Small companies that are struggling financially sometimes can’t get a loan or line of credit to tide them over. So to keep the lights on, they turn to what’s called a merchant cash advance, or MCA. If they eventually can’t afford the payments, the person who signed a personal guaranty on the MCA may be asking: should they settle with the funder or go into bankruptcy? Once an MCA funder has filed suit, there are really only a few options: you negotiate a settlement, you litigate the case in court, or you declare bankruptcy.
If your business got an MCA, basically that means you were selling some of your future sales and receivables to get cash up front. The company who gave you the money also put UCC liens on your business assets, which includes your bank account. The funder withdraws money daily or weekly from the business account, either a percentage of the business’s sales or an estimate of the business’s monthly revenue. Very expensive, and a business can easily get stuck in a circle of having to take new MCAs to pay off the old ones. MCAs have high default rates, like 20% to 30%. These withdrawals pretty much take up all of the business’s accounts receivable and income, which makes it very difficult to operate the business.
People almost always sign personal guarantees on an MCA advance. That means you are on the hook for the debt if the business can’t pay it back. So the funder can sue the person who signed the guarantee, and go after personal assets. Some funders have also required a confession of judgment. This is a document you sign in advance that lets the funder record a judgment against you on the public record and skip the lawsuit because you have already admitted liability. That means they can go straight to enforcing the judgment. We haven’t seen these used as often since New York changed the rules in CPLR section 3218 and prohibited them against out-of-state defendants, but there are still some shady funders who like to use them. A UCC lien is the funder’s legal claim on your business’s assets (including your bank accounts) that it files if you get a funding and lets it take your collateral if you default.
Funders who buy up a piece of your future sales look at the deal a certain way. They say it’s not a loan; it’s closer to you selling them something, like an investment in the company. They do this so that if you run into trouble, they can avoid some of the common defenses businesses try to use. On March 5, 2024, New York Attorney General Letitia James filed a lawsuit against Yellowstone Capital, Delta Bridge Funding and other individuals for exploiting small businesses with fraudulent loans and charging sky-high interest rates disguised as merchant cash advances. She’s asking the court for at least $1.4 billion in interest and fees collected from small businesses and for an order to stop their alleged illegal practices.
Settlement Is Negotiating with the Funder to Pay Back Less
Settlement is negotiating with the funder to pay back less than what you owe in total. In most cases the advance has to be in default already, and the funder may request documentation about why you need to settle. Many funders want a lump-sum payment to settle, but in some cases a payment plan is possible. There’s no court action involved in a settlement, and the business itself doesn’t need to shut down if it can afford the settlement amount.
Assuming settlement is out of the question, the business has the option to fight the funder’s lawsuit in court. Getting an attorney experienced in these disputes is crucial. These lawyers need to look at the fine print to figure out what’s a fair way to fight this case. The case is easier to fight if the agreement can be said to be a loan, and not a purchase of future revenue. New York state courts use a three-part test to determine if the agreement is a loan or a purchase, which is whether the agreement: (1) includes a reconciliation provision; (2) has a finite term; and (3) has a recourse provision in the case of bankruptcy (Principis Capital, LLC v. I Do, Inc., 2d Dept. 2022). Lawyers for funders are now using this three-part test to draft agreements that will pass this test. Which means that for many business owners, fighting the lawsuit is putting off the inevitable: a judgment against the business, and against you.
Chapter 7 Is the Form of Bankruptcy Most Businesses Use
Chapter 7 is the form of bankruptcy most businesses use when they’re closing down. It’s also known as “liquidation bankruptcy.” A Chapter 7 can be filed by the business, by the owner personally, or by both. If the owner files a Chapter 7 personally, it’ll stop all collection activity - including MCA lawsuits - through the automatic stay. It can also discharge the owner’s personally guaranteed debts, including MCA personal guarantees, so the owner can get a financial fresh start. If only the business files, it’ll stay the business’s MCA lawsuits, but it won’t discharge the owner’s debt. Sometimes the business doesn’t need to file when it’s closing down, but it can be helpful to stop lawsuits or attempts to enforce a judgment against it. In many cases, the owner’s best choice is just to file a personal Chapter 7, then rebuild their credit and start a new business if they want to.
If the owner wants to keep the business open, the company can file for bankruptcy under Subchapter V of Chapter 11. It’s typically more expensive than Chapter 7, and it usually makes sense only if the business is viable or has value. Subchapter V is a stripped-down version of Chapter 11 designed to cut costs for small businesses, and it allows the business to try to restructure its debt. The business is eligible for Subchapter V if its secured and unsecured debts add up to $7,500,000 or less. It is not a guarantee of success: fewer than 50% of cases in Subchapter V reach a confirmed plan, and even fewer actually complete the plan.
Pick a Direction Sooner Rather than Later
So what wins - settlement or bankruptcy? Mostly it comes down to whether the business can stay alive and whether the owner has anything to pay. Settlement avoids bankruptcy court. If the business can afford the settlement, it keeps running. The funder usually wants the account to be in default first and may also want a lump-sum payment. Defending the lawsuit in state court is an option, but after the funders started drafting around the three-factor test, it usually just drags things out until there is a judgment anyway. A personal Chapter 7 can discharge the personal guarantee, but it’s mostly for owners who are shutting down. Subchapter V can keep a going concern afloat, but it costs more than Chapter 7, and less than half the cases actually get a plan confirmed.
Delancey Street is not a law firm, and we do not file bankruptcies. If bankruptcy is the best option for you, you should consult with a bankruptcy lawyer. If you want to explore the possibility of settling your MCA debt and preserving your business, we are happy to examine your advance agreements and your finances with you and let you know whether settlement makes sense. Whatever you decide, you need to pick a direction sooner rather than later or let the daily withdrawals and collection lawsuits pick it for you.
