Does Your Merchant Cash Advance Company Pass The Scrutiny Test?
The merchant cash advance business has come under repeated fire of late from regulators, legislators and customers. “Every aspect of the industry is under scrutiny right now. Syndication agreements, underwriting, and collections are the subject of bills in Congress and across multiple states,” says Steven Zakharyayev, managing attorney for Empire Recovery Services in Manhattan, which offers debt recovery services to financial companies. So how should funders respond amid these obstacles? Here are a few pointers to help funders succeed despite ongoing challenges from a legal, regulatory, business and public relations perspective:
DIFFERENTIATE BETWEEN CASH ADVANCES AND LOANS AND MODEL BUSINESS DEALINGS ACCORDINGLY
In the eyes of the law, merchant cash advances and loans are very different. With a cash advance, a funder advances the merchant cash in exchange for a percentage of future sales, plus a fee. A loan, on the other hand, is a lump sum of cash in exchange for monthly payments over a set time period at an interest rate that can be fixed or variable. While the two types of funding options have certain similarities, funders have to be extremely careful to make appropriate distinctions in their business practices; otherwise legal trouble can easily ensue, experts say.
Most funders know that they are supposed to draw a bright line between merchant cash advance and lending, but it’s critical they put this knowledge into practice. Funders have to ensure the distinction is evident in their business lexicon, says Gregory J. Nowak, a partner in the Philadelphia office of law firm Pepper Hamilton LLP who focuses on securities law.
For example, it’s extraordinarily important that funders don’t refer to merchant cash advances as loans in their business dealings. Business records, emails and other documents can be requested in litigation for discovery purposes. If the funder’s internal documentation refers to cash advances as loans, it’s going to be hard for the company to argue that they aren’t, in reality, loans.
“Most judges want to see consistency of treatment and that includes your vocabulary,” Nowak says. “The word ‘loan’ should be banned from their email and Word files.”
There’s a fair amount of litigation surrounding what is and what isn’t a cash advance. This can be helpful guidance for funders in setting out the criteria they need to follow to be able to defend their activities as cash advances. Even so, the line is somewhat of a moving target and funders need to be stalwart in these efforts given heightened regulatory scrutiny, experts say.
“If it looks like a loan, the law will treat it as a loan—and all the consequences that follow such a determination,” says Christopher K. Odinet, an associate professor of law at the University of Oklahoma College of Law.
BE CAREFUL ABOUT YOUR COLLECTION POLICIES
Obviously companies want to collect their payments. But some funders are too quick to file lawsuits, which could lead to unwanted trouble, says Paul A. Rianda, who heads a law firm in Irvine, Calif.
“The business model of sue first, ask questions later can be a problem,” says Rianda, whose clients include merchant cash advance companies.
The concern is that when funders sue, merchants start talking to attorneys and that could open the MCA firm to other types of lawsuits. The more a funder sues, the more it increases media attention and invites examination by state regulators and others. “You invite class action lawsuits and regulatory scrutiny that you really don’t want. It’s a boomerang thing,” he says.
The issue is especially pertinent now as legislators grapple with how to handle the thorny issue of confessions of judgement, more popularly known as COJs. For instance, since the start of the year, New York courts and county clerks have become much more rigid in processing confessions of judgments.
Certainly, not all funders use COJs. Just recently, for instance, Greenbox Capital suspended the use of COJs indefinitely, in response to the heightened industrywide debate over their use. While there’s no all-encompassing directive to stop using COJs, experts say it is incumbent upon funders to ensure they are used in a responsible and proper manner, especially amid political and regulatory uncertainty.
For instance, it would be irresponsible and potentially actionable to execute on a COJ simply because the merchant doesn’t remit receivables the merchant cash advance company purchased because he didn’t generate receivables, says Catherine M. Brennan, a partner at the law firm Hudson Cook LLP in Hanover, Maryland.
To be lawful, the COJ has to be based on a breach of performance under the agreement. Fraud, for instance, is actionable. But simple failure to remit receivables because the business has failed is not, she says.
“Conflating those two things—breaches of repayment versus performance—leads to a world of hurt,” she says. “MCA transactions do not have repayment as a concept.”
In places like New York, where COJs are more controversial, funders have to be especially careful about using them properly, experts say. Even though COJs are still enforceable under New York law for the time being, funders should understand every county processes them a bit differently, says Zakharyayev of Empire Recovery Services. “If they have a preferred county for filing, they should ensure their COJs are not only compliant with state law, but also complies with local rules,” he says.
What’s more, funders should ensure their COJs are properly notarized under New York law, ensure party names and the amount confessed is accurate, and avoid blanket statements such as naming each and every county in New York as a possible venue for filing, he says.
While some funders have suggested changing their venue provisions to a COJ-friendly state if New York outlaws COJs, Zakharyayev says he recommend New York funders keep their venue in New York regardless since it would still be one of the most efficient states to enforce a judgment. “I’ve filed COJs outside of New York and, even without a COJ, New York is much more efficient in judgment enforcement as New York courts are less restrictive in allowing the judgment creditor to pursue the debtor’s assets,” he says.
BE CAREFUL WHEN RAISING THIRD-PARTY MONEY
Aside from their dealings with merchants, funders also have to be cautious when it comes to interactions with potential investors.
Some companies have ample balance sheets and don’t need money from third parties to fund their operations. But funders that decide for business purposes to solicit money from investors, have to be careful not to run afoul of SEC rules, says Nowak, the attorney with Pepper Hamilton.
He recommends funders treat these fundraising efforts as if they are issuing securities and follow the rules accordingly. Otherwise they risk being the subject of an enforcement action where the SEC alleges they are raising money using unregulated securities. “You need to be very careful here because these rules are unforgiving. You can’t ignore them,” Nowak says.
TACKLE ACCOUNTING CHALLENGES
Accounting is another business challenge many funders face. Some have fancy customer relationship management systems, but the systems aren’t always set up to provide the detailed information the accounting department’s needs to effectively reconcile the firm’s books, says Yoel Wagschal, a certified public accountant in Monroe, New York, who represents a number of funders and serves as chief financial officer at Last Chance Funding, a merchant cash advance provider.
Ideally, a funder’s CRM and accounting systems should be integrated so both sales and accounting receive the relevant data without the need for either department to input duplicate data. The two systems need a way to get information from each other, without someone manually entering the data in both systems, which is inefficient and prone to error, Wagschal says.
DON’T SKIMP ON LEGAL SERVICES
There’s no set standard for funders to follow when it comes to legal advice. Some funders have in-house counsel, some contract with external law firms and some don’t have attorneys at all, which, of course, can be a risky proposition.
Some funders use contracts they’ve poached from a reputable funder online or from a friend in the industry, says Kimberly M. Raphaeli, vice president of legal operations at Accord Business Funding in Houston, Texas. The trouble is what flies in one state may not be legal in another, she says.
Many contracts include things such as jury waivers and class-action waivers or COJs and depending on the state, the rules surrounding the enforcement of these types of clauses may be different. So it’s really important to know the nuances of the state you’re doing business in and even potentially the states where your merchants are located, she says.
Having dedicated legal staff is arguably better. But at the very least, funders should have an attorney on speed dial who can provide advice on contracts, compliance and other areas of their business. Even when a funder has in-house attorneys, Raphaeli says it’s a good idea to tap external counsel to review documents in situations where potential liability exists. Not only does this offer a second set of eyes, it can provide added peace of mind. “A funder should never shy away from paying a little bit of money for long-term business security,” Raphaeli says.
FOLLOW BEST PRACTICES
The Small Business Finance Association, an advocacy group for the non-bank alternative financing industry, has developed a list of best practices for industry participants to follow. These encompass principles of transparency, responsibility, fairness and security.
“It’s a very competitive market and companies are trying to differentiate themselves. I think it’s important to make sure you’re following industry standards,” says Steve Denis, executive director of the association whose members include funders and lenders.
Funders also need to be mindful that best practices can change based on business and competitive realities, so it’s important for funders to review procedures periodically, says Raphaeli, of Accord Business Funding. Because the industry is fast-moving, a good rule of thumb might be for a funder to review the entire set of policies and procedures every 18 months. But more frequent review could be necessary if outside factors such as new case law or regulation demand it, she says.
“Periodically taking a look at your collections techniques, your default procedures, even your funding process down to your funding call – these are all critical components of having a successful MCA funder,” she says.
TAKE PAINS TO AVOID INDUCTION INTO THE PUBLIC HALL OF SHAME
While there is no shortage of unseemly news stories involving MCA, funders need to do their best to avoid negative press. This means being extra careful about the way they present themselves to businesses, at public speaking engagements, at conferences, industry trade shows, brokers and others, says Denis of the Small Business Finance Association.