NH Legal Perspective: Merchant cash advances: What to know before signing

This article, written by attorney James LaMontagne, was originally published by the NH Union Leader and can be found here.

As a bankruptcy, restructuring and creditors’ rights attorney, as well as a chapter 11 bankruptcy trustee, I have seen an increasing number of debtors both in and outside of bankruptcy with merchant cash advance (“MCA”) debt.

An MCA is not a traditional bank loan but an alternative form of financing where an MCA funder provides a lump sum of cash to a business in return for a lien on, or the purchase of, the business’s accounts receivables and/or its debit and credit card sale transactions. The common explanation by business owners for the MCA debt is “the business’s cash flow had slowed down and the business needed a quick infusion of cash to maintain its day-to-day operations and keep the doors open.”

U.S. Bank study found that approximately 82% of small businesses fail as a result of cash flow problems, so it is not surprising that MCAs, with their high approval rates and speedy funding, are, to some, an attractive financing option. However, for others, MCA factor rates and aggressive repayment schedules can bring about more problems than they solve. Whether an MCA is right for your business or not, here are some points to consider before taking a MCA.

MCAs can be valuable to those businesses or business owners that have less than perfect credit and/or need quick cash. It is estimated that the MCA approval rate is as high as 84%. When compared with the loan approval rates of so-called big banks (68%) and the Small Business Administration (65%), MCAs present as an attractive option. Additionally, MCA funders often close their transactions within a day or two, thereby providing cash-strapped businesses with the immediate cash they need.

However, MCAs also come with significant risks and therefore may not be the answer for every business. MCAs can be very expensive. MCA funders charge origination fees, funding fees, and administrative fees, to name a few. Additionally, while MCA funders don’t charge interest, they do charge a factor rate. This factor rate is typically between 1.1 and 1.5 of the entire loan or sale amount. MCAs also often have very aggressive repayment terms including daily or weekly automatic withdrawals from the business’s bank account and short repayment periods. This structure results in expensive financing. For example, a $100,000 MCA with a factor rate of 1.5 and a 15-month repayment period equates to an annual interest rate of approximately 40%.

A business must also be very careful not to default under a MCA. While, in my experience, some MCA funders will temporarily restructure payments to prevent an immediate shutdown of a business, MCA agreements often have harsh default provisions. MCA funders will often charge default fees and penalties that immediately and significantly increase the amount of the debt. MCA agreements often require the business and the MCA personal guarantors to execute a confession of judgment allowing the MCA funder to immediately obtain judgment against the business and/or the personal guarantors upon default. MCA funders are also quick to issue demand letters under Article 9 of the Uniform Commercial Code to a defaulting business’s debtors demanding that the business’s debtors redirect payments, otherwise due to the business, to the MCA funder.

Even in bankruptcy, MCAs present challenging legal issues for the business-debtor. The majority of these legal issues revolve around the characterization of the MCA. The business-debtor often desires to characterize the MCA as a secured loan while the MCA funder argues that the MCA is a true sale of the business-debtor’s account receivables.

The characterization of a MCA within a bankruptcy case will have a significant impact on the business-debtor. If the MCA is characterized as a secured loan, the MCA funder may have a claim in the bankruptcy case secured by the business-debtor’s account receivables but those account receivables will be available to the debtor-business in its reorganization efforts. Furthermore, the MCA funder’s claim will be subject to competing secured creditors’ claims, priorities and potential cram-down by the business-debtor. Finally, the MCA funder would also be subject to the automatic stay among other provisions of the bankruptcy code.

Conversely, if the MCA is characterized as a true sale of account receivables, those receivables may not constitute property of the business-debtor’s bankruptcy estate and therefore unavailable to the business-debtor as it attempts to reorganize. Further, the automatic stay would not prevent the MCA funder from engaging in post-petition collection action against those account receivables, and the MCA funder may otherwise avoid the bankruptcy case altogether.

In determining whether an MCA is a true sale of account receivables or a secured loan, courts that have addressed the issue focus on the language of the transaction documents, the rights and recourse that the MCA funder has against the business-debtor in the event of default, and the course of dealings between the business-debtor and the MCA funder during the business relationship.

In conclusion, the decision to take an MCA is specific to every business, but the decision should not be made without understanding the advantages and disadvantages of MCAs.