Businesses looking to access capital have several options in today’s environment, from traditional bank loans to alternative financing arrangements. In a traditional receivables sale (or factoring agreement), a business sells an existing debt at a discount and transfers the risk of collection to the buyer: the business gets immediate cash, and the buyer potentially profits on collection. One riff on the traditional discounted sale of receivables is the merchant cash advance: an arrangement where instead of buying an existing debt, a merchant cash advance company buys a percentage of future receipts. But not all merchant cash advances are what they seem. On June 6, 2022, the Southern District of New York granted summary judgment to a plaintiff on a civil RICO claim against the principal of a merchant cash advance company, finding that the agreement was not in fact a purchase of future receivables, but a high interest loan in violation of New York’s criminal usury cap of 25%. Fleetwood Services, LLC v. Ram Capital Funding, LLC et al., 1:20-cv-5120 (June 6, 2022) (opinion by Liman, J.).
How can a business distinguish between a legitimate financing arrangement and one that is a disguised usurious loan? In a merchant cash advance, the mechanics of the collection typically occur through daily payments. Sometimes the business’s credit card processor divides up receivables, sending the purchased percentage to the merchant cash advance company and the remaining receivables back to the business. In many cases, however, the parties agree to use an ACH transfer of a fixed daily payment that is supposed to approximate the purchased percentage of receipts.
Take, for example, a business with $100,000 a month in receivables. If a merchant cash advance company purchased 20% of the next $100,000 in receivables at a discount, the merchant cash advance has purchased $20,000. Expecting that that $100,000 will be generated in a month, the parties reach a daily payment by taking that $20,000 and dividing it by 20 (the number of business days in the month) to reach a daily payment of $1,000. The parties then agree that the merchant cash advance company will automatically withdraw an $1,000 (via ACH) payment each day until it has received the full purchased amount.
And what if the business does not generate the expected $100,000 in that month? On the face of the merchant cash advance, after all, the agreement does not entitle the merchant cash advance company to $20,000 in a month – only 20% of receivables. To deal with fluctuation in the actual receipts generated, the agreements contain a clause called a reconciliation provision. This provision is supposed to allow the business to contact the merchant cash advance company and recoup any withdrawals in excess of the purchased percentage of receivables.
One problem that can render these clauses illusory is if there is a limited window for filing for reconciliation. In the Fleetwood Services case above, the Court noted that the agreement specified that the reconciliation would occur “on or about the eighteenth day of each month” but that elsewhere in the agreement it was an event of default if the business missed four payments. Thus, although the agreement purported to purchase only a percentage of receipts, the functioning of the agreement would put the merchant in default and subject to collection for the full amount of the agreement if a decline in receivables actually occurred such that the business had insufficient funds to make the daily payments through the designated time for reconciliation. As such, reconciliation was functionally inaccessible and illusory.
While Fleetwood Services focused on the narrow timing for invoking reconciliation as the factor that rendered it illusory, there are a number of features in reconciliation clauses that may make them illusory, including: 1) if the merchant cash advance company retains discretion on whether to grant reconciliation; 2) if the merchant cash advance company retains discretion over what evidence to require for reconciliation; 3) if the timing for invoking reconciliation, in comparison with the default provisions, means that default will occur before reconciliation can be achieved; and 4) if the daily payment is not an accurate reflection of the percentage of receivables purchased.
Ultimately, with any financial product, businesses should be certain that they understand their rights under the agreement and be mindful that there are products in the marketplace that contain traps for the unwary.
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