The Evolution of Cash Advances
Over the years, the way that cash advances to merchants have been funded and collected has changed. Below I will review the way the industry has changed and discuss some of the implications of those changes.
The Pure Cash Advance:
In the beginning, the cash advance model was closely linked to the credit card processing of the merchants. Most companies only provided cash advances to merchants that could show a steady flow of credit and debit card receipts. The cash advance was repaid by way of split funding of the merchant’s payment processing. By that I mean the credit card processor would pay a certain percentage (usually less than 10%) of the merchant’s credit card processing receipts to the company that provided the cash advance with the balance paid to the merchant. This was usually accomplished by way of a redirection letter signed by the merchant and presented to the merchant’s processor directing how the funds were to be distributed.
The documents for these types of transactions were usually similar looking to those used in providing a loan to a merchant. The cash advance agreement was typically fairly long and included provisions like a personal guarantee and security provisions including calling for a UCC-1 filing. As to the personal guarantee, most of the things that triggered it were really actions that amounted to fraud such as getting the cash advance and then switching to another payment processor in a couple of weeks to avoid having to repay the advance.
Possibly partly because of the similarity in the merchant advance agreement to loan documents, a number of lawsuits were filed by a San Diego law firm here in federal court Orange County, California. The lawsuits alleged that the cash advances were really disguised loans and hence violated the usury laws. A number of the lawsuits were settled for considerable amounts of money.
The first reaction of many companies in the cash advance business to these lawsuits was to simplify their cash advance agreements. Gone or severely limited were the personal guarantee provisions. As I stated above, maybe they are not really needed anyway given the fact that you could sue the owners of the merchants for fraud in most cases. Gone too were the long agreements. The new agreements were shorter, simpler to read and understand and did not have all the security provisions like a loan document. The upshot was the given that the characteristics of a loan were removed, the companies would have a better argument that it was not a loan disguised as something else.
But, the reliance on the need for split funding with a third party processor continued and necessarily limited companies in the space. They did not have control over the merchant’s funds so there was inevitably some additional risk. Some companies solved that problem by becoming independent sales organizations with control over the merchant’s funds. But others could not justify the expenditure or just did not want to get into that business. So what was the solution? Automated clearing house (ACH) transactions.
The New ACH Age:
Using ACH transactions to take money out of the merchants’ bank account changed the game. Now, the merchant’s processor did not have to be involved. The merchant gives its consent to the cash advance company to periodically take cash from the merchant’s bank account. So, if you were a purist, the cash advance company would on a daily basis look at the merchant’s credit card receipts and deduct the correct amount based on the applicable percentage from the merchants’ bank account. It was a little more risky in that the merchant could change the bank account but that risk is seen by many to be reasonable.
But how often to take money out of the bank account and how much became an issue. It is very labor intensive to look at a merchant’s processing every day so some started to do weekly or less frequent withdrawals. But that still is a lot of effort. So some people decided that they would estimate the amount that should be taken out weekly or daily and then just automatically take out that amount of cash from the merchant’s bank account. But that meant to actually take out the stated percentage, there had to be a true up on a monthly basis. By that I mean the actual amount collected based on the estimates had to be compared with what should have been taken out based on the percentage of the merchants processing that should have been collected.
However, I found that some people just took out the estimated amount only and did not true up. But if you were doing that for credit card processing, why not do it for all the merchants’ revenue? That way, you would be able to provide larger advances to merchants. You would also be able to provide cash advances to merchants that collected little if any revenue by credit card. In effect, the ACH method increased the number of merchants that can get a cash advance.
But all this still leaves open the question of those lawsuits. The further you go away from the pure cash advance the more likely some lawyer is going to argue it is just a disguised loan. So on one end of the spectrum if you provide a cash advance with a simple agreement, split funding only credit card processing proceeds, provide for no personal guarantee, record no security interest and largely keep away from suing merchants, arguably you will decrease the risk of getting sued. But if you ACH money from the merchant with no direct relationship to the processing volumes, require a personal guarantee and file a security interest and aggressively sue merchants’ that default, you might find yourself more likely to get sued for usury. It is just a matter of your appetite for risk as to where you want to end out on that spectrum.
The information contained herein is for informational purposes only and should not be relied upon in reaching a conclusion in a particular area. The legal principles discussed herein were accurate at the time this article was authored but are subject to change. Please consult an attorney before making a decision using only the information provided in this article.