When does a “purchase” of future receivables become a loan?
By Robert W. Dremluk, Partner
Writing in The New York Law Journal, our Partner Robert W. Dremluk notes that merchant cash advances (MCAs) have become an increasingly common source of alternative financing for small and mid-sized businesses. But when an MCA agreement lands in bankruptcy court, the label on the contract may settle the question.
The issue courts are increasingly examining is straightforward: Is the transaction actually a sale of future receivables—or is it a loan in disguise?
That distinction can have significant consequences for both sides.
Substance Over Form
MCA agreements are typically structured as purchases of future receivables. A business receives an upfront payment and agrees to remit a percentage of future receipts until it collects the purchased amount.
Courts, however, may look beyond the contractual language and examine how the transaction actually operates.
Among the factors that can matter:
- Risk of loss: Does the MCA provider genuinely bear the risk that receivables may decline or disappear?
- Reconciliation: Can the merchant meaningfully reduce payments when its actual receivables decrease?
- Recourse and guarantees: Do personal guarantees or other provisions effectively require repayment regardless of receivables?
- Default provisions: Does a default simply end the arrangement, or does it accelerate a fixed unpaid balance?
The more an agreement operates like a traditional debt obligation, the greater the potential for recharacterization as a loan.
Choice of Law Isn’t Always the Final Word
MCA agreements often include choice-of-law provisions that select jurisdictions whose laws are viewed as favorable to the provider.
But bankruptcy courts can independently examine whether to enforce that choice. Where the selected jurisdiction has little meaningful connection to the transaction, and applying its law would conflict with the public policy of a state with a stronger connection, the contractual choice may face scrutiny.
That can be particularly important when a merchant operates primarily in one state and generates its receivables there.
Why Recharacterization Matters
For borrowers, recharacterization can open the door to defenses under applicable usury laws and potentially alter the amount owed.
For MCA providers, the consequences can be substantial. A transaction characterized as a loan rather than a purchase may result in an unsecured claim rather than ownership of purchased receivables. Depending on applicable state law and the transaction’s effective interest rate, additional penalties may also come into play.
In re Denali Construction
A recent Texas bankruptcy decision, In re Denali Construction, illustrates the stakes.
The court examined the substance of an MCA transaction, including its reconciliation provisions and whether the provider actually assumed meaningful risk that the purchased receivables would not materialize. The court ultimately treated the transaction as a loan and declined to enforce the contractual choice-of-law provision.
The consequences were significant: the court voided liens, relieved guarantors of liability, and awarded the borrowers treble damages on two judgments exceeding $2.6 million each, along with approximately $108,000 in attorneys’ fees.
What Should MCA Providers and Borrowers Know?
For MCA providers, the takeaway is that genuine risk-sharing matters. Reconciliation provisions should function as real mechanisms for adjusting payments based on actual receivables—not simply appear in the agreement.
For borrowers, the takeaway is equally important: the contract’s label does not necessarily determine its legal treatment. An agreement described as a purchase may still be scrutinized as a financing transaction if its practical operation resembles a loan.
As courts continue examining MCA agreements through a substance-over-form lens, both providers and businesses should pay close attention to the economics and mechanics of the transaction—not just the words on the page.
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The foregoing content is for informational purposes only and should not be relied upon as legal advice. Federal, state, and local laws can change rapidly and, therefore, this content may become obsolete or outdated. Please consult with an attorney of your choice to ensure you obtain the most current and accurate counsel about your particular situation.
