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Does Your Merchant Finance Agreement Pass The “Purchase” vs. “Loan” Test?

Does Your Merchant Finance Agreement Pass The “Purchase” vs. “Loan” Test?
By Gregory E. Galterio


The worst nightmare of every merchant finance company is a judicial determination that its purchase agreements are actually usurious loans in disguise. That nightmare became a reality for two companies in recent decisions from the New York State Supreme Court.1 However, if only some essential precautions had been taken, the outcomes of both cases could have been markedly different.

A. The Importance Of Proper Documentation

Given the flurry of recent New York case law, it has become imperative that receivables purchasers take a closer look at their standard form merchant agreements, guaranties, and other legal paperwork. The presence or absence of key language in a merchant agreement and/or guaranty could make or break a court’s decision on whether the transaction evidences a purchase or a loan. Here are four questions that should be at the top of every merchant finance company’s checklist:

1. Does your merchant agreement contain an adequate “non-recourse” provision? In other words, does it sufficiently state that the merchant’s receivables are the purchaser’s only source of recovery unless the merchant is in material breach? If no, a court will be more inclined to view the merchant agreement as a disguised loan; if yes, a court is more likely to find that it is a bona fide receivables purchase.2

2. Does your merchant agreement contain an adequate “reconciliation” clause? If fixed periodic debits are being made from the merchant’s account, the agreement should provide for a credit and/or refund to the merchant in the event that the aggregate debits exceed the specified percentage of receivables for a given accounting period. Under New York law, the absence of a reconciliation provision in such a situation would be an indicator of a loan, whereas its presence would be an indicator of a bona fide receivables purchase.3

3. Does your merchant agreement make bankruptcy or a non-willful merchant breach an event of default which automatically triggers liability under a personal guaranty? If yes, a court may be inclined to view the agreement as a disguised loan; if no, a court is more likely to find that it is a bona fide receivables purchase.4

4. Is your merchant agreement for a definite term, or is it dependent upon the indefinite time it will take to generate enough receivables to satisfy the merchant’s obligations? Courts have found that the former scenario is indicative of a loan while the latter is indicative of a purchase.5

Obviously, it has never been enough for a merchant agreement to state: “this agreement is not a loan.” However, now more than ever, subtleties in contractual language can mean the difference between recovery and forfeiture, as well as potential exposure to criminal usury charges. Accordingly, merchant finance companies are best advised to double check that all of their legal documentation is consistent with current developments in the law.

B. The Importance Of Witness Preparation

You wouldn’t send a soldier off to war without basic training and a weapon. It should be no different when it comes to a witness. Whether it is signing an affidavit or giving live testimony, your witness must be adequately prepared, appropriately qualified, and sufficiently knowledgeable of all evidence he or she will be offering in support or defense of a case.

Any witness must have comprehensive knowledge of the essential terms and conditions of all of the company’s transactional documentation, as well as personal familiarity with recordkeeping and document retention practices. He or she must also be fully educated on the hallmarks of receivables purchase agreements versus the attributes of loans. Otherwise, the results could be disastrous.

What happens when you send witnesses to court unprepared? They may be unable to identify or explain a non-recourse provision. They may be unable to articulate why the purchaser is at risk of recovery if the merchant cannot generate sufficient accounts receivable in the normal course of its operations. They may incorrectly testify that the purchaser has unfettered power to declare the merchant in default for willful nonpayment and trigger a personal guaranty. It can even get as deplorable as presenting the judge with an illegible copy of the merchant agreement, or one in microscopic typeface. Worst of all, sloppy preparation and poor testimony such as the foregoing is precisely what can lead a court to come to an “inevitable conclusion that the real purpose of the Agreement was for plaintiff to lend money to defendants at the usurious interest rate set forth therein, and that defendant agreed to borrow the money based on the same usurious terms dictated by plaintiff,” as the New York State Supreme Court recently did.6

It should come as no surprise that courts are beginning to scrutinize the language of merchant finance agreements with heightened intensity, or that the trend is destined to become nationwide. Accordingly, the importance of sound documentation, robust witness education, and proper witness preparation cannot be overemphasized.

Should your company have questions or require strategic guidance, the attorneys at Jaffe & Asher LLP are experienced draftsmen and trial attorneys with many years of experience in the creditors’ rights sector. Our client roster includes numerous merchant finance companies for which we provide a full spectrum of legal counsel. Whether it is contract revision, counterclaim defense, operational issues, and/or the collection of delinquent accounts and enforcement of judgments in all 50 states, we are here to add value, and you will find our services to be remarkably affordable.

1Merchant Funding Services, LLC v. Volunteer Pharmacy, Inc., 55 Misc.3d 316, 44 N.Y.S.3d 876 (Sup. Ct. Westchester Co. 2016); and Pearl Capital Rivis Ventures, LLC v. RDN Const., Inc., 54 Misc.3d 470, 41 N.Y.S.3d 397 (Sup. Ct. Westchester Co. 2016).

2Compare Merchant Funding Services, LLC v. Volunteer Pharmacy, Inc., 44 N.Y.S.3d at 880 (finding a loan where the funder failed “to point to a non-recourse provision in the Agreement by which it assumed the risk that it might not be able to collect payments from VP's accounts receivable”); with Merchant Cash and Capital, LLC v. Yehowa Medical Services, Inc., 2016 WL 4478805, at *5, 2016 N.Y. Slip Op. 31590(U) (Sup. Ct. Nassau Co. July 29, 2016)(finding a bona fide receivables purchase where “[u]nder the terms of the subject Agreement, if Seller/Defendant produces no daily revenue, no payments are required, and there is no absolute obligation of repayment”).

3Compare Professional Merchant Advance Capital, LLC v. C Care Services, LLC, No. 13-CV-6562 RJS, 2015 WL 4392081, at *4 (S.D.N.Y. July 15, 2015) (“it could be argued that the Agreement, which obligates Defendants to make a minimum weekly payment irrespective of C Care's accounts receivable and subjects Plaintiff to no downside whatsoever aside from the risk that the borrower will fail to make the required payments, is in fact a loan”); with Retail Capital, LLC v. Spice Intentions Inc., 2017 WL 123374, at *2, 2016 N.Y. Slip Op. 32614(U) (Sup. Ct. Queens Co. Jan. 3, 2017) (holding that agreement was not a loan where it “provided a reconciliation . . . to ensure that neither entity collected more or less of the sales proceeds than they were contractually entitled to collect from the designated bank account”).

4Compare Pearl Capital Rivis Ventures, LLC v. RDN Const., Inc., 41 N.Y.S.3d at 401 (“the Court is further troubled by the witness's testimony to the effect that plaintiff is able to escape an element of risk by deeming a borrower's failure to pay to be willful or otherwise unjustified, and entitling it to seek payment in full under the personal guarantee”); with IBIS Capital Group, LLC v. Four Paws Orlando LLC, 2017 WL 1065071, at *5, 2017 N.Y. Slip Op. 30477(U) (Sup. Ct. Nassau Co. March 10, 2017) (“the Agreement provided no liability in the event that the seller's business failed because it could not generate sufficient revenue to continue operating”).

5See, e.g., Chartock v. National Bank of California, 2017 WL 849921, at *1, 2017 N.Y. Slip Op. 30357, at 2 (Sup. Ct. Queens Co. Jan. 17, 2017)( the “purchased amount was to be paid over an indeterminate amount of time”); see also Merchant Cash and Capital, LLC v. South Jersey Speed LLC, 2016 WL 7655830, at *4, 2016 N.Y. Slip Op. 32591(U) (Sup. Ct. Nassau Co. 2016)(holding that an agreement with a fixed daily payment amount did not constitute a loan because “that amount may be increased or decreased based upon daily average revenues, and therefore the duration of the repayment period may also increase or decrease”).

6Pearl Capital Rivis Ventures, LLC v. RDN Const., Inc., 41 N.Y.S.3d at 401.
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