Is a merchant cash advance a loan that can be challenged as usurious?

Every business needs working capital and a steady cash flow. But for many small businesses and the employees they rely on, the COVID-19 slowdown is causing an exceptional strain. When cash is running short, alternative financing like a merchant cash advance might seem like the best bet, but it is essential to understand the risks involved when choosing a funding source.

Merchant cash advance, or MCA, is a way for small businesses to quickly get a lump sum of cash in exchange for future receivables, selling your future revenues for cash on hand. The typical term of a merchant cash advance is between six to twelve months, repaid daily or weekly by one of two methods. To pay it off, you hand over a predetermined percentage of the credit or debit card sales made in your store. Or a fixed amount is debited from the company bank account daily or weekly until the debt is satisfied with fees.

Steep Cost

Small businesses can get a fast cash infusion with a merchant cash advance, but it can come with a steep cost. A merchant cash advance is much more expensive than a traditional bank loan, so it’s important to know exactly what you are getting into. The ultimate cost depends on the lender’s perceived risk, with factor rates typically between 1.2 and 1.5. That works out to a maximum of 200% annualized rate.

With exorbitant fees, merchant cash advances can lock small businesses into debt cycles where they take a new advance to pay off the old one. Some businesses fight collection, arguing that the cash advance is a disguised usurious loan. Whether this defense works varies between cases. Courts have treated MCAs as both sales of receivables and loans. If the court sees it as a loan, usury laws apply.

Telling a Loan from a True Sale

Not all cash advances are alike. It can be hard to decide if you are selling a receivable or getting a loan secured by one. There are huge risks in getting it wrong. The correct designation determines whether or not usury laws apply, whether the provider is or is not a secured creditor, and determines whether or not payments to the provider are clawable, recoverable transfers in the event of the payor’s bankruptcy.

There’s been a rash of recent litigation over these devices and most cases come from New York state courts. Many providers write into the agreements clauses stating that New York law applies to all disputes. Providers choose New York because its courts have treated them favorably.

While there is no hard and fast rule for telling a loan from a true sale, courts have laid out several factors that distinguish the two.

The first item to evaluate in a factor rate MCA agreement is the presence or lack of a reconciliation clause. In the reconciliation clause, the merchant reserves the right to downwardly adjust fixed daily payments to mirror daily receipts.

The second thing to look at in a factor rate agreement is the lack of a definite time period. If the contract does not have a fixed term, that fits the contingent nature of collecting future sales.

The third factor is whether the MCA provider has or does not have recourse against the merchant if the merchant shuts down or files for bankruptcy.

Finally, two other factors to look at in a factor rate agreement include whether or not the MCA provider files a UCC-1, giving it a security interest in the receivables, and whether or not there is a personal guaranty. Again, those are factors. They are not definitive.

The million dollar question is whether repayment is absolute or contingent on the merchant earning future income. If the provider bears risk and repayment is contingent, the advance is likely a true sale, even if the provider has filed a UCC-1 or taken a personal guaranty, so long as the guaranty is not broader than the merchant’s obligations. One caveat to the guaranty question: If the guaranty exposes the business owner to personal liability even if the business does not have future sales, then repayment is no longer contingent, and the guaranty may be broader than the business’ obligations.

In California, some courts have looked past the form of the documents in order to determine the actual transaction. If the agreement is for the purpose of making a loan at a usurious rate, it is a loan.

Other courts have not yet been asked to sort this out, but if they do, they will probably weigh the same factors. Fees can be exorbitant, and the return of receivables may feel like debt servitude. So you must fully understand your obligations before you enter into an agreement.

Preferential or in the Ordinary Course

The bankruptcy courts, for the most part, have asked whether the MCA payments were preferential or in the ordinary course under § 547(c)(2). Courts generally look to the relationship for answers. In a merchant cash advance case, the regular schedule of advance after advance after advance can cause payments to be deemed ordinary course.

Before you commit to another advance, look at all your funding and workout options.

In the case law, the majority of the trial courts in New York find a true sale of future receivables in cash advance agreements. K9 Bytes v. Arch Capital, 56 Misc. 3d 807, 57 N.Y.S.3d 625 (N.Y. Sup. Ct. 2017). A cash advance provider has a security interest in the receivables according to the contract, but that does not change the contingent repayment nature of the agreement. Rapid Capital Finance v. Natures Market, 57 Misc.3d 979 (N.Y. Sup. Ct.); see also Colonial Funding v. Epazz, 252 F. Supp. 3d 274 (S.D.N.Y. 2017). A guaranty no broader than the agreement left repayment contingent, Platinum Rapid Funding v. VIP Limousine (N.Y. Sup. Ct. Oct. 27, 2016). One rationale for the cash advance being a disguised loan is that the agreement put the risk of non-collection on the debtor. In re Qualia Clinical (Lange v. Inova), 441 B.R. 325 (B.A.P. 8th Cir.), aff’d, 652 F.3d 933 (8th Cir. 2011). In California, at least two courts have gone the other way and looked behind the documents to see the substance of the transaction. If the purpose of the agreement was to make a usurious loan, it was a loan. Essex Partners v. Merchant Cash & Capital (C.D. Cal. Aug. 1, 2011); Milana v. Credit Discount Co., 27 Cal.2d 335 (1945). In bankruptcy, other courts have held that where cash advances were repeatedly paid to creditors and made in the regular course of business, the transfers satisfy section 547(c)(2)’s ordinary course of business requirement. In re Hill (Bankr. N.D. Ill. 2018), 589 B.R. 614. The frequency with which the transfers were made to the provider is a relevant consideration in determining whether the transfers are in the ordinary course of business. In Cornerstone Tower Services (Bankr. D. Neb. Nov. 9, 2018), a relationship of just two and a half months, with no routine and formed during financial distress, left the provider unable to carry its burden.