If your company signed a merchant cash advance (MCA) agreement, the funder will probably claim it’s buying your future receivables in a “true sale,” not lending you money. But the label doesn’t control. You may still find the transaction is a loan, even if your agreement doesn’t say so. So the difference between “loan” and “true sale” is a very big deal. Once it’s a loan, you and your successors (for instance, a bankruptcy trustee) can bring claims against the funder that you couldn’t bring against a buyer. Recent cases suggest the courts are becoming sympathetic to companies where the documents and the funder’s conduct allow them to treat the arrangement as a loan.
Three Recent Federal Cases
In three recent federal cases — Fleetwood, Haymount and Lateral, all out of the Southern District of New York — small-business owners claimed the funders violated usury laws and the Racketeer Influenced and Corrupt Organizations Act, or RICO. In each case, the financing arrangement was pretty much the same. The funder said it bought future receivables, and the paperwork called it a “true sale.” The contract spelled out that the business would pay an estimated percentage of its daily collections, but the funder was actually taking a fixed amount out of the bank account every day, no matter how much money the business collected. If there weren’t enough money to cover the payment one day, the automatic ACH debit would bounce and the business was in default.
In each case, the business had secured the “advance” by granting a security interest not just in its accounts receivable but also in its other assets, and the guarantors were on the hook (that’s “recourse” for anyone who’s new). These transactions also contained all the typical events of default that you would find in a loan agreement. Although the contracts included a clause for reconciling the payments to the actual amounts collected, the funders had plenty of ways to avoid actually doing the math, and the failure to reconcile was one of the owners’ allegations. Bottom line: the risk of loss still fell on the business, not the funder.
In Fleetwood, a judge looked at the whole agreement, and said yes, it was a loan, not a purchase of future receivables. In Haymount, Judge Rakoff said the funder didn’t deny it had implied interest rates of over 50% a year, twice New York’s criminal usury rate, and that the owners had adequately pleaded that the debts were unenforceable “unlawful debts” under RICO, even though that was only at the motion to dismiss stage. In Lateral, the court agreed that the complaint pleaded sufficient facts that the agreements were loans, and were thus subject to usury, and let the usury and RICO claims proceed.
And in all three cases, the court actually calculated the effective interest rate. In Fleetwood it was 278.5 percent, in Haymount more than 50 percent, and in Lateral several different agreements with rates ranging from 100 percent to 300 percent. A rate like that would violate the usury laws of most states. Worse, in at least one of these cases, the funder never actually gave the full amount it promised. Still, it collected the full daily fixed payment as though it had. It figured slow collections were the owner’s problem, not its own, which just isn’t the way a real sale should work.
But the courts also seem to have been swayed by the funders’ conduct, including the way they dealt with Fleetwood. For instance, when Fleetwood asked that the daily debit be temporarily suspended because it was having trouble, the collection agent told it in all caps: “UNFORTUNATELY … WE DO NOT OFFER ‘BREAKS’. DOING THAT WOULD PUT YOU IN AUTOMATIC DEFAULT,” and the funder kept pulling the money. There was never an attempt to reconcile the money that was withdrawn. There was also no argument by the funder when affidavits from other customers supporting claims made to the New York Attorney General were submitted. One customer facing its own seasonal slowdown requested that the payments be reduced, but was told: “We will take everything from you…. We are from New York…. Don’t mess with us.” One asked for a week’s break because they were waiting for their own customers to pay, and was told: “I don’t care about your problems” and “I’ll default you before you can get out of the bathroom.” So, bad behavior didn’t decide the case, but it doesn’t help a funder already facing an uphill fight.
The Ultimate Economic Risk
So what actually decides it? Once all the documents and the actions of the parties and the economic realities are examined, “the ultimate economic risk” falls where? If it falls on the business, it is more likely a loan; if it falls on the funding party, it is more likely a purchase. As the Fleetwood court explained it, a true purchase of receivables is one in which the funder assumes the risk that the business’ customers will not pay and the business’s debt is extinguished. It is a loan where the funder holds only a security interest, the business remains liable for the debt and retains the risk that its customers will not pay and the funder risks only that the business will be unable to repay the debt.
These rulings are a reminder that courts are beginning to take note of what some funders are up to, and offer some benchmarks for business owners who feel like they’ve been mistreated. In New York federal courts, MCAs may be considered loans if the contracts really don’t transfer economic risk to the funder, or if the funder’s actions don’t reflect what would be deemed commercially reasonable and in line with the terms of its own agreements. That opens the doors for usury and RICO actions against the funder, and for the funder to potentially face much more unfavorable treatment in the business’s bankruptcy. All cases are different: Fleetwood was decided on a summary judgment motion, while Haymount and Lateral were early decisions on motions to dismiss.
Disclosure Rules
Several states, too, have been leaning toward keeping businesses protected. California and New York adopted laws that are similar to the kind of disclosure rules used for consumer loans for commercial financing transactions above certain amounts. The rules apply to all non-exempt MCA providers and factors, whether the deal is a loan or a true sale. What does that mean for you, the owner? Take your advance agreement out and compare it to these factors: fixed daily debit, security interest in all assets, personal guarantee, loan-style defaults, reconciliation never performed. If you see those, the “true sale” label at the top of the document isn’t the end of the story.
This is not to say that all merchant cash advances are loans. They might be or they might not be. It all depends on the documents, the relationship between the parties, and the economics of the transaction. But if your account is being drained each and every day by a funder that claims it is an owner of your receivables, that funder’s label is not the end of the matter. We’re still early in these cases, so they can change. Before you sign anything new with a funder, get a good professional to review the deal you have now.
