Merchant Cash Advance- a Wolf in Sheep’s Clothing

What is a Merchant Cash Advance (“MCA”) and what are the real differences between a MCA and a traditional business loan? We’ll answer the former in a moment but the short answers for the latter are the cost of the money and how the money is to be paid back. Let me explain…

When a business takes out a traditional “loan”, the lender is agreeing to provide a specific sum of money to the business and the borrowing business agrees to pay back that sum plus interest over a specified period of time. If the loan is paid back sooner, it costs the business less since interest is charged on the outstanding principle balance. Does this sound like obvious and familiar territory thus far? Good. 

Alternatively, an MCA provides a cash advance against a business’s future sales or earnings, but with NO interest. In return, the business agrees to pay back a fixed amount. However, the business must start making daily or weekly payments almost immediately until the cash advance is paid off. Unlike with a traditional business loan, the payback is fixed so there is no benefit in the business paying it back early.

Got that? No? Let’s dig a little deeper. In a traditional business loan, a lender is lending  money for which a business can reduce the cost by paying it back faster. Conversely, an MCA company claims to be purchasing future sales or earnings, but then requires the business to pay that back, even before those sales or earnings come to fruition — or worse — even if they never come to fruition at all! Since an MCA is an “advance” on the money that a business expects it is going to make, the MCA company is not technically “lending” any of their money- they take a portion of credit and debit sales and charge a factor rate, which means that early repayment won’t help save anything. For example, if a company takes a $10,000 MCA advance with a 1.2-factor rate, no matter how quickly that company pays back the advance they’ll still have to repay $12,000. And that’s with zero interest.

It’s not hard to see that MCA’s are generally not a great idea for any business, but they do have several tempting benefits that still make them popular. For instance:

• MCA lenders do not have to adhere to typical regulations and they do not require a business to have good credit to get an MCA. This is a particular advantage for risky businesses or businesses that have applied for traditional loans but have been denied. Some examples of “risky businesses” are restaurants, liquor stores or, more recently, cannabis dispensaries (where legal).

• Because there aren’t as many regulations or as much red tape, an MCA company can often offer money to fund a business in mere days (as opposed to traditional loans that could take weeks or months). For businesses that are struggling just to make payroll or pay rent, this is an attractive benefit with a short term solution that could potentially solve an immediate problem.

That being said, there are some very important risks and drawbacks that businesses should aware of:

• As stated, MCA’s are generally not regulated. That’s why MCA companies can offer significant funds so quickly. The problem with no regulations is that MCA companies can contractually implement whatever rules they want! For many businesses, that means they must start paying their MCA back immediately and make tremendous, crippling daily or weekly payments up to 200% of the amount advanced (and remember- that’s with “zero interest”)! The payment is so much higher than normal business financing because a traditional bank receives a monthly percentage on the balance the business owes, not the total amount of the loan.

• Businesses are not technically “borrowing money” with an MCA. The business is “selling” its future returns to gain instant cash (which could eventually put the business in a tougher spot than where it started) (see case law below). 

• If even a single payment is missed, massive fees could immediately apply regardless of the reason. But, as stated, since MCA companies are largely unregulated, they can make up whatever rules they want, which means a host of hidden fees that only continue to drive up the cost.

• Finally, it is an MCA company’s goal to make the borrowing business as dependent on the MCA company as possible. In many cases, the contracts will disallow the business from obtaining a traditional loan in order to pay off the MCA, because this traps the business into taking out MORE MCA’s from the same company! They will even often offer additional “services” like a reverse consolidation, which, again, will only continue to drive up the business debt in to repayment oblivion. 

Traditional banks normally offer two types of business loans- unsecured and secured. Secured loans are loans that are backed by collateral (like real property) that the lender can seize if the business stops making payments. Unsecured loans are loans that are not backed or secured by collateral. If a business stops making payments with an unsecured loan, the lender’s only real option is to sue the business and obtain a money judgment for the unpaid amount. 

More importantly, when a business applies for and receives a traditional loan, the business obtains the funding it needs to “keep the lights on”. But, unlike MCA’s, because traditional loans are regulated they have dedicated repayment plans that tell the business exactly how much it needs to pay back, when it needs to make the payments and for how long the term of the loan is. There are many, many statutes and regulations that protect business borrowers, including (for example) Financial Services Law sections 801-811 (defined in section 600.1[l] as the Commercial Finance Disclosure Law [“CFDL”]) which require providers of commercial financing that are subject to the CFDL to provide disclosures to potential recipients of commercial financing, and the Small Business Truth in Lending Law which requires key financial terms such as the amount financed, fees and annual percentage rate to be disclosed at the time a credit provider or broker makes an offer of financing of $500,000 or less. These regulations do not apply to MCA’s.

With traditional business loans the end of the repayment plan is fixed, unless the business decides to pay the loan back in full prior to the end date. Additionally, under New York law, the maximum interest rate that you can charge is 16 percent per annum. If a lender exceeds this amount, they may be liable for civil usury; if the interest rate is higher than 25 percent per annum, it could be considered criminal usury. As can be seen, traditional lenders adhere to much more conservative interest rates. They are also required to be much more upfront about their costs, which means there are typically fewer hidden fees. Plus, in the event that the business sees significant profitability, it can always pay a loan off early, saving years of potential interest-only payments. This is not possible with MCA’s as their factor rate means you always end up paying back more than you borrowed, and usually significantly more, regardless of when the payback occurs. 

But aren’t these just technicalities? Are we really convinced that MCA’s are not a specific type of loan? In short- if it looks like a wolf and howls like a wolf, isn’t it actually a wolf (or in this case, an MCA) regardless of the parties contracting for it to be called a sheep? The local case on point here is Singh v. The LCF Group, 2023 N.Y. Slip Op. 33014 (2023) (citing Second Department case law), which highlights in painstaking detail the analysis the Courts use in adjudicating challenges to MCA agreements. In March of 2020, at the beginning of the COVID-19 pandemic, Plaintiffs faced financial stress and, out of desperation when traditional loan methods failed, turned to MCA agreements to fund its projects and continued operations. Defendant, an MCA company, entered into a several loan agreements containing personal guarantees with Plaintiffs pursuant to which the Plaintiffs purportedly sold future receipts and became obligated to make daily payments to Defendant until a set amount was paid back. Plaintiffs Complaint alleged, inter alia, that the MCA Agreements were, in actuality, illegal business loans that were repayable at a criminally usurious interest rate. Defendants argued the Plaintiffs’ claims must be dismissed because the agreements were not loans, much less usurious loans, and that the transactions were a purchase and sale of future receivables, not loans subject to usury laws.

The Court granted Defendants’ Motion to Dismiss. “The central question in this action is whether the parties’ MCA Agreements are usurious loans concealed in the sheep’s clothing of a purchase of future receivables. Plaintiffs cannot establish usury, however, because the MCA Agreements are not loans. ‘The rudimentary element of usury is the existence of a loan or forbearance of money, and where there is no loan, there can be no usury, however unconscionable the contract may be.’ LG Funding LLC v. United Senior Properties of Olathe, LLC, 181 A.D.3d 664, 665 (2d Dept. 2020). In determining whether a transaction constitutes a usurious loan, the court must consider the transaction in its totality, judged by its true character, rather than by the name, color, or form that the parties have seen fit to give it. Id. at 665. The transaction is not a loan unless the principal sum advanced is absolutely repayable. Generally, courts balance three factors in determining whether repayment is absolute or contingent: “1) whether there is a reconciliation provision in the agreement; 2) whether the agreement has a finite term; and 3) whether there is any recourse should the merchant declare bankruptcy.” Id. Accord Principis Capital, LLC v. I Do, Inc., 201 A.D.3d 752, 754 (2d Dept. 2022)’” (emphasis added).

“In sum, the Court concludes that the MCA Agreements are not loans. To be sure, there are aspects of the transactions that are troubling, particularly the high interest rates alleged by Plaintiffs and the limitations on reconciliation in the MCA Agreements. Indeed, it is not lost on the Court that the Amended Complaint, at its core, presents the subject transactions as a Dickensian web of debt that ultimately resulted in bankruptcy. The Court also notes that several recent federal cases-many of them cited by Plaintiff-have applied what appears to be a heightened level of scrutiny to merchant cash advance agreements. But that is not the law of this state. Accordingly, unless and until binding precedent provides additional guidance in determining if and when merchant cash advance agreements are disguised loans, the Court must apply controlling New York State case law.”

And there we have it folks- MCA Agreements are definitively NOT loans! No usury despite unconscionability. The right to contract freely wins again (the Courts would allow us to agree the sky is green if it was in contract form). It is interesting to note that the Court in Singh acknowledged not only that there were “problems” with the MCA Agreements, but several recent federal cases have applied a heightened level of scrutiny to MCA Agreements. New York (at least for the time being) has not adopted the heightened federal scrutiny. Regardless, the end analysis is that although MCA’s are legal, independent, contractual entities, traditional loans are always the better option. MCA’s may make getting fast cash easier, but the long-term consequences are disproportionately greater than the immediate benefits. In the long run, MCA’s can do significantly more harm than good. It is clear that MCA’s should be a last resort (or even better- not used at all)! 

If you are a business owner or manager and are considering taking out a business loan or a MCA, you should seriously considering hiring an attorney to help you review the necessary documents and make sure you know what you are getting into (before you find out the hard way).