Merchant Cash Advance: A History

BY GRANT PHILLIPS, ESQ., GRANT PHILLIPS LAW

After the Great Recession, as a direct result of the housing debacle, banks reacted with a plethora of new internal regulations, making it almost impossible for the average small business to qualify for a business loan. In addition, government intervention to save the banking industry brought with it more regulations, making it exceedingly more difficult for small businesses to obtain financing. As such, the time was ripe for someone to address the lack of credit and lending to small businesses.

What arrived next was enormous growth in a previously obscure lending instrument, ubiquitously known as a merchant cash advance or MCA, a seemingly legal transaction whereby a lender is permitted to charge what ordinarily would be considered usurious interest without being guilty of breaking the law.

MCAs were neither proprietary nor patented when the Great Recession ended. In fact, its creation occurred more than a decade earlier, but there was a large increase in MCA origination in 2010, which can be attributed to the economic circumstances and fledging economy at that time. It was a perfect combination of circumstance and timing. Small business lending had all but dried up, demand for funding had risen sharply and the resulting turmoil presented both the conditions and timing necessary for the MCA industry to grow exponentially.

The industry has been booming ever since and since it has no regulation or barrier to entry, hundreds of participants have entered the MCA sphere. While many engage in deceptive lending practices together with other predatory abuses, including illegal collection methods, harassment and fraud, there are some participants that do follow the law. However, since many MCA lending scandals have sprung forth, states like New York are accumulating case law on MCAs and their legality.

However, sadly, many businesses have been destroyed because of these funding instruments. It is easy to fall prey to an MCA. After all, once a business is denied conventional financing or an SBA loan, they can become desperate and vulnerable to the non-stop barrage of cold caller sales people offering easy and quick money, creating a slippery slope.

MCA Origins

As previously stated, the MCA concept, while relatively new to small businesses in 2010, was in fact “invented” more than two decades earlier. Specifically, an individual by the name of Barbara S. Johnson is listed as the official inventor of split-funding, a system that allows for automatic splitting of funds received by credit card, with some going to an MCA funder and the remainder to the merchant. This act of repayment to an MCA funder from a single credit card processor lay the grounds for the MCA. 

Johnson obtained a patent for the system in 1997 while running four Gymboree Playgroup & Music franchises. Unable to get working capital to fund a summer marketing campaign, Johnson wondered whether she could borrow against future credit card sales derived from parents bringing their kids back for fall classes. About a year later, Johnson and her husband founded Advance Me, an MCA funder. Later, her company would become CAN Capital.

What is an MCA?

In an MCA, a funder provides a small business with a lump sum of cash for the right (not guarantee) to receive a percentage of the businesses’ future generated accounts receivable. The amount received by the funder in return is usually in excess of 100% when calculated as an APR.

Amazingly, the law currently permits this transaction, deeming the funding transaction one of purchasing future receivables and, therefore, not a loan. If it is not a loan, it is not governed by usury, and if there is no usury, the MCA funder is free to charge the small business whatever it so desires. This legal nuance is what permits an MCA from receiving what ordinarily would be deemed usurious interest, thereby allowing for the absurd and astronomical amounts of money required to be repaid by a small business to an MCA funder.

Designed to Prey

The MCA industry is designed to target and prey upon small businesses that need cash but can’t get it, which is a common occurrence during economic downturns. Through heavy spending and a massive focus on solicitation and marketing, primarily via robotic cold calling performed by sales people known in the industry as ISOs (independent sales organizations), MCA providers repeatedly call business owners offering “deals” for business financing that are highly tempting but more often than not non-existent. The ISO space is competitive and like MCA funders, no regulation exists to govern these brokers.

With such a landscape at hand, it’s no wonder a litany of MCA providers has emerged. The lack of licensing, background checks, regulation and disclosures has made the MCA a predatory lender’s favorite instrument. Where else can an investor receive an APR that exceeds 500% and for it to be legal?

Not a Loan

Let’s briefly go over the differences between a traditional loan and an MCA. A traditional loan is repayable absolutely and gives no contingencies to the borrowing company to not pay. On the other hand, a true MCA is not repayable absolutely and thus there are circumstances where the money provided by the MCA funder is not repayable.

The difference between traditional loans and MCAs is even more stark when it comes to interest payments. Pursuant to state regulations, a lender cannot charge interest that exceeds a state’s usury laws. In New York, for example, the charging of interest in excess of 25%, when calculated as an APR, is illegal and considered criminal usury. However, the same law holds that if the funding instrument is structured as an MCA and refers to the transaction and the contract as the “purchase of the borrower’s future receivables,” there is no interest cap.

This is because, at present, the law holds that the purchase of future receivables, at a discount, is not considered a loan. If the instrument used to finance the business is not recognized as a loan by the law, the buyer of the receivables (lender or funder) can ask for a payback number of future receivables that ordinarily would breach usury when calculated as an APR. Moreover, an MCA payback is usually structured to be automatically debited from a business’ account on a daily basis, meaning double dipping and unauthorized debits are par for the course.

The Wild West

As with most new markets, regulation has simply been unable to keep up with the revolutionary MCA industry and failed to rein in abuses. Accordingly, the MCA market has developed into an environment akin to the Wild West

Like most money-making bonanzas, abusers have created systematic practices designed to drain merchants of all revenues and hold them hostage in the event they cannot afford to make repayments. In addition to auto debiting, MCAs also uses tools like lock boxes, personal guarantees, absolute power of attorney and more.  

Unfortunately, instead of increasing scrutiny and new legislation, the MCA market has grown unregulated over the last decade, and even some publicly traded companies are entering the MCA world. Moreover, large credit card processors like Square, PayPal and Stripe are offering MCAs today, while Shopify and even Amazon have gotten into the MCA space. With their merchant’s data readily available, it is particularly worrisome that conglomerate players such as this are involved too.

What about usury? Most states have usury laws on their books that set the maximum amount of interest you can charge on a loan. This number may vary depending on state, with several permitting MCAs but also having usury laws. However, as delineated earlier in this article, the law states that usury applies to a loan and not an MCA.

Changing the Regulations

It is imperative that legislation be passed to provide more protections to borrowers. Thankfully, New York is on the cusp, as it passed SB 5740 in 2021, with the bill expected to take effect in mid-2022. In addition, California has similar legislation on its books. SB 5740 requires MCA funders to disclose certain information about MCA terms to potential borrowers. This is a good start to reforming the space and limiting abuses. Too many businesses have been forced to shut down or file bankruptcy because of these insidious loans. The hope is SB 5740 will address many of the current abuses taking place in the MCA world.

Humbly, I believe courts also have a critical role to play in the fight against predatory lending abuses, including those perpetuated in MCAs. Just because a document says “merchant cash advance” or “purchase of future receivables,” it does not automatically make the instrument a true MCA. Rather, the actions of the funder must be analyzed and the particular facts examined to determine whether the matter is a loan or a legal MCA.

Until courts take this stance and more states adopt effective regulation, we must challenge the funders, their contracts, their fees, their APR and their abusive practices and illegal collection tactics to end this “non-loan” sham. Better yet, new and transparent methods of merchant lending must be created. Absent that, is there a way to challenge, settle or legally fight an MCA?

The answer is an emphatic yes! Seeking assistance when struggling to repay an MCA funder is a borrower’s right and it should be taken. Borrowers must be allowed to restructure the MCA and, if need be, challenge any abuses. To do so, small businesses should contact an MCA attorney, who will provide the benefit of experience and the knowledge of the law. Borrowers will then know their rights and, more importantly, what can be done to end daily ACH payments, stop illegal collection efforts and settle an MCA.