Merchant Cash Advance (MCA) agreements continue to proliferate as an alternative funding mechanism for small and mid-size businesses. MCA transactions are typically structured as a purchase and sale of future receivables, not a loan. However, when a merchant files for bankruptcy, the threshold legal question – whether the MCA constitutes a “true sale” or a “disguised loan” – becomes critically important to the funder’s treatment under the Bankruptcy Code, including application of the automatic stay, avoidance actions and recovery under a plan of reorganization. This alert summarizes the current state of the law, the bankruptcy estate implications, and practical guidance for structuring transactions to strengthen a true sale characterization.
Background
In a typical MCA transaction, the funder pays an upfront sum in exchange for the right to collect a fixed amount of the merchant’s future receivables. Courts analyzing whether a transaction is a true sale or disguised loan look beyond the labels used in the transaction and instead focus on the transaction’s economic substance. There are two primary approaches to this inquiry.
- The leading approach is the three-factor test, where the court considers:
- Reconciliation: True sales are supported by an agreement that contains a genuine reconciliation provision, allowing the merchant to adjust or reduce payments to reflect actual receivables generated.
- Finite Term: A disguised loan is indicated by an agreement with a fixed maturity date. A true sale, meanwhile, is contingent on receivables being generated – with no fixed endpoint.
- Recourse: A disguised loan also is revealed by an agreement providing for recourse for non-payment due to business failure points; in a true sale, there is no recourse as the funder bears the risk that receivables never materialize.
- An alternative approach weighs eight factors that are largely similar to the three-factor framework.
Under either framework, the allocation of risk is a key consideration. Courts closely examine which party bears the risk that receivables are never generated, and use that allocation of risk to determine whether the transaction is a true sale or disguised loan. Where the funder bears the risk, the more likely the MCA is to be classified as a true sale.
Bankruptcy Implications and Timing
The characterization of an MCA as a true sale or a loan has profound consequences in bankruptcy:
- True Sale: The purchased receivables are owned by the funder – not the debtor. As such, they fall outside the bankruptcy estate. The funder is not a creditor but an owner of the property, with protection from potential avoidance actions. A true sale places the receivables outside the bankruptcy estate and its distribution scheme (e.g., outside a reorganization repayment plan). In reality, in a true sale context, a funder should expect to navigate through the bankruptcy case, seeking protection of its rights to receivables post-petition.
- Disguised Loan: The receivables remain property of the estate. The funder is a creditor – secured only to the extent of a properly perfected security interest, and otherwise unsecured. The funder is subject to the automatic stay, plan treatment, the risk of being under-secured, avoidance actions for payments collected within 90 days of the petition date and, potentially, state usury laws. The future receivables purportedly purchased will be property of the bankruptcy estate pursuant to Section 541(a). Post-petition receivables are likely not subject to the funder’s security interest under Section 552(a) because property acquired by the estate or debtor after commencement of the case is not subject to a pre-petition security interest without the ability to prove that post-petition receivables were proceeds of pre-petition collateral (i.e., the funder’s advance).
Timing is a challenging issue in MCA bankruptcy disputes. Bankruptcy law determines estate property as of the petition date. MCA agreements, meanwhile, purport to sell future receivables that may not be generated until after the bankruptcy petition is filed. A funder asserting true-sale treatment therefore faces the challenge of proving ownership of post-petition receivables. This is a conceptually difficult proposition that has become increasingly litigated.
Courts have approached the issue inconsistently but are trending toward a skeptical view of MCA structures with a heightened willingness to recharacterize them as loans, including decisions that found payments collected by the MCA funder in the 90 days prior to petition date were subject to clawback, and disallowed the MCA funder’s claims in full. Notably, there are cases where courts have recognized that properly structured MCA transactions constitute true sales of future receivables. In those cases, the purchased receivables were deemed owned by the MCA funder and not part of the debtor’s bankruptcy estate, thereby limiting exposure to avoidance, clawback and preference actions.
Practical Takeaways
Importantly, recharacterization of MCA structures is not automatic, and courts intensely scrutinize the specific documentation and facts of each transaction. The varying outcomes underscore the inherently fact-intensive nature of the inquiry and the importance of precision in deal structuring.
To strengthen the likelihood of a true-sale characterization and reduce bankruptcy risk:
- MCA agreements should 1) contain a meaningful reconciliation provision that allows for adjusted remittances based on actual collections, 2) avoid fixed repayment terms, and 3) tie remittances to the generation of receivables rather than an absolute repayment obligation.
- The transaction should be structured to allocate the risk of a good-faith business failure to the funder.
- Consideration also should be given to the filing of a UCC-1 financing statement (UCC-1) to preserve the funder’s status as a secured creditor in the event of recharacterization. Although a UCC-1 filing may be viewed as evidence of a lending relationship, it may help preserve secured status in the event the transaction is recharacterized as a disguised loan.
Lathrop GPM frequently represents MCA funders, lenders and creditors in bankruptcy and related disputes, including adversary proceedings. If you have questions regarding the enforcement, recovery or bankruptcy-related treatment of MCA agreements, please contact Jay Ross or Erika Mortensen, or your regular Lathrop GPM attorney.
*Madeline Kleven, a Summer Associate for Lathrop GPM, contributed significantly to this content.