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.

According to New York Civil Practice Law and Rules section 3016(b), in a fraud cause of action in a complaint, “the circumstances constituting the wrong shall be stated in detail”.  Contrast this with the standard for a libel or slander pleading in 3016(a): ” the particular words complained of shall be set forth in the complaint”. Lawyers might be excused for thinking that there was a slightly less exacting standard for fraud than defamation.

In a 2014 decision, the Appellate Division First Department was very specific about specificity, dismissing a fraud claim “because the words used by defendants and the date of the alleged false representations are not set forth”, Gregor v. Rossi, 120 A.D.3d 447 (1st Dept. 2014). The Court in effect closed the gap between fraud and defamation pleadings, requiring that even a fraud pleading name the speaker of a misrepresentation and quote the words used. Trial courts in the First Department, which covers Manhattan and the Bronx, have since applied the new rule to dismiss fraud claims. In Board of Mgrs. of 141 Fifth Ave. Condominium v 141 Acquisition Assoc. LLC, 2015 N.Y. Misc. LEXIS 3775 (Supreme Court New York County 2015) the court held that “the amended complaint does not set forth a specific statement and, often, does not identify a specific document in which these statements allegedly occurred. Such allegations are insufficient to state a fraud claim”. In Davoli v Dourdas, 2015 N.Y. Misc. LEXIS 1345 (Supreme Court New York County 2015) the court stated that “The particularity requirement of CPLR 3016(b) requires, in general, that the complaint specify the language of the alleged misstatements and the time and place that were made”.

Experienced defense practitioners are used to seeing fraud claims included as afterthoughts in what are essentially law suits for breach of contract. By raising the bar on specificity, the Appellate Division has acted to discourage this practice, and to require plaintiffs not to make allegations of fraud unless they really have facts to back it up.

An unpleasant but common experience: an old judgment against you comes back to haunt you. Possibly you didn’t even know it existed: the complaint may have been served in the wrong place and you never got a copy, or the opposing party may even have filed a false affidavit claiming you were served (known as “sewer service”).

The first way many of us find out that an old judgment (from as long as twenty years ago) is still out there is when we are notified by our bank that a restraining notice has been served and funds are frozen. A collection law firm, usually a specialist, has taken on the mission of finding you and making your life difficult. Restraining notices are issued by the lawyer, no judge’s signature needed, and are often shot-gunned out to every bank in town until one finds you.

An unpleasant new wrinkle from the last few years is that if a bank with branches in New York received a restraining notice in New York based on a New York judgment, it would restrain your account with that bank even in another state.   I think this development was caused by a widespread misunderstanding of a decision by New York’s highest judicial body, the Court of Appeals, which had not intended to authorize this behavior (Koehler v. Bank of Bermuda Ltd., 12 N.Y.3d 533). Recently, the Court of Appeals in a new case (Motorola Credit Corp. v Standard Chartered Bank, 2014 NY Slip Op 07199 (2014)) issued a clarification that New York restraining notices do not affect banks in other states. It seems as if some national banks haven’t yet heard the news, though.

A restraining notice on your bank account is harmful and distressing, but it can be challenged. If you were never served with the original complaint (and, in certain circumstances, even if you were) it may be possible to vacate or reopen the judgment, and make the restraining notice go away. These claims can often be settled, sometimes for pennies on the dollar. Finally, the banks themselves are required to send you a notice explaining that there are circumstances under which you can seek an exemption, for example if the frozen funds were social security (which is untouchable) or your salary in a pay roll account (they can only freeze ten percent).

As New York Business Divorce reports today, the lack of a shareholder agreement caused a New York widow of a dentist, who was practicing dentistry in a professional corporation, to be left with nothing.  

Despite the fact that the deceased dentist was a 75% shareholder in the dentist professional corporation and his widow had found a dentist purchaser for the dentist practice offering $530,000, the minority dentist shareholder was able to defeat her and will likely be able to force her to sell her late husband's share in the business for $0.  

The reason for all this was the fact that shareholders of professional corporations must all be licensed to exercise the profession of the corporation, in this case dentistry.  If one dentist dies, his non dentist heirs, here the widow, are severely limited in their rights to exercise rights of a shareholder.  

However, all of this could have been prevented by a properly drafted shareholder agreement including provisions dealing with the death of any shareholder and his heirs' rights.  The shareholder agreement would have preempted the New York default provisions contained in the business corporation law.  These default provisions caused the widow's dilemma.  

Read New York Business Divorce for a full analysis of the case.