Be On The Look Out For Merchant Cash Advance Claims
September 3, 2024
In this Surety Today: The Blog post we discuss a type of financing that contracting companies and other businesses have increasingly been turning to for short term funding that sureties should be aware of. I have run into these lenders a few times recently and thought I should share with the surety industry what I have learned. I am talking about Merchant Cash Advance (“MCA”) lenders. I say “lenders,” but they would balk at being called a lender, because they work very hard to structure their agreements in such a way to try to avoid the lending regulations, laws and licensing requirements. This is relevant to sureties because such lenders may attempt to come after bonded contract funds asserting UCC secured creditor rights, as was the case in one of my current matters. A surety may also need to do battle with such creditors in bankruptcy, as is also happening in one of my current matters. Finally, such creditors may be part of the principal’s accounts payable in a financing situation and the surety may want to push back against allocating funds to such creditors. Of course, a surety would have all of its traditional surety defenses to such circumstances, what I am discussing here is just an additional potential defense.
These MCA entities purport to purchase a portion of a company’s future account receivables at a discount price, then require the merchant to repay the entire “purchased amount” by automatic electronic fund transfers at set amounts every business day. The agreements in such transactions all tend to have very similar provisions and are carefully designed to give the appearance of a purchase/sale transaction, however, many courts have held that such transactions are simply disguised loans that are usurious, illegal and unenforceable. For example, numerous courts in New York have held that MCA receivable purchase agreements are in fact loan transactions. See State of N.Y. v. Richmond Cap. Group LLC, 2023 WL 6053768, at *1-2 (N.Y. Sup. Ct. Sept. 15, 2023) (considering “140 sample merchant cash advance agreements” and determining that “the MCAs were loans, not a legitimate purchase of accounts receivables”); AKF, Inc. v. W. Foot & Ankle Ctr., 632 F. Supp. 3d 66 (E.D.N.Y. 2022) (determining that revenue purchase agreement was a loan and unenforceable because of usury defense); Lateral Recovery LLC v. Queen Funding, LLC, No. 21-CV-9607, 2022 WL 2829913, *5-6 (S.D.N.Y. July 20, 2022); Haymount, 2022 WL 2297768, at *7 (holding that an agreement was a loan); Fleetwood Servs., LLC v. Ram Cap. Funding, LLC, No. 20-CV-5120 (LJL), 2022 WL 1997207, at *9–14 (S.D.N.Y. June 6, 2022)(holding that an agreement was a loan); Davis v. Richmond Capital Grp., LLC, 150 N.Y.S.3d 2, 4, 194 A.D.3d 516 (1st Dep’t 2021) (holding that a complaint sufficiently alleged that agreements were loans subject to usury laws); Professional Merch. Advance Capital, LLC v. C Care Servs., LLC, 2015 U.S. Dist. LEXIS 92035, *11, 13, 2015 WL 4392081, *4 (S.D.N.Y.2015) (“[l]ooking beyond the form of [the] transaction and examin[ing] its substance, it could be argued that the Agreement, which obligates Defendants to make a minimum weekly payment irrespective of C Care’s accounts receivable and subjects Plaintiff to no downside whatsoever aside from the risk that the borrower will fail to make the required payments, is in fact a loan.”); Crystal Springs Cap., Inc. v. Big Thicket Coin, LLC, 220 A.D.3d 745, 747–48, 198 N.Y.S.3d 142, 145 (2023).
In addition to the New York courts, courts in other jurisdictions have also reached the conclusion, in addressing similar MCA agreements, that such transactions are loans. See Major’s Furniture Mart, Inc. v. Castle Credit Corp., 602 F.2d 538, 539-46 (3d Cir. 1979)(court held that the “district court did not err in determining that the true nature of the [accounts receivable] transaction … was a secured loan, not a sale.”); Lange v. Inova Cap. Funding, LLC (In re Qualia Clinical Serv., Inc.), 441 B.R. 325 (8th Cir. BAP 2011)(court held that a contract for purchase and sale of debtor’s accounts receivables was not a true sales agreement, but rather, was in the nature of a disguised financing agreement, pursuant to which the debtor retained ownership interests in accounts despite its purported sale to the funding company); CapCall, LLC v. Foster (In re Shoot the Moon, LLC), 635 B.R. 797 (Bankr. D. Mont. 2021)(court considered 18 merchant cash advance contracts, applying a multipart framework for characterizing transactions, determined that MCA contracts were loans, and awarding usury damages); Kerr v. Commercial Credit Grp., Inc. (In re Siskey Hauling Co., Inc.), 456 B.R. 597, 600-07 (Bankr. N.D. Ga. 2011)(court observed that “[w]hen a buyer of accounts receivable holds substantial recourse against the seller, thereby shifting all risk of non-collection on the seller, courts have routinely held the transaction to be a financing arrangement and not a sale.”).
In the past few years, these MCA agreements and lenders have come under increased attacks. In December, 2020, the State of New Jersey filed suit against 8 entities involved in MCA lending. The Complaint stated:
Defendants drafted their Merchant Agreements to bury myriad unconscionable terms that, among other things, eliminate the distinctions between loans . . . and legitimate MCA’s . . . Under these Merchant Agreements, unlike legitimate MCA contracts, the fixed daily payments extracted from Consumers’ accounts have little to no relation to the businesses’ receivables, and Consumers whose businesses are struggling have been either stymied in their efforts to adjust their daily payment amounts or driven by Defendants into an even worse financial situation. . . . Defendants have through various other devices, shifted risk onto consumers – both businesses and their owners – in ways that are inconsistent with legitimate MCA contracts and that have facilitated Defendants’ unconscionable collection practices. In short, by masking their MCAs as purchases of accounts receivables, as opposed to what they really are – unlawful and usurious loans – Defendants have sought to avoid responsibility for their predatory lending.
On December 27, 2022, the parties in the New Jersey action entered into a Consent Order in which the Defendants agreed to a $27 million settlement that included complete forgiveness of $21 million in illegal MCA loans among other damages and restrictions. The New Jersey case pales in comparison to the suit filed by the New York Attorney General against 30 MCA lenders and individuals on March 5, 2024, seeking in excess of $1.4 Billion in damages. The NY AG stated that:
[t]he merchant cash advances . . . are a form of short-term, high-interest funding for small businesses. . . . The perpetrators of this scheme provided contracts that fraudulently described each transaction as a purchase of a portion of a merchant’s future revenues, with flexible payment amounts and open-ended terms. In reality, the predatory lenders collected payments at fixed daily amounts, which they debited directly from merchants’ bank accounts over short repayment terms, such as 60 or 90 days. . . . As a result, the transactions were actually short-term loans with ultra-high interest rates of up to 820% per year.
The most recent NY AG filing, follows closely on the heels of $77 Million judgment the NY AG obtained against another MCA lender and a consent order reached by the Federal Trade Commission against other MCA lenders.
Once a court sees the transaction as a loan instead of a purchase/sale, the terms of such a transaction are very likely to be usurious. Consider the following example, a merchant wants to borrow $20,000. It enters into an MCA agreement with an amount to be paid to the merchant of $20,000 in exchange for the finance company “purchasing” $29,600 in the merchants future accounts receivable. The merchant actually only receives $18,701 of proceeds, with the remaining $1,299 being retained by finance company for its fees and other charges, but the merchant is required to pay back the full $29,600 in daily payments. The daily payment of $360 is required each business day (5 days a week). At that payment rate, the total $29,600 loan repayment amount would be paid in 114.8 days – the loan term. Comparing the total loan amount to be repaid ($29,600) with the actual amount of the loan received by the merchant of ($18,701) yields the total amount of interest to be paid of $10,899. Using the formula APR = (((Interest charges + fees) ÷ loan amount) ÷ number of days in loan term x 365) x 100) yields an annualized interest rate of 117% [($10,899 ÷ $29,600 = .368209) ÷ 114.8 = .0032073995 x 365 = 1.1707008175 x 100 = 117.07].
Unless provided to the contrary elsewhere under New York law, under New York usury law, the maximum legal interest rate on a loan is 16% per year, and interest higher than that is considered civil usury. N.Y. Banking Law § 14-a (McKinney). Interest higher than 25% is considered criminal usury. N.Y. Penal Law § 190.40 (McKinney). Under New York usury law, as is true in other jurisdictions, usurious loans are void and unenforceable. Blue Wolf Capital Fund II, L.P., 105 A.D.3d at 182; Adar Bays, 37 N.Y.3d at 333 (“loans proven to violate the criminal usury statute are subject to the same consequences as any other usurious loans: complete invalidity of the loan instrument.”); AKF, Inc., 2024 WL 2941746, at *10-11; James Davis v. Richmond Capital Group, LLC, 194 A.D.3d 516, 517, 150 N.Y.S.3d 2 (1st Dep’t 2021). In Seidel v. 18 E. 17th St. Owners, Inc., 79 N.Y.2d 735, 740, 598 N.E.2d 7 (1992) the court stated that “[t]he consequences to the lender of a usurious transaction can be harsh: the borrower is relieved of all further payment–not only interest but also outstanding principal, and any mortgages securing payment are cancelled. In effect, the borrower can simply keep the borrowed funds and walk away from the agreement.”
The takeaway here is that if the surety finds itself dealing with an MCA creditor of its principal, the surety should examine the nature and terms of the MCA agreement under applicable law to determine if such agreement is enforceable or if such agreement may be void and unenforceable. Not all MCA transactions are improper and numerous courts, including New York courts, have upheld such transactions, I am simply raising the issue for consideration as a possible defense.
If you have questions regarding the issues discussed in this post, please do not hesitate to contact Michael A. Stover, Esq. (410-659-1321/mstover@wcslaw.com) or any member of the Surety and Fidelity Practice Group.
