In the Merchant Cash Advance (MCA) world, few legal issues are as serious—or as frequently misunderstood—as usury arguments and loan recharacterization risk. These two concepts are at the heart of many disputes involving merchants, funders, and brokers. When an MCA is structured poorly or explained incorrectly, it can lead to lawsuits, financial losses, contract cancellation, and permanent damage to a business’s reputation.
As alternative financing expands and becomes a mainstay for American small businesses, merchants are becoming more knowledgeable and more willing to legally challenge MCA agreements. Because of this, brokers and funders must clearly understand how usury laws operate, why an MCA is legally different from a traditional loan, and what specific factors may cause a court to “pierce the veil” of the contract and treat an MCA as a loan.
What Are Usury Laws?
Usury laws limit the amount of interest that can legally be charged on a loan. These laws have deep historical roots, dating back centuries, intended to prevent “predatory” lending that could trap a borrower in a cycle of debt. In the United States, there is no single federal usury rate for business transactions; instead, each state sets its own interest rate caps, which vary wildly from 6% to 25% or more depending on the jurisdiction and the type of entity involved.
If a lender charges more than the legal limit, the consequences are severe. Depending on the state, the loan can be declared invalid, the lender may be forced to forfeit all interest, or in extreme cases (such as criminal usury in New York), the lender may lose the right to collect the principal balance entirely.
However, an important legal distinction applies: Usury laws apply to loans—not to every financial transaction. This distinction is the bedrock of the MCA industry.
Why an MCA Is Not a Loan (When Structured Properly)
A compliant Merchant Cash Advance is legally structured as a purchase of future receivables, not a loan. In this arrangement, the funder is not “lending” money; they are “buying” an asset—specifically, a portion of the merchant’s future sales—at a discount.
A true MCA differs from a loan in three fundamental ways, often referred to by legal experts as the “Three-Factor Test”:
1. No Absolute Obligation to Repay: In a loan, the borrower must pay back the money regardless of how the business performs. In an MCA, if the merchant’s business fails for legitimate economic reasons (and not due to fraud or breach of contract), the funder loses their investment.
2. No Fixed Term: Loans have a maturity date. An MCA is finished whenever the purchased amount of receivables has been collected. This could take three months or twelve months, depending on the merchant’s daily sales volume.
3. The Funder Bears the Risk: The funder assumes the “downside risk” of the merchant’s business. If sales drop to zero, the daily remittance should, in theory, also drop to zero.
The Evolution of Loan Recharacterization
Loan recharacterization is the process by which a judge looks past the title of a document—even if it says “THIS IS NOT A LOAN” in bold capital letters—to examine the actual mechanics of the deal. Courts focus on “substance over form.” If the underlying reality of the transaction places all the risk on the merchant and guarantees a return for the funder, a court is likely to reclassify the deal as a loan.
This risk has intensified recently as several high-profile court cases in New York and Florida have scrutinized MCA contracts. When an MCA is recharacterized, the “factor rate” is converted into an Annual Percentage Rate (APR). Since MCA factor rates are designed for short-term, high-risk scenarios, the resulting APR often exceeds 100%, well above any state’s usury cap.
Common Arguments Merchants Use in Usury Disputes
When merchants challenge MCA agreements in court, their attorneys typically look for “loan-like” features to prove the agreement is a sham.
1. Fixed Payments Without Adjustment
If a funder takes a fixed daily amount (ACH) from a merchant’s bank account and refuses to adjust that amount when the merchant’s sales drop, it looks like a loan payment. A legitimate MCA must have a “reconciliation” or “adjustment” mechanism.
2. “Default” for Business Failure
If the contract states that the merchant is in “default” simply because they went out of business, the court will see this as a guaranteed repayment. A compliant contract must specify that business failure (without bad faith) is an inherent risk the funder accepts.
3. Overly Broad Personal Guarantees
While personal guarantees are common, they must be “limited.” If a business owner personally guarantees the repayment of the funds under all circumstances, the “risk” has been shifted from the funder to the individual, making it look like a personal loan.
4. The Absence of Reconciliation Rights
Reconciliation is the process where a funder reviews the merchant’s actual bank statements and “trues up” the payments to match the agreed-upon percentage of revenue. If a funder makes it impossible or overly burdensome for a merchant to request a reconciliation, the court may view the right as “illusory” (fake).
Key Factors Courts Consider: The Judicial Lens
Judges generally look at the “holistic” nature of the deal. In the landmark New York cases, courts have identified three “hallmarks” of a loan:
● Is there a reconciliation provision? Is it “mandatory” or “discretionary”? (Mandatory is better for the funder).
● Is the term of the agreement finite? If the funder can calculate exactly when they will be paid back to the day, it is likely a loan.
● Does the funder have recourse if the merchant goes bankrupt? If the funder is a “creditor” in bankruptcy rather than an “owner of assets,” the recharacterization risk spikes.
The Broker’s Vital Role in Compliance
Brokers are often the first point of contact for a merchant. If a broker markets an MCA as a “low-interest loan” or a “six-month term loan,” they are creating a paper trail of evidence that can be used against the funder in court.
Brokers must adopt the following habits:
● Use Precise Language: Always refer to “purchased amounts,” “factor rates,” and “deliverables,” never “interest rates” or “terms.”
● Manage Expectations: Ensure the merchant understands that if their sales go up, they pay faster; if sales go down, they have the right to pay slower.
● Vetting Funders: Only work with funding houses that have robust, transparent reconciliation departments.
Why Merchants Should Understand the Structure
For the merchant, understanding the difference between a loan and an MCA is about survival. An MCA is an expensive form of capital because it is high-risk for the funder. If a merchant treats it like a loan and expects a fixed monthly cost, they may find themselves in a cash-flow crunch.
However, when a merchant understands their right to reconciliation, the MCA becomes a flexible tool. It breathes with the business. In a slow month, the merchant’s obligation to the funder decreases, providing a safety net that a traditional bank loan—with its rigid monthly payments—simply does not offer.
Best Practices to Reduce Legal Exposure
To protect the longevity of the industry, all participants should follow these rigorous
Standards:
1. Drafting Clear Contracts: Contracts should explicitly state that the transaction is a “purchase and sale of future receipts” and include a clear, easy-to-read reconciliation Clause.
2. Functional Reconciliation: It is not enough to have a clause in the contract; the funder must actually perform reconciliations when requested. Having a dedicated “Reconciliation Email” or portal is a best practice.
3. Avoid “Collateralizing” Assets: Taking a security interest in real estate or equipment can sometimes tip the scales toward a loan classification. MCA security should ideally be limited to the business’s future receipts.
4. Audit Communication: Funders should regularly audit the emails and recordings of their sales and collections teams to ensure no one is using loan-based terminology.
5. Transparency in Fees: Clearly disclose all upfront fees (origination, underwriting, etc.) so the merchant knows exactly how much “net” funding they are receiving.
The Future of the Industry
The MCA industry is currently facing a “regulatory wave.” States like California, New York, Utah, and Virginia have passed disclosure laws requiring funders to provide APR-like calculations to merchants. While this does not technically make the MCA a “loan,” it shows that the gap between traditional lending and alternative finance is narrowing in the eyes of the law.
Final Thoughts
Usury arguments and loan recharacterization risk are the “tectonic plates” of the MCA industry—always shifting and capable of causing major disruptions. However, problems usually arise not because the product itself is unlawful, but because it is incorrectly structured or poorly communicated.
When designed correctly, an MCA is a powerful financial instrument that provides capital to businesses that the traditional banking system has abandoned. It is a legitimate sale of future receivables where the funder shares the merchant’s business risk. That shared risk is the legal “shield” that protects the industry from usury claims.
For the industry to remain sustainable, it must prioritize clarity and compliance. Deals that are structured with integrity and explained with transparency are the ones that stand up in court and, more importantly, create lasting, successful partnerships between funders and the American small business owner.
