Unmasking a Multi-Million Dollar Small Business Lending Fraud

A Texas small business owner had a profitable electronics retail operation for years until her merchant cash advance began draining her revenues faster than she could recover. She had fallen behind on a credit card, and a colleague referred her to an MCA funding company that he described as an alternative bank loan. He told her, "They get you money quick and don't even run your credit."

He said she could get "up to $200,000." She went online and applied, putting "$150,000" as the requested amount. She was surprised when the firm approved the whole $150,000 - with same-day funding - and listed as the purpose: "expand business."

The electronic signature page she was shown contained only three fields, but the document they sent back had many pages. The language was confusing, but she understood that she was pledging her accounts receivable as "collateral" for the advance.

Within weeks, the "advance" had left her business in financial distress. The daily withdrawals severely cut into her operating revenues. She stopped making them when it became impossible to cover rent. At that point, the MCA firm sent a written demand notice to pay the outstanding balance in full and threatened to withdraw the sum from her accounts. When she didn't comply, she received another notice: a claim filed for "confession of judgment."

What is Small Business Lending Fraud?

Not every source of working capital offers terms that promote business growth. Many predatory lenders are quick to approve huge loans without due diligence and use confusing language to bypass regulation. In the process, they bury small businesses with astronomical interest rates that continue to climb. These lenders can present loans in ways that prevent borrowers from realizing what's in store until they've already signed the agreement.

"Lending fraud" refers to lenders who impose credit requirements that drive a borrower deeper into debt, demand excessive penalties, engage in unlawful collections, or resort to violence and threats. Avoiding it means staying alert for the common red flags and doing careful research. A more reasonable form of capital comes from a lender who reviews your company's cash flow, verifies your sources of income, asks about personal or business collateral, considers your other loans and credit history, requests a guarantee, and presents clear interest rates and fees.

Classification as a "Purchase Agreement"

When small business borrowers complain of "predatory lending," they're generally referring to the practices of certain MCA funders. The Federal Trade Commission has long argued that MCA contracts should be disclosed with proper regulation, but state and federal loopholes make MCAs difficult to prosecute. Two of the major ones: MCAs operate outside standard contract law, and they use an unconventional contractual provision called a confession of judgment.

The New York State Attorney General found that many MCAs get around legal regulation by saying the advance is a purchase, not a loan. As a result, MCA contracts are not legally subject to standard banking and lending regulations. The purchase agreement disguises the loan as the purchase of your company's future receivables. The FTC considers MCA funders that require additional repayments after a business is in default to have redefined the advance as a loan instead of a purchase.

An MCA's easy-approval criteria makes it different from conventional bank loans based on an applicant's demonstrated ability to pay. An MCA provides quick cash in exchange for automatic daily or weekly debits from a business's bank account, subtracting payments directly before revenue comes in and other operating expenses are paid. The business must make minimum payments until the advance, along with an agreed-upon fee, is paid in full. This "flat" fee remains the same regardless of the repayment time frame. The agreement may say your business received a $50,000 advance and is obligated to repay $65,000. What the company is not obligated to tell you is the effective annual percentage rate on the transaction - a lack of disclosure that can lead a borrower to misinterpret an MCA agreement as "affordable" funding when the true cost may be much higher.

If your business can make the agreed-upon payments, you'll be paying off your advance at an APR that can approach triple digits. The effective rate can go even higher if you fall behind. There is generally no obligation for MCAs to inform a business exactly how much it's paying over the life of the loan.

Because many small businesses use their revenue to cover ongoing expenses like rent, this structure quickly cuts into what the company can pay in costs and payroll, even if the funds helped with a one-time capital expense. Many business owners end up taking out more loans from the same or another lender to make ends meet, spiraling deeper into debt under multiple MCA contracts.

"Confession of Judgment" Provisions

For decades, financial services firms have used confession of judgment provisions to garnish a client's funds directly in the event of a dispute or missed payment, even if that client lives in a different state. At the federal level, confessions of judgment in commercial transactions have been under attack for several years, after research showed out-of-state business debtors had their accounts frozen and suffered other financial losses before they were even aware of a dispute.

The problem is exploited in states where courts have yet to prohibit this contractual tool, so at a practical level confessions of judgment are still an area of active law. A true loan payment requires regular payments that amortize the loan amount and the interest. Since that would force an MCA funder to compete with other financial services, the funder will attempt to garnish your company's funds instead, without being forced to comply with the repayment structures of regular lending.

Factors that help develop an effective legal strategy in an MCA dispute include exorbitant default fees or interest; a company raising your loan rate after funding or accelerating payment frequency; collection methods that exceed the number of payments needed to pay off the debt; violent threats or attempts to coerce you into compliance; pressure to sign an admission of default or guilt; a funder registered in a state with particularly tolerant courts; and a lender that failed to verify your business actually has the means to pay off an advance before making the loan.

A free contract review costs nothing and takes a day or two. Call (888) 837-7053, or send the agreements to Delancey Street for a straight read on your options.