Merchant cash advances can provide an easy solution to a small business’s cash flow problem. However, these types of loans are often seen as predatory and, in some states, usury. While it can be a fast solution to a business’s issues, it can also lead to some major issues. Here, we will discuss what a merchant cash advance mean for a business, and how we can rid ourselves of these issues in bankruptcy.
What is a Merchant Cash Advance?
Merchant cash advance are the business version of a payday loan. A relatively small amount of money loaned at a high rate of interest. They are often marketed to small businesses that need working capital immediately, but may be unable to qualify for a loan.
Generally, merchant cash advances are seen as an alternative to traditional financing. In exchange for an immediate advance of cash from the party giving the money, the “purchaser,” the business sells its future receivables. The purchaser then performs regular audits of the business’s records.
All this means that the cash advance is actually not considered a loan. These advances are actually considered a sale of the business’s future funds. This allows these loans to skirt the strict usury laws which limit the amount of interest that can be charged. In turn, this means these cash advances often come with interest rates between 200-400%. There are often also hidden fees and provisions in the agreements that solely benefit the purchaser. These include penalties for seeking other loans and modifications to the payment schedule, all to make the loan that much more unaffordable.
Merchant Cash Advances in New Jersey
Recently, the New Jersey Attorney General, Matthew J. Platkin, settled with eight companies accused of unconscionable, misleading, and abusive lending, servicing, and collection tactics that caused financial harm through their merchant cash advances. Specifically, these companies were sued under violations of the New Jersey Consumer Fraud Act. Under the terms of this settlement, the companies would dismiss any collections efforts currently pending against customers, provide current customers with enhanced rights to request modifications, and have more transparent agreements with future customers.
The action against these lenders comes after years of determining whether these business practices are even legal in New Jersey. Often, these companies are accused of violating usury laws as applied to loan companies. While the courts have not articulated a precise test or standard for determining whether a transaction structured as a sale of receivables is really a secured obligation, they have identified factors that should be considered.
- Whether the purchaser of the future receivables acquires the risk of loss or whether the risk remains with the seller
- Whether the purchaser has the opportunity to recover more than just the principal plus interest, such as retaining all collections
- Whether the seller of the receivables continues to collect the receivables and is allowed to co-mingle it with other funds- (if it is a true sale of future receivables then the purchaser usually gets to collect the set percent of receivables)
- Whether or not the maker of the MCA is absolutely entitled to repayment under all circumstances. For a true loan, it is essential to provide for repayment absolutely and at all events or to secure the principals in some way as distinguished from being put in a hazard.
- The MCA agreement must have an indefinite term, evidencing the contingent nature of the repayment plan.
- Whether the purchaser of receivables has any recourse should the merchant declare bankruptcy.
The burden of proof falls on the seller of the future interests to prove the agreement was a loan and not a sale. The largest factor in this is to determine who assumes the risk in the case that the seller defaults. If the buyer assumes the risk, it is not considered a loan.
Merchant Cash Advances in Bankruptcy
The above test for characterization of the advance is important for claims and objections. For example, a debtor may object to a proof of claim filed by a creditor with whom the debtor had entered into a cash advance agreement and may seek to recharacterize the transaction as a loan rather than a sale. This characterization in turn affects how advances are treated.
The purpose of a business filing for bankruptcy is to either liquidate under chapter 7, or reorganize under chapter 11. Filing for bankruptcy an at least prevent the purchaser from continuing collection efforts against a debtor while the business is in bankruptcy. Debtor can attempt to negotiate with the purchaser for some payment over time, and include that payment in the debtor’s chapter 11 plan. Alternatively, in a chapter 7 the purchaser would likely just collect anything securing their loan, usually in the form of the accounts receivable.
Be Aware of Risks
One large risk for business owners, even if the business files for bankruptcy, is the threat of personal guarantees. If the agreement for the advance has a personal guarantee, where the business owner guaranteed the amount of money owed to the purchaser, that business owner may still be on the hook for money owed. Even if the business itself files for bankruptcy, this will mean the debt still exists as a liability to the business owner.
Merchant cash advances are known for being predatory against unknowing small business owners. While it may help a business in the short term, in the long term it can be detrimental to a business owner. A concerned business owner should contact an experienced bankruptcy professional to explore options and seek guidance.
