Available at SSRN: https://ssrn.com/abstract=6192358

Abstract
Over the last several years, Merchant Cash Advances (MCAs) have risen in prominence as a form of short-term financing for distressed small businesses. MCA transactions are distinct from most small-business lending because they are not structured as loans at all. Rather, in exchange for a lump sum of cash, the merchant purports to sell to the funder an unidentified percentage of its future receipts or receivables. This structure allows funders to sidestep the application of lending regulations and usury protections, but it strains the foundations of commercial law and generates a host of interpretive challenges. Bankruptcy, district, and circuit courts across the nation are grappling with the true nature of MCA transactions to determine what rights in the underlying receivables are transferred and when that transfer occurs. These issues rise in prominence if a merchant seeks bankruptcy protection, as the extent of the estate’s interest in property—and by extension the application of any number of bankruptcy provisions—hangs in the balance. This essay provides a comprehensive analysis of MCA agreements and other forms of revenue-based financing. Drawing from a robust literature involving recharacterization of financial transactions, this essay advances an analytical framework for evaluating the nature of MCA transactions and explores how recharacterization affects both bankruptcy and non-bankruptcy entitlements.

Desperation Finance: Merchant Cash Advances and the Bankruptcy System

Bankruptcy judges sometimes see financial products that look less like lending and more like a distress flare.

Professor Kara Bruce’s forthcoming article, Desperation Finance: Merchant Cash Advances in Bankruptcy and Beyond, provides a thorough and deeply useful examination of one of the most troubling recent examples: Merchant Cash Advances (MCAs)—a form of financing marketed to struggling small businesses but frequently carrying effective interest rates well above 100% and sometimes far higher.

MCAs are intentionally structured not as loans but as “sales” of a percentage of future receivables. That formal structure allows funders to argue that usury laws do not apply, even though the economic reality often resembles extremely high-interest lending.

When bankruptcy inevitably follows—as it often does—the legal system must answer a deceptively simple question:

Is an MCA really a sale of receivables, or is it a disguised loan?

The answer determines everything from property of the estate, to preference liability, to fraudulent transfer analysis, and even Subchapter V eligibility.

Bruce’s article provides a roadmap through that thicket.

How Merchant Cash Advances Work

The typical MCA transaction looks like this:

1. A distressed business receives an immediate cash advance.

2. In exchange, it “sells” a portion of future receivables.

3. The funder collects repayment through daily ACH withdrawals from the merchant’s bank account.

The arrangement is marketed as flexible—payments supposedly fluctuate with revenue. But courts increasingly find that the supposed flexibility is illusory, buried beneath reconciliation provisions that are difficult or impossible to invoke.

More troubling are the economics.

One example cited in the article involved:

• $75,000 advanced

• $111,750 required repayment

• daily withdrawals of $1,117

That translates into an effective interest rate of about 115% per year—before fees.

And many MCA borrowers do not stop at one advance. Businesses often stack multiple MCAs, sometimes pledging more than 100% of their anticipated revenue.

That spiral usually ends in litigation or bankruptcy.

 

Bankruptcy Complications

Once the debtor files bankruptcy, MCA agreements create several recurring legal disputes.

1. Property of the Estate

MCA funders often argue that the receivables were already sold prepetition, so the revenue belongs to them—not the bankruptcy estate.

But that argument runs headlong into a basic property principle:

You cannot sell property that does not yet exist.

Future receivables cannot be transferred until they are generated. As a result, courts increasingly hold that post-petition receivables remain property of the estate, regardless of MCA language.

2. Avoidance Litigation

MCA payments frequently become the target of preference or fraudulent transfer actions.

Funders argue that daily withdrawals are merely collecting their own property. Trustees respond that the withdrawals are payments on an antecedent debt.

Courts increasingly accept the latter view.

In other words, those daily ACH sweeps may be avoidable transfers.

3. Fraudulent Transfer Issues

The question often becomes whether the debtor received reasonably equivalent value.

Some courts say yes—because the MCA provided a “lifeline” when no other lender would.

Others are more skeptical, especially where the transaction simply refinanced earlier MCAs at astronomical cost.

Why Courts Are Increasingly Recharacterizing MCAs

Bruce argues that the key legal battle is recharacterization—whether the transaction is really a loan.

Several features push courts in that direction:

• Fixed repayment obligations

• Personal guaranties

• acceleration clauses

• aggressive collection remedies

• daily withdrawals regardless of revenue

These features look far more like secured lending than a sale of receivables.

And once recharacterized as loans, MCAs can trigger:

• usury defenses

• preference liability

• fraudulent transfer claims

• regulatory enforcement

Desperation Finance Is Not Limited to Small Businesses

While MCAs affect businesses, the same economic pattern appears throughout consumer bankruptcy practice.

The common thread is simple:

Borrowers with no access to conventional credit turn to lenders willing to exploit that desperation.

Three examples stand out.

Consumer Desperation Finance

Payday Loans

Payday lending has long been the consumer analogue to MCAs.

Typical features include:

• extremely short repayment terms

• triple-digit APRs

• automatic bank withdrawals

The structure frequently leads borrowers to roll over loans repeatedly, creating a cycle nearly identical to MCA stacking.

Many Chapter 7 debtors arrive with multiple payday loans outstanding, often consuming a large portion of monthly income.

Title Loans

Vehicle title loans may be even more destructive.

These loans:

• are secured by the borrower’s vehicle

• carry extremely high interest rates

• permit quick repossession upon default

For many debtors, losing the car means losing the ability to work, which accelerates the downward spiral into bankruptcy.

Check-Cashing Loans

“Check loans” and other storefront finance products operate similarly:

• high fees disguised as service charges

• repayment structures designed to force refinancing

• minimal underwriting

All are variations on the same theme: credit extended not because repayment is likely, but because collateral or fees guarantee profit.

Desperation Finance in the Legal Profession

Perhaps the most uncomfortable example of desperation finance appears not in consumer lending—but in the financing of bankruptcy attorney fees themselves.

Kallen v. U.S. Trustee

A recent decision from the District of Arizona illustrates the risks of third-party fee financing in consumer bankruptcy cases.

In Kallen v. U.S. Trustee, a Chapter 7 firm entered into a financing arrangement with EZLegal, a company that advanced funds to the firm for debtor legal fees. Under the initial structure, EZLegal advanced 75% of the $3,000 flat attorney fee to the firm and in return obtained the right to collect and retain the entire $3,000 fee from the debtor.

Later versions of the arrangement shifted to a 62% / 38% split, with EZLegal retaining roughly $1,149 of the $3,000 fee while the firm accepted $1,860 as payment for its services.

Debtors were required to sign “Promises to Pay” making them directly obligated to EZLegal, including default interest rates of up to 300% annually—terms that were not disclosed in the attorney compensation disclosures filed with the bankruptcy court.

After extensive proceedings, the bankruptcy court found a years-long pattern of disclosure violations, conflicts of interest, and misleading statements. The court voided all retention agreements in the financed cases and imposed sweeping sanctions.

Among other remedies, the court ordered:

• Full disgorgement of fees totaling $1,644,566,

• removal of negative credit reporting tied to the agreements, and

• a two-year ban on filing bankruptcy cases in the District of Arizona.

The district court affirmed.

The Lesson

The facts of Kallen show how easily the economics of desperation finance can creep into bankruptcy practice itself.

When third-party lenders step between a debtor and counsel—especially without full disclosure—the risks multiply:

• undisclosed fee-sharing,

• conflicts of interest,

• misleading compensation disclosures, and

• fee structures that resemble consumer credit products more than legal representation.

Courts have traditionally given bankruptcy attorneys significant flexibility in structuring payment arrangements. But Kallen demonstrates that when those arrangements drift too far toward high-cost consumer lending, the consequences can be severe.

A Structural Problem

What links MCAs, payday loans, title loans, and some bankruptcy-fee financing arrangements is not simply high cost.

It is structural vulnerability.

The borrowers involved share several characteristics:

• lack of access to traditional credit

• urgent need for liquidity

• weak bargaining power

• limited regulatory protection

These conditions allow financial products to flourish that would never survive in ordinary credit markets.

Bankruptcy as the End of the Line

In many cases, bankruptcy is the only mechanism capable of stopping the cycle.

But even there, the legal system must untangle complex questions about:

• property rights

• transaction characterization

• avoidance powers

Bruce’s article shows that courts are gradually developing a coherent framework.

But the broader lesson is simpler.

When credit markets produce products with triple-digit effective interest rates, the problem is rarely innovation.

It is desperation.  And desperation finance almost always ends in bankruptcy,  whether for the small business owner with MCAs, consumers with payday loans  or consumer debtors attorney with bifucated factoring finance. 

To read a copy of the transcript, please see: