Merchant Cash Advance Disputes Are Getting Wilder
By tradition, the Merchant Cash Advance (MCA) industry was born in New York, and its law continues to be the law of choice in many MCA agreements. This has led to a lot of litigation because, unlike dozens of other states, New York has a 25% criminal usury cap on business loans. In many cases, MCA funders argue that MCA agreements are not loans and are therefore exempt; while business customers (known as ‘merchants’) seeking to evade their obligations, unsurprisingly, argue that these are in fact capped loans.
There are now dozens of trial decisions and several appellate decisions on this issue. This well-developed MCA case law has resulted in more careful drafting of MCA agreements in recent years, but some recent decisions suggest that MCA litigation is about to get wilder.
MCA agreements are purchases of future receivables, not loans. When properly drafted, MCA agreements should not be subject to a usury cap, as an MCA is not structured like a loan. In practice, however, wear caps have fueled much litigation against MCA backers, particularly in New York.
MCA transactions are similar to traditional factoring agreements. The funder purchases future receivables at a pre-determined price, and repayment depends on the success of the venture. Above all, unlike a loan, the company has no absolute obligation to repay. A trader does not have to hand over receivables that it does not receive as a result of business bankruptcy, and the trader’s remaining non-receivable assets cannot be seized. There is also no interest rate in the MCA agreement that would result in an increase in the gross amount the company is required to remit if its receivables are delivered over a longer period than originally estimated. These fixed discounts are estimates of an agreed percentage of average daily receivables which can be adjusted at the merchant’s request if receivables decrease. Initially, the MCA funder takes the risk of not being reimbursed if the company goes bankrupt.
Nevertheless, merchants will often sue MCA backers seeking to nullify deals they claim are merely “disguised” loans with absolute repayment obligations. Merchants generally claim that when their fixed daily receivables installment amounts are annualized, they would effectively be paying the backer a rate well over 25% per annum. Most lawsuits have been dismissed at the trial court level because the written agreements prove that the MCAs were not loans. In addition, many courts have found that despite various protections for funders – such as security agreements, personal performance guarantees, and admissions of judgment – funders still run the substantial risk of never recovering their investments. if the business fails.
This has been particularly true of MCA agreements which contain a “reconciliation” clause which allows the company to request, and require the funder to provide, an adjustment of the company’s daily installments to reflect the decrease in average debts. Such agreements, which reflect the actual ebbs and flows of the business and adjust remittances accordingly, are generally not considered loans.
MCA Appeal Decisions. New York, the most important state for the MCA law, until recently had no guidance from any appellate court.
In 2018, the First Department issued a terse ruling that appeared to give the MCA deals a green light in New York. See Champion Auto Sales vs. Pearl Beta Funding159 AD3d 507, 507 (1st Dep’t 2018) (finding that “[t]The evidence demonstrates that the underlying agreement which led to the judgment by confession was not a usurious transaction. “). However, the decision did not provide any detailed framework for determining what provisions of an MCA agreement could transform it from a legal purchase agreement into a loan sharking.
Some of these details were provided by the second department in LG Funding v. United Senior Props. of Olathe181 AD3d 664, 666 (2d Dep’t 2020), which adopted a three-part test used by some lower courts to determine whether an MCA agreement was a loan: “(1) if there is a reconciliation clause in the agreement; (2) whether the agreement has a fixed term; and (3) whether there is a remedy if the merchant declares bankruptcy.The nature of the reconciliation provision was particularly important for the second ministry, which is focused on the use of the term “may” in the reconciliation provision, which could give the funder discretion to adjust installments to reflect the decrease in receivables.
This has spawned a significant number of disputes over whether reconciliation is a corporate right (and therefore the agreement is not a loan) or discretionary and illusory (thus creating an absolute payment obligation similar to a loan) . When the courts before LG Financing largely on the donor side, subsequent decisions have closely examined the obligation of reconciliation. Where the LG Financing indicate that a deal can be a loan, courts have granted preliminary injunctions in favor of merchants or dismissed motions to dismiss brought by lenders.
Last month, the First Department of Davis v. Richmond Capital Group2021 NY Slip Op. 03111, ¶ 1 (1st Dep’t May 13, 2021), affirmed the dismissal of a motion to dismiss, finding that the MCA agreements in question may be loans due to:
the discretionary nature of the reconciliation clauses, the allegations that the defendants refused to authorize the reconciliation, the selection of daily payment rates which did not appear to represent a good faith estimate of the claims, the provisions providing for the rejection of a direct debit two or three times without notice notice of an event of default entitling defendants to immediate reimbursement of the full amount purchased and not recovered, and provisions allowing defendants to recover the personal guarantee in the event of inability to pay or bankruptcy of the plaintiff company.
This probably means that after Davis The trial court’s decision will focus on additional provisions in the MCA agreements beyond the LG Financing factors to determine the true nature of the transaction. Further, the decision suggests that, even if the MCA agreement was valid at the time it was entered into, a later failure by the funder to provide a reconciliation would not only constitute a breach, but could prove that a funder dealt its deal as a loan rather than an MCA.
The impact of “Davis” is felt. The past few years have seen a series of lawsuits against MCA funders by state and federal investigators alleging usury and violations of other consumer protection laws.
In People of New York State vs. Richmond Capital GroupNY Co. Index No. 451368/2020, the New York Attorney General alleges that certain funders and their officers violated criminal usury law due to their pre-contractual conduct: transactions are described as “loans” in sales calls, emails, advertising materials and web pages, which also discuss payment terms, and because they are taken out as loans, in looking at credit scores and bank balances rather than historical debt. The NYAG also alleges that post-contractual conduct makes agreements ready, including filing judgment admissions or executing personal guarantees on one-time missed payments, filing false affidavits, double-dipping daily installments, and refusing to grant reconciliations .
On June 2, 2021, Supreme Court Justice Andrew Borrok heard oral argument and denied the MCA respondents’ motions to dismiss the NYAG’s motion. He rejected what he described as their “form over substance” argument that because MCAs are not structured as loans, they cannot be usurious. Instead, citing the recent First Department report Davis decision, he said the NYAG had sufficiently alleged fraudulent conduct on the part of the funders to overcome any rejection based on arguments of documentary evidence by the funders.
The court seems to interpret Davis as allowing it to look not only beyond the four corners of an MCA agreement to determine whether there was usurious intent at the time of the transaction, but also subsequent misconduct that could retroactively subject loans from MCA agreements to New York criminal usury law.
The recent Davis The decision will likely spur usury litigation against the MCA companies. Donors using legacy agreements written when the MCA industry was in its infancy are the target of such litigation, but even regularly updated agreements need to be reconsidered in this environment.
However, exposure to litigation – and frankly criminal litigation – cannot be mitigated by having a well-drafted form alone. Future litigation and investigations may examine not only the four corners of the MCA agreements, but also the pre- and post-contract behaviors of funders, vendors, underwriters and independent sales offices, to determine whether the product was properly presented and whether the actors acted. in accordance with the terms of the agreements.
In addition, various state legislatures (including New York) have introduced or passed legislation covering MCA agreements. These require certain pre-contractual disclosures of the terms of the agreements, including, most confusingly, an annual percentage rate (APR) and a repayment term. However, MCAs have neither and would be accused of breaching two of the three LG Financing factors if they did.
The time to update MCA agreements, bring itself into full compliance with New York law, and train staff in the basics of MCA law, was yesterday, but the momentum to do so has not expired. MCA funders should contact an experienced MCA attorney to review their forms and advise on best practices.