclosure statement (sort of like a prospectus), and a plan, along with the cost of first day motions. None of these folks is friendly or inexpensive. The absolute priority rule says that if the owner wishes to retain the equity, they must pay the senior classes in full, or contribute new value. There’s a lot more to it, but basically that’s the simplified end of it. The Absolute Priority Rule was also the basis for some pretty intense plan fights. It was a poor tool for small businesses who weren’t cash rich.

Sub-Chapter V began as an experiment. If your client has debts of $7,500,000 or less and isn’t in the business of owning real estate, they may choose to file bankruptcy under it. In Sub-Chapter V there’s no disclosure statement. Only a plan is filed, and the debtor’s got four months to get it done. The absolute priority rule no longer applies. A feasible plan is one that pays free cash to creditors over the life of the plan, typically five years. There is no U.S. Trustee fee. (Otherwise, there’d be a charge equal to a percentage of the case size.) The Sub-Chapter V trustee participates and administers plan payments. There’s no creditors committee unless the court orders one. What does all this mean for your client? Sub-Chapter V is a way they can keep the business, without paying the senior creditors in full. It’s cheaper, and it’s quicker. COVID relief raised the dollar limit from $2,725,625, and it should stay there permanently. There’s a proposal to extend it. This is capitalism as it should be. Companies seeking new lives deserve help, not obstacles.

MCA Lending

The concept behind MCA lending is simple: the merchant nominally sells a portion of future income to the lender at a discount, say $250,000 of future income for $185,000. In practice, however, the MCA lender resembles a predator. You know that MCAs are often repaid via daily debits of a fixed percentage, often with high fees. But did you know that the typical APR on an MCA is more than 100%? Watch for MCA lenders who file statements behind the factor, who have stacked on each other, and timed withdrawals so they come in just after the factor funds the client. When that withdrawal hits, the MCA lender scoops your funds, with a series of others crowding behind it. Often you don’t find out till it’s too late. MCA loans start out sounding good for the business. But they are like fentanyl. The business gets a quick high, with immediate relief, and they are trapped in a death spiral that often does not end well.

The DIP strategy works best if the factor is in first position, although it isn’t necessary. You need to make sure that the client is capable of functioning without the MCA debt. If it is not, then all you are doing is proposing a way to pay pennies on the dollar for a cash stream that will not cover the company’s bills. If after paying the financing costs and the operating costs, the company has positive cash flow, then it’s time to value the collateral and equity behind your lien. The most valuable collateral is usually accounts and inventory. If the client has inventory, then the situation is better. Second and later MCA lenders often have no equity behind the first position lender. Junior MCA lenders have in most cases lent into air.

A bankruptcy court must use state law, including Article 9, to decide property interests. If you want a lien, the security agreement has to grant one. Remember that some MCAs don’t reach after-acquired collateral, because under UCC 9-204 there has to be express language. Goods that get sold and paid for generate proceeds. Some industries, like staffing and trucking companies, have only accounts. Read the agreement under which each MCA was funded carefully. Ask if the MCA lender got real security for its funds. Because the bank account is the point where the business puts its receivables, the MCA lenders take daily withdrawals from the account. Without a control agreement, their lien on the cash in the account is vulnerable. A deposit account needs to have a control agreement to be perfected. Without one, the MCA lender only has a junior lien.

A bankruptcy court can split a lien into two parts, one secured by its collateral value and the rest unsecured. Under Sec. 506 the court will value collateral and the secured part of a lien goes up to the collateral value, and the unsecured part is left over. Under Sec. 552, the lien created by the original security agreement reaches post-petition proceeds only to the extent the original security agreement provides, and proceeds exist. The court may grant the MCA lender a replacement lien as adequate protection. If the MCA lender has some equity in the inventory proceeds, it gets a replacement lien to protect that value, nothing more. Inventory deals may leave something to pay the MCA; transportation deals, staffing deals, rarely. In any case, showing the annual rate is going to look bad. It’s the rare court that doesn’t want honest debtors to succeed. Many MCA lenders do not perfect until default, delaying to avoid discovery. Under Sec. 547(c)(3), if an MCA lender doesn’t perfect its lien until after the 30 days runs, and within 90 days of filing bankruptcy, it risks a preference claim. Verify that each MCA perfected its lien on time.

Get a DIP Loan Approved, Confirm Plan

When a client files bankruptcy, they may request permission from the court to use cash collateral, financing, employee wages, and critical vendor payments. This is called a first day motion. If you’re making a debtor-in-possession loan, you’ll need to get permission from the court to advance the client money. This is the DIP em part. The factor keeps funding the client under court order while the junior liens are left behind. A debtor-in-possession motion gives the court a chance to look at the effective rate charged. The motion can offer the MCA lenders a replacement lien in the same validity, priority and extent as existed before filing. Most MCA lenders, particularly juniors, ignore first day motions. There’s a lot of death in a replacement lien. If the junior lender has a lien that entitles it to no collateral, then the new lien has the same priority, and no value. The junior MCA lender is well behind the factor, and has nothing. There is little sympathy for predatory lenders in a bankruptcy courtroom.

The client files a plan within four months after filing for bankruptcy. It has to be feasible. It needn’t pay the MCA liens in full. Only bankruptcy dollars are repaid. To be viable, the debtor has to pay free cash flow, after paying DIP financing and operating costs, to the creditors. The result for the MCA lenders is often a fraction of the face amount owed. Typically, MCA liens will be valued at unsecured status. Finally, the plan is confirmed, the MCA liens are dumped, and the client keeps the company. Sometimes there’s a third-party injunction, and the guarantor is protected.

Sub-Chapter V is debtor-friendly, and a good option for factors. Filing puts the automatic stay into effect, which means that the MCA lenders cannot jump on the client the moment they file. The factor often gets good protection as DIP lender. The end result of a case here is, in many cases, that the factor is the only secured party at the end. If the debtor has a feasible plan that pays free cash to creditors over its life, the plan will be confirmed, assuming, of course, the debtor is being honest. I know my explanation is simplistic. But the strategy really works.