Post Authored by Alex Whitt
Small businesses start with big dreams. The question for every business owner is “how do we get from here to there?” For better or worse, money is going to have a lot to do with it. Ideally, the business owner has access to credit. But, there is one form of debt that can severely harm small businesses who are unaware of its perils.
These are often called “Merchant Cash Advances” (“MCAs”). MCAs are not technically loans; rather, they are sales. In fact, what makes them attractive to business owners is that they are offered more freely than traditional loans. The MCA provider will pay the business owner a lump sum in exchange for a percentage of the business’ sales. The percentage of the business’ sales often translates into daily deductions directly from its bank accounts. The deductions end once the MCA has recouped the lump sum, along with any additional fees.
While loans are diligently regulated at both state and federal levels, MCAs are often not regulated to the same degree. For example, usury laws often prevent lenders from charging exorbitant interest rates. Such laws presumably do not apply to an MCA. After all, the MCA is not a loan in the traditional sense. Instead, MCAs employ a “factor rate.” What an unknowing business owner may not realize is that such a “factor rate” could translate into what would otherwise be a triple-digit interest rate.
The fact that the initial lump sum could balloon into an unmanageable debt has a profound impact on daily operations. As part of many MCA agreements, the MCA provider has direct access to the business’ bank accounts, from which it can seek recovery. The business must bring in cash on a daily basis faster than the initial MCA amount grows.
If cash does not flow into the business fast enough to pay down the MCA, business owners face a profoundly difficult choice: either default or secure new financing. Such businesses usually do not qualify for other, more traditional lines of credit as a means of relief. Either they were unable to secure such funding on the outset and so turned to an MCA, or the debt brought on by the MCA is spiraling out of control. In any event, the business owner may either seek a new MCA or, more commonly, a new MCA provider will appear to alleviate the owner’s money woes. When the business enters into a new MCA agreement, circumstances are paradoxically both different and the same. On the one hand, the new MCA must be sizeable, necessary to put a dent in the previous one. On the other, it will likely have similarly unfavorable terms for the debtor. The business must still bring in cash faster than the MCA amount grows, but now the amounts are much larger. As this cycle continues, insolvency seems inevitable.
In the event of the business’ default, the MCA provider has other methods of receiving funds from both the business and its owner. Like most contracts, an MCA agreement will have a choice-of-law provision. The MCA may provide for the jurisdiction of a state which recognizes “confessions of judgment,” whereby the debtor accepts liability for the agreed-upon amount of damages in the contract, effectively waiving the right to normal court proceedings. With a judgment in hand, the MCA provider can then register that judgment in another jurisdiction and begin collection proceedings, against the debtor and third parties. Moreover, business owners may have guaranteed the MCA, putting their personal assets at risk as well.
For many businesses and their owners facing these circumstances, their only sanctuary is in the bankruptcy courts. The bankruptcy code will provide immediate relief in the form of an automatic stay, a federal injunction against any efforts to collect against the debtor. This can stop the MCA providers from depleting bank accounts on a daily basis. It can also stop actions to collect on judgments or against the business owner’s personal assets. While no one wants to find themselves in bankruptcy court, it can offer breathing room to get a respite from the vicious cycle that MCAs throw businesses into.
About the Author:
Alex Whitt is an associate at Hiltz Zanzig & Heiligman LLC and concentrates on representing consumer debtors in chapter 7 and chapter 13 cases. Alex attended the University of Iowa where he graduated with honors with degrees in English and Linguistics. He then attended law school at The John Marshall Law School in Chicago. While in law school, Alex served as Executive Justice of the Moot Court Honors Program and worked as an extern for then Chief Bankruptcy Judge Bruce W. Black. Alex graduated from the John Marshall Law School in the top ten of his class. He serves as a Director in the Young Lawyer Section’s Executive Council of the Chicago Bar Association.