(Last Updated On: January 30, 2020)

Easy Money or Debt Trap?

Merchant Cash Advances are often the small business owner’s last resort for cashflow. When an SBA loan or any other business loan is out of reach, Merchant Cash Advance businesses are eager to give the business owner money. It only takes a couple of days, minimal paperwork, and the money flows into the account. However, it is often a slippery slope into a debt spiral with no return.

Many articles have been written about how Merchant Cash Advances work, for example this one by nerdwallet.

But, as the nerdwallet article points out, the contracts underlying these transactions can be complicated and are certainly not standardized. The rules for default are all over the place and it really pays to know your rights under the Merchant Cash Advance agreement before you default and are faced with sometimes very aggressive debt collectors who will go after your business accounts, personal assets (if you gave a guaranty) and enter a judgment against you without you even knowing (if you signed a confession of judgment). The industry is not regulated and there are lenders out there who are engaged in what can only be described as predatory lending practices. New York has recently outlawed confessions of judgment against out of state borrowers.

Usurious Loan or Sale of Receivables?

When faced with out of control lenders trying to enforce under the Merchant Cash Advance, many borrowers have tried to characterize the merchant cash advance as a usurious loan. If you do the math, many of these transactions cost more than 100% interest. The nerd wallet article actually has a calculator how to really determine the cost of this kind of financing.

In New York, it is considered a criminally usurious loan if a lender charges more than 25% interest. If one succeeds on that argument, the entire agreement would be void and the borrower would not have to pay any interest or principal on the loan.

Unfortunately, many New York courts have now decided that a merchant cash advance is not a loan, but a sale of your future receivables. Therefore, the rules about usury do not apply and Merchant Cash Advance lenders can get away with highway robbery. How do you make the distinction between a loan and a sale of receivables?

Courts have explained that there are certain factors that a court should look for to see if repayment is absolute or contingent. Does the merchant lender have the risk of the merchant’s business going down, i.e. no receivables to collect? Or does the lender have a right to repayment no matter what?
Courts named three factors that should be present in any MCA agreement in order not to be a usurious loan: (1) a reconciliation provision that allows the merchant to adjust the fixed daily ACH payments to the amount of its actual daily receipts (answer should be yes); (2) an indefinite contract term, which is consistent with the contingent nature of each and every collection of future sales. . (answer should be yes).; and (3) whether the merchant financing company has recourse if the merchant declares bankruptcy (answer should be no).

Every Agreement must be Analyzed

Of course, every merchant lender out there, if smart enough, will now draft their agreements so that all these factors are present. But still, not everybody is skilled, and many of the other protections merchant lenders may want to put into their agreements to protect themselves may convince a court otherwise. Every agreement needs to be analyzed whether it is a usurious loan or a sale of receivables.

Every once in a while, a judge will still entertain the idea that such a transaction is a loan. In McNider Marine, LLC v. Yellowstone Capital, LLC, a judge ruled on a motion to dismiss by the lenders:

 “In determining whether a transaction is usurious, the law looks not to its form, but to its substance, or real character”

“After analyzing specific MCA agreements, many New York courts have found that they constitute legitimate purchases of accounts receivables instead of loans with usurious interest rates. Courts that found otherwise, that MCA agreements were usurious loans disguised as purchases of accounts receivable, typically found no provisions for forgiveness or modification of the loans, such as viable and enforceable reconciliation provisions, in the event that the funding companies could not collect the daily amounts required”

“Focusing on the reconciliation provision in a given merchant agreement is appropriate because it often determines the risk to the funding company. If the funding company truly is collecting a specified percentage of accounts receivable, then the funding company bears the risk of a downturn in the merchant’s business. The specified percentage typically is replaced by a fixed payment (as it was here), but if that payment is reconciled when accounts receivable drop below the merchant’s original estimation, then it may take the merchant far longer to repay the amount advanced than the funding company had anticipated.”

If, however, the merchant is unable to adjust fixed payments in the event of a reduction of its accounts receivable, and the funding company can collect the amount due and owing by way of a personal guarantee and confession of judgment, there is far less risk to the funding company. Therefore, whether the merchant may reconcile its fixed payment amount when there is a reduction of accounts receivable is often determinative of whether repayment is absolute or contingent. If repayment is absolute, then the arrangement must be considered a loan as opposed to a purchase of accounts receivable.
In this case, the court finds that plaintiffs have demonstrated that the reconciliation provisions contained in the addenda to the July and October agreements were illusory. First, the court cannot find from the language in the agreements that Yellowstone had any duty to reconcile. In fact, Yellowstone likely could refuse to even consider reconciliation if it contended that McNider Marine failed to sufficiently document a basis for it. Furthermore, even if Yellowstone was required to reconcile, there was no time to do so because McNider could request reconciliation only within five business days following the end of a calendar month. McNider Marine defaulted on December 16, 2016, so it could not request reconciliation until the first week of January 2017. Yellowstone filed for a judgment by confession on December 22, 2016 and obtained that judgment on December 28, 2016.”
The notion of reconciliation for McNider Marine appears particularly futile because the fixed daily payment in the October agreement was not a good faith estimate of 15% of its receivables to begin with inasmuch as there was no evidence that the receivables had increased over 40% from the July estimate. Without the right to effectively reconcile the fixed dollar amount, the agreement resulted in a loan payable over a fixed term with a criminally usurious interest rate in excess of 285%.”

Have your Situation checked by a Lawyer

So, many things can go wrong. Lenders may not draft their agreements properly and it could actually turn out to be a usurious loan. Lenders may try to enforce the agreements against the terms of the agreement and in the process freeze your entire business. Lenders may fail to properly enforce their rights against you. For example, many of the predatory lenders try to bully you and your third-party debtors into paying them directly, despite the fact that they have not properly entered the judgment in your home state and have no right to demand direct payment.

If you are under the squeeze of a merchant lender gone wild, it pays to run your contract and the events by a lawyer. The worst case scenario is that your lawyer can help you to savely negotiate a way out of debt.

About Imke Ratschko


Imke Ratschko is a New York Attorney helping small businesses, business owners and entrepreneurs with all things "Small Business Law," such as litigation, contracts, business owner disputes, shareholder and operating agreements, sale or purchase of a business, investors, and starting a business. You can reach her at 212.253.1027 or by email.