“Merchant Cash Advance” Business Litigation in New York
Will it Heat Up as a result of Covid?
By Ray Beckerman
It has become a common commercial practice for “lenders” who wish to earn a return beyond the criminal usury rate to enter into contracts to purchase future receipts, commonly referred to as “merchant cash advance” (“MCA”) agreements, as alternatives to loan agreements.
Under MCA agreements, the financing party is supposed to be a “purchaser” of future receipts rather than a lender, and the financed party is supposed to be a “seller” of its future receipts rather than a borrower.
The basic arrangement is that the financer pays money to the merchant, and gets back a much larger sum of money paid out of future receipts, with these payments being electronically debited from the seller’s account. Additionally, a number of fees are debited as well.
The difference between the amount the merchant gets, and the amount he repays, is usually well in excess what would be permitted under criminal usury law, which is probably the lender’s motivation for adopting this structure in the first place.
Typically, the merchant cash advance agreement disclaims any intention for the transaction to constitute a loan, states in vague terms that if the projected receipts are not received by the merchant then the repayment amounts may be reduced or even forgiven (a “reconciliation” clause), and contains various forms of security, such as a confession of judgment and personal guaranty by a principal of the merchant.
The favored forum selection in these agreements, regardless of where the merchants are located, appears to be the courts of New York State, so over the years the New York courts have been confronted with a great number of disputes over these agreements in which the “seller” merchant challenges the enforceability of the underlying ‘purchase and sale’ transaction as usury in disguise.
Sometimes the usury issue is presented as an affirmative defense, in litigation brought by the finance company, or in motions to vacate a confession of judgment against the principal, and occasionally it presents as part of a merchant’s affirmative claim, under RICO or otherwise, against the finance company.
The seminal case in this area, which essentially synthesized a significant body of caselaw into a coherent framework for analysis, is the March 2020 decision by the Appellate Division, Second Department, in LG Funding v United Senior Props. of Olathe, 181 A.D.3d 664 (2 Dep’t 2020), a case in which the merchant was paid approximately $100,000.00 in exchange for allowing its bank account to be debited $129,000.00, and the merchant interposed an affirmative defense of criminal usury.
Although the LG v. United decision came down just as the Covid lockdowns began, the facts and underlying documents in the record predate the Covid pandemic by several years. But we anticipate that Covid has greatly increased the number of defaults under merchant cash advance agreements, and this issue will be coming up time and again for years to come.
LG v. United was a lawsuit by the finance company to recover on a defaulted MCA. The decision came about in the context of a motion by plaintiff for summary judgment and to dismiss defendant’s affirmative defense and counterclaim for criminal usury. The Court dismissed the counterclaim, but upheld the affirmative defense.
The Court applied the following test:
Unless a principal sum advanced is repayable absolutely, the transaction is not a loan (see Rubenstein v Small, 273 App Div 102, 75 N.Y.S.2d 483). Usually, courts weigh three factors when 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 (see K9 Bytes, Inc. v Arch Capital Funding, LLC, 56 Misc 3d at 816- 819; see also Funding Metrics, LLC v D & V Hospitality, Inc., 62 Misc 3d 966, 970, 91 N.Y.S.3d 678 [Sup Ct, Westchester County]).
181 A.D. 3d at 666.
Applying this analysis to the merchant cash advance agreement in question, the Court found that there were factual issues as to whether the MCA as in fact a disguised usurious loan:
Here, with respect to a reconciliation provision, the agreement provides that the plaintiff “may, upon [United’s] request, adjust the amount of any payment due under this Agreement at [its] sole discretion and as it deems appropriate” (emphasis added). The agreement also contains provisions suggesting that United’s obligation to repay was absolute and not contingent on its actual accounts receivable. In this regard, the agreement provides that United’s written admission of its inability to pay its debt or its bankruptcy constitute events of default under the agreement, which entitle the plaintiff to the immediate full repayment of any of the unpaid purchased amount (cf. Champion Auto Sales, LLC v Pearl Beta Funding, LLC, 159 AD3d 507, 69 N.Y.S.3d 798). The agreement provides that in the event United files for bankruptcy or is placed under an involuntary filing, the plaintiff would be entitled to enforce the provisions of the personal guaranty executed by Julian and Thoma, United would be required to deliver to the plaintiff a confession of judgment in the amount of the purchased amount, and the plaintiff would be allowed to enter the confession of judgment as a judgment. These provisions suggest that the plaintiff did not assume the risk that United would have less-than-expected or no revenues. Thus, we agree with the Supreme Court’s determination denying that branch of the plaintiff’s motion which was pursuant to CPLR 3211(a)(1) and (7) to dismiss the affirmative defenses alleging that the transaction at issue is a criminally usurious loan.
181 A.D. 3d at 666.
Thus, the bottom line in LG v. United is that a merchant cash advance agreement should be scrutinized, with special attention being given to the following three factors:
1. Whether there is a reconciliation provision, and if so whether it is absolute, or whether it is discretionary with the financing company.
2. Whether the agreement has a finite term.
3. Whether the finance company has reserved security, such as personal guarantees and/or confessions of judgment, which insulate the finance company form the risk of the merchant’s insolvency.
In future articles, we will discuss other merchant cash advance cases, some of which have come about during the period of the Covid 19 pandemic, and see how the courts have been applying these principles to the agreements before them.