Merchant Cash Advance Redux: Loan vs. True Sale – New York Federal Courts Weigh In
In oyour message of February 14, 2022, we have highlighted some consequences regarding the treatment of a cash advance (“MCA”) transaction as a “loan” rather than an “actual sale” of receivables or future receivables and the implications of a such treatment for an ACM supplier. Among the takeaways was that a court’s characterization of an MCA transaction as a loan opens up an MCA provider to a host of potential claims by cash advance recipients (“customers”) and their successors (for example., trustees in bankruptcy) that are not otherwise available if the transaction is treated as an actual sale.
Recent trends in case law seem to show a development of sympathy for customerswhen the underlying documentation and business practices of the MCA provider allow the courts to qualify a loan transaction. MCA transactions are designed by MCA providers to achieve certain economic returns in a structure where their risk of loss is minimized. Recent case law may, however, encourage MCA providers to rethink the terms and structures of transactions in order to best avoid these transactions being qualified as loans. Borrowers will be reassured by these cases that, if their transaction has some indicia of a loan, a court may be inclined to treat it as such, regardless of the label.
Since our last article, at least three reported decisions from the Southern District of New York have analyzed MCA transactions in the context of usury claims and violations of the Racketeer Influenced Corrupt Organizations Act (“RICO”) ). The underlying transactions were, for the most part, similar. In each, the MCA supplier purported to purchase its customer’s future receivables using documentation indicating that the transaction was a “genuine sale”. Pursuant to the agreements, the MCA supplier would withdraw a contractually fixed amount daily from its customer’s bank account, regardless of the amount of daily recoveries, although the MCA agreements also provided that payments to the MCA supplier would be based on a estimated percentage of daily collections. If there were not enough collections on a given day, the ACH withdrawal would be rejected and the customer would be in default.
In each case, the customer granted a security interest in its accounts receivable and other non-reimbursable customer assets and there was recourse against certain guarantors. In addition, the MCAs listed the events of default commonly seen in lending transactions. The allocation of economic risk, based on these contractual provisions alone, clearly points to the customer.
The analyzes undertaken by the three SDNY courts followed similar routes to arrive at similar results.
a. The Fleetwood Court said the following:[v]To see the [MCA] Contract as a whole, the Court concludes that it is a loan and not a contract for the purchase of future receivables”. Having reached this conclusion, the Court then analyzed the claims of usury and RICO, both of which require as a predicate of liability that the underlying transaction requires the repayment of a debt (that’s to say., a loan).
b. The Haymont The court described the main action in the complaint as where the defendants were liable under RICO, for operating “a business that lends money to small businesses at criminally usurious rates of interest and then uses various inappropriate tactics to recover these loans”. After a lengthy analysis of the loan versus actual sale factors, Judge Rakoff found that the plaintiff had sufficiently pleaded that the MCA agreements at issue functioned as loans. “Because the transactions should be treated as loans, at least at this stage, and because defendants do not dispute that the interest rates implied on these transactions far exceed 50% per annum (twice the rate of New York State criminal usury), the Court finds that the Complaint has sufficiently pleaded that the debts created by the MCA agreements that the Defendants issue are unenforceable “unlawful debts” under RICO statute.
vs. The Lateral The court also analyzed RICO’s claims based on underlying usury claims. Again, for the purposes of adjudicating on the defendants’ motion to dismiss, the court said:[o]Overall, the complaint pleads enough facts to show that the transactions reflected in the merchant agreements are loans subject to usury laws. » It allowed RICO and attrition claims to continue.
In each case, the Court went to the trouble of calculating the interest rate built into the transaction and in each case, the result would violate applicable usury laws in most states: Fleetwood – 278.5%; Haymont – greater than 50%; Lateral – multiple agreement with interest ranging from 100% to 300%. Furthermore, in at least one of the cases, the MCA provider never advanced the contractually promised full amount to the customer, but continued to withdraw the fixed daily amount from the customer’s bank account as if the full promised amount had been advanced. . That collections slowed was a risk to be borne by the customer and not by the MCA provider (as would be the case in a real sale).
The courts also appeared to be influenced by the business behavior of some of MCA’s suppliers. For example, the Fleetwood Court pointed out several facts that influenced its decision. At one point in its relationship with the MCA provider, Fleetwood requested a pause in the daily fixed ACH withdrawal to reflect a slowdown in collections, to which a collection agent replied “UNFORTUNATELY…WE DO NOT OFFER ANY” BREAKS”. DOING THIS WILL PUT YOU IN AUTOMATIC DEFAULT”, and [the MCA provider] continued to debit amounts from the Fleetwood account,” and reconciliations were never performed to address excessive ACH withdrawals. Further, the MCA provider has made no attempt to dispute similar statements in affidavits from other customers submitted to the New York Attorney General. A client, after being informed of a seasonal slowdown in collections, requested a reduction in daily payments and was told by the MCA provider: “We’ll take it all from you…. We are from New York…. Don’t mess with us. Another customer requested a one-week adjustment to its payment obligations as it was awaiting payment on its customers’ receivables. The same MCA provider replied, “I don’t care about your problems” and “I’m giving up on you before you can get out of the bathroom.” Although not decisive, bad behavior does not help an MCA provider who may already be facing an uphill battle.
What is decisive, however, is with whom, after examination and analysis of all documents, the business transactions between the parties and the economics of the transaction, the ultimate economic risk lies. If the balance is tilted towards the client, loan qualification is the most likely outcome. If the risk distribution scales lean towards the MCA provider, the trade will be more likely to qualify as a buy.
The Fleetwood The Court summarized the risk analysis as follows:
“The ultimate question…is whether the transaction involves a transfer of risk. When the putative “lender and not the [putative] the borrower bears the risk of non-performance by the debtor of the account” and “the debt of the borrower is extinguished” by the operation, then “the risk of the lender as to the performance of the accounts is direct”, and the transaction is properly characterized as a purchase of accounts receivable. (quote omitted). On the other hand, the transaction is rightly qualified as a loan when “the lender only holds a security [and] the lender’s risk is derivative or secondary, i.e. the borrower remains responsible for the debt and bears the risk of non-payment by the debtor of the account, while the lender only bears the risk that the non-payment – payment from the account debtor renders the borrower unable to satisfy the loan. (quote omitted).
These recent rulings are a signal that the courts are taking note of the behavior of some ACM providers and providing guidance for aggrieved customers. They also signal to MCA providers that SDNY courts are willing to find their MCA agreements to be loans if the parties’ agreements do not properly allocate economic risk and if an MCA provider’s behavior is not commercially reasonable and consistent with its contractual commitments. obligations, thus opening the way to usury and RICO claims against the MCA supplier as well as disadvantageous and potentially costly treatment in the event of customer bankruptcy.