Merchant cash advances do not fall under the category of traditional business loans. This is mainly because MCAs involve a different borrowing method and repayment structure. In a merchant cash advance, a business sells a portion of its future card sales in exchange for an advance amount. Unlike loans, monthly repayments are not fixed, and no interest is charged. Instead, a fixed percentage of sales gets automatically deducted on a daily, weekly or monthly basis.
Since a merchant cash advance differs from business loans in multiple ways, it also presents a separate set of legal challenges. Their regulations, compliance standards, consumer protection rules, default criteria, and other legal aspects often vary from those of traditional bank loans. In this blog, we will explore the legal challenges related to merchant cash advances in detail, their possible causes, and how you can protect yourself from potential legal risks.
How does a merchant cash advance work?
Now that we’ve discussed how merchant cash advances differ from traditional business loans, let’s break down the MCA process to understand how it actually works:
1. A business applies for MCA funding: The business initiates the process by applying for MCA funding. The provider typically asks for basic business information and card sales history to assess eligibility. Usually, MCA providers do not perform a strict credit check, which is a common practice for bank loans. That is the reason why even businesses with poor credit can also qualify for MCA.
2. Transferring the advance funds: After the eligibility is confirmed, the MCA provider transfers the agreed-upon amount to the business within 24-72 hours. In urgent cases, some providers may offer same-day funding.
3. Repayment process: Repayment begins as early as the next business day. A fixed percentage is automatically deducted from the business’s daily, weekly, or monthly card sales. For example, if an MCA agreement requires a 12% repayment rate, then £1,000 in card sales means £120 will go towards repaying the advance.
4. Completing the agreement: The MCA agreement comes to an end once the advance amount plus the fee is fully repaid. Since the repayments are based on a fixed percentage of the sales volume, most agreements last between 6 and 12 months.
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Key legal issues in merchant cash advance
Merchant cash advances are legal in the UK. However, there are differences as to how a merchant cash advance contract is governed by credit laws versus traditional business law. An MCA involves the purchase of a business’s future receivables, and it falls into a separate legal category rather than being treated as a business loan.
Merchant cash advances vs. traditional loans
The process of an MCA does not follow the typical loan model, which is why the regulatory standards around them are limited. They also don’t come with a defined interest rate or fixed repayment terms. This unique classification provides the basis for most of the legal challenges to arise. For example, MCA providers are not legally required to show an APR in their contracts. For experienced business owners, calculating the APR on their own might not be a problem. But for new users, it can be difficult to understand how the total cost of an MCA compares to other options without knowing the APR.
Limited regulatory protections
One of the biggest disadvantages of MCA is that it is not protected by the Financial Conduct Authority (FCA). That is because MCAs are not loans, so they do not fall under the FCA’s consumer credit regulations.
Factor rate and APR misunderstandings
The main cost of an MCA is calculated from a factor rate, which is set at a percentage of the total borrowed amount or fixed pennies per pound. This can make it feel easier for businesses to manage daily, weekly or monthly payments because they just see a set amount coming out of sales. The problem is that when the businesses don’t get a clear yearly cost like APR, it gets hard to tell how expensive the MCA really is compared to a normal loan.
Potential for predatory terms
MCA contracts may include clauses in the fine print that are unfavourable for businesses. If a business does not read the agreement carefully, it might get locked into a long-term commitment with unknown risks. Two of the major examples of such clauses are the confession of judgment and the automatic renewal clause.
A confession of judgment clause means that in a case of MCA default, the lender is automatically set to win the court judgment without any due process. With this clause, a business basically gives up the right to defend itself legally. It puts assets in danger because the provider does not even need to prove in court that the business defaulted.
An automatic renewal clause says that when an MCA agreement ends, it can automatically restart without the business’s permission. This means the business is now paying new fees and starts the repayment process all over again.
Regulations for MCAs in the UK
The legal position of the MCAs allows businesses to get cash support in as fast as 24 hours without any strict credit checks or spending restrictions. But this flexibility also comes with protection and ethical concerns for the consumers. Here is what you should know about the current MCA regulations to deal with merchant cash advance lenders.
Current UK legal framework
The MCAs don’t fall under the protection of FCA, which is why they lack protection standards set up for consumer credit safety. These rules include a maximum limit on interest rates, restrictions on automatic contract renewal, the right to legally defend, showing APR in contracts, and a transparent disclosure of fees. Because merchant cash advances are not bound by these regulations, the contracts may include high fees, automatic renewal clauses and aggressive repayment terms.
The FCA’s position on merchant cash advance
The Financial Conduct Authority doesn’t directly regulate MCAs, but it encourages lenders to provide transparent fee breakdowns and uphold professional and fair standards in their practice. Reputable merchant cash advance lenders follow these standards and provide detailed fee disclosure, clear contract terms, and flexible repayment rules to maintain a credit standard for their customers.
Customer data protection
MCA providers still need to comply with the General Data Protection Regulation (GDPR) to responsibly handle sensitive customer information and financial insights. This means that any personal or business data collected during the application process must only be accessible by the relevant authorities.
Red flags and risk mitigation in merchant cash advance
Knowing the red flags to watch for and how to mitigate potential pitfalls is crucial.
1. Identifying high-risk MCA providers
Not all MCA lenders play by the same rules. Some may take advantage of the lack of strict regulations. Are you dealing with a lender who’s reluctant to discuss terms in detail? Or maybe they’re avoiding questions about additional fees or penalties? Trust your instincts; if something feels off, it probably is.
Another red flag is the promise of “guaranteed approval.” MCAs should still involve an assessment of your sales history and business stability.
2. Questions to ask MCA providers
Mitigating risks often comes down to asking the right questions. Ask potential MCA providers for a full breakdown of fees, factor rates and repayment terms. Ask questions like:
- What are the total costs if sales dip unexpectedly?
- Are there penalties if I repay early?
3. Consulting legal and financial experts
When to consider a legal action in a merchant cash advance agreement? Well, if your MCA provider is enforcing aggressive repayment terms, automatic debits, or initiating a confession of judgment, it may be time to seek legal help.
Get help from a financial expert as well. He/she can help you dissect contract language, spot potential red flags and assess whether the agreement fits your business’s financial goals.
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FAQs
Defaulting on an MCA can result in serious consequences, including the seizure of business and personal assets if a personal guarantee was signed. MCA providers may also enforce a confession of judgment clause, leading to immediate legal action without court proceedings.
MCAs are generally suited to businesses with strong, steady sales and clear revenue projections. Seasonal businesses or those with inconsistent cash flow may find the repayment structure difficult to manage, making MCAs a potentially risky choice.
Business loans, credit lines, and invoice factoring can provide cash flow without the legal risks associated with MCAs. These options usually have more predictable terms and may offer lower interest rates, reducing the financial burden.
To exit a merchant cash advance, first review your contract for early repayment terms or penalties. You may negotiate with the provider for a reduced repayment rate or settlement. Alternatively, consider refinancing through a line of credit, which may offer lower fees and a more manageable repayment schedule. Consulting a financial expert can also help assess options.
