This week, the American Bankruptcy Institute posted an article (which is reprinted below) identifying a growing trend that may impact a large sector of the economy: alternative lenders making risky loans. As many know, the 2008-2009 meltdown ensnared a lot of big and established financial institutions and if not for substantial government intervention the fallout would have been worse and perhaps longer-lasting.
For purposes of context, a Wikipedia report states that the “financial crisis of 2007–2008, also known as the global financial crisis and the 2008 financial crisis, is considered by many economists to have been the most serious financial crisis since the Great Depression of the 1930. It began in 2007 with a crisis in the subprime mortgage market in the United States, and developed into a full-blown international banking crisis with the collapse of the investment bank Lehman Brothers on September 15, 2008. Excessive risk-taking by banks such as Lehman Brothers helped to magnify the financial impact globally. Massive bail-outs of financial institutions and other palliative monetary and fiscal policies were employed to prevent a possible collapse of the world financial system. The crisis was nonetheless followed by a global economic downturn, the Great Recession. The European debt crisis, a crisis in the banking system of the European countries using the euro, followed later. In 2010, the Dodd–Frank Wall Street Reform and Consumer Protection Act was enacted in the US following the crisis to “promote the financial stability of the United States”. The Basel III capital and liquidity standards were adopted by countries around the world.”
If one juxtaposes the above summary of the 2008-2009 crisis with the ABI’s summary of the current high-risk lending environment (see below), there are notable parallels that should make insolvency professionals take note. Of particular relevance is the current tendency of less regulated institutions to engage in risky transactions (some of which are not unlike the subprime mortgages (see above) that helped precipitate the 2008-2009 meltdown).
According to the ABI:
“A decade after reckless home lending nearly destroyed the financial system, the business of making risky loans is back, the New York Times reported on Tuesday. This time, the money is bypassing the traditional, and heavily regulated, banking system and flowing through a growing network of businesses that have stepped in to provide loans to parts of the economy that banks abandoned after 2008. With almost $15 trillion in assets, the shadow-banking sector in the U.S. is roughly the same size as the entire banking system of Britain, the world’s fifth-largest economy. In certain areas — including mortgages, auto lending and some business loans — shadow banks have eclipsed traditional banks, which have spent much of the last decade pulling back on lending in the face of stricter regulatory standards aimed at keeping them out of trouble. But new problems arise when the industry depends on lenders that compete aggressively, operate with less of a cushion against losses and have fewer regulations to keep them from taking on too much risk. Recently, a chorus of industry officials and policymakers — including Federal Reserve Chair Jerome H. Powell — have started to signal that they’re watching the growth of riskier lending by these nonbanks. “We decided to regulate the banks, hoping for a more stable financial system, which doesn’t take as many risks,” said Amit Seru, a professor of finance at the Stanford Graduate School of Business. “Where the banks retreated, shadow banks stepped in.” Lately, that lending is coming from companies like Quicken Loans, loanDepot and Caliber Home Loans. Between 2009 and 2018, the share of mortgage loans made by these businesses and others like them soared from 9 percent to more than 52 percent, according to Inside Mortgage Finance. While they don’t have a nationwide regulator that ensures safety and soundness like banks do, non-banks say that they are monitored by a range of government entities, from the Consumer Financial Protection Bureau to state regulators.”
In the November/December issue of the ABF Journal, attorney Jefferey Wurst explains the different types of MCAs and how Courts have ruled regarding the vehicle.
According to Mr. Wurst, first there “are MCAs that advance money and get repaid solely from the collection of future receivables (assuming the risk of collection) and those that advance money and get repaid by taking daily or weekly ACH payments from the client’s bank account whether or not any receivables actually exist.” “Second are MCAs that rely on the performance of receivables found in factoring, which are generally based on true sales of the future receivables and without recourse.”
Mr. Wurst goes on to explain that one of the key issues involves the characterization of the MCA as a loan or a purchase of a receivable. The answer to this question determines whether the MCA is subject to usury statutes (to the extent they exist). According to Mr. Wurst, under “New York law, the penalty for lenders making a usurious loan is not being deprived of any interest payments, as it is in many jurisdictions, but being deprived of receiving both interest and principal. In other words, the borrower gets a windfall by forgiveness of debt when it has borrowed money under usurious terms. Thus, it should not come as a surprise that when confronted with a lawsuit to recover on advances made to a merchant, that merchant attempts to claim the high cost of funds they are paying is usurious.”
Mr. Wurst then explains that “[w]hether an MCA is a usurious loan first depends on whether the merchant sold the receivable or borrowed money with the receivable as collateral. Whether the sale of the receivable was a true sale under applicable law determines this.”
The analysis regarding a true sale or a loan is complex and not suitable for a discussion here, but if you have any questions about how an MCA will be classified (i.e., true sale or loan), the attorneys at FactorLaw can assist. If would like to speak to one of our experienced attorneys, please call (312) 878-6976 or fill out a contact form here.