The merchant cash advance has become a popular, if unofficial, financial instrument in the small business world. It’s not a bank loan. These deals are marketed as sales: the business sells a slice of its future income in exchange for cash today. The payments come out of sales every day or week, much more often than a bank does. The catch is the effective interest rate, which can be astronomical. Once sales dip, it’s hard to keep up. In that situation, owners often wonder: should they just default, or should they declare bankruptcy? At the core of the dilemma is the fact that many owners feel trapped. They got the cash, the payments are draining their business, and now they have a very tough decision.
There are two ways to run out of money on an MCA. You can just stop paying, and the funder still calls it a sale of receivables. If you file bankruptcy, though, a judge will actually look behind the label and decide if it’s really a sale or really a loan. That changes the playing field for the business. Bankruptcy courts don’t buy the label. They take these deals apart carefully and often recharacterize them as loans in disguise. That can be a huge blow to the funder and a huge bonanza for you, the debtor.
What happens if a judge says the “advance” was really a loan? Three nasty things.
- One, your contract can be declared void under some state usury statutes.
- Two, the funder’s claim may be thrown out in bankruptcy.
- Three, any payments you already made to the funder can be clawed back as preferences or fraudulent transfers.
Three-factor Test
Just how does a court decide if a so-called sale is really a loan? Three recent bankruptcy decisions, In re JPR Mechanical, In re Williams Land, and In re Global Energy Services, show how it works. Only one was filed in New York, but all three MCA contracts were governed by New York law. So each applied the three-factor test from LG Funding v. United Senior Properties of Olathe, later adopted in Fleetwood Services v. Ram Capital Funding. Here are the three factors:
- First, does the payback change based on what you actually brought in - does the contract have a reconciliation clause?
- Second, is there a fixed schedule telling you exactly when you’ll pay?
- Third, can the funder chase you or your guarantor in bankruptcy?
Start with reconciliation. In Global Energy, the contract said the payments got adjusted based on how much money was actually collected. That meant the funder took the risk if things didn’t go well, and that pushed the court toward calling it a true sale. In JPR and Williams Land, the courts said those reconciliation clauses were empty promises, so that pointed the other way, toward a loan.
Another dead giveaway for a loan is a fixed term. In JPR and Williams Land the contract had a clear end point, or at least it was fixed for a practical period, which implied there was a schedule to repay the money that didn’t depend on the amount of receivables coming in. That pointed toward a loan. In Global Energy there was no deadline at all, which cut the other way.
As for the third factor - recourse - courts again looked at personal guaranties and security interests, as well as the ability of the funder to file a proof of claim in bankruptcy. In JPR and Williams Land, these all pointed to a loan. In Global Energy, the funder had expressly assumed the risk of insolvency and bankruptcy was not an event of default - so that weighed in favor of a true sale.
The key question the courts ask is this: if the payments don’t show up, who takes the hit? In a true sale, the funder takes the risk - recovery comes from the receivables themselves. In a loan, the borrower bears the risk - the lender is promised money no matter what. In JPR and Williams Land, courts said the funder took almost no risk if the debtor defaulted: the payments didn’t change, reconciliation was limited, and the funder could still go after the debtor, the debtor’s assets, and the guarantors. In Global Energy, the opposite: the funder did take the risk because payment depended on the debtor collecting its receivables, reconciliation was enforceable, and there was no recourse in bankruptcy. So the real divide between a sale and a loan often comes down to who gets stuck with the loss if the business can’t pay.
The outcomes show what is at stake. In Williams Land, the court said the real interest rate was 101.1%, which broke New York’s criminal usury limit of 25% a year. Because it was criminal usury, the whole deal was void from day one. That opened the door for the debtor to claw back what it paid and fight the funder’s claim. In JPR, the court avoided more than $3 million in transfers as preferences. And in Global Energy, the court found the deal was a true sale and threw out the usury claims.
So what is the choice, default or bankruptcy? Like everything, it depends. Bankruptcy can radically improve your side of an MCA negotiation. If the company is stuck with a bad contract, you or a chapter 7 trustee should carefully review the deal to see if it can be recharacterized as a loan. If you can, your next moves are to object to the creditor’s proof of claim, file avoidance actions, and attack the contract as usurious. But it’s not a sure thing. Global Energy demonstrates that an MCA can be held as a true sale if drafted correctly. Also keep in mind that the usury claim depends on the state law that governs the contract. In New York, for example, interest cannot exceed 25% per annum, while Illinois has no similar usury law for corporate borrowers.
Before you fold, or before you hand over a chunk of tomorrow’s sales, read the agreement the way a bankruptcy judge would. Is the “reconciliation clause” more than window dressing? Is there a fixed term, written or de facto? Did you personally guarantee it, give a security interest, or promise that filing bankruptcy counts as a default? Each of those is a clue that it’s a loan. The more of those boxes you check, the more teeth bankruptcy may give you against that funder.
