Many small private and public company’s struggle financially, especially in the last year due to the economic impact of COVID-19 and the governmental restrictions imposed on business operations. Our firm has recently been called upon to defend some of these companies against aggressive and somewhat abusive merchant cash advance funders. While our firm is known for defending public companies in complex financial litigation in Federal and State courts around the country, more recently, we have been approached by earnest small business owners who have fallen victim to seemingly unlawful business practices by some Merchant Funders. Not all Merchant Cash Advance companies are shady, but in our recent experience, some appear to be.
Highlighting this issue are two recently filed cases, one by the New York State Attorney General’s Office in state court, and the other, by the Federal Trade Commission in federal court, both cases targeting a few specific Merchant Cash Advance companies and their owners. The NYAG case claims that these transactions are actually loans, subject to NY’s criminal usury statute (that would result in the entire transaction being void), and the FTC case that focuses on the mode and method of deceptive advertising practices used by these same Merchant Cash Advance funders to lure in unsuspecting and vulnerable companies.
Since our firm has a lot of experience with the application of the criminal usury statute in litigation, many business owners from around the country have come to us requesting our assistance. In the last 2 months, we have secured 5 Temporary Restraining Orders (TRO’s) against Merchant Funders attempting to collect against our clients and their owners on what appear to be illegal contracts. So, let’s take a look at what a Merchant Cash Advance really is.
Merchant Cash Advances May Seem Too Good to be True
Business owners often look for quick ways to get out of financial trouble. Merchant Cash Advances seem like a plausible solution to financial cash flow shortages but there may be hidden dangers that all business, private and public, should consider before entering into a financing agreement where your company receivables are used to pay back the cash “advance”. Understanding what a merchant cash advance is, how it works, and how they are repaid can help you understand why this route may be more harmful than helpful to your business.
What is a Merchant Cash Advance?
A true merchant cash advance is not technically a loan. A merchant cash advance company provides funding to a business owner in exchange for a portion of the business’s future receivables. The theory is that the MCA Funders are buying a percentage of the businesses receivable’s before you collect them. Merchant cash advances were typically aimed at retail businesses that mostly did credit and debit card sales, however, they now cast a much wider net. The MCA Funder “advances” cash to be used in your business operations while securing direct access to the merchant’s bank accounts and “pulling” daily or weekly amounts, purportedly representing a “percentage” of your collected revenues.
Why Some Small Businesses Choose Merchant Cash Advances to Fund their Cash Flow.
Although true merchant cash advances are a financing option of last resort, they do have their pluses:
- They’re quick. You can often get an MCA within a week or so with limited paperwork. Providers typically look at a business’s daily receipts to determine if the owner can repay.
- Physical collateral isn't (usually) required. Real MCAs are technically “unsecured” so you don't need to provide physical collateral. This means you don’t have to supply business assets upfront to back your financing — and risk losing those assets if you can't afford to repay. However, the MCA provider will likely require a personal guarantee as well as a Confession of Judgment which are written agreement(s) that make you personally responsible for repaying the advance. If this is the case, the MCA provider can recoup any losses in the event that your business can't pay. However, courts have been holding that the existence of a personal guarantee and a confession of judgment are indications of loans, and not a purchase of receivables.
- When sales are down, your payment “may” be too. When the repayment schedule is based on a fixed percentage of your sales, repayments should adjust based on how well your business is doing. This is called a reconciliation provision. In a real MCA, that provision mandates the honest MCA Funders to adjust the amount of the daily or weekly payments based on your actual collected receivables, upon the businesses request. Real Merchant Cash Advance agreements impose this mandatory provision because the concept behind the MCA is that the funder is taking a “risk” on your ability to collect receivables and that their recovery or repayment is solely limited to that ability. Many courts have rendered decisions that a reconciliation must be mandatory and absolute. If it's just permissive, such as the merchant "may" reconcile, then the courts found the inability of the borrower to actually force a mandatory reconciliation is more of an attribute of a loan. If the MCA Funder can collect other ways, those other ways can be signs of the agreement actually being a loan, subject to the state’s usury laws.
How are Merchant Cash Advances Repaid?
Merchant cash advances can be repaid in one of two ways:
- A percentage of your receivables: In this option, the funder automatically withdraws a certain percentage of your sales which percentage is fixed in accord with your contract, until the advance is repaid in full.
- Fixed daily or weekly withdrawals: In this option, the funder takes a fixed amount from your business bank account on a daily or weekly basis, plus fees, until the balance is paid in full. These are known as Automated Clearing House (ACH) withdrawals.
Because merchant cash advances are not technically a loan, they are not regulated the same way loans are. As a result, arguably the most important aspect to note is that merchant cash advances have “factor” rates rather than “interest” rates. However, courts have indicated that if the repayment is based on a daily or weekly fixed amount, without a mandatory reconciliation provision, then this aspect of the transaction also points to it being a loan, again, subject to the states usury laws.
Should you Avoid Merchant Cash Advances?
Let’s take a close look at the drawbacks of this financing option.
- Your APR could be in the triple digits. The annual percentage rate or total annual borrowing cost with all fees and interest included, typically ranges from about 40% to 750%, depending on the lender, the size of the advance, any extra fees, how long it takes to repay the advance in full and the strength of the business’s credit card sales. The criminal usury interest rate in New York is capped at 25%. Anything over may subject the MCA Funder to having a court declare the transaction void.,
- Higher sales mean a higher APR. For MCA’s repaid with a percentage of your receivables, the APR depends not just on the total fees paid but also on how fast you repay the loan. If your sales are weak, your payments spread out over a greater length of time and your APR drops. If you are raking in sales, you repay the MCA faster — and, subsequently, APR goes up.
- There’s no benefit to repaying early. Since you have to repay a fixed amount of fees no matter what, you get no interest savings from early repayment. This differs from a traditional “amortizing” small-business loan, in which early repayment would result in less interest paid. It also means that if you decide to refinance, you’ll still have to pay all of the agreed-upon fees, and you may also get hit with an early repayment penalty.
- There’s no federal oversight. The merchant cash advance industry is not subject to federal regulation because MCAs are structured as commercial transactions, not loans. Instead, they are regulated by the Uniform Commercial Code in each state, as opposed to banking laws. However, MCA Funders are subject to truth in advertising laws enforced by the Federal Trade Commission.
- Your credit score may be pulled. Although MCAs typically are an option for business owners with bad credit, that doesn’t mean the MCA provider won’t at least check your credit score during the application process. Background credit checks are a common requirement for MCA providers.
- There's a debt-cycle danger. The speed and ease of applying for and receiving MCAs can put you into a debt cycle, especially if you don’t qualify for other types of financing. Borrowers may find themselves in need of another advance soon after taking on their first one due to the extremely high costs and frequency of repayments of MCAs, which can cause cash-flow problems. A daily payment of hundreds of dollars, for example, could put a strain on the cash flow of many small businesses and put them at risk of default.
- Contracts can be confusing. The costs and repayment structure of MCAs can make them difficult to understand. Contracts are often loaded with unfamiliar terms, such as specified percentage (the percent you repay out of credit card sales), purchase price (the amount you receive) and receipts purchased amount (total payback amount). MCA providers do not provide APRs, which makes it impossible to compare with other financing products. You may also be required to sign a legal document called a confession of judgment, that forfeits your right to defend yourself if the funder takes you to court.
- Confession of judgment: Many MCA contracts also require you to sign a confession of judgment. A confession of judgment means you have given up your rights to defend yourself if the funder takes you to court. Many courts view a Confession of Judgment as a means of guaranteeing to the MCA Funder absolute repayment and thus finding the agreement a loan subject to the state’s usury laws.
To Sum Things Up
It all comes down to a risk analysis, both for you and the MCA Funder. Merchant cash advances can seem tempting because of the speed and ease in which your business can receive funding. However, the cost, predatory lending practices, and the potential to be trapped in a debt cycle with MCAs often do more harm than good for struggling businesses.
There is also a risk that the transaction may actually be disguised as an MCA agreement, when in actuality, the provisions of the transaction mitigates the MCA Funders risk of repayment, making it a loan subject to the state’s usury laws.
It should be noted that a large majority of Merchant Cash Advance companies are located in New York, and as such, are subject to New York law including New York’s criminal usury statute. Massachusetts, California, Texas, Florida and about 30 other states all have usury laws as well.
If your business is struggling with a Merchant Funding obligation and you don’t know where to turn, The Basile Law Firm, P.C. may be able to help. Our team of experienced business and litigation attorneys may help you get your business back on the road to financial freedom. Call us for a free consultation at 516.455.1500 or email us at info@thebasilelawfirm.com.