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Legal Complexities in the Revenue-Based Financing Industry: An Analysis of Recent Court Cases

Jeffrey S. Paige is the General Counsel of CFG Merchant Solutions. Visit: https://cfgmerchantsolutions.com

Navigating the intricate legal landscape of the revenue-based financing industry has become increasingly complex, with recent court cases providing profound insights into the sector’s regulatory dynamics. Amidst legislative shifts, litigation between funders and merchants, and public enforcement actions, three prominent court cases have recently emerged, each offering further guidance into the nuanced legal dynamics governing this innovative sector.

SBFA vs. DFPI: Constitutional Challenges to California’s Regulatory Framework

In the Small Business Finance Association (SBFA) vs. California Department of Financial Protection and Innovation (DFPI), 9th Cir., Case No. 24-50, SBFA challenged the constitutional validity and federal preemption of California’s Commercial Financing Disclosure Law. Central to SBFA’s stance is the contention that the state’s regulatory framework infringes upon the First Amendment rights of its members. SBFA asserts that the regulations compel its members to disseminate inaccurate disclosures to customers, while simultaneously prohibiting any communication that could rectify or clarify purportedly misleading information. Furthermore, SBFA contends that California’s customized interpretation of the Annual Percentage Rate (APR) conflicts with the federal Truth in Lending Act (TILA), potentially causing confusion among merchants. The DFPI moved for summary judgment to dismiss the complaint.

Updates and Nuances: Recent Ruling on SBFA vs. DFPI

On December 4, 2023, the trial level judge ruled in favor of the DFPI, granting their motion for summary judgment and dismissing the case.

First Amendment Argument: The judge disagreed with SBFA, concluding that the disclosures would help small businesses understand the costs and were neither misleading nor unduly burdensome.

Federal Preemption Argument: The judge deferred to the Consumer Financial Protection Bureau (CFPB)‘s authority to resolve preemption issues. In March 2023, the CFPB ruled that the Commercial Financing Disclosure Law (CFDL) does not conflict with TILA.

The SFBA has filed an appeal of the lower court’s grant of summary judgment with the United States Court of Appeals for the Ninth Circuit. On May 28, 2024, SBFA filed their appellate brief setting forth the facts on the record on summary judgment and their specific legal arguments, emphasizing the reversible errors made by the district court, particularly regarding the false and misleading nature of the compelled disclosures, the controversy surrounding the use of APR metrics on products (like receivables-based funding transactions) that APR was not designed to properly describe, and the lack of justification for the regulations. The preemption argument is not being raised on appeal. Following this, on June 6, 2024, the Appellee DFPI’s unopposed motion for an extension of time to file the answering brief was granted. The answering brief of the DFPI is now due on August 30, 2024.

Given these developments, SBFA’s challenge continues to underscore significant constitutional, substantive, and procedural issues within California’s regulatory framework.

The People v. Richmond Capital Group: Uncovering Predatory Practices

In the case of The People v. Richmond Capital Group, 195 N.Y.S.3d 637 (N.Y. Sup. Ct. 2023, unpublished slip copy), allegations of predatory practices have uncovered crucial legal considerations for revenue-based financing providers. Initially filed by the People in 2020, the court ultimately found for the People, holding that the Defendants in that case were “predatory lenders” making thinly disguised loans with usurious interest. The keys to this decision were the reconciliation duty (which was allegedly never performed by the Defendants despite the mandatory contract provisions and requirement that merchants submit bank statements to Defendants on a monthly basis), the fact that the transactions were explicitly based upon fixed repayment amounts with fixed repayment timeframes (as opposed to revenue based funding products, where remittance of the purchased receivables may vary in amount and duration along with the merchant’s revenue stream), contract provisions such as making a few missed payments or declaration of bankruptcy events of default (shifting the risk of loss off of the funder), and the fact that Defendants always referred to their products as loans, and not a bona fide purchase and sale of future receipts. The reprehensible conduct of certain Defendants who harassed, bullied, and made numerous fraudulent statements to their merchant customers certainly did not help their cause. In September 2023 and February 2024, the court issued further decisions addressing accounting and disgorgement of funds, but the core principles related to reconciliation and data remain the same. It’s unclear if Richmond Capital Group appealed any of these rulings.

U.S. Info Group, LLC v. EBF Holdings: Implications for ISO Behavior and Funder Accountability

2023 WL 6198803 (S.D.N.Y., 2003), a case out of the Southern District of New York involving New York law, involves allegations by a Plaintiff against a receivables-based funder similar to those in Richmond Capital, but with a very different set of facts, and a different outcome. U.S. Info Group attempted a civil Racketeer Influenced and Corrupt Organizations Act (RICO) claim against EBF Holdings, alleging that the receivables-based funding transaction at issue was a disguised usurious loan under New York law.

In September 2023, the court dismissed the case entirely on the funder’s motion to dismiss the third amended complaint. The judge ruled that U.S. Info Group failed to adequately allege facts demonstrating a “RICO enterprise” or widespread fraud scheme involving EBF Holdings and their affiliates. In addition, the Court re-iterated the major hallmarks of a true purchase and sale receivables-based funding transaction: (i) that the contract contained a reconciliation provision (and that the funder actually preforms reconciliations where warranted such that the provision is not illusory); (ii) that the risk of non-performance due to bankruptcy or declined revenue of the merchant always rests with the funder; and (iii) that there is no finite, fixed repayment term, which would be typical of a loan.

Legal Recommendations for Funders

Funders should consult with knowledgeable and capable attorneys in this area of law to establish and effectuate clear provisions in their contracts along with steadfast adherence to their contract terms and best practices.
As for the DFPI and California’s disclosure requirements, they remain the law of the land unless the final, unappealable decision of a court states otherwise. Thus, funders should consult with their attorneys to ensure strict compliance with California’s disclosure law and regulations.

In conclusion, the recent legal battles involving the revenue-based financing industry underscore the need for continuous vigilance, genuine commitment to proper contract terms and best practices in servicing those contracts, and adaptation to emerging regulatory paradigms, in order to ensure sustainable growth and legal compliance within this dynamic sector.