District Court Offers Guidance on Merchant Cash Advances in Precedent-Setting Decision

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On May 9, in Colonial Funding Network, Inc. v. Epazz, Inc., the U.S. District Court for the Southern District of New York dismissed counterclaims alleging the overcharging of interest and the affirmative of usury. The decision is the first federal case to recognize that a contractual relationship establishing a bona fide merchant cash advance (MCA) does not create a loan. Beyond that, the decision offers helpful guidance on how to structure a legally enforceable MCA agreement.

In Colonial Funding, the parties’ MCA agreement required the subject cash advance to be repaid in daily payments equal to 15 percent of defendant Epazz’s daily collected receivables. To this end, the agreement authorized plaintiff TVT Capital to make daily withdrawals in agreed-upon, set amounts from a designated bank account into which Epazz was required to deposit sums it collected. In addition, TVT was required to reconcile its withdrawals on a monthly basis against the bank statement for the designated deposit account. If TVT’s withdrawal on a given day was higher or lower than 15 percent of the receivables Epazz had collected on that day, TVT was required to debit or credit the deposit account for the difference. If, however, Epazz failed to provide TVT with the bank statement needed to make reconciliations, “TVT [was] not required to reconcile future payments.” The parties’ dispute arose when Epazz stopped making deposits into the account. Colonial, as servicing provider for TVT, responded by filing a lawsuit in New York Supreme Court, which was removed to federal court.

Epazz counterclaimed, alleging that the parties’ MCA agreement actually created a usurious loan. In considering this argument, the district court noted that, under New York law, “there can be no usury unless the principal sum advanced is repayable absolutely.”

Applying this standard to the MCA agreement in question, one could argue that the nature of the parties’ relationship would convert to a loan if Epazz ceased delivering bank statements to TVT; i.e., from that point forward, TVT would be entitled to collect daily payments in specified uniform amounts, with no obligation to reconcile, until the advance was repaid in full. In the district court’s view, however, if this contingency were to occur, Epazz’s obligation to repay would remain tethered to 15 percent of its daily collected receivables, and, in the absence of reconciliation, TVT’s daily withdrawals would be presumed to have been made in appropriate amounts. In this regard, the district court’s opinion stressed that “Epazz, rather than [Colonial] controls whether daily payments will be reconciled.” Moreover, “[n]o allegation is made that TVT ever denied Epazz’s request to reconcile the daily payments.”

After reviewing the structure of the parties’ MCA relationship, the district court noted that Epazz’s argument that the relationship constituted a loan rested on three specific cases. With respect to the first of those cases, Merchant Cash & Capital LLC v. Edgewood Group, LLC, 2015 U.S. Dist. LEXIS 94018, 2015 WL 4451057 (S.D.N.Y. July 20, 2015), the district court stated that “[w]hether the arrangement was a loan was not briefed and was not determinative to the outcome [of the case.]” The Colonial Funding court then noted that the judge in Merchant Cash reviewed a supplemental filing made by the plaintiff MCA provider and concluded that the parties’ relationship “appear[ed] to be structured not as a loan but as the sale of accounts receivable” because the MCA agreement required weekly reconciliations of payments made against collected receivables.

In regard to the second case cited by Epazz (Clever Ideas, Inc. v. Rest. Corp., 2007 N.Y. Misc. LEXIS 9248 (N.Y. Sup. Ct. Oct. 12, 2007)), the district court noted that the contract at issue had “included neither a reconciliation provision, nor payment contingent on the amount of receipts generated.” Hence, the court opined that “the clear facts [of Clever Ideas] differ from those in this case.”

The district court next determined that Platinum Rapid Funding Group Ltd. v. VIP Limousine Services, Inc., 2016 N.Y. Misc. LEXIS 4131 (N.Y. Sup. Ct. Oct. 27 2016), the third case cited by Epazz, presented facts that more closely resembled the dispute at hand. In Platinum, the New York Supreme Court held that the respective repayment obligations of the merchant and its co-defendant principal owner were not unconditional and the “deposited receipts from future transactions” constituted the sole source of repayment of the subject MCA. In this regard, the court concluded that the personal guaranty of the merchant’s principal owner did not give rise to a loan because the “personal guaranty [was] no broader than the [merchant’s] obligations under the Agreement, and the requirement of payment by the Guarantor [was] no greater than that of the Merchant.”

Finally, in addition to the above cases, the Colonial Funding court considered the parties’ dispute in light of Merchant Cash & Capital, LLC v. Transfer International Inc., 2016 N.Y. Misc. LEXIS 4515 (N.Y. Sup. Ct. Nov. 2, 2016). In that case, the amount of the merchant’s daily payment “could be adjusted downward in the event that the average daily receipts were less than anticipated, and adjusted upward in the event that the average daily receipts were greater than anticipated.” According to the defendant, these adjustments made the subject MCA arrangement a usurious loan. The New York Supreme Court disagreed on the basis that the “plaintiff assumed the risk that, if the receipts were less than anticipated, the period of repayment would be correspondingly longer, and the investment would yield a correspondingly lower annual return.”

Based on its review of the parties’ relationship in Colonial Funding, the district court concluded that Epazz’s obligation to repay was not absolute and did not constitute a loan under applicable law. Rather, the court found that “[p]ayment depends upon a crucial contingency; the continued collection of receipts by Epazz from its customers.” That condition, the court noted, was stated explicitly in the parties’ agreement: “Payments made to FUNDER in respect to the full amount of the Receipts shall be conditioned upon Merchant’s sale of products and services and the payment therefore by Merchant’s customers in the manner provided in Section 1.1.”

Furthermore, Epazz’s contention that the agreement amounted to a loan because it required specified daily payments was “contradicted by the reconciliation provisions which provide that if daily payments are greater than 15% of Epazz’s daily receipts, TVT must credit the difference to Epazz, thus limiting Epazz’s obligation to 15% of daily receipts.” Accordingly, the court dismissed Epazz’s counterclaim for the overcharge of interest and affirmative defense of usury.

Takeaways

  • Colonial Funding reinforces that, in order to avoid an MCA being deemed a usurious loan, (i) the provider’s acquired interest in the merchant’s accounts receivable must constitute the sole source of repayment and (ii) the contract must include a mechanism for reconciling required contract payments against the financial performance of the purchased receivables.
  • Colonial Funding also illustrates that the line between an MCA and a loan may be a fine one. Without effective contract drafting, a court could consider a default provision requiring fixed payments with no reconciliation requirement as giving rise to a loan. In Colonial Funding, the court noted that the right to require reconciliations rested solely with the defendant merchant, and, if the merchant chose to forgo that right by failing to provide a bank statement to the MCA provider, the provider could presume that its daily withdrawals corresponded to 15 percent of the merchant’s daily collected receivables.
  • Requiring the merchant’s principal owner(s) to give a personal guaranty will not render an otherwise bona fide MCA a usurious loan so long as the terms of the guaranty mirror the obligations of the merchant. For example, in Colonial Funding, the guarantor was obligated, along with the merchant, to deposit each day’s collected receivables into a designated account. The guarantor was not, however, obligated to make up any deficiencies in the amounts deposited out of his pocket, which would have constituted a loan.
Last modified: June 6, 2017
Mark T. Dabertin is a Special Counsel at Pepper Hamilton LLP, where he is a member of the Marketplace Lending practice group. He has over 25 years of broad-based experience in financial services law and consumer and regulatory compliance. Mr. Dabertin’s career encompasses extensive experience in consumer and business lending, safety and soundness matters, and anti-money laundering. His compliance innovations at large financial institutions have often resulted in fundamental changes to existing firm-wide processes.

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