Bankruptcy Code Transforms Merchant Cash Agreements Into Security Agreements For Bankruptcy Administration Purposes

By: Donald L Swanson

Merchant cash agreements (“MCAs”) purport to be a sale of a merchant’s future accounts receivable to the MCA lender for a specified price, to be paid over time from the proceeds of the merchant’s future accounts receivable.

Issues exist under state law on whether MCAs are true sales or disguised security agreements. Since MCAs involve high rates of return, such issues are significant in bankruptcy courts on such specialized questions as whether an MCA violates state usury laws (see, e.g., Cap Call, LLC v. Foster (In re Shoot the Moon), 635 B.R. 797 (Bankr. D. Mont. 2021)).

Transformation for Bankruptcy Administration

But I’ve always thought the true sales v. disguised security agreement distinction for MCAs under state law is irrelevant for bankruptcy administration purposes.  That’s because:  

• the Bankruptcy Code transforms all MCAs, including MCAs that are true sales under state law, into garden variety security agreements for bankruptcy administration purposes. 

Here’s how.

The U.S. Constitution says that states cannot impair contracts (Art. 1, Sec. 10, Cl. 1).  But the U.S. Constitution authorizes Congress to do that very thing (i.e., to impair contracts) through the Constitution’s bankruptcy clause (Art. 1, Sec. 8, Cl. 4).  The result is that contractual rights between a debtor and its various creditors are adjusted as a matter of course in every bankruptcy case, as authorized and provided in the Bankruptcy Code.

The transformation of an MCA (including an MCA that qualifies under state law as a true sale) into a security agreement at bankruptcy filing is accomplished by a series of definitions in the Bankruptcy Code.  Such definitions include the following:

• “security agreement” is defined in § 101(50) as an “agreement that creates or provides for a security interest”;
• “security interest” is defined in § 101(51) as a “lien created by an agreement”;
• “lien” is defined in § 101(37) as a “charge against or interest in property to secure payment of a debt or performance of an obligation”;
•  “debt” is defined in § 101(12) as a “liability on a claim”;
• “claim” is defined broadly in § 101(5) as a “right to payment” or a “right to an equitable remedy for breach of performance.”

It cannot be doubted that an MCA creditor holds a “claim” in its debtor’s bankruptcy case or that its claim is secured by a “charge against or interest in” its debtor’s receivables—which means, as a matter of Bankruptcy Code definitions, that such claim and such charge or interest qualify as a “security agreement” under § 101(50).

Implications for Bankruptcy Administration

Such reality has many implications for the administration of a bankruptcy case under the terms and provisions of the Bankruptcy Code, including the following:

• § 552 serves to cut-off all post-petition receivables from any “lien” that results from any pre-petition “security agreement”;
• under § 361, the MCA lender is entitled to adequate protection in the form of a post-petition lien on debtor’s post-petition accounts receivable;
• under § 506(a), the MCA lender’s claim is bifurcated, based on the value of its collateral, into an allowed secured claim and an under-secured claim (i.e., an allowed general unsecured claim);
• under § 506(b), the MCA lender’s claim is entitled to post-petition interest and other charges, if the value of its collateral exceeds the amount of its claim;
• under § 502(b)(2), an MCA lender’s claim that is under-secured is not entitled to accrue post-petition interest; and
• under § 726(a)(5), when debtor is solvent, the MCA lender’s claim is allowed to accrue post-petition interest—but only at “the legal rate.”

In other words, an MCA claim is transformed, automatically, by the Bankruptcy Code, at bankruptcy filing, into a garden variety security agreement and treated accordingly for bankruptcy administration purposes.

Conclusion

The Bankruptcy Code automatically transforms all MCAs, including MCAs that are true sales under state law, into garden variety security agreements for bankruptcy administration purposes.

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