Legal Briefs

Can California Lenders Pay Referral Fees to Unlicensed Brokers?

A new California law is drawing attention to a much-misunderstood issue – whether California Finance Lenders can pay referral fees to unlicensed ISOs. Effective January 1, 2016, the answer is yes, but only for commercial loans with an annual percentage rate of less than 36% where the lender reviews documents to verify the borrower’s ability to repay. These restrictions benefit non-profit lenders making business development loans, and shut out their higher-cost commercial lender competitors from paying referral fees to unlicensed ISOs.

Existing regulations under California’s Finance Lender’s Law (“CFLL”) prohibit paying any compensation to unlicensed persons or companies for “soliciting or accepting applications for loans.” 10 CCR 1451(c). This prohibition does not apply to referrals for merchant cash advances or referrals to banks, which are not subject to the CFLL. A number of not-for-profit CFLL lenders offering business development loans complained that it was unfair that they could not pay referral fees to an unlicensed ISO while their higher-cost competitors, the merchant cash advance companies, could.

California SB 197, supported by Opportunity Fund, California’s largest not-for-profit commercial lender, and the California Association of Micro-Enterprise Organizations, a group of more than 170 organizations, agencies, and individuals dedicated to furthering micro-business development in California, aimed to remedy this perceived problem. According to an information sheet on SB 197 available on the Opportunity Fund’s web site:

Often, merchant advance companies offer less favorable terms to small businesses than commercial lenders; however, small businesses never learn about the commercial lenders that offer more favorable terms, because those lenders cannot compensate entities to refer business to them.

http://www.opportunityfund.org/media/blog/introducing-sb-197-(block)!/ (last accessed on December 9, 2015)

The legislature approved SB 197 and Gov. Jerry Brown signed it last October. Starting on January 1, 2016, a CFLL lender can pay a fee to an unlicensed person in connection with a referral of a prospective borrower if:

• The referral by the unlicensed person leads to the consummation of a commercial loan (defined as a loan with a principal amount of $5,000 or more the proceeds of which are intended by the borrower for use primarily for other than personal, family or household purposes);
• The loan contract provides for an annual percentage rate that does not exceed 36%; and
• Before approving the loan, the lender:
  1. Obtains documentation from the prospective borrower documenting the borrower’s commercial status. Examples of acceptable forms of documentation include, but are not limited to, a seller’s permit, business license, articles of incorporation, income tax returns showing business income, or bank account statements showing business income; and
  2. Performs underwriting and obtains documentation to ensure that the prospective borrower will have sufficient monthly gross revenue with which to repay the loan pursuant to the loan terms. The lender cannot make a loan if it determines through its underwriting that the prospective borrower’s total monthly expenses, including debt service payments on the loan for which the prospective borrower is being considered, will exceed the prospective borrower’s monthly gross revenue. Examples of acceptable forms of documentation for verifying current and projected gross monthly revenue and monthly expenses include, but are not limited to, tax returns, bank statements, merchant financial statements, business plans, business history, and industry-specific knowledge and experience. If the prospective borrower is a sole proprietor or a corporation and the loan will be secured by a personal guarantee provided by the owner, the lender must consider a credit report from at least one consumer credit reporting agency that compiles and maintains files on consumers on a nationwide basis.

The licensee must also maintain records of all compensation paid to unlicensed persons in connection with the referral of borrowers for a period of at least 4 years.

SB 197 also provides that a lender that pays compensation for a referral to an unlicensed person is liable for “any misrepresentation made to that borrower in connection with that loan.” It is not clear whether the lender is liable only for misrepresentations made by the unlicensed person who receives compensation for the referral, or if the regulator will interpret this provision more broadly. Further, lenders must provide such prospective borrowers this specific written statement in 10-point font or larger at the time the licensee receives an application for the loan:

You have been referred to us by [Name of Unlicensed Person]. If you are approved for the loan, we may pay a fee to [Name of Unlicensed Person] for the successful referral. [Licensee], and not [Name of Unlicensed Person] is the sole party authorized to offer a loan to you. You should ensure that you understand any loan offer we may extend to you before agreeing to the loan terms. If you wish to report a complaint about this loan transaction, you may contact the Department of Business Oversight at 1-866-ASK-CORP (1-866-275-2677), or file your complaint online at www.dbo.ca.gov.

Lenders must require prospective borrowers to acknowledge receipt of the statement in writing.

SB 197 defines “referral” to mean either the introduction of the borrower and the lender or the delivery to the lender of the borrower’s contact information. The following activities by an unlicensed person are not authorized:

• Participating in any loan negotiation;
• Counseling or advising the borrower about a loan;
• Participating in the preparation of any loan documents, including credit applications;
• Contacting the lender on behalf of the borrower other than to refer the borrower;
• Gathering loan documentation from the borrower or delivering the documentation to the lender;
• Communicating lending decisions or inquiries to the borrower;
• Participating in establishing any sales literature or marketing materials; and
• Obtaining the borrower’s signature on documents.

Many for-profit CFLL licensees may find the narrow exemption that permits CFLL licensees making commercial loans to accept referrals from non-licensed entities impractical. The industry may instead choose to focus on the existing prohibition against paying non-licensees for “soliciting or accepting applications for loans” to avoid the limitations on the loan terms.

Legal Brief: Kalamata v. Biz2Credit and Itria Ventures

The typical merchant cash advance contract contains language that prohibits the merchant from stacking multiple merchant cash advances. Some cash advance companies, however, induce merchants to stack. This is where the legal concept of “tortious interference with contract” comes in. Tortious interference places legal liability on a person who wrongfully causes another person to breach an existing contract. In the merchant cash advance industry, these lawsuits usually involve disputes over whether a stacking cash advance company intentionally caused a merchant to stack additional cash advances, thereby breaching an existing contract. This is an evolving area of the law and what conduct constitutes tortious interference is a hot topic in the legal field.

Tortious interference is one of several claims that came up in Kalamata Capital’s recent lawsuit against Biz2Credit Inc. and Itria Ventures, LLC, and the court has already issued its first ruling on what conduct might constitute tortious interference with cash advance agreements.

Kalamata sued Biz2Credit and Itria for, among other things, stacking. One of Kalamata’s arguments was that Biz2Credit and Itria tortiously interfered with Kalamata’s contract. Biz2Credit and Itria filed a motion to dismiss. They argued that Kalamata failed to allege facts that would support a claim of tortious interference with contract. The court denied their motion because Kalamata alleged that 1) it had a business relationship with a merchant, 2) that Biz2Credit and Itria knew of that relationship and intentionally interfered with it, 3) that Biz2Credit and Itria acted solely out of malice, used improper means, illegal means, or means amounting to an independent tort, and 4) that the interference caused injury to Kalamata.

Kalamata alleged that, under its contract with Biz2Credit, Kalamata paid Biz2Credit commissions for referrals and for managing all of Kalamata’s accounts, including the referrals, on Biz2Credit’s online platform. Kalamata also alleged that the contract with Biz2Credit prohibited Biz2Credit from soliciting Kalamata’s merchants. The crux of the lawsuit is Kalamata’s claim that Biz2Credit secretly referred Kalamata’s merchants to Biz2Credit’s closely related company, Itria, and intentionally induced those merchants to stack additional cash advances in breach of the merchants’ contracts with Kalamata, despite an alleged agreement between Kalamata and Biz2Credit that prohibited Biz2Credit from doing so. Biz2Credit and Itria disputed Kalamata’s claims and argued that they were permitted to solicit any account that Biz2Credit referred to Kalamata or serviced for Kalamata.

Ultimately, the court found that if Biz2Credit was, solely for malicious purposes, sharing Kalamata’s confidential customer information with Itria, Kalamata’s competitor, and, if Itria and Biz2Credit were knowingly inducing Kalamata’s customers to breach their merchant agreements with Kalamata, then such conduct would rise to the level of tortious interference.

As this was a decision on a motion to dismiss, the motion focused on the legal sufficiency of Kalamata’s claims and did not address the merits of either party’s factual assertions.

Whoops! Lender Drafts Choice of Law Clause with Wrong State; Court Finds Interest Rate Usurious

A recent case out of Illinois serves as a reminder that when it comes to usury law compliance, its always best to double, or even triple check your contracts.

Preferred Capital Lending, a Nevada company that provides cash advances to attorneys working on personal injury cases, agreed to make a loan to the defendant. The defendant signed the promissory note in Preferred Capital’s Las Vegas office and the note expressly provided that it was executed in the State of Nevada. When the defendant later defaulted on the loan, Preferred Capital filed a breach of contract action in Nevada. The case, however, was transferred to Illinois pursuant to the loan contract’s choice of law clause which provided that that state’s law would govern.

In response to the complaint, the defendant filed a motion for summary judgment arguing that the loan carried an interest rate that exceeded Illinois’ usury cap. Preferred Capital countered that it had made a mistake when drafting the choice of law clause and that the clause should have stated that Nevada’s law applied. The court was unpersuaded by Preferred’s argument:

Preferred Capital contends that the Illinois choice-of-law provision was a mistake and the loan documents should have indicated that the law of Nevada, which has repealed its usury laws, applies to the loan documents. This assertion rings hollow in light of the fact that Preferred Capital analyzed its breach of contract claim under Illinois law in its opening motion for summary judgment, and expressly stated in a footnote that it was doing so pursuant to the Illinois choice-of-law provision in the promissory note at issue.

As a result, the court applied Illinois law and found that the amount of interest provided in the agreement violated the Illinois Interest Act.

Now to be fair, Preferred Capital operates offices in both Nevada and Illinois. So its understandable how a Illinois choice of law clause appeared in the loan documents. What’s less clear, though, is why Preferred Capital initially argued that the agreement should be governed by Illinois law given that it had originally filed the matter in Nevada. In any event, the oversight proved costly as Preferred Capital now finds itself defending a usury claim rather than collecting on the outstanding loan.

Preferred Capital Lending v. Chakwin, 2015 U.S. Dist. LEXIS 137383 (N.D. Ill. Oct. 7, 2015)