Our clients sometimes go to sleep to the sound of MCA debits, and wake up to the sound of them. “Will there ever be an end?” they ask us. Many of them assume a bankruptcy filing wipes out the UCC lien their merchant cash advance funder recorded. It does not. The lien does not simply disappear when a bankruptcy petition is filed. Bankruptcy is a tool that lets you renegotiate and restructure your debts; it does not erase liens automatically. The lien remains attached to the collateral unless a bankruptcy proceeding takes specific action to modify it.
What Rights a Creditor Has in Your Assets
When a business files, the bankruptcy court does not make up its own law; it follows state law to figure out what rights a creditor has in your assets. That means we look at the Uniform Commercial Code (UCC) Article 9. The lender’s first hurdle is to have a security agreement that creates a lien on the collateral. What matters next is the fine print, because the lender’s lien does not attach to after-acquired property unless the security agreement says it does. This is UCC 9-204. Not every MCA agreement does.
The lender’s security interest does extend to proceeds. “Proceeds” mean what you got when you sold, leased, or otherwise disposed of the collateral. For inventory, that means cash proceeds or accounts generated from the sale. In a trucking or staffing business, you have no inventory. All you have are accounts. The factor or the bank is likely your first lien holder. Money in the bank account has a special rule. To perfect a security interest in the deposit account, the lender must get a deposit account control agreement. Your MCA lender will likely not have one, and thus it is not perfected as to the deposit account funds.
The moment the petition is filed, the automatic stay goes up. Everyone — including the MCA lender — has to stop pursuing any claim they have against the debtor, including the daily debits. Timing also matters. Many MCA lenders wait until the day they have a claim (default) before filing their UCC financing statement. They don’t want the other lenders to discover them, apparently. The rule here is the preference rule (Bankruptcy Code section 547(c)(3)), which says that the secured party should be perfected within 30 days of the lien attaching. If the secured party waits until the 90 days prior to the bankruptcy filing and perfects at that time, it is subject to a preference claim for improving its position from unsecured to secured in the 90 days before the filing.
Now, how much do MCAs really cost? MCAs purchase future income at a discount (i.e., “we’ll give you $185,000 today for $250,000 of future income”) and take daily debits and charge heavy fees. Interest rates easily exceed 100% APR. Doing this math doesn’t particularly help the MCA lender in a small business case where the judge just wants to give the debtor a chance to reorganize honestly.
The bankruptcy court can split a lien into two parts (Bankruptcy Code section 506): there is a secured part and an unsecured part. A lien is only secured up to the value of the collateral, and unsecured for the rest. Typically an MCA lender files behind a bank, or a factor. Many MCA lenders pile on top of each other. And you should ask, Is there any equity behind the first lender in the inventory (or the accounts)? More often than not, the answer is no, and almost never for MCA lender No. 2 or beyond. So they finance “air.” However, if the MCA lien retains some value, section 552 of the Bankruptcy Code allows the lien to reach post-filing proceeds only if the agreement so provides and there are proceeds. The inventory business may have proceeds; trucking and staffing businesses generally do not. In the latter cases, the lender would have a junior lien on accounts and an unperfected lien on a bank account. If there is equity, the court can grant a replacement lien to the creditor as adequate protection.
Subchapter V
For a small company, the most useful part of Chapter 11 is something called Subchapter V. Congress has added “subchapter V” of Chapter 11 for small businesses in 2019. This is to address a variety of problems that owner-operators of small businesses face when trying to use Chapter 11 to deal with creditors. For example: a creditor’s committee and U.S. Trustee must be appointed under traditional Chapter 11, a costly disclosure statement must be prepared and distributed, costly first day motions must be sought from the court, and the absolute priority rule prevents owner-operators of small businesses from continuing to run and reorganize their businesses in Chapter 11 unless all their creditors are paid in full or they put in new money. Here are the Subchapter V qualifications: your total debt must be $7,500,000 or less, it was originally $2,725,625, but the legislature raised it in COVID relief laws. (Check to see what the current qualifying amount is.) And you are not in the business of owning real estate. You file your plan, which must be filed within four months of filing, without the disclosure statement and with no absolute priority rule. You pay your free cash to your creditors over a plan, usually five years. There are no U.S. Trustee fees. You have a Subchapter V trustee, who will administer the payment of your plan. There’s no creditors’ committee unless the court requires one.
Can the Business Survive Without the MCA Debt
Before any of this matters, you have to ask: Can the business survive without the MCA debt? If you can create a budget showing a positive cash flow, or at least a paper positive, after paying the first lender and all operating costs, you’ll have the first key to successfully emerge from bankruptcy. Financing a debtor requires court permission, commonly called DIP financing. The current first-position lender or factor can continue funding through an approval of a DIP financing motion. MCA lenders are offered “replacement liens” with the same validity, priority and extent that they enjoyed pre-petition. For a MCA lender with no equity, that “replacement lien” is just air. Most junior MCA lenders do not even participate in the first-day proceedings; they get notice but not much more, and there is little they can do about it.
The last key piece of information is the plan, which needs to show that the business can generate positive cash flow, when you get out of bankruptcy. You don’t need to pay all the MCA lenders their full claims, and probably not anything close to it. The MCA lender’s lien has to be valued and usually will be valued as unsecured. Confirmed plans pay the MCA lender bankruptcy dollars, often pennies on the dollar, and effectively strip away their secured claims. In some cases a third party injunction in the plan can also protect the owner who signed a personal guarantee.
So, UCC lien versus bankruptcy: which one wins? The short answer: the UCC lien doesn’t magically disappear when a small business files for bankruptcy. The value of the UCC lien in bankruptcy depends on what the contract covered, whether the lender was perfected, whether there was equity behind the senior lender or factor, and when the financing statement was filed. For a junior MCA lender behind a factor, the value is often low to zero. In a Subchapter V case, that claim can be treated as unsecured. Not every business is a candidate for bankruptcy: before you file, ask if the business is viable without the MCA debt, and always seek advice.
