One of the most interesting financial innovations pre-COVID-19 was the creation of the merchant cash advance transaction, or MCAT. While the MCA industry has grown significantly, MCAT originators have faced a significant challenge — the risk that the funding structures they use to generate funding from investors, including MCA participations, could be found to involve the issuance of unregistered securities.
The consequences of structuring a transaction in a manner that inadvertently produces a noncompliant transaction in securities can be severe. In the absence of an applicable statutory or regulatory exemption, the public offering of unregistered securities constitutes a criminal violation of the federal securities laws. Such an offering subjects the issuer to rescission risk, and also potentially sanctions and penalties for securities law violations. If the rules are not followed, the issuer will have effectively given the purchasers a regulatory put — i.e., a right to rescission of the investment, whereby the investor gets his or her money back regardless of the then-current value of the investment. The “savings” realized in “cutting a corner” rarely offsets the rescission and remedial costs, penalties and sanctions.
An improperly structured master participation agreement (MPA) governing the sale of participations in MCATs and/or poor execution of a good distribution plan pose the risks that participations already sold could be declared void and subject to rescission, and both the MCAT provider/lead participant and its primary individual actors could be subject to criminal prosecution and monetary penalties.
The key to this analysis is whether the interests sold under the MPA are securities and who and how can they be sold to investors.
While MCATs are a somewhat new development, an analogy can be drawn to the more familiar concept of “factoring,” wherein a “factor” buys existing receivables from a merchant at a discounted price. The merchant gets its cash much more quickly and shifts the entire burden of collection to the factor. If the customer does not pay, the factor bears the financial risk. Accordingly, the discount pricing imposed in such a transaction takes into account the collection risk as well as the time value of money. Factoring as a practice is even ensconced in its own section of the Investment Company Act of 1940, as amended (’40 Act). A private investment pool that is primarily engaged in the business of “purchasing or otherwise acquiring notes, drafts, acceptances, open accounts receivable, and other obligations representing part or all of the sales price of merchandise, insurance, and services” (and having met certain other requirements) is exempt from registration as an investment company (i.e., mutual fund). Such a pool must still comply with the other securities laws governing private placements and broker-dealer involvement.
The existence of a ’40 Act exemption, however, begs the question of whether a pool of factoring transactions is even in the ambit of the ’40 Act since the assets in the pool must in fact be securities for the ’40 Act to apply in the first instance. For that, we must turn to the definition of the term “securities” in the ’40 Act itself as well as elsewhere in the securities laws and published decisions. And unlike factoring, where there is a bright-line rule, there is no similar exception for pools of MCATs under the ’40 Act.
Are MCATs and MCA Participations Securities?
Pools of MCATs potentially are pools of securities, pools of securities-based forward contracts, or even — if a board of exchange were to formalize the terms and start trading them — a pool of futures contracts regulated by the CFTC. Determining the nature of MCATs, therefore, as securities or something else, is essential as MCAT originators attempt to broaden their reach and bring new investors into this potentially lucrative but definitely risky investment opportunity.
To date, many MCAT originators retain the MCATs on their balance sheets, and raise investor capital by issuing debt or debentures (the latter of which are clearly securities) that may or may not be secured by an identified pool of MCATs; issuing equity off the balance sheet of the provider but that has a dilutive effect; selling MCATs to special purposes vehicles (SPVs) that, in turn, raise capital by selling debt or equity issued by the SPV; or even selling “participations.” All of these techniques implicate the Securities Act of 1933 and Regulation D, and the SPV structures implicate the ’40 Act. With respect to the last structure — participations — there is almost as much misinformation and wishful thinking out there as there is hard information.
Participations are listed in the definition of a “security” under the Securities Act and in the ’40 Act. Nevertheless, “participations” in loans among banks that are regulated by the Office of the Comptroller of the Currency have generally been ignored by the SEC. But when a nonbank originator tries to sell “participations” in a pool of MCATs still held on the balance sheet of the originator, the analysis gets interesting. We have previously written on this issue and will not republish that discussion here. However, the ongoing lack of clarity cannot be ignored.
There are a few formulaic approaches: If the investor is to be in direct privity with the merchant, disclosures and documentation should be prepared to roll this transaction under one of the exemptions under the Securities Act for private placements. If the interests are being sold via a general offering, the originator should prepare a disclosure document and file a Form D under Regulation D, invoking the protections of Rule 506(c), which allows “general solicitations in the context of a private placement” under the JOBS Act. The originator will also need to verify the accredited investor status of the investor — mere self-certification by the investor is not sufficient. We do not know for certain that participations are securities but, under the suspicion that they likely are, the issuer in this case has delivered disclosure and gotten verification that the investor is, in fact, accredited. This is a relatively inexpensive way — computed on a risk-adjusted basis — to dot the i's and cross the t’s.
If the participation is to be in a pool with other investors, fitting the participation under one of the various exceptions under the ’40 Act is also prudent. Most likely this would fit within the general exception of section 3(c)(1), provided each pool has fewer than 100 investors. There are myriad other limitations, but identifying which exceptions apply and staying within the guardrails will ultimately make these structures less likely to garner regulatory scrutiny. No structure is impenetrable, but some of the methods identified are tried and true.
Case Law Addressing the Securities Question
As noted above, understanding the evolution of the securities laws and definitions is an ongoing exercise. The issue of whether a contract creates a security may arise in many contexts, including the sale of participations in MCATs. In a decision issued on March 5, 2020, in NTV Management, Inc. v. Lightship Global,1 the Supreme Court of Massachusetts considered whether a contested contract to arrange third-party financing involved “effecting transactions in securities for the account of others” under the Massachusetts Uniform Securities Act and the Federal Securities Exchange Act of 1934. The principal question before the court was whether the obligation of plaintiff NTV Management to “source capital and structure financing transactions from agreed-upon target investors and/or lenders” for defendant Lightship Global required NTV to register as a securities broker-dealer. In the course of finding that NTV was not required to register because there was no transaction in “securities,” the court reviewed the definition of the term “security” under state and federal law.
The NTV Management case did not involve MCAT participations. The case is relevant to these transactions, however, because it places a spotlight on the importance of an investor’s ability to control its own fate in receiving a favorable return with respect to determining whether a security exists. The NTV Management litigation began when NTV sued Lightship for breach of contract. A jury trial was held, and the jury found Lightship liable for breach of contract and breach of the implied covenant of good faith and fair dealing. The trial judge, however, proceeded to vacate the verdict by granting Lightship’s motion to “invalidate” it on the basis that NTV had failed to register as a securities broker. If NTV were, indeed, required to register, not having done so rendered the parties’ contract void and unenforceable. NTV appealed the judge’s decision in the Appeals Court, and the case was transferred to the Massachusetts Supreme Court on that court’s own initiative.
The NTV Management court noted that under the ’34 Act or Massachusetts law, two inquiries are necessary to determine whether a contract on its face triggers the obligation to register as a broker-dealer: (1) whether the contract requires that the transactions "effected" be in "securities" and (2) whether the contract requires a person to "effect" such transactions. The court’s analysis focused solely on the first of these inquiries, noting that “whether a particular instrument is, in fact, a security is a nuanced inquiry, [and] one that is context dependent.”2 Quoting from the U.S. Supreme Court’s landmark decisions in Marine Bank v. Weaver3 and SEC v. Howey,4 respectively, the court elaborated that: “The scope of the term ‘security’ is ‘quite broad’ and includes ‘ordinary stocks and bonds, along with the ‘countless and variable schemes devised by those who seek the use of the money of others on the promise of profits.’”5 The court then added the caveat, quoting Marine Bank, that, “When Congress originally defined the term [security] in the Federal context, however, it did not intend to provide a broad . . . remedy for all fraud.”6
Both the Massachusetts and federal securities laws recite specific examples of instruments that are securities. According to the Massachusetts court, those examples are considered controlling “unless the context otherwise requires.” In addition to these statutory tests, the U.S. Supreme Court has developed judicial tests for determining whether a given instrument is a security, including the “family resemblance” test that was first applied in Reves v. Ernst & Young to certain debt instruments.7 Under Reves, an instrument described as a “note” is presumed to be a security unless it bears a strong “family resemblance” to one or more of the categories of notes the Supreme Court has recognized as not being a security. Where, however, the character of the contested instrument is unclear, the NTV Management court noted that the judicial inquiry will focus on determining whether the instrument is an “investment contract.”8 The U.S. Supreme Court defined this term in Howey and United Housing Foundation v. Forman9 as “an investment in a common venture premised on a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others.”10 This four-part inquiry — (1) an investment of money, (2) in a common venture, (3) with the expectation of profit and (4) dependence on the efforts of others — is commonly known as the “Howey Test.”
The NTV Management court evaluated the security status of plaintiff NTV’s vague commitment to “source capital and structure financing transactions from agreed-upon target investors and/or lenders” under the Howey Test. In doing so, the court cited Forman for the position that a “transaction likely involves an investment contract, and thus securities, where an investor, on the promise of profits, provides capital to a venture over which the investor has no meaningful control,” adding, citing Reves, that a “critical question in determining whether ‘equity’ financing is an ‘investment contract’ is the degree of control the financing party obtains in the venture.”11
Regarding the foregoing, the court noted that “NTV would solicit . . . financing” only from “agreed-upon” sources, over which Lightship retained the rights of “coordination, oversight, and direction.” In addition, the court further noted that “neither an ‘equity’ transaction nor a ‘debt’ transaction necessarily implies a ‘transaction in securities,’” before concluding that it was unable to determine the degree of control that Lightship might have over possible financing structures resulting from NTV’s efforts.12
Finally, the court analogized the contract at issue to the transaction described in a 2014 SEC “no action” letter concerning the possibility for securities broker registration in connection with an contractual commitment to arrange financing for the sale of a business.13
The rights of “coordination, oversight, and direction” that were strongly emphasized by the court in NTV Management are likely to be severely constrained or absent in a typical MPA for participations in MCATs. The participant in these agreements is normally given only a brief period of time (e.g., 24 hours) in which to decide whether to accept or reject the participation being offered. Upon expiration of the allotted time, acceptance is presumed if no rejection has been communicated. In this regard, although the MPA will invariably require the participant to conduct an independent evaluation of each merchant’s business and creditworthiness, these evaluations are likely to rely on information supplied by the MCA provider due to time constraints and costs. Finally, as with many participations, the purchaser of an MCAT participation likely takes all of its rights from the lead and, by design, has no privity of contract with, or ability to pursue collections directly against, the underlying merchant.
Leaving aside NTV Management, the majority of courts that have considered the securities status of loan participation agreements between banks, which are closely analogous to MCAT participation agreements, have concluded that no transaction in securities was created. For example, after acknowledging that a participation in a loan could be a security even though the underlying loan is not a security, the federal district court for the Southern District of New York asserted in Banco Espanol de Credito v. Security Pacific National Bank14 that, “Every circuit court that has ever considered the question has concluded that loan participations are not securities.”15
This blanket statement must be taken in context and with a large dose of caution: The Banco Espanol case, and most of the decisions cited by the Banco Espanol court as authority for the foregoing assertion, involved one or more regulated banks.16 The existence of a bank in the transaction is significant because the U.S. Supreme Court noted in Reves that the existence of another applicable regulatory scheme renders it unnecessary to rely on the federal securities laws to protect investors. Participations between investors and an MCA originator do not have “another applicable regulatory scheme” available to protect investors, other than the federal securities laws.
In addition, with respect to the reliance on the effort of others prong of the Howey Test, the Massachusetts court in NTV Management noted that “since the principal and interest owed to the plaintiffs were fixed, the return did not fluctuate depending upon the efforts of [defendants] Integrated or Security Pacific.”17 We note that this last factor is probably satisfied in favor of finding an investment contract under Howey in the case of an MCAT participation where the likelihood of the participant’s realizing a return is both variable and heavily dependent on the lead’s ability to identify those cash-strained merchants that are likely to survive.
The plaintiffs in Banco Espanol appealed to the Second Circuit Court of Appeals, which upheld the district court’s decision.18 The latter court attached considerable importance to the brief duration of the subject participations. In this regard, the Second Circuit agreed with the district court’s conclusion that the short-term nature of the bank-originated participations (i.e., the terms of most underlying loans ranged from overnight to 30 days) was consistent with the goal of receiving a quick return on excess cash, as opposed to seeking to invest in the underlying business enterprises.19 In addition, aside from the fact of short duration, the Second Circuit accepted the district court’s rationale that because the participants “did not receive an undivided interest in a pool of loans, but rather purchased participation in a specific, identifiable short-term . . . loan, the loan participation did not have an identity separate from the [nonsecurity] underlying loan.”20 Finally, the court also cited the purchaser’s acknowledgment contained in the subject MPA providing that the purchaser “has independently and without reliance upon Security [Pacific] and based upon such documents and information as the participant has deemed appropriate, made its own credit analysis.”21
In his dissent to the Second Circuit’s majority opinion in Banco Espanol, Chief Judge Oakes emphasized that prospective participants “were not in a position to approach the hundred or more possible borrowers in the [underlying loan] program and conduct their own [credit] examinations.”22 To this end, Oakes noted that “potential purchasers were not presented with one loan and asked if they wanted to participate in it, but were solicited, often on a daily basis, and offered a range of investment options involving different issuers with different maturities and interest rates.”23 Hence, as a practical matter, the potential purchasers lacked the ability to perform their own reviews.
Nonbank cases involving the security status of loan participations include Commercial Discount Corp. v. Lincoln First Commercial Corp, which was decided by the U.S. District Court for the Southern District of New York in 1978.24 In finding that the subject participation agreement was an investment contract under the Howey Test, the Commercial Discount court strongly emphasized the defendant’s control over the underlying loan, coupled with the passive nature of the plaintiff’s investment, “Lincoln First undoubtedly had superior control over information on the underlying loan to Piccard: it received daily reports from Piccard and retained ultimate power to declare a default. . . . CDC's expectation in entering this enterprise was that it was to be a passive investor.”25
Challenges for MCA Providers Offering Participations
MCA providers face unique — if not overwhelming — challenges in seeking to reduce the risks under the securities laws in offering participations. Due to intense competition from both other MCA providers and lenders, allowing participants more time to evaluate investments to try to comply with the favorable precedents would likely prove disastrous, as a merchant facing an urgent need for cash is likely to turn to other funding sources as opposed to waiting for the subject provider to act. Furthermore, given the nature of the investment opportunity and the risks embedded in MCATs, attempting to share control over merchant relationships with participants would be economically risky, in addition to being practically impossible for a host of other reasons.
Alternatively, opting for a syndication arrangement, under which each new investor becomes a co-funder along with the MCA provider and has privity of contract with the merchant, could minimize the risk of running afoul of securities laws, but would likely prove unwieldy for a more than a small number of participants.
In view of the above, an MCA provider seeking to offer participations in MCATs is likely left with only one option: structuring its MCAT participations in a manner that complies with securities laws. Accepting the legal risk of rescission and SEC investigations and penalties is just not a tenable option. Given the high stakes, the best way to manage the risk is to embrace the substance of the applicable federal securities laws.
The NTV Management decision emphasizes the risk that a court may find a security in the form of an investment contract where the subject agreement governing the terms of an investment gives the investor no meaningful control over the underlying asset(s), thereby making the investor completely dependent on the entrepreneurial efforts of the issuer for purposes of the Howey Test. This risk exists in any MPA agreement for participating in MCATs where the lead has sole control over the relationship with the merchant, including with respect to the lead’s ability to declare the merchant in default without seeking approval from participants.
The most effective risk mitigation plan for minimizing the risk that a given MCA participation involves the unauthorized issuance of securities would be to comply with the applicable federal securities laws. This compliance can be achieved cost-effectively through the use of standardized documents and deal terms and series structures to name a few, and the use of commercially available accredited investor verification programs.
1 2020 Mass. LEXIS 139 (Mass. 2020).
2 Id. at *13.
3 455 U.S. 551 (1982).
4 328 U.S. 293 (1946).
5 NTV Management, 2020 Mass. LEXIS at *12.
6 Id. at *12-13.
7 494 U.S. 56 (2004).
8 NTV Management, 2020 Mass. LEXIS at *14.
9 421 U.S. 837 (1975).
10 NTV Management, 2020 Mass. LEXIS at *14
12 Id. at *17.
13 Id. at *20.
14 1991 U.S. Dist. LEXIS 5853 (S.D.N.Y. 1991).
15 Id. at *16.
16 McVay v. W. Plains Serv. Corp., 823 F.2d 1395, 1398-1400 (10th Cir. 1987); Union Nat’l Bank of Little Rock v. Farmers Bank, 786 F.2d 881, 884-85 (8th Cir. 1986); Kan. St. Bank in Holton v. Citizens Bank of Windsor, 737 F.2d 1490, 1493-95 (8th Cir. 1984); Union Planters Nat’l Bank of Memphis v. Commercial Credit Bus. Loans, Inc., 651 F.2d 1174, 1180-85 (6th Cir.) cert. denied, 454 U.S. 1124, 71 L. Ed. 2d 111, 102 S. Ct. 972 (1981); Am. Fletcher Mortgage Co. v. U.S. Steel Credit Corp., 635 F.2d 1247, 1253-55 (7th Cir. 1980), cert. denied, 451 U.S. 911 (1981); United Am. Bank of Nashville v. Gunter, 620 F.2d 1108, 1115-19 (5th Cir.1980).
17 Banco Espanol, 1991 U.S. Dist. LEXIS at *26.
18 973 F.2d 51 2d Cir. (1991).
19 Id. at 55.
20 Id. at 54.
21 Id. at 53.
22 Id. at 57 (Oakes, J. dissenting)
23 Id. at 59.
24 1978 U.S. Dist. LEXIS 19531 (S.D.N.Y. 1978).
25 Id. at *16.