Merchant cash advances have rapidly gained prominence as a versatile and accessible funding solution. However, behind this financial innovation lies a complex web of legal considerations that both merchants and funders must navigate.
As the demand for merchant cash advances continues to grow, so too does the need for a comprehensive understanding of the legal intricacies that accompany them.
Today, we’ve brought in the expertise of Jacob H. Nemon, a partner at Carter Ledyard & Milburn, to shed some light on all things related to the legal nuances of merchant cash advance agreements.
In this fourth installment of Onyx IQ’s Executive Interview Series, Jacob covers a number of topics, including his interesting beginnings in the industry, contract transparency and usury laws, funder compliance with state and federal regulations, and the importance of funder/merchant legal education.
To get caught up on the series, check out our previous interviews:
- Elizabeth Schuerman, VP of Sales, Onyx IQ
- Mike Dell, Business Development Specialist, Wall Street Funding
- Dave Shollock, Director of Business Development, Merit Business Funding
Let’s get started.
Background and Professional Experience
Q: How did you get into the world of revenue-based financing?
Almost 12 years ago now, I started at a small law firm that was doing a lot of outside counsel work for one of the grandfathers of the merchant cash advance industry.
As a young junior associate for a small firm, I focused on litigation involving some of the independent sales offices and processors involved in merchant cash advance and credit card processing.
Through that experience, I learned a lot about the merchant cash advance space. I also learned about the players in the industry who founded a lot of the big firms out there.
In 2015 I moved to my current firm, just when merchant cash advance litigation was blowing up. That was when merchants started alleging that these contracts were really loans and not purchased receivables. They claimed that they were loans, and as such, should be subject to state usury laws.
These disputes formed the early case law that defines what merchant cash advance law is today, and I was there. So I got to know a tremendous amount about merchant cash advance litigation.
And once you know what the bad times look like, or what a bad contract looks like, you can start planning for the good times and write a good contract.
So from my litigation experience, I began drafting merchant cash advance contracts and focusing on how to improve them. I’ve kept up with the developments in litigation, which have improved our understanding over time of how these things work. Because of my experience, I’m pretty knowledgeable across the landscape of these types of disputes, and so I’m able to give good advice to clients as a result.
Q: What does a typical day look like for you at Carter Ledyard?
I’m primarily a litigator, so I would say 95% of what I do is litigation.
It’s not all merchant cash advance litigation, but I do have a big chunk of merchant cash advance litigation. I’m not a collections attorney, although I will dabble in that where the cases get challenging.
When I get involved in merchant cash advance disputes, it’s usually when the merchant is asserting a usury defense, or a fraud defense, or something that takes this from being a garden variety collections case, to something where you need more white glove service to ensure that the case is handled correctly and that the contract is interpreted in the context of the case law on these matters.
These are high stakes cases for funders, because if you have a court declare your contract to be a usurious loan, even if it’s a trial-level court and it’s not technically a precedential decision, and even with this mound of good case law in your favor, every single merchant that comes after is going to grab that negative decision and use that against you.
So MCA funders are very sensitive to ensure that their cases are decided correctly and to challenge bad decisions. I hope to push before a judge that the agreements at issue are well-drafted contracts—that they are true purchases of receivables.
Industry Outlook: Legal Challenges in the MCA Industry
Q: What would you say are the primary legal challenges that funders are facing in the MCA industry?
It still revolves around usury, but it’s taking a different shape.
New York State courts are pretty good on usury disputes, and now we don’t just have trial courts decisions, but we have solid appellate decisions. These decisions can bind the lower courts in three of the four appellate divisions of New York State, which have all said that a merchant cash advance is a purchase of receivables when it meets three criteria:
- There’s a reconciliation provision.
- It has unlimited duration, so that it can be extended if the merchant’s receivables slow down, or runs out of receivables altogether, or shuts down.
- There’s no provision in the agreement that makes bankruptcy an event of default.
So that’s a three-factor test that the courts have gifted us. This is in the New York State courts, and most judges follow the precedent.
That said, the challenge in New York State courts is the funders themselves. If they’re not following the terms of their own contract, if they’re treating it as something other than a purchase of receivables (like a loan) because they expect merchants to pay regardless of whether their clients generate receivables, then a court could look at that and recharacterize that as a loan, and then you’re in trouble.
The other thing is that the federal courts in the past year and a half have been looking at this very differently than state courts, considering factors other than the three-part test—although that’s trending back towards what the state courts have done.
Q: How are cases being decided at the federal-level?
In June 2022 this case called Fleetwood was decided by a federal district court that stated that they were going to look holistically at the agreement, and not just apply the three-factor test. That judge looked at the relative risks that the funder held and the risks that the merchant held.
Following up on that, a bunch of federal courts came down with decisions that ripped apart merchant cash advance agreements, as they found specific provisions that were thought of as being in there for the purpose of rendering the agreement a loan.
And judges started looking at these cases under a federal statute called RICO (Racketeer Influenced and Corrupt Organizations Act), which was originally introduced to go after the mob.
In this statute, there’s a civil component that provides that when a group of people commit a violation of state usury law and collect upon an unlawful debt, there’s a federal civil claim that can be brought against them.
If that claim is successful, it would not only invalidate the agreement, but would also charge the funder with the requirement to pay actual damages (the amount of money that the merchant paid to the funder), plus the merchant’s attorney fees, and “treble damages”, which basically triple the actual damages as a punishment for violating the law.
These cases brought the definition of what is and isn’t a merchant cash advance beyond what the drafting attorneys may have ever considered at the time they wrote the agreements. So despite no bad intent by the funders or their counsel, this may have put a lot of existing contracts at risk of being found to be loans even though they were never intended as such.
2022 saw a lot of those decisions, but just recently in June of this year, the Fleetwood decision was appealed to the United States Court of Appeals for the Second Circuit, which decides federal appeals emerging out of New York.
And the appellate court, although it found that the particular contract at issue was a usurious loan, actually clarified that the standard for testing whether these things are loans or not is the New York State standard—the three-part test that I mentioned earlier.
So now we know, even going into federal courts, what we can argue and therefore how we can draft these agreements to meet the federal court requirements as well. So there’s a lot more predictability now than there was even a few months ago. And we’ll see how that case is applied by the lower courts.
It will be interesting to see what comes out in the next couple of months or the next year.
Q: So these court decisions have impacted how contracts are drafted for MCAs?
Absolutely.
And those lower court decisions are going to continue to impact because this is an area where judges decide whether a contract with a merchant is or is not a loan. So regardless of whether you agree with it, the judges are the judges, and therefore you have to accommodate the judges’ way of looking at things.
Even this appellate decision didn’t say that the judge was wrong in looking at all these other factors. Although we have these three factors, other judges might think that this is only guidance, not a limitation, to say what factors they could consider.
To answer your question more directly, yes, we’re still drafting carefully. When we draft an MCA contract, we take into consideration what we know about how these judges are thinking and we talk it through with our clients.
In the old days a lot of people just recycled contracts somebody else wrote. But now, just because something was previously used in a contract doesn’t mean it’s good. So we look carefully into every aspect, and if something doesn’t serve a purpose and it raises eyebrows, we just get rid of it.
Q: What is your take on the recent rise in state-level disclosure laws?
It’s a compliance cost for sure.
Some of the regulations seem to make little sense. Particularly the New York and California regulations that require disclosure of an APR on a product that’s not a loan and doesn’t have an APR. This seems kind of absurd.
As a result, the numbers that the funders are forced to put into these disclosures just to be in compliance, are astronomical numbers that don’t reflect the true nature of the transaction or what the merchant may actually get charged. Because in a merchant cash advance there’s a fixed amount that gets delivered back to the funder, regardless of whether it takes two months or two years to deliver.
With a loan, if you miss payments, you could end up paying prepayment premiums, regular interest or default interest. If you don’t pay and drag out litigation with a lender, Interest accrues over years and your $100,000 loan might end up costing you $1,000,000 if you don’t get on top of that.
So when a regulator says you need to put an APR on an MCA disclosure form, and the APR looks something like 350% interest, that’s not true. And it’s unfair to require funders to make untrue statements about the nature of their product.
That said, some of the disclosure rules that have come out from other states have been relatively fair and they’re only asking you to put a cover page on the contract that says exactly what it is. It’s an added disclosure cost, but if you’re a well-run funder [with the right technology] you can do that.
Legal Education for Funders and Merchants
Q: As an attorney, what approach do you recommend to funders with respect to collections?
Number one—and I think this is huge—is communication between funder and merchant.
There have been a lot of aggressive funders out there, people who have jumped on the first technical violation of the agreement and brought suit or enforced their security provisions.
I tell my clients that’s not necessarily the right approach. If you’re being defrauded, maybe, but if you’re simply dealing with a merchant who’s going through cash flow issues, you need to be accommodating. My advice generally is to just be above board with them, be helpful.
It’s a good business practice—when you’re good to your people, it’ll bring you repeat customers. So don’t push that red button immediately: call them, reach out, work with them so that they can continue doing business and you can continue receiving a portion of their receivables.
Q: What’s your role in educating your funder clients with respect to how they should approach merchant cash advances?
Most of the funders I deal with are more established at this point. They know the business, they know the product, they know what they’re selling.
But I find that very often sales representatives and other people working in the organizations are less educated about what they’re selling. They need to know that they are the front line—they’re the ones communicating with the merchants.
They need to have a good understanding of what a merchant cash advance product is, use the right language, not call it a loan—it’s not a loan. They need to understand who the merchant is, the general obligations that the merchant undertakes, and they need to explain that to the merchant.
People are often focused on making a sale and they’ll tell the merchant what they think the merchant wants to hear, but they need to make sure that when they’re doing that, they’re doing it candidly, explaining what the product is and what the risks are. And they must never mislead the merchant in any way.
Q: And what about the funder’s responsibility to educate merchants?
Have a phone call with them if they have trouble.
You don’t necessarily need to start a 101 class for your merchants—they should be reading their contracts—but helpful information on your website would be good, to point them to where they can look in the contract and who they need to call if they’re having issues.
Merchant cash advance agreements are long documents. They are complicated financial transactions. And as you know, many people don’t read every line of every contract that they sign, so they might not even know that they have rights in there.
So if a merchant calls you up and says, “hey, I’m having difficulty making payments,” you can say “look, you have this right under the agreement to reduce your payments.”
If a merchant’s cash flow is slow, funders should talk to them, they can ask for their bank statements and work out what their payments should be—which could even be a reduction. And I think most professional funders are doing this.
At the end of the day, everyone’s trying to make a living and everyone’s trying to run a business. And although it isn’t always a legal obligation, it just makes good business sense to work with your people and accommodate them.
Wrapping Up
Q: Besides agreements, documents, and the litigation itself, what should MCA funders be coming to you for advice on?
They need to think about their fundraising, and talk through the issues with a securities lawyer, such as one of my talented colleagues in Carter Ledyard’s corporate department.
When somebody raises money from investors, when they’re doing syndications, they need to ensure that they’re complying with the law. And it’s not straightforward.
When you’re raising money from other people, securities laws may come into consideration, and those have added elements of compliance. Your syndication agreements must have proper disclosures with them. You need to speak to a securities lawyer to ensure that—this is an area where there can be criminal prosecutions if you don’t do it right.
This vulnerability isn’t specific to the merchant cash advance industry—there are scammers everywhere. So funders need to ensure that they’re complying, and that they’re dealing with investors who are trustworthy.
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