There’s one harsh truth every business lawyer needs to understand – merchant cash advance (MCA) defaults are a brutal reality. And, they’re becoming increasingly common as the popularity of MCAs explodes. So, what exactly happens when a client defaults on their MCA? And more importantly, how can you protect them from the fallout?Buckle up, because this guide is going to take you down the dark alley of MCA defaults. We’ll explore the gritty consequences, the legal landmines to avoid, and the savvy strategies for damage control. It’s not going to be pretty, but knowledge is power – and you’ll need to be armed to the teeth.
The Nightmare Begins: Understanding MCA Default Triggers
First thing‘s first, let‘s get on the same page about what constitutes an MCA default. While the specific terms vary between providers, there are a few common tripwires:
- Missing a single payment (yes, just one!)
- Bounced or rejected payments due to insufficient funds
- Closing down the business
- Filing for bankruptcy
- Fraud or breach of other agreement terms
The kicker? Many MCA agreements allow the funder to demand full, immediate repayment after a default. So, that manageable daily debit can quickly snowball into a suffocating lump sum. It’s like falling behind on your rent, only to have the landlord say “cool, just pay the next 12 months right now or get out.”
The Debt Collector’s Favorite Playground
Once a default is triggered, it’s open season for the MCA company‘s collections team. And these guys don’t play nice – they have a legal claim to your client‘s future receivables. 1 So, what are some of their favorite debt-collecting tactics?
- Freezing or garnishing your client’s bank accounts and merchant accounts to recover the balance
- Issuing payment demands directly to their customers or credit card processors (a surefire way to kill cash flow)
- Securing a judgment against your client through a cognovit note or confession of judgment clause (more on those landmines later)
- Pursuing personal assets and funds if there’s a personal guarantee involved
In other words, they can quickly turn your client’s life into a financial apocalypse. All while staying within the bounds of the agreement your client signed. It’s a collections free-for-all that would make a mobster proud.
The Credit Score Massacre
But wait, there‘s more! Even if your client somehow survives the MCA company‘s scorched-earth collection efforts, their credit could still be left in tatters. See, while MCAs themselves don’t appear on credit reports, any judgments obtained by the funder will. 2So, if the MCA company successfully sues your client, that judgment will be a permanent scar on their credit history. Good luck getting a mortgage, car loan, or any other type of financing for the next 7-10 years! It’s a vicious cycle – the MCA default damages their credit, which then makes it even harder to access working capital to pay off the debt. A real catch-22 nightmare.
The Deadly Double Threat: Cognovits and Personal Guarantees
Remember those legal landmines I mentioned earlier? Well, here they are in all their glory – the cognovit note and personal guarantee provisions. If these appear in your client‘s MCA agreement, you better lace up your combat boots.A cognovit or “confession of judgment” clause allows the MCA company to secure a judgment against your client without them ever stepping foot in court. 3 With a simple filing, the funder can start seizing assets and garnishing wages. No defense, no appeals – just the financial death penalty.Then there are the personal guarantees, which essentially make your client personally liable for the business debt. So even if they shut down operations, the MCA company can come after their personal assets like homes, cars, investments, you name it.These two provisions combine to create a doomsday scenario where your client is legally defenseless and has no assets shielded from creditors. It’s the business equivalent of handing the keys to your life savings over to a gang of loanshharks.
The Courtroom Battlefield: Litigation Strategies
Hopefully your client’s agreement doesn’t contain those nuclear provisions, because then you’ll have to take the fight to the courtroom. Here are some potential litigation angles:
- Challenge the MCA as a usurious loan rather than a factoring agreement (interest rate limits may apply)
- Claim deceptive practices, lack of underwriting, or unconscionability in the contract formation
- Argue violation of creditor harassment laws if the collections efforts cross the line
- For smaller businesses, leverage bankruptcy protections and the fresh start provisions
The key is to be strategic and pragmatic. An outright win may be tough with a properly structured MCA, so the focus should be on negotiating a reasonable settlement. Every dollar you can claw back for your client is a win.
Preventing Future Defaults: Red Flags and Best Practices
Of course, an ounce of prevention is worth a pound of cure. Before your client ever signs an MCA agreement, make sure you examine it with a microscope. Red flags to watch for include:
- Excessive fees, factor rates over 1.4, or effective APRs over 50%
- Cognovit notes, personal guarantees, or other liability expansion provisions
- Lack of clear default definitions or cure periods
- Minimal or no underwriting requirements for the client’s business
- Funder’s ability to pursue legal action in a creditor-friendly jurisdiction
If any of those apply, seriously reconsider whether the MCA is worth the risk for your client’s business. There are usually better financing options available, even for struggling companies.And if an MCA is truly the only path forward? Make sure your client understands the risks and consequences of default. Have them sign comprehensive personal risk acknowledgment forms. That way, there are no surprises if things go south later.