Failing the Duck Test: Merchant Cash Advances are Loans

Bankruptcy – Adversary Proceedings – 9th Circuit.


In the aftermath of the 2008 economic recession, lawmakers sought to put an end to the overtly risky, subpar lending practices used to exploit consumers and mislead investors. To battle this, Congress passed the Dodd-Frank Act (DFA) in 2010. The DFA was designed to prevent excessive risk-taking that led to the financial crisis, provide common-sense protections for American families, and created a new consumer watchdog – the Consumer Financial Protection Bureau – to prevent mortgage companies and pay-day lenders from exploiting consumers. However, while reform from this era is responsible for many improvements to the lending industry, the ripple effect it has caused, shares a similar responsibility for a new wave of consumer exploitation.

By and large, small businesses have restricted access to essential ‘commercial and industrial’ (C&I) loans, offered by banks or other heavily regulated lending institutions, that larger corporations frequently enjoy. In their working paper published in April of 2018, “The Impact of the Dodd-Frank Act on Small Businesses,” researchers Michael D. Bord and John V. Duca of the National Bureau of Economic Research sought to uncover what factors may be contributing to the sharp decline in lending to small businesses since the implementation of the DFA. Here are their findings:

“There are concerns that the Dodd-Frank Act (DFA) has impeded small business lending. By increasing the fixed regulatory compliance requirements needed to make business loans and operate a bank, the DFA disproportionately reduced the incentives for all banks to make very modest loans and reduced the viability of small banks, whose small-business share of C&I loans is generally much higher than that of larger banks. Despite an economic recovery, the small loan share of C&I loans at large banks and banks with $300 or more million in assets has fallen by 9 percentage points since the DFA was passed in 2010, with the magnitude of the decline twice as large at small banks. Controlling for cyclical effects and bank size, we find that these declines in the small loan share of C&I loans are almost all statistically attributed to the change in regulatory regime. Examining Federal Reserve survey data, we find evidence that the DFA prompted a relative tightening of bank credit standards on C&I loans to small versus large firms, consistent with the DFA inducing a decline in small business lending through loan supply effects.”

The costs to remain compliant with the DFA effectively price out small-cap banks from providing modest term loans – short term debt  – to small business, and makes the practice wholly unattractive to larger banks. These unintended ramifications have eliminated what few equitable financial resources small businesses had to grow and remain competitive with larger corporations in the marketplace.

For corporations and business owners, taking on short-term debt is a necessary and widespread practice. Even the most successful companies like Amazon and Microsoft require short term debt to fund operations and meet financial obligations. The demand from small businesses for short term debt did not vanish overnight the same way their access to funding did. As a result, many underserved – at times desperate – small business owners are left with with no choice but to seek funding from alternative sources, not regulated by the DFA. Scarcity driven demand and legislative loopholes have opened the door for unscrupulous lenders to perform regulatory sleights of hand, creating a new and risky lending instrument known as a “merchant cash advance” (MCA).

An MCA is used to describe the purchasing of future accounts receivables from a business in exchange for a lump sum payment. The merchant then may utilize this lump sum in the same way they would a short-term loan. However, under the law, this form of lending may not be considered a loan and therefore may not be charged off by the merchant in bankruptcy under Chapter 11 of the United States Bankruptcy Code. Rather, this type of transaction is considered a sale because the MCA lender has effectively purchased the future receivables of the debtor/borrower.

MCAs are the business world’s version of payday advance loans, where a relatively small amount of money is loaned in exchange for future earnings. But, while payday loans are repaid via the debtors next paycheck, merchant cash advances are repaid via daily withdrawals from the merchant’s bank account. 

For some merchants, particularly contractors, a daily repayment structure can be difficult to keep up with. Contractors typically receive payments periodically and depending on the job or client, it can sometimes take 30 to 60 days from the time they provide a service for payment to arrive in their bank account. Without daily cashflow income, daily withdrawals from an MCA lender can quickly cause even a successful small business to run into severe financial strain. In most cases, once a merchant fails to maintain enough cash in their bank account to make the lender’s payment, they are automatically placed in default and required to immediately repay the debt in full. MCA lenders have little empathy for a borrower that has generated enough future receivable income to pay off their debt in full. The day they miss a payment is the day they default.

CapCall v Foster

In September of 2021, The United States Bankruptcy Court District of Montana 9th Circuit delivered a groundbreaking opinion in CapCall, LLC. v. Foster (In re Shoot the Moon, LLC.) challenging the legality of merchant cash advance lending.

In CapCall, LLC. v. Foster, CapCall, a merchant cash advance lender from the state of New York, sought a declaratory judgment that would allow them to claim ownership over $228,449.93 in segregated funds from the bankruptcy estate of Shoot the Moon, LLC. This would essentially bypass the United States Trustee and their ability to disburse proceeds to secured creditors. Foster had already sold off nearly all of Shoot the Moon’s business assets. The net proceeds of these assets amounted to a sum that was substantially less than the total amount in claims held by numerous secured creditors with perfected security interest senior to CapCall. If they succeeded, CapCall would have been entitled to recover converted proceeds from the bankruptcy estate before all other creditors.

Selling or Borrowing?

The important issue at stake in CapCall v. Foster was how the court should decide the legal classification of the transactions between CapCall and Shoot the Moon LLC. CapCall argued that their lending practices where in fact “sales” while Foster argued they were loans. If a sale did occur, then CapCall did acquire absolute ownership of Shoot the Moon, LLC’s accounts receivables and would be entitled to recover before the other creditors. On the other hand, if the transactions were instead loans, CapCall’s merchant cash advances entitled them to securities, not ownership, and their interests would subsequently fall junior to the interests of other creditors. Classifying the transactions as a loan would result in CapCall recovering $0, because under section 506(d) of the Bankruptcy Code, if liens senior to a creditor (CapCall) exceed the value of the collateral, the creditor is left with an unsecured claim and no enforceable lien.

The Duck Test

“If it looks like a duck, swims like a duck, and quacks like a duck… it probably is a duck.”

The Court’s opinion came down to an abductive comparison between how CapCall classified their practices “on paper” and how those practices actually manifested in the real world. In other words, do CapCall’s merchant advances look like a loan, read like a loan, act like a loan? If so, then they’re probably loans, and must be treated as such.

Judge Whitman L. Holt stated that CapCall’s merchant agreement too closely resembled that of a loan and therefore could not be categorized as a true sale. In addition, CapCall was in violation of Montana’s usury laws – which protect consumers from predatory interest rates in specific types of lending instruments – and lacked any ownership over Shoot the Moon’s bankruptcy estate.

CapCall v Foster has put a crack the traditional way MCAs are being perceived under the law. Although this case alone will not be enough to bring about wholesale change within the MCA industry, it is the first legal victory for victims of it. Developments in this area of law will be important to keep an eye on in the coming year as more and more small businesses experience recession pains and begin being steered towards MCAs.

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