MCA Debt in Bankruptcy: 6 Ways Courts Have Treated the "Purchase of Receivables"

When a business owner sells receivables to a financing company for cash, and then files bankruptcy, the bankruptcy court faces a choice: treat it as a sale or treat it as a loan and fight over the difference. It turns out that there have been six different results. The label on the agreement doesn’t decide the matter. The strongest result for the financing company is that it’s a true sale: the financing company owns the receivables. Five others, when it’s seen as a loan: usury defense, receivables stay with the estate, payments are recoverable preferences, fraudulent transfer suits can move forward, and receivables arising after filing can’t be taken.

The fundamental purpose of a financing agreement is to provide cash to a business without the constraints imposed by traditional lenders. The funding company does not want to be limited by usury (high interest rate) laws. They do not want the debtor in bankruptcy to recover money paid as a preference. They don’t want to have the debtor in bankruptcy raise a fraudulent transfer defense to having taken the receivables. And finally, they do not want a bankruptcy trustee to scoop up any accounts receivables that came in after filing, cutting out the financing company altogether.

So how do judges tell a real sale from a financing disguised as a sale? They ask who is at risk. If the financing company eats the loss if receivables go uncollected, that looks like a true sale. If the debtor pays no matter what happens, and the financing company gets repaid in any event, it looks like a loan even if the contract calls it a sale. Courts look for a reconciliation clause, a finite period to collect, and recourse if the merchant files bankruptcy. However, despite the recitation of these factors, they are not the end-all. Some courts look at the transaction as a whole.

A True Sale

The first result is where the financing agreement is upheld as a true sale. That’s what happened in In re R&J Pizza Corp.: the debtor had no remaining interest in its receivables. The financing company had no security interest in the receivables (it didn’t need one since it was the owner) and took no recourse if the receivables were uncollected. As a result, in this case, the sale was real and the receivables were removed from the debtor’s estate. To succeed on this approach, the financing company needs to be at risk that it will not be paid if the debtor does not collect the receivables. If the financing company takes a security interest and has the debtor repay no matter what, this approach will fail.

In Guttman v. EBF Holdings, the court distinguished the deal between debtor and funding company from a loan because of an enforceable reconciliation clause, no fixed period, and bankruptcy not an event of default. The court held that the usury laws did not apply and so dismissed the usury claims.

If a Financing Agreement Is a Loan

Second, if the funder is not at risk because of the finance agreement, the court can attack it as a loan (because that’s what it really is) and then decide the loan void because of usury. In In re Shoot the Moon, eighteen merchant cash advances were seen as usurious loans under Montana law, and the merchant was awarded $1,216,685 against the funding company. Usury laws have teeth. In re Williams Land is an example where the effective interest rate worked out to be 101.1%, far above New York’s 25% criminal usury cap, and the court declared the whole MCA agreement void from day one.

Third, if a financing agreement is a loan, the courts could hold that the receivables stay with the estate. In Crosby Tugs, the funding company, Aqua Capital, advanced $350,000 against “future receipts” of $543,750. The loan was repaid by daily sweeps of the debtor’s bank account, and repayment was not tied to any customer. Aqua Capital had a security interest in all assets and a personal guaranty. There was a confession of judgment. The court looked at the three factors which have been accepted as guidance in other cases: reconciliation clause, duration, and recourse in event of bankruptcy. The reconciliation clause would only lower the debtor’s weekly payment, not the balance owed. Further, one missed payment ended the reconciliation requirement altogether, so it was “illusory.” The financing agreement set no fixed term but there was a de facto term: the loan balance divided by the daily payment amount. And no matter what, the debtor bore the entire risk of nonpayment. As a result, the court saw this as a loan and the receivables remained in the estate. Again, Shoot the Moon went the same way. The court found CapCall had no ownership or enforceable security interest in the card receivables. The trustee was entitled to the $228,449.93 in segregated disputed funds.

Fourth, if a financing agreement is a loan, the court could see it as a preference, a payment made in the 90 days before filing bankruptcy that can be taken back by a bankruptcy trustee. In J.P.R. Mechanical, the trustee won summary judgment avoiding MCA payments within 90 days before filing while insolvent. The reconciliation clause was illusory, and the trustee avoided over $3 million as preference payments.

Fifth, if the financing agreement is seen as a loan, it may be a fraudulent transfer. One form of fraudulent transfer is “constructive.” The trustee can undo transfers within two years of filing bankruptcy if the debtor got less than reasonably equivalent value while insolvent. To make the point, there is no need to prove that the loan is void as a usurious loan. In In re Anadrill Directional Services, the debtor owed $1,016,000 after receiving $650,000, and the court let the trustee proceed with those claims.

Sixth, in In re IVF Orlando, the court said the debtor had no receivables to sell to the financing company, it only had a hope they might exist some day. As a result, the receivables that arose after filing belonged to the bankruptcy estate and not the financing company.

Look into the Contract

If you’ve filed or are planning to file bankruptcy and you’ve received MCA funding, it’s important to look into the contract. Don’t take the label “sale” at face value. Look at the reconciliation clause, the term of the agreement, the recourse if you file bankruptcy, whether there is a guaranty or confession of judgment, and if there is a lien on all your assets. With the right facts, the debtor or a trustee can recharacterize the agreement, recoup transfers to the funder, and recapture receivables the funder thought it bought.