Merchant Cash Advances & Your Business – Just Say No

If you own a small business, there is a good chance you have been solicited to “borrow” money through a merchant cash advance (“MCA”). To a company facing liquidity issues or that is otherwise unable to borrow from a bank or other traditional lenders, an MCA can look like a very attractive option: it can provide needed cash to a business quickly (sometimes in less than a week) with little underwriting or due diligence and despite poor credit history.  In addition, an MCA is not governed by a borrowing base and has few reporting requirements. This is because an MCA is not marketed as a loan. Instead, a provider of an MCA (“MCA Provider”) takes the position that its cash advance is not a loan but, rather, a purchase of a company’s future revenue from sales.

MCAs are also easy to find because they are heavily advertised and marketed in a way that suggests the flexibility of pegging “repayment” amounts to a company’s gross sales so that the more a company’s gross sales are in a given period, the more it “pays back” in that period. The less a company’s gross sales in a period, the less it has to “payback”¹ They do so for a few reasons, including trying to avoid usury laws. Many courts, however, have held MCAs to be loans, and that’s a good thing from the perspective of their borrowers. We, by the way, use the term “borrower” throughout this article to refer to the counterparty to the MCA Provider (that is, to the company getting funded). in that period.

If this sounds too good to be true, that’s because it usually is. An MCA is essentially the “business version of payday loans: [they provide] a relatively small amount of money loaned at a high rate of interest.”² Don Swanson, Merchant Cash Advances Are Loans, Not Sales, And Violate Usury Laws (In re Shoot the Moon), last visited 12/18/22.

An MCA in Plain English

MCA Providers typically offer cash to a business entity in exchange for a percentage of that entity’s future sales. For example, an MCA might fund $50,000 upfront to a company in exchange for $80,000 of the company’s future sales. The cash provided by the MCA will then be paid back, from a percentage of the company’s daily or weekly credit card or other receipts.³ Again, the use of the words “paid back” begs the question: MCA Providers argue that there is nothing to be paid back because such words describe what happens in the context of a loan between lender and borrower.

The dollar amount repaid each day or week is, thus, not a fixed amount. Instead, an MCA Provider typically receives a set percentage from each sale. MCA Providers typically require the company to either utilize a pre-approved credit card processor for all credit card transactions or provide the MCA Provider with authorization to unilaterally make withdraws (sometimes daily) from the company’s bank account.

And because MCA Providers take the position that they are not lenders and that the money they advance are not loans, they typically advertise that they can provide “short-term financing,” “alternative business funding,” or use other terms that avoid the use of the word “loan.”

MCA Agreements Are Not Written in Plain English

Sometimes, though, words are just words and many courts, putting substance above form, have held MCAs to be loans (more on that below).

Moreover, while the legal documents that must be signed to obtain an MCA may appear straightforward,  the terms of most are difficult to understand.  And, from what many clients tell us, are often inconsistent with what they were told before signing.

Yet most businesses that enter into an MCA do so without the involvement of an attorney. Why is this? We think the reasons are fourfold:

• Desperation for cash.
• Too much optimism about their ability to ‘sell’ their way out of their problems.
• Being deceived by the short length of the legal documents involved, the MCA lender’s apparent non-use of attorneys, and the very ‘hard sell’ by trained MCA salespeople.
• A lack of understanding regarding far better options that exist (but which likely cease to exist once they go down the MCA route).⁴  Viable options, depending on the exact circumstance, may include bankruptcy (Chapters 7, 11, and Subchapter V of Chapter 11), assignments for the benefit of creditors, friendly foreclosures, and out-of-court workouts. For more information, you may wish to read Dealing with Corporate Distress 07: Chapter 11 is Not Always the Answer: Strategic Alternatives For and Against Distressed Businesses, Subchapter V of Chapter 11: A User’s Guide, Turn that Frown Upside Down- Using Subchapter V’s Unlimited Debt Limit & Confirmation Requirements to Eradicate Personal Guarantees, RISE OF THE ALTERNATIVES: the increasing use of alternatives to chapter 11 bankruptcy for selling an insolvent business in the United States, and 5 Alternative Lending Solutions for Small Business Financing.

Many MCA Providers require a borrower to grant a security interest in some or all of its assets, and require the borrower’s owner to not only personally guarantee the MCA but also to.

Disadvantages of an MCA from the Borrower’s Perspective

Where to begin?  Below we detail the cost, repayment terms, and how an MCA is likely to kill your company’s relationship with its existing secured lender (and why that can be a fatal move).

There’s also the common requirement that the owner of the borrower personally guarantee the borrower’s obligations under the MCA (and that the owner enter into a consent judgment that can be entered automatically against the owner if there is a default)

There are of other disadvantages, but the bottom line is that borrowing money through an MCA will likely be a severe impediment to a company’s chance of ever overcoming its financial distress.

Cost

To get a sense of how expensive MCAs are, here is a sampling of the economics of some MCAs we dealt with in 2022⁵ This chart is an except from a much larger dataset the authors maintain. Each MCA at issue was entered into in 2021 or 2022, to borrowers located in several different states. Numbers are rounded.:

See footnote 6 here.⁶ “Stacking” refers to the practice of taking out multiple cash advances from different MCA Providers in quick succession, to meet an immediate need for funds.

We’re talking effectively triple digit interest rates once one factors in the realities of how repayment terms work (see below) and all the various fees listed above.⁷ The MCAs summarized in this chart do not include the names of the respective MCA Provider or borrower, and numbers are rounded, to maintain anonymity.

Repayment Terms

As we state above, MCAs are often touted as not requiring a set dollar amount payment in any given remittance period (which is just a fancy term that usually means weekly or monthly). This is true, as far as it goes. But what happens when a borrower cannot pay the agreed upon remittance amount? The answer involves an ironic insidiousness.

Taking a step back, MCAs typically set an “initial remittance”⁸ The term “remittance” is by no means universally used; we often see MCAs that refer simply to a “daily amount,” for example. amount, which may be a daily or weekly amount. As our chart shows, the MCAs we summarize all happen to be weekly remittance amounts. This is the minimum amount the borrower has agreed, at least initially, to pay on a weekly basis from its sales to the MCA Provider. So, again, what happens if the borrower cannot pay the required remittance amount?

If many MCA Providers are to be believed, all a borrower needs do is ask for a change to the remittance amount, which the MCA agreement commonly says the MCA Provider may agree to as often as once a month, and the remittance amount will be adjusted to come in line with what the borrower can afford to pay.

Just a few small problems (that’s sarcasm, just to be clear):

• The language we see isn’t “will.” It’s “may.”
• A distressed business commonly experiences rapidly declining sales, which makes it all that the initial remittance in fact will not be serviceable, causing borrowers to consider taking on more debt by stacking, which in turn can quickly lead to a vicious death spiral.
• The likelihood that there will be an event of default at the time a borrower makes such a request is, in our experience, about 100%.

Speaking of 100%, upon an event of default, it is common for the MCA agreement to require, upon an event of default, that the remittance amount be increased to equal 100% of all future receipts (compare that to the second-to-last row in the chart). That’s a pretty efficient way to choke the life out of a business.

Other than that, Mrs. Lincoln, how was the play?

Killing Your Relationship with Your Senior Secured Lender

Every MCAs arrangement we’ve seen gives the MCA Provider the ability to automatically withdraw funds from the borrower’s account or to utilize a pre-approved credit card processor for all credit card transactions which sends a portion of the credit card receipts to the MCA Provider and a portion to the company.⁹ MCA lenders have a history of commonly not honoring properly perfected liens of other creditors.  And because MCA lenders are commonly provided direct access to a borrower’s operating accounts. With such access, they can swipe cash despite their clearly subordinate position, simply ignoring senior liens. For asset-based lenders that lend against receivables, an MCA provider’s access to the company’s bank account gives it earlier access to the same accounts receivable, which was previously pledged to the senior lender as its collateral.

There are several significant problems with this, not the least of which is that if the borrower has an existing secured lender, the loan and security documents that govern the relationship between the borrower and that existing secured lender most certainly require the borrower to obtain the secured lender’s consent before entering into an MCA. And if that existing secured lender’s security interest  covers accounts receivable or credit card receivables, selling them may constitute conversion on the part of the borrower. At the very least, whatever the MCA Provider “paid” the borrower would constitute proceeds that the existing secured lender may try to claw back.

Don’t get us wrong. We’re not wallflowers. And we don’t mind a good fight. But we don’t like to fight with a hand tied behind our back. Nor do we like to fight when an acceptable negotiated resolution is possible.

And every business borrower needs to understand that the law provides significant rights to senior secured lenders as compared to a junior secured lenders, especially when the junior secured lender oversteps the limited rights it does have in contravention of the superior rights of a senior secured lender.

What we’re saying is that if you need to pick a friend and an enemy, it’s better to pick the stronger player as the friend when you can, and the senior secured lender is almost always stronger than an MCA Provider.

We’ll Say it Again

Quoting ourselves from an earlier paragraph, “and that existing secured lender most certainly requires the borrower to obtain the secured lender’s consent before entering into an MCA.”  Here’s the thing: that is not going to happen.

We’ve never encountered a distressed company that has an MCA that sought (let alone obtained) its existing secured lender’s consent to enter into that MCA. And when the existing secured lender ultimately learns that its borrower entered into an MCA, it is often game over.

Let’s take a step back: a typical MCA borrower already has existing debt owing to a conventional bank or other asset-based lender (“ABL”). And that bank or ABL, in turn, has first lien on substantially all the borrower’s assets. Indeed, the reason the borrower is seeking an MCA loan in the first place is often that it has already used the proceeds of its existing loan or has no further availability under its line of credit.

Nonetheless, some misguided distressed borrowers will enter into MCAs and, in doing so, breach their legal obligations to their existing secured lenders.¹⁰ To be clear, these breaches usually include, at the least, the act of transferring the existing secured lender’s collateral outside of the ordinary course of business; incurring debt out of the ordinary course of business; granting an unpermitted lien on the assets of the company; and a guarantor granting an unpermitted guaranty by a guarantor.

Why Does it Matter if an MCA is Loan?

So, we’ve said over and over that whether an MCA is loan or true sale transaction can have significant implications:

• If the MCA is characterized as a loan, the transaction may be subject to applicable usury laws and, consequently, RICO violations. Violating usury laws can result in generous relief of interest payments to the company and stiff penalties and potential criminal liability to the MCA Provider.
• If characterized as a loan, that provides a straightforward path for a senior secured lender to prevail against the MCA Provider, since the MCA Provider in that event clearly has nothing more than a junior security interest.
• In a bankruptcy of the borrower, if the MCA is characterized as a true sale of future receivables, then the receivables purchased will not property of the borrower’s bankruptcy estate and, among other things, the MCA would not be subject to the automatic stay and would not be prevented from post-petition collection efforts.

Not only are courts around the country cracking down on abusive MCA Providers, but federal and state regulators are cracking down on lenders targeting small businesses with high-cost MCAs, abusive collection tactics, and in some instances asserting RICO violations against the MCA Providers.

For example, the FTC is using its enforcement powers under the FTC Act and the Gramm-Leach-Bliley Act to file suits to crack down on abusive MCA providers. The FTC recently sued FTA Providers alleging that the Providers engaged in aggressive, and potentially misleading, marketing practices and used potentially abusive collection tactics.  The FTC alleged that the defendants made unauthorized withdrawals from accounts and used unfair collection practices, including threatening physical violence. In addition, the FTC alleged that the defendants illegally weaponized “confessions of judgment,” contractual terms that allowed defendants to pursue the guarantors’ personal assets in court and obtain uncontested judgments against them.

As part of a settlement, RAM Capital Funding, LLC and its owner Tzvi Reich, were permanently banned from the MCA and debt collection industries, and were required to pay $675,000 to settle the charges and to vacate any judgments against its customers and release any liens against their customer’s assets.¹¹ Press Release, Merchant Cash Advance Providers Banned from Industry, Ordered to Redress Small Businesses, (January 5, 2022), https://www.ftc.gov/news-events/news/press-releases/2022/01/merchant-cash-advance-providers-banned-industry-ordered-redress-small-businesses

A Case Law Example

In In re Shoot the Moon, LLC, 635 B.R. 797 (Bankr. D. Mont. 2021), in which the court found the MCA at issue to be a loan, is illustrative of the world of hurt that result can cause for an MCA Provider.

After deciding that the MCA was a loan, the court addressed whether the loan violated usury laws.

First, the court was required to determine what state law applied – New York or Montana.  After conducting an extensive choice of law analysis, the court found that Montana law applied which allows interest at a rate not exceeding the greater of 15% or an amount that is six percentage points per year above the prime rate.  In addition, the Montana statute provides that where a lender has sought interest in excess if the maximum allowed, the statutory penalty is “forfeiture of a sum double the amount of interest” charged and an express remedy for the borrower or its successor to recover “a sum double the amount of interest paid.” As the interest rate exceeded the maximum provided by Montana law, the Court granted the plaintiff (a bankruptcy trustee) judgment in the amount of $1,216,685 on his usury claim.

The bankruptcy trustee also alleged that the payments received by the MCA Provider during the 90-day period prior to the bankruptcy were preferential transfers. The court, after analyzing whether the MCA Provider received more than it would in a liquidation and finding there were senior lenders ahead of the MCA Provider who were undersecured, entered judgment against the MCA Provider on the trustee’s preference claim.

Finally, because the MCA Provider was liable to the bankruptcy estate on a preference claim, the court disallowed its unsecured proof of claim under Bankruptcy Code §502(h) until it satisfied the judgment related to the preference claim.

How Do Courts Decide Whether an MCA Was a Loan?

When evaluating whether an MCA is a loan or true sale, courts have focused primarily upon three questions¹² See, for example, In re Shoot the Moon, LLC, 635 B.R. 797, 812-820 (Bankr. D. Mont. 2021) and Fleetwood Services, LLC v. Ram Funding, LLC, 2022 WL 1997207 (S.D. New York):

• What do the transaction documents say?
• What rights and remedies does the MCA Provider have?
• What has been the course of dealing between the parties?

What do the Documents Say?

• Does the MCA agreement documents state that transaction was not intended to be loans but rather purchases of future sales or receipts?  Do the documents consistently refer to the transaction as a “sale” and “purchase” and refer to the parties as “seller” and “purchaser”? Simply designating a transaction as a “sale” does not, alone, change the nature of the transaction, but it does set the tone of the transaction.
• Does the amount of funds provided to the borrower equal a fair market value of the future sales conveyed to the MCA Provider? If the answer is yes, then this factor would help a court determine the transaction lean toward being a true sale.
• Do the documents include a broad grant of a security interest in assets other than the future sales/receivables? Such broad security interests are more characteristic of a loan rather than a true sale of receivables. A simple protective security interest in the accounts/receivables purchased, on the other hand, is more characteristic of a true sale of receivables.
• Does the seller/borrower have the option to change the periodic payment amounts? Is this option subject to the approval of the MCA Provider? Borrowers typically do not have a unilateral option or right to extend the repayment terms of their loans and certainly not without having to pay more (interest) to the lender. However, if this option is subject to the discretion of the MCA Provider, then it is not really an option at all.

What Rights and Remedies Does the MCA Provider have?

• Do the rights, recourse, and other various protections against default afforded to the MCA Provider go far beyond its rights in the receivables? The further the remedies go, the more the transaction will resemble a loan rather than a true sale of receivables.
• Is there a personal guarantee? If so, how broad is it? Is it a full guaranty of performance and payment or is it limited to non-credit related affirmative acts and factual misrepresentations?
• Is there a broad grant of power of attorney from the borrower?
• Does the MCA Provider have the right to debit the borrower’s general deposit accounts like a lender often does?
• Does the borrower have the right to repurchase the receivables? If so, then the transaction is more likely to be viewed as a loan and not a true sale, because the interest in the receivable is more like a secured interest provided to a lender that can be satisfied by the borrower.

What Has Been the Course of Dealing Between the Parties?

• Did the correspondence and course of dealing between the parties involve dialogue typically used for a debtor-creditor relationship, including references to “loans”, “terms” and “balances”?
• Were the parties stacking or “rolling” funds from one transaction to the next? If the parties are stacking (successive MCAs of the same future receivables already sold to the MCA Provider on top of each other before the prior MCA is paid back in full) or rolling (rolling the terms of a prior MCA into a larger MCA using the same previously sold future receivables), then the transaction is more likely to be viewed as a loan (i.e. commercial loans are often modified by increasing the loan amount and a continued grant of the same collateral, however true receivable purchasers do not keep buying the same receivables).
• Were the proceeds of the receivables sold commingled with other funds by the company or was the company required to use a processor to collect the receivables? A true purchaser of receivables will require the proceeds of the receivables it purchases to be directed to the purchaser or, at a minimum, segregated from other proceeds.

Before You Go

As we say above, a financially distressed company (or not-for-profit, for that matter) has options. Too many organizations simply delay too long before seeking the help of an experienced restructuring attorney. And with delay, the number of good, viable options decrease. Don’t let that be your organization.

Did you enjoy this article? Care to learn more about financing available to small business owners? The following on-demand webinars may prove valuable:

• The Business Borrowing Basics Series
• Restructuring, Insolvency & Troubled Companies 2022
• Crowdfinance 101

For more information about our on-demand webinar series, click here.

©2023. DailyDAC^TM, LLC d/b/a/ Financial Poise^TM. This article is subject to the disclaimers found here.

Article Footnotes:

• 1
  They do so for a few reasons, including trying to avoid usury laws. Many courts, however, have held MCAs to be loans, and that’s a good thing from the perspective of their borrowers. We, by the way, use the term “borrower” throughout this article to refer to the counterparty to the MCA Provider (that is, to the company getting funded).
• 2
  Don Swanson, Merchant Cash Advances Are Loans, Not Sales, And Violate Usury Laws (In re Shoot the Moon), last visited 12/18/22.
• 3
  Again, the use of the words “paid back” begs the question: MCA Providers argue that there is nothing to be paid back because such words describe what happens in the context of a loan between lender and borrower.
• 4
    Viable options, depending on the exact circumstance, may include bankruptcy (Chapters 7, 11, and Subchapter V of Chapter 11), assignments for the benefit of creditors, friendly foreclosures, and out-of-court workouts. For more information, you may wish to read Dealing with Corporate Distress 07: Chapter 11 is Not Always the Answer: Strategic Alternatives For and Against Distressed Businesses, Subchapter V of Chapter 11: A User’s Guide, Turn that Frown Upside Down- Using Subchapter V’s Unlimited Debt Limit & Confirmation Requirements to Eradicate Personal Guarantees, RISE OF THE ALTERNATIVES: the increasing use of alternatives to chapter 11 bankruptcy for selling an insolvent business in the United States, and 5 Alternative Lending Solutions for Small Business Financing.
• 5
  This chart is an except from a much larger dataset the authors maintain. Each MCA at issue was entered into in 2021 or 2022, to borrowers located in several different states. Numbers are rounded.
• 6
  “Stacking” refers to the practice of taking out multiple cash advances from different MCA Providers in quick succession, to meet an immediate need for funds.
• 7
  The MCAs summarized in this chart do not include the names of the respective MCA Provider or borrower, and numbers are rounded, to maintain anonymity.
• 8
  The term “remittance” is by no means universally used; we often see MCAs that refer simply to a “daily amount,” for example.
• 9
  MCA lenders have a history of commonly not honoring properly perfected liens of other creditors.  And because MCA lenders are commonly provided direct access to a borrower’s operating accounts. With such access, they can swipe cash despite their clearly subordinate position, simply ignoring senior liens. For asset-based lenders that lend against receivables, an MCA provider’s access to the company’s bank account gives it earlier access to the same accounts receivable, which was previously pledged to the senior lender as its collateral.
• 10
  To be clear, these breaches usually include, at the least, the act of transferring the existing secured lender’s collateral outside of the ordinary course of business; incurring debt out of the ordinary course of business; granting an unpermitted lien on the assets of the company; and a guarantor granting an unpermitted guaranty by a guarantor.
• 11
  Press Release, Merchant Cash Advance Providers Banned from Industry, Ordered to Redress Small Businesses, (January 5, 2022), https://www.ftc.gov/news-events/news/press-releases/2022/01/merchant-cash-advance-providers-banned-industry-ordered-redress-small-businesses
• 12
  See, for example, In re Shoot the Moon, LLC, 635 B.R. 797, 812-820 (Bankr. D. Mont. 2021) and Fleetwood Services, LLC v. Ram Funding, LLC, 2022 WL 1997207 (S.D. New York)