The following is a case update written by Dean T. Kirby, Jr. a member of the firm of Kirby & McGuinn, A P.C., analyzing a recent decision of interest:
PIRS Capital, LLC v. D&M Truck, Tire & Trailer Repair, Inc., 2020 WL 4913201 (NY Sup. Ct. New York County 2020) held that a financing arrangement structured as a sale of future accounts receivable was not in substance a usurious loan. A copy of the opinion may be found here.
D&M Truck, Tire and Trailer Repair, Inc. entered into a Merchant Agreement and Security Agreement with PIRS Capital, LLC, a commercial finance company. Under the Agreement, PIRS purchased $316,050 in D&M’s future accounts receivable for $245,000. PIRS was in turn authorized to debit from D&M’s bank account 12.1% of the account receipts every weekday until the $316.050 was repaid in full. Performance under the Agreement was personally guaranteed by Mr. O’Neil, the principal of D&M. Later, the Agreement was amended to permit PIRS to debit the fixed sum of $1,225 every weekday, subject to periodic adjustments.
PIRS had withdrawn $147,000 from the D&M account over a five month period until D&M defaulted by blocking access to the account. PIRS filed an action against D&M and O’Neil in the New York Supreme Court stating claims for breach of contract and breach of the guaranty. The defendants claimed that the Agreement was a prohibited usurious loan. In support of that defense, they alleged that D&M’s receivables had already been pledged to another factoring company, as evidenced by a UCC-1 financing statement filed with the New York Secretary of State four years earlier.
PIRS amended its complaint to include a cause of action for fraud, based on the defendants’ claim that they had already sold the receivables. PIRS moved for summary judgment on both the contract and fraud claims. The Court granted summary judgment on the contract claims. Because the fraud claim was pleaded in the alternative, it denied summary judgment on the fraud claim, stating that it was “academic.”
The sole issue in the case was whether the agreement between D&M and PIRS was a loan as a matter of law. In ruling that the agreement called for the purchase of future receivables and not a loan, the Court followed several recent New York cases, including K9 Bytes, Inc. v. Arch Capital Funding, LLC, 56 Misc. 3d 807, 817, 57 N.Y.S.3d 625, 633 (N.Y. Sup. Ct. 2017); and IBIS Capital Group, LLC v. Four Paws Orlando LLC, 2017 WL 1065071 at *5 (Sup.Ct. Nassau Co. March 10, 2017). The Court applied a three part test.
The first of the three prongs was whether the agreement contains “a reconciliation provision that allows the merchant (here, defendant D & M) to seek adjustments of the amount remitted to the purchaser (here, plaintiff). If a transaction does not have a reconciliation agreement, then it is more likely to be a loan than a purchase of future receivables.” In this case, the amendment changed the repayment structure from one in which payments were measured as a percentage of future collections to one calling for a fixed payment amount, but providing for an adjustment of that amount.
The second prong is whether the transaction called for a fixed or a “non-finite” term. The Court explained that “[o]rdinarily, a loan consists of a face value, repayable (with interest) over a finite period DEFINED in the transaction documents. If a transaction instead has a non-finite term, that suggests that the transaction is instead a purchase of future receivables. In that scenario, the length of time required to complete the transaction will be contingent [on the amount of receivables generated and collected] [EMPHASIS in original].” The Court noted that neither the original agreement nor the amendment specified a definite payment term.
The third prong is “whether the purchaser has any recourse in the event of the merchant’s bankruptcy. If the purchaser does have recourse, especially through a personal guaranty, that is a consideration pointing toward treating the agreement . . . as a loan rather than as a receivables purchase.” The Court stated that the guaranty “weighs to some extent in favor of treating the transaction here as a loan.”
The Court quoted K-9 Bytes, supra., in holding that despite the guaranty the other aspects of the factoring agreement were “sufficiently risky such that they cannot be considered loans, as a matter of law.” That is, “under no circumstances could [plaintiff] be assured of repayment, because its agreements are contingent on a merchant’s success, and the term is indefinite.” K9 Bytes, Inc. v. Arch Capital Funding, LLC, 56 Misc. 3d at 818.
The Court disregarded the defendants’ contention that the transaction had to be a loan because D&M had already sold its receivables to another factor, and that PIRS must have known this because of the UCC-1 on file. There was no evidence even as to whether that prior factoring transaction was in effect after four years.
New York’s body of usury law, which favors lenders, is particularly important because so many lenders are based in New York and specify that their finance contracts will be interpreted and enforced under New York law. Among the points of New York law mentioned by the Court was the rule that usury may only be asserted as an affirmative defense and not as a basis for recovery of illegal interest paid.
In its opinion the Court fails to mention what seems a universal principle of usury law, that the substance of a transaction, and not its form, determines whether a transaction will be regarded as a loan. This principle has been oft-repeated in New York cases. See, e.g., O’Donovan v. Galinski, 62 A.D.3d 769, 769, 878 N.Y.S.2d 443 (2009); and around the country see, e.g., Milana v. Credit Disc. Co., 27 Cal. 2d 335, 340, 163 P.2d 869, 871 (1945); Party Yards, Inc. v. Templeton, 751 So. 2d 121, 123 (Fla. Dist. Ct. App. 2000); In re Allen-Morris, 523 B.R. 532, 539 (E.D. Mich. 2014).
The principle of “form over substance” is troublesome to apply with respect to factoring transactions, because factoring is clearly a financing arrangement. Businesses need cash immediately and a finance company will provide it via a transaction designed to produce a rate of return from funds advanced. For purposes of perfection and priority, the Uniform Commercial Code treats a sale of accounts the same as a security interest in accounts. Each must be perfected by filing a financing statement. As to recourse, guaranties and security agreements are common features of factoring agreements, especially those involving smaller merchants.
The terms “reconciliation provision” or “reconciliation agreement” do not appear in a single usury case, nationwide which does not involve New York law. It seems unclear why the inclusion of a provision providing for the adjustment of payments, the purpose of which may be to insure that payments are made at a certain level when the percentage remission of collections don’t match the lender’s repayment expectations, would mitigate against calling the transaction a loan.
The bottom line may be this. Factoring has been a long recognized financing structure that occupies a special niche in state laws regulating lenders. However, it is fair to say that particularly oppressive factoring agreements may be in more danger of being treated as usurious loans.
These materials were written by Dean T. Kirby, Jr. a member of the firm of Kirby & McGuinn, A P.C., located in San Diego, California. Mr. Kirby is a member of the ad hoc group and a member of the Commercial Transactions Committee of the Business Law Section. Editorial contributions were made by the Honorable Meredith Jury (United States Bankruptcy Judge, C.D. Cal, Ret.), also a member of the ad hoc group. Thomson Reuters holds the copyright to these materials and has permitted the Insolvency Law Committee to reprint them. This material may not be further transmitted without the consent of Thomson Reuters.