Wayward Merchants
April 19, 2018
Wayward merchants and outright criminals are continuing to bilk the alternative small-business funding industry out of cash at a dizzying pace. In fact, an estimated 23 percent of the problematic clients that funders reported to an industry database in 2017 appeared to have committed fraud, up from approximately 17 percent in the previous year. That’s according to Scott Williams, managing member of Florida-based Financial Advantage Group LLC, who along with Cody Burgess founded the DataMerch database in 2015. Some 11,000 small businesses now appear in the database because they’ve allegedly failed to honor their commitments to funders, Williams says.
Whether fraudulent or not, defaults remain plentiful enough to keep attorneys busy in funders’ legal departments and at outside law firms funders hire. “I do a lot of collections work on behalf of my cash-advance clients, sending out letters to try to get people to pay,” says Paul Rianda, a California-based attorney. When letters and phone calls don’t succeed, it’s time to file a lawsuit, he says.
Lawsuits become necessary more often than not by the time a funder hires an outside attorney, according to Jamie Polon, a partner at the Great Neck, N.Y.- based law firm of Mavrides Moyal Packman Sadkin LLP and manager of its Creditors’ Rights Group. “Typically, my clients have tried everything to resolve the situation amicably before coming to me,” he observes.
That pursuit of debtors isn’t getting any easier. These days, it’s not just the debtor and the debtor’s attorney that funders and their attorneys must confront. Collections have become more difficult with the recent rise of so-called debt settlement companies that promise to help merchants avoid satisfying their obligations in full, notes Katherine Fisher, who’s a partner in the Maryland office of the law firm of Hudson Cook LLP.
Meanwhile, a consensus among attorneys, consultants and the funders themselves holds that the nature of the fraudulent attacks is changing. On one side of the equation, crooks are hatching increasingly sophisticated schemes to defraud funders, notes Catherine Brennan, who’s also a partner in the Maryland office of Hudson Cook LLP. On the other side, underwriters and software developers are becoming more skilled at detecting and thwarting fraud, she maintains.
Digitalization is fueling those changes, says Jeremy Brown, chairman of Bethesda, Md.-based RapidAdvance. “As the business overall becomes more and more automated and moves more online – with less personal contact with merchants – you have to develop different tools to deal with fraud,” he says.
A few years ago, the industry was buzzing about fake bank statements available on craigslist, Brown recalls. Criminals who didn’t even own businesses used the phony statements to borrow against nonexistent bank accounts, and merchants used the fake documents to inflate their numbers.
Altered or invented bank statements remain one of the industry’s biggest challenges, but now they’ve gone digital. About 85 percent of the cases of fraud submitted to the DataMerch database involve falsified bank documents, nearly all of them manipulated digitally, Williams notes.
Merchants alter their statements to overstate their balances, increase the amount of their monthly deposits, erase overdrafts, or hide automatic payments they’re already making on loans or advances, Williams says. Most use software that helps them reformat and tamper with PDF files that begin as legitimate bank statements, he observes.
To combat false statements, alt funders are demanding online access to applicants’ actual bank accounts. Some funders ask for prospective clients’ usernames and passwords to examine bank records, but applicants often consider such requests an invasion of their privacy, sources agree.
That’s why RapidAdvance has joined the ranks of companies that use electronic tools like DecisionLogic, GIACT or Yodlee to verify a bank balance or the owner of the account and perform test ACH transfers – all without needing to persuade anyone to surrender personally identifiable information, Brown says.
Other third-party systems can use an IP address to view the computing device and computer network that a prospective customer is using to apply for credit, Brown says. RapidAdvance has received applications that those tools have traced to known criminal networks. The systems even know when crooks are masking the identity of the networks they’re using to attempt fraud, he observes.
RapidAdvance has also developed its own software to head off fraud. One program developed in-house cross references every customer who’s contacted the company, even those who haven’t taken out a loan or merchant cash advance. “People who want to defraud you will come back with a different business name on the same bank account,” Brown says. “It’s a quick way to see if this is somebody we don’t want to do business with.”
Sometimes businesses use differing federal tax ID numbers to pull off a hoax, according to Williams at DataMerch. That’s why his company’s database lists all of the ID numbers for a business.
All of those electronic safeguards have come into play only recently, Brown maintains. “We didn’t think about any of this five years ago – certainly not 10 years ago,” he says. In those days, funders were satisfied with just an application and a copy of a driver’s license, he remembers.
Since then, some sage advice has been proven true. When RapidAdvance was founded in 2005, the company had a mentor with experience at Capital One, Brown says. One piece of wisdom the company guru imparted was this: “Watch out when the criminals figure out your business model.” That’s when an industry becomes a target of organized fraud.
As that prediction of fraud has become reality, it hasn’t necessarily gotten any easier to pinpoint the percentage of deals proposed with bad intent. That’s because underwriters and electronic aids prevent most fraudulent potential deals from coming to fruition, Brown notes. The company looks at the loss rates for the deals that it funds, not the deals it turns down.
Brown guesses that as many as 10 percent of applications are tainted by fraudulent intention. “It’s meaningful enough that if you miss a couple of accounts with significant dollar amounts,” he says, “then it can have a pretty negative impact on your bottom line.”
Some perpetrators of fraud merely pretend to operate a small business, and funders can discover their scams if there’s time to make site visits, Rianda notes. Other clients begin as genuine entrepreneurs who then run into hard times and want to keep their doors open at all costs, sources agree.
Applicants sometimes provide false landlord information, something that RapidAdvance checks out on larger loans, Brown notes. Underwriters who call to verify the tenant-landlord relationship have to rely upon common sense to ferret out anything “fishy,” he advises.
Underwriters should ask enough questions in those phone calls to determine whether the supposed landlord really knows the property and the tenant, which could include queries concerning rent per square foot, length of time in business and when the lease terminates, Brown suggests. All of that should match what the applicant has indicated previously.
Lack of a telephone landline may or may not provide a clue that an imposter is posing as a landlord, Brown continues. Be aware of a supposed landlord’s verbal stumbles, realize something’s possibly amiss if a dubious landlord lacks of an online presence, note whether too many calls to the alleged landlord go into voicemail and be suspicious if a phone exchange with a purported landlord simply “feels” residential instead of commercial, he cautions.
Reasonable explanations could exist for any of those concerns, but when in doubt about the validity of a tenant-landlord relationship it pays to request a copy of the lease or other type of verifications, according to Brown. Then there are the cases when the underwriter is talking to the actual landlord, but the applicant has convinced the landlord to lie. It could happen because the landlord might hope to recoup some back rent from a merchant who’s obviously on the verge of closing up shop.
Occasionally, formerly legitimate merchants turn rogue. They take out a loan, immediately withdraw the funds from the bank, stop repaying the loan, close the business and then walk or run away, notes Williams. “We view that as a fraudulent merchant because their mindset all along was qualifying for this loan and not paying it back,” he says.
Collecting on a delinquent account becomes problematic once a business closes its doors, Rianda notes. As long as the merchant remains in business, funders can still hope to collect reduced payments and thus eventually get back most or all of what’s owed, he maintains.
In another scam sometimes merchants whose bank accounts are set up to make automatic transfers to creditors simply change banks to halt the payments, Brown says. That move could either signal desperation or indicate the intent to defraud was there from the start, he says.
Merchants with cash advances that split card revenue could change transaction processors, install an additional card terminal that’s not programmed for the split or offer discounts for paying with cash, but those scams are becoming less prevalent as the industry shifts to ACH, Brown says. Industrywide, only 5 percent to 10 percent of payments are collected through card splits these days, but about 20 percent of RapidAdvance’s payments are made that way.
Merchants occasionally blame their refusal to pay on partners who have absconded with the funds or on spouses who weren’t authorized to apply for a loan or advance, Brown reports. Although that claim might be bogus, such cases do occur, notes Williams of DataMerch. People who own a minority share of a business sometimes manipulate K-1 records to present themselves as majority owners who are empowered to take out a loan, Williams says.
In a phenomenon called “stacking,” merchants take out multiple loans or advances and thus burden themselves with more obligations than they can meet. Whether or not that constitutes fraud remains debatable, Rianda observes. Stacking has increased with greater availability of capital and because some funders purposely pursue such deals, he contends.
Some contracts now contain covenants that bar stacking, notes Brennan of Hudson Cook. As companies come of age in the alt-funding business, they are beginning to employ staff members to detect and guard against practices like stacking, she says.
Moreover, underwriting is improving in general, according to Polon “The vetting is getting better because the industry is getting more mature,” he says. “The underwriting teams have gotten very good at looking at certain data points to see something is wrong with the application – they know when something doesn’t smell right.” They’re better at checking with references, investigating landlords, examining financials and requesting backup documentation, he contends.
Despite more-systematic approaches to foiling the criminal element and protecting against misfortunate merchants, one-of-a-kind attempts at fraud also still drive funders crazy, Brown says. His company found that a merchant once conspired with the broker who brought RapidAdvance the deal. The merchant and the broker set up a dummy business, transferred the funds to it and then withdrew the cash. “The guy came back to us and said, ‘I lost all the money because the broker took it,’” he recounts. “Why is that our problem?” was the RapidAdvance response.
Although such schemes appear rare, some funders are developing methods of auditing their ISOs to prevent problems, notes Brennan. They can search for patterns of irregularities as an early-warning system, she says. It’s also important to terminate relationships with errant brokers and share information about them, she advises, adding that competition has sometimes made funders reluctant to sever ties with brokers.
Although fraud’s clearly a crime, the police rarely choose to involve themselves with it, Brown says. His company has had cases where it lost what it considered large dollar amounts – say $50,000 – and had evidence he felt clearly indicated fraud but the company couldn’t attract the attention of law enforcement, he notes.
Rianda finds working with law enforcement “hit or miss,” whether it’s a matter of defaulting on loans or committing other crimes. In one of his cases an employee forged invoices to steal $100,000 and the police didn’t care. In another, someone collected $3,000 in credit card refunds and went to jail. If the authorities do intervene, they may seek jail time and sometimes compel crooks to make restitution, he notes.
“Engaging law enforcement is generally not appropriate for collections,” according to Fisher from Hudson Cook. However, notifying police agencies of fraud that occurs at the inception of a deal can sometimes be appropriate, says Fisher’s colleague Brennan, particularly when organized gangs of fraudsters are at work.
At the same time, sheriffs and marshals can help collect judgments, Polon says. He works with attorneys, sheriffs and marshals all over the country to enforce judgments he has obtained in New York State, he says. That can include garnishing wages, levying a bank account or clearing a lien before a debtor can sell or refinance property, he notes.
When Rianda files a lawsuit against an individual or company in default, the defendant fails to appear in court about 90 percent of the time, he says. A court judgment against a delinquent debtor serves as a more effective tool for collections than does a letter an attorney sends before litigation begins, Rianda notes.
But even with a judgment in hand, attorneys and their clients have to pursue the debtor, often in another state and sometimes over a long period of time, Rianda continues. “The good news is that in California a judgment is good for 10 years and renewable for 10,” he adds.
So guarding against fraud comes down to matching wits with criminals across the country and around the world. “It makes it hard to do business, but that’s the reality,” Brown concludes. Still, there’s always hope. To combat fraud, funders should work together, Brennan advises. “It’s an industrywide problem … so the industry as a whole has a collective interest in rooting out fraud.”
Law Firm Sued for Tortious Interference With Loans and MCAs
January 31, 2018Rhode Island Superior Court has a tortious interference case on its hands. Small Business Term Loans, Inc., and BFS West, Inc. v Christopher M. Mulhearn, and Law Office of Christopher M. Mulhearn, Inc. is yet another front in the debt settlement war enveloping the alternative finance industry.
Here, the plaintiffs (known to many as BFS Capital), allege that Mulhearn and his law office attempt to persuade BFS Capital’s customers to breach their obligations to BFS Capital while routinely making misleading representations to their customers, including by promising to save them money by settling their obligations to BFS Capital for a discounted amount when they have no legitimate basis for being able to make such promises.
At least seven customers are alleged to have breached their agreements as a result of the defendants’ actions.
The defendants have not yet responded to the complaint. The suit is registered in Providence/Bristol County Superior Court of Rhode Island under case # PC-2018-0094.
Other such companies that have found themselves on the receiving end of a tortious interference lawsuit include MCA Helpline, Protection Legal Group, and Creditors Relief.
Are Lawsuits the New UCCs?
December 5, 2017
Back when merchant cash advance funders first began to file UCCs, competitors immediately began to look them up and turn them into leads. The practice became so widespread that MCA funders began filing under pseudonyms to throw people off the scent. But soon, competitors began to figure out who the pseudonyms belonged to and the game continued. Funders tried other methods like having the UCC service providers themselves be named as the secured parties. Eventually, competitors realized that although they couldn’t figure out who the true secured party was on these, they could at least reasonably identify the named debtor as having obtained funding. Eventually some funders gave up and stopped filing UCCs altogether.
These days, a new breed of public records detectives are harvesting the NY state court records for lawsuits against merchants in default. Though they don’t always wait until a merchant has already been sued, the public dockets make it easy for them to obtain all the details they need to pitch services such as debt settlement and legal aid.
An unfortunate consequence of that is that these so called advocates may not have the merchants’ interests at heart and they can greatly complicate communication between the parties.
See previous coverage:
- 4th Alleged Co-conspirator in Fake Debt Settlement Company Arrested
- ISOs Alleged to Be Partners in Debt Settlement “Scam” in Explosive Lawsuit
- Is The End Near For This Debt Settlement Firm?
- A Tale of “Debt Restructuring”?
The practice of trolling the dockets is becoming so popular that a similar trend may be cropping up, funders filing lawsuits under obscure entity names. While it’s too early to tell if debt settlement lead hunters could get so aggressive as to actually make it untenable to file a lawsuit or a confession of judgment, it is something to keep an eye on. Unlike a UCC, which may only reveal a description of the secured interest and the merchant’s name, the dockets may reveal the actual contract itself, all of the terms, what platform it was funded on, how much remains outstanding, etc. There’s vastly more than could ever be gleaned from a UCC. The downside, of course, is that it suggests a merchant breached a contract and may not be an ideal candidate for additional funding. But to a debt settlement firm (unsavory or not), that might just be the prospect they’re looking for.
Are lawsuits the new UCCs? Time will tell.
ISO Alleged to Have Forged a Confession of Judgment
November 6, 2017
Underwriters, keep your eyes on the notary stamps.
A lawsuit filed in the New York Supreme Court last week by a merchant cash advance company against an ISO and several co-defendants, alleges that an ISO was partially responsible for damages when a merchant defaulted.
And they make a compelling argument. In this case where a Confession of Judgment (COJ) was required to approve the deal, the merchant, who defaulted within 30 days of being funded, claims to have never signed one, despite the ISO having delivered a signed one to the funder.
Well then who signed it?
Upon inspection, the notary stamp on the COJ belonged to a notary in Nassau County, NY, where the contract logically would’ve been notarized. But the merchant is based in Florida and claims to have been in Florida at the time the COJ was allegedly signed.
So who would’ve been in Nassau County that day?
According to the funder, it was the ISO, since the ISO is based on Long Island and the ISO is the one that delivered the signed COJ to them.
These are just the allegations at this point, of course, since the defendants have not even yet had a chance to respond.
The complaint, however, adds another twist, that after the ISO got the deal funded, they then referred it to a debt settlement company, who assisted the merchant in defaulting.
As you might imagine, the debt settlement company is a named co-defendant.
The case is filed under Index Number: 656692/2017 in the New York Supreme Court. You can view the entire complaint here.
What Shakeout? Breakout Capital Secures $25 Million Credit Facility
February 8, 2017
Put a tally up on the board for small business lenders in 2017. McClean, VA-based Breakout Capital, which just announced a move into a larger office last week, has also secured a $25 million credit facility with Drift Capital Partners. Drift is an alternative asset management company.
Breakout is young by today’s industry standards, founded only two years ago by former investment banker Carl Fairbank, who is the company’s CEO. And don’t count them out just because they’re not in New York or San Francisco. Washington DC’s Virginia suburbs have become somewhat of a hotspot for fintech lenders. OnDeck, Fundation, StreetShares and QuarterSpot all have offices there, Fairbank points out. “And Capital One is right up the street,” he adds while explaining that the community has a strong talent pool that is familiar with creative lending. Breakout has already grown to about 20 employees and they’re still growing, he says.
Fairbank considers Breakout to be a more upmarket lender, whose repertoire includes serving the near-prime, mid-prime customer. CAN Capital and Dealstruck had focused on this area and both companies stopped funding new business in 2016. As I point this out, I ask if that suggests that segment is perhaps too difficult to make work.
“Candidly, that’s the part of the market that I feel the best about,” he says matter of factly. The company tries to product-fit deals based on the borrower, and will even make monthly-payment based loans. “I think the subprime side with the stacking and the debt settlement companies is a very very difficult place to play right now,” he says, adding that they have worked with subprime borrowers using their original bridge program but that they’ve kind of pulled back from doing those. As with all programs regardless, their goal is to graduate merchants into better or less costly products later on. We have helped merchants move on to get SBA loans, he maintains.
That all sounds very hands on, and part of it is, Fairbank confirms while asserting that technology does indeed do a lot of the legwork. “There’s absolutely a human element to underwriting these deals,” he says. He also agrees with much of what RapidAdvance chairman Jeremy Brown wrote in a AltFinanceDaily op-ed titled, The New Normal. Both Breakout and RapidAdvance refer to themselves as technology-enabled lenders, an acknowledgement that tech is a component of the company, not the entire company itself.
“I think we will see the beginning of the demise of fully automated, no manual touch funding,” Brown wrote in his article.
Brown also predicted that the legal system will ultimately impose order on some industry practices like stacking or that a state like New York could take a public policy interest in products he believes have legal flaws. As he was writing that, Governor Cuomo’s office published a budget proposal that redefined what it means to make a loan in the state. And it leaves much to be desired, some sources contend. Two attorneys at Hudson Cook, LLP, for example, published an analysis that demonstrates how its wording is ambiguous and far-reaching.
“What they really need to do is take the time to think through the implications and basically do a full study of the market to ensure that what they’re pushing forward is going to have the desired consequences,” Breakout’s Fairbank offers on the matter.
This doesn’t mean he’s anti-regulation. The company already holds itself to high standards and customer suitability and is a founding member of the Coalition for Responsible Business Finance.
“I personally do believe that there’s bad forms of lending or cash advances in the market and I’m sure that’s what Cuomo thinks as well but at the same time, it’s getting pushed very quickly and they really really ought to step back and do the research to understand the broader implications and to understand what exactly they’re trying to accomplish,” he maintains.
His pragmatism extends to the OCC’s proposed limited fintech charter, which he finds intriguing, assuming it gets buttoned up. “I believe it’s a concept worth pursuing,” he says, explaining that regulators will need to get comfortable with unsecured lending.
In the meantime, he’s optimistic about Breakout’s prospects. “In a time when institutional appetite for alternative finance companies has dried up, we believe our ability to raise a credit facility in this market speaks volumes about what we have already accomplished, our position as a leading player in the space, and our prospects for strong, but measured, growth,” Fairbank is quoted as saying in a company announcement. The company was also invited and joined the Task Force for the PLUM Initiative, a collaboration between the U.S. Small Business Administration (SBA) and the Milken Institute to more effectively provide capital to minority-owned businesses throughout the United States. The Task Force consists of a very select group of industry leaders, who are in positions to improve access to capital in underserved markets, according to the announcement.
While other companies are making adjustments or in his opinion, continuing to make questionable underwriting decisions, Fairbank thinks his formula for success works. “I think that we do look at deals differently than most folks because I intentionally built the core of my underwriting team with folks who are not from this space so they take a more traditional approach and mix it with some of the greatest aspects of alternative finance.”
RCG Advances Permanently Banned From MCA Business by FTC
June 6, 2022
It’s déjà vu. Five months after the FTC successfully banned someone from engaging in the MCA business, the agency has secured a similar outcome from additional defendants. This time it’s RCG Advances and its operator that are banned, according to the final settlement announced by the parties. In addition, RCG is required to make an upfront payment of $1.5M to the FTC and refund $1.2M to its previous customers that it had allegedly deceived.
The penalty may appear rather small in the big picture, but it is possibly as strong an outcome as the FTC could’ve hoped to obtain given the odd circumstances that befell the case. For example, the FTC filed its suit against RCG in June 2020 under Section 13(b) of the FTC Act, one of the most common tools in its legal arsenal. Less than a year later, the Supreme Court of the United States ruled that despite long-standing precedent, 13(b) did not give the FTC legal authority to obtain monetary relief, which from the FTC’s point of view, defeated the entire purpose of bringing such claims. In light of the ruling, the FTC was forced to change its strategy in the RCG case. In May 2021, the FTC asked the Court if it could amend its lawsuit to state that what the defendants had actually done all along was violate the Gramm-Leach-Bliley Act. It was perhaps a more difficult path forward.
By January, the first settlement was announced. This RCG settlement now follows that. One defendant in the case has not settled and the proceedings are still ongoing.
Lender Ranking Website Accused By FTC Of Misleading Rankings
February 6, 2020LendEDU, a Hoboken-based company that lists and ranks loan providers, came under fire this week after the FTC filed a complaint detailing how LendEDU charged businesses for higher positions in its rankings of lenders and promoted fake testimonials. Providing ratings for student loan refinancing, personal loans, and mortgage lenders, it is the first of these loan types that is in the spotlight.
While LendEDU initially denied that it received any compensation for its lists, saying, “ratings are comparatively objective and not influenced by compensation in anyway” and that “research, news, ratings, and assessments are scrutinized using strict editorial integrity,” this assertion was disproved by the FTC’s investigation.
Emails were discovered which featured CEO Nathaniel Matherson and Vice President of Products Alexander Coleman discussing with a business the pricing per click to hold the #1 spot on the best student loan refinancing company list, as well as what sort of traffic could be expected at this ranking. Accompanying this was a contract between LendEDU and a student loan refinancing company, revealing that in return for compensation the company would drop “[n]o lower than position three” in the rankings. It was also found that if businesses who were already in the rankings refused to pay for the clicks they received, they would drop down in the list.
The testimonials that featured prominently on LendEDU’s homepage, which noted alleged consumers’ names, colleges, and years of graduation, were found to be wholly false, with the people portrayed in them being nonexistent.
And the reviews of LendEDU that were found on Trustpilot and subsequently posted to the company’s own website, were also shown to be fake. Of the 126 reviews, 123 were found to be 5-stars; and only 11 were proven to be from customers (this was confirmed as the emails matched those used by customers), the other 115 were deigned to be written by friends, family members, and associates of LendEDU members, as well as by LendEDU employee’s themselves under false names.
All this is coming after LendEDU landed in hot water following a controversy in 2018 that saw Matherson admit to working with others to create a fictitious expert on student loans, named Drew Cloud, who would give interviews and comments to publications, creating a pro-student loan refinancing discourse. According to Matherson, Cloud “was created as a way to connect with our readers (ex. people struggling to repay student debt) and give us the technical ability to post content to the WordPress website.” Cloud was even given a pixelated face and backstory that extended into high school, imbuing him with a passion for journalism even in his teenage years. Neither Matherson’s comments on Cloud nor his fictional biography do anything to explain how or why his creators decided to give him a name that is quite clearly fake.
LendEDU promptly agreed to settle the charges and pay $350,000 while not admitting or denying the allegations. The public has 30 days to comment on the settlement prior to it becoming final.
The FTC Wants To Police Small Business Finance
October 22, 2019
On May 23, the Federal Trade Commission launched an investigation into unfair or deceptive practices in the small business financing industry, including by merchant cash advance providers.
The agency is looking into, among other things, whether both financial technology companies and merchant cash advance firms are making misrepresentations in their marketing and advertising to small businesses, whether they employ brokers and lead-generators who make false and misleading claims, and whether they engage in legal chicanery and misconduct in structuring contracts and debt-servicing.
Evan Zullow, senior attorney at the FTC’s consumer protection division, told AltFinanceDaily that the FTC is, moreover, investigating whether fintechs and MCAs employ “problematic,” “egregious” and “abusive” tactics in collecting debts. He cited such bullying actions as “making false threats of the consequences of not paying a debt,” as well as pressuring debtors with warnings that they could face jail time, that authorities would be notified of their “criminal” behavior, contacting third-parties like employers, colleagues, or family members, and even issuing physical threats.
“Broadly,” Zullow said in a telephone interview, “our work and authority reaches the full life cycle of the financing arrangement.” He added: “We’re looking closely at the conduct (of firms) in this industry and, if there’s unlawful conduct, we’ll take law enforcement action.”
Zullow declined to identify any targets of the FTC inquiry. “I can’t comment on nonpublic investigative work,” he said.
The FTC investigation is one of several regulatory, legislative and law enforcement actions facing the merchant cash advance industry, which was triggered by a Bloomberg exposé last winter alleging sharp practices by some MCA firms.
The Bloomberg series told of high-cost financings, of MCA firms’ draining debtors’ bank accounts, and of controversial collections practices in which debtors signed contracts that included “confessions of judgment.”
The FTC long ago outlawed the use of COJs in consumer loan contracts and several states have banned their use in commercial transactions. In September, Governor Andrew Cuomo signed legislation prohibiting the use of COJs in New York State courts for out-of-state residents. And there is a bipartisan bill pending in the U.S. Senate authored by Florida Republican Marco Rubio and Ohio Democrat Sherrod Brown to outlaw COJs nationwide.
Mark Dabertin, a senior attorney at Pepper Hamilton, described the FTC’s investigation of small business financing as a “significant development.” But he also said that the agency’s “expansive reading of the FTC Act arguably presents the bigger news.” Writing in a legal memorandum to clients, Dabertin added: “It opens the door to introducing federal consumer protection laws into all manner of business-to-business conduct.”
FTC attorney Zullow told AltFinanceDaily, “We don’t think it’s new or that we’re in uncharted waters.”
The FTC inquiry into alternative small business financing is not the only investigation into the MCA industry. Citing unnamed sources, The Washington Post reported in June that the Manhattan district attorney is pursuing a criminal investigation of “a group of cash advance executives” and that the New York State attorney general’s office is conducting a separate civil probe.
The FTC’s investigation follows hard on the heels of a May 8 forum on small business financing. Labeled “Strictly Business,” the proceedings commenced with a brief address by FTC Commissioner Rohit Chopra, who paid homage to the vital role that small business plays in the U.S. economy. “Hard work and the creativity of entrepreneurs and new small businesses helped us grow,” he said.
But he expressed concern that entrepreneurship and small business formation in the U.S. was in decline. According to census data analyzed by the Kaufmann Foundation and the Brookings Institution, the commissioner noted, the number of new companies as a share of U.S. businesses has declined by 44 percent from 1978 to 2012.
“It’s getting harder and harder for entrepreneurs to launch new businesses,” Chopra declared. “Since the 1980s, new business formation began its long steady decline. A decade ago births of new firms started to be eclipsed by deaths of firms.”
Chopra singled out one-sided, unjust contracts as a particularly concerning phenomenon. “One of the most powerful weapons wielded by firms over new businesses is the take-it-or-leave-it contract,” he said, adding: “Contracts are ways that we put promises on paper. When it comes to commerce, arm’s length dealing codified through contracts is a prerequisite for prosperity. “But when a market structure requires small businesses to be dependent on a small set of dominant firms — or firms that don’t engage in scrupulous business practices — these incumbents can impose contract terms that cement dominance, extract rents, and make it harder for new businesses to emerge and thrive.”
As the panel discussions unfolded, representatives of the financial technology industry (Kabbage, Square Capital and the Electronic Transactions Association) as well as executives in the merchant cash advance industry (Kapitus, Everest Business Financing, and United Capital Source) sought to emphasize the beneficial role that alternative commercial financiers were playing in fostering the growth of small businesses by filling a void left by banks.
The fintechs went first. In general, they stressed the speed and convenience of their loans and lines of credit, and the pioneering innovations in technology that allowed them to do deeper dives into companies seeking credit, and to tailor their products to the borrower’s needs. Panelists cited the “SMART Box” devised by Kabbage and OnDeck as examples of transparency. (Accompanying those companies’ loan offers, the SMART Box is modeled on the uniform terms contained in credit card offerings, which are mandated by the Truth in Lending Act. TILA does not pertain to commercial debt transactions.)
Sam Taussig, head of global policy at Kabbage, explained that his company typically provides loans to borrowers with five to seven employees — “truly Main Street American small businesses” — that are seeking out “project-based financing” or “working capital.”
“The average small business according to our research only has about 27 days of cash flow on hand,” Taussig told the fintech panel, FTC moderators and audience members. “So if you as a small business owner need to seize an opportunity to expand your revenue or (have) a one-off event — such as the freezer in your ice cream store breaks — it’s very difficult to access that capital quickly to get back to business or grow your business.”
Taussig contrasted the purpose of a commercial loan with consumer loans taken out to consolidate existing debt or purchase a consumer product that’s “a depreciating asset.” Fintechs, which typically supply lightning-quick loans to entrepreneurs to purchase equipment, meet payrolls, or build inventory, should be judged by a different standard.
A florist needs to purchase roses and carnations for Mother’s Day, an ice-cream store must replenish inventory over the summer, an Irish pub has to stock up on beer and add bartenders at St. Patrick’s Day.
The session was a snapshot of not just the fintech industry but of the state of small business. Lewis Goodwin, the head of banking services at Square Capital, noted that small businesses account for 48% of the U.S. workforce. Yet, he said, Square’s surveys show that 70% of them “are not able to get what they want” when they seek financing.
Square, he said, has made 700,000 loans for $4.5 billion in just the past few years, the platform’s average loan is between $6,000 and $7,000, and it never charges borrowers more than 15% of a business’s daily receipts. The No. 1 alternative for small businesses in need of capital is “friends and family,” Goodwin said, “and that’s a tough bank to go back to.”
Panelist Gwendy Brown, vice-president of research and policy at the Opportunity Fund, a non-profit microfinance organization, provided the fintechs with their most rocky moment when she declared that small businesses turning up at her fund were typically paying an annual percentage rate of 94 percent for fintech loans. And while most small business owners were knowledgeable about their businesses — the florists “know flowers in and out,” for example — they are often bewildered by the “landscape” of financial product offerings.
“Sophistication as a business owner,” Brown said, “does not necessarily equate into sophistication in being able to assess finance options.”
Panelist Claire Kramer Mills, vice-president of the Federal Reserve Bank of New York, reported that the country’s banks have made a dramatic exit from small business lending over the past ten years. A graphic would show that bank loans of more than $1 million have risen dramatically over the past decade but, she said, “When you look at the small loans, they’ve remained relatively flat and are not back to pre-crisis levels.”
Mills also said that 50% of small businesses in the Federal Reserve’s surveys “tell us that they have a funding shortfall of some sort or another. It’s more stark when you look at women-owned business, black or African-American owned businesses, and Latino-owned businesses.”
On the merchant cash advance panel there was less opportunity to dazzle the regulators and audience members with accounts of state-of-the-art technology and the ability to aggregate mountains of data to make online loans in as few as seven minutes, as Kabbage’s Taussig noted the fintech is wont to do.
Instead, industry panelists endeavored to explain to an audience — which included skeptical regulators, journalists, lawyers and critics — the precarious, high-risk nature of an MCA or factoring product, how it differs from a loan, and the upside to a merchant opting for a cash advance. (To their credit, one attendee told AltFinanceDaily, the audience also included members of the MCA industry interested in compliance with federal law.)
A merchant cash advance is “a purchase of future receipts,” Kate Fisher, an attorney at Hudson Cook in Baltimore, explained. “The business promises to deliver a percentage of its revenue only to the extent as that revenue is created. If sales go down,” she explained, “then the business has a contractual right to pay less. If sales go up, the business may have to pay more.”
As for the major difference between a loan and a merchant cash advance: the borrower promises to repay the lender for the loan, Fisher noted, but for a cash advance “there’s no absolute obligation to repay.”
Scott Crockett, chief executive at Everest Business Funding, related two anecdotes, both involving cash advances to seasonal businesses. In the first instance, a summer resort in Georgia relied on Everest’s cash advances to tide it over during the off-season.
When the resort owner didn’t call back after two seasonal advances, Crockett said, Everest wanted to know the reason. The answer? The resort had been sold to Marriott Corporation. Thanking Everest, Crockett said, the former resort-owners reported that without the MCA, he would likely have sold off a share of his business to a private equity fund or an investor.
By providing a cash advance Everest acted “more like a temporary equity partner,” Crockett remarked.
In the second instance, a restaurant in the Florida Keys that relied on a cash advance from Everest to get through the slow summer season was destroyed by Hurricane Irma. “Thank God no one was hurt,” Crockett said, “but the business owner didn’t owe us anything. We had purchased future revenues that never materialized.”
The outsized risk borne by the MCA industry is not confined entirely to the firm making the advance, asserted Jared Weitz, chief executive at United Capital Service, a consultancy and broker based in Great Neck, N.Y. It also extends to the broker. Weitz reported that a big difference between the MCA industry and other funding sources, such as a bank loan backed by the Small Business Administration, is that ”you are responsible to give that commission back if that merchant does not perform or goes into an actual default up to 90 days in.
“I think that’s important,” Weitz added, “because on (both) the broker side and on the funding side, we really are taking a ride with the merchant to make sure that the business succeeds.”
FTC’s panel moderators prodded the MCA firms to describe a typical factor rate. Jesse Carlson, senior vice-president and general counsel at Kapitus, asserted that the factor rate can vary, but did not provide a rate.
“Our average financing is approximately $50,000, it’s approximately 11-12 months,” he said. “On a $50,000 funding we would be purchasing $65,000 of future revenue of that business.”
The FTC moderator asked how that financing arrangement compared with a “typical” annual percentage rate for a small business financing loan and whether businesses “understand the difference.”
Carlson replied: “There is no interest rate and there is no APR. There is no set repayment period, so there is no term.” He added: “We provide (the) total cost in a very clear disclosure on the first page of all of our contracts.”
Ami Kassar, founder and chief executive of Multifunding, a loan broker that does 70% of its work with the Small Business Administration, emerged as the panelist most critical of the MCA industry. If a small business owner takes an advance of $50,000, Kassar said, the advance is “often quoted as a factor rate of 20%. The merchant thinks about that as a 20% rate. But on a six-month payback, it’s closer to 60-65%.”
He asserted that small businesses would do better to borrow the same amount of money using an SBA loan, pay 8 1/4 percent and take 10 years to pay back. It would take more effort and the wait might be longer, but “the impact on their cash flow is dramatic” — $600 per month versus $600 a day, he said — “compared to some of these other solutions.”
Kassar warned about “enticing” offers from MCA firms on the Internet, particularly for a business owner in a bind. “If you jump on that train and take a short-term amortization, oftentimes the cash flow pressure that creates forces you into a cycle of short-term renewals. As your situation gets tougher and tougher, you get into situations of stacking and stacking.”
On a final panel on, among other matters, whether there is uniformity in the commercial funding business, panelists described a massive muddle of financial products.
Barbara Lipman: project manager in the division of community affairs with the Federal Reserve Board of Governors, said that the central bank rounded up small businesses to do some mystery shopping. The cohort — small businesses that employ fewer than 20 employees and had less than $2 million in revenues — pretended to shop for credit online.
As they sought out information about costs and terms and what the application process was like, she said, “They’re telling us that it’s very difficult to find even some basic information. Some of the lenders are very explicit about costs and fees. Others however require a visitor to go to the website to enter business and personal information before finding even the basics about the products.” That experience, Lipman said, was “problematic.”
She also said that, once they were identified as prospective borrowers on the Internet, the Fed’s shoppers were barraged with a ceaseless spate of online credit offers.
John Arensmeyer, chief executive at Small Business Majority, an advocacy organization, called for greater consistency and transparency in the marketplace. “We hear all the time, ‘Gee, why do we need to worry about this? These are business people,’” he said. “The reality is that unless a business is large enough to have a controller or head of accounting, they are no more sophisticated than the average consumer.
“Even about the question of whether a merchant cash advance is a loan or not,” Arensmeyer added. “To the average small business owner everything is a loan. These legal distinctions are meaningless. It’s pretty much the Wild West.”
In the aftermath of the forum, the question now is: What is the FTC likely to do?
Zullow, the FTC attorney, referred AltFinanceDaily to several recent cases — including actions against Avant and SoFi — in which the agency sanctioned online lenders that engaged in unfair or deceptive practices, or misrepresented their products to consumers.
These included a $3.85 million settlement in April, 2019, with Avant, an online lending company. The FTC had charged that the fintech had made “unauthorized charges on consumers’ accounts” and “unlawfully required consumers to consent to automatic payments from their bank accounts,” the agency said in a statement.
In the settlement with SoFi, the FTC alleged that the online lender, “made prominent false statements about loan refinancing savings in television, print, and internet advertisements.” Under the final order, “SoFi is prohibited from misrepresenting to consumers how much money consumers will save,” according to an FTC press release.
But these are traditional actions against consumer lenders. A more relevant FTC action, says Pepper Hamilton attorney Dabertin, was the FTC’s “Operation Main Street,” a major enforcement action taken in July, 2018 when the agency joined forces with a dozen law enforcement partners to bring civil and criminal charges against 24 alleged scam artists charged with bilking U.S. small businesses for more than $290 million.
In the multi-pronged campaign, which Zullow also cited, the FTC collaborated with two U.S. attorneys’ offices, the attorneys general of eight states, the U.S. Postal Inspection Service, and the Better Business Bureau. According to the FTC, the strike force took action against six types of fraudulent schemes, including:
- Unordered merchandise scams in which the defendants charged consumers for toner, light bulbs, cleaner and other office supplies that they never ordered;
- Imposter scams in which the defendants use deceptive tactics, such as claiming an affiliation with a government or private entity, to trick consumers into paying for corporate materials, filings, registrations, or fees;
- Scams involving unsolicited faxes or robocalls offering business loans and vacation packages.
If there remains any question about whether the FTC believes itself constrained from acting on behalf of small businesses as well as consumers, consider the closing remarks at the May forum made by Andrew Smith, director of the agency’s bureau of consumer protection.
“(O)ur organic statute, the FTC Act, allows us to address unfair and deceptive practices even with respect to businesses,” Smith declared, “And I want to make clear that we believe strongly in the importance of small businesses to the economy, the importance of loans and financing to the economy.
Smith asserted that the agency could be casting a wide net. “The FTC Act gives us broad authority to stop deceptive and unfair practices by nonbank lenders, marketers, brokers, ISOs, servicers, lead generators and collectors.”
As fintechs and MCAs, in particular, await forthcoming actions by the commission, their membership should take pains to comport themselves ethically and responsibly, counsels Hudson Cook attorney Fisher. “I don’t think businesses should be nervous,” she says, “but they should be motivated to improve compliance with the law.”
She recommends that companies make certain that they have a robust vendor-management policy in place, and that they review contracts with ISOs. Companies should also ensure that they have the ability to audit ISOs and monitor any complaints. “Take them seriously and respond,” Fisher says.
Companies would also do well to review advertising on their websites to ascertain that claims are not deceptive, and see to it that customer service and collections are “done in a way that is fair and not deceptive,” she says, adding of the FTC investigation: “This is a wake-up call.”
