Less Than Perfect — New State Regulations
December 21, 2018
You could call California’s new disclosure law the “Son-in-Law Act.” It’s not what you’d hoped for—but it’ll have to do.
That’s pretty much the reaction of many in the alternative lending community to the recently enacted legislation, known as SB-1235, which Governor Jerry Brown signed into law in October. Aimed squarely at nonbank, commercial-finance companies, the law—which passed the California Legislature, 28-6 in the Senate and 72-3 in the Assembly, with bipartisan support—made the Golden State the first in the nation to adopt a consumer style, truth-in-lending act for commercial loans.
The law, which takes effect on Jan. 1, 2019, requires the providers of financial products to disclose fully the terms of small-business loans as well as other types of funding products, including equipment leasing, factoring, and merchant cash advances, or MCAs.
The financial disclosure law exempts depository institutions—such as banks and credit unions—as well as loans above $500,000. It also names the Department of Business Oversight (DBO) as the rulemaking and enforcement authority. Before a commercial financing can be concluded, the new law requires the following disclosures:
(1) An amount financed.
(2) The total dollar cost.
(3) The term or estimated term.
(4) The method, frequency, and amount of payments.
(5) A description of prepayment policies.
(6) The total cost of the financing expressed as an annualized rate.
The law is being hailed as a breakthrough by a broad range of interested parties in California—including nonprofits, consumer groups, and small-business organizations such as the National Federation of Independent Business. “SB-1235 takes our membership in the direction towards fairness, transparency, and predictability when making financial decisions,” says John Kabateck, state director for NFIB, which represents some 20,000 privately held California businesses.
“What our members want,” Kabateck adds, “is to create jobs, support their communities, and pursue entrepreneurial dreams without getting mired in a loan or financial structure they know nothing about.”
Backers of the law, reports Bloomberg Law, also included such financial technology companies as consumer lenders Funding Circle, LendingClub, Prosper, and SoFi.
But a significant segment of the nonbank commercial lending community has reservations about the California law, particularly the requirement that financings be expressed by an annualized interest rate (which is different from an annual percentage rate, or APR). “Taking consumer disclosure and annualized metrics and plopping them on top of commercial lending products is bad public policy,” argues P.J. Hoffman, director of regulatory affairs at the Electronic Transactions Association.
The ETA is a Washington, D.C.-based trade group representing nearly 500 payments technology companies worldwide, including such recognizable names as American Express, Visa and MasterCard, PayPal and Capital One. “If you took out the annualized rate,” says ETA’s Hoffman, “we think the bill could have been a real victory for transparency.”
California’s legislation is taking place against a backdrop of a balkanized and fragmented regulatory system governing alternative commercial lenders and the fintech industry. This was recognized recently by the U.S. Treasury Department in a recently issued report entitled, “A Financial System That Creates Economic Opportunities: Nonbank Financials, Fintech, and Innovation.” In a key recommendation, the Treasury report called on the states to harmonize their regulatory systems.
As laudable as California’s effort to ensure greater transparency in commercial lending might be, it’s adding to the patchwork quilt of regulation at the state level, says Cornelius Hurley, a Boston University law professor and executive director of the Online Lending Policy Institute. “Now it’s every regulator for himself or herself,” he says.
Hurley is collaborating with Jason Oxman, executive director of ETA, Oklahoma University law professor Christopher Odinet, and others from the online-lending industry, the legal profession, and academia to form a task force to monitor the progress of regulatory harmonization.
For now, though, all eyes are on California to see what finally emerges as that state’s new disclosure law undergoes a rulemaking process at the DBO. Hoffman and others from industry contend that short-term, commercial financings are a completely different animal from consumer loans and are hoping the DBO won’t squeeze both into the same box.
Steve Denis, executive director of the Small Business Finance Association, which represents such alternative financial firms as Rapid Advance, Strategic Funding and Fora Financial, is not a big fan of SB-1235 but gives kudos to California solons—especially state Sen. Steve Glazer, a Democrat representing the Bay Area who sponsored the disclosure bill—for listening to all sides in the controversy. “Now, the DBO will have a comment period and our industry will be able to weigh in,” he notes.
While an annualized rate is a good measuring tool for longer-term, fixed-rate borrowings such as mortgages, credit cards and auto loans, many in the small-business financing community say, it’s not a great fit for commercial products. Rather than being used for purchasing consumer goods, travel and entertainment, the major function of business loans are to generate revenue.
A September, 2017, study of 750 small-business owners by Edelman Intelligence, which was commissioned by several trade groups including ETA and SBFA, found that the top three reasons businesses sought out loans were “location expansion” (50%), “managing cash flow” (45%) and “equipment purchases” (43%).
The proper metric to be employed for such expenditures, Hoffman says, should be the “total cost of capital.” In a broadsheet, Hoffman’s trade group makes this comparison between the total cost of capital of two loans, both for $10,000.
Loan A for $10,000 is modeled on a typical consumer borrowing. It’s a five-year note carrying an annual percentage rate of 19%—about the same interest rate as many credit cards—with a fixed monthly payment of $259.41. At the end of five years, the debtor will have repaid the $10,000 loan plus $5,564 in borrowing costs. The latter figure is the total cost of capital.
Compare that with Loan B. Also for $10,000, it’s a six month loan paid down in monthly payments of $1,915.67. The APR is 59%, slightly more than three times the APR of Loan A. Yet the total cost of capital is $1,500, a total cost of capital which is $4,064.33 less than that of Loan A.
Meanwhile, Hoffman notes, the business opting for Loan B is putting the money to work. He proposes the example of an Irish pub in San Francisco where the owner is expecting outsized demand over the upcoming St. Patrick’s Day. In the run-up to the bibulous, March 17 holiday, the pub’s owner contracts for a $10,000 merchant cash advance, agreeing to a $1,000 fee.
Once secured, the money is spent stocking up on Guinness, Harp and Jameson’s Irish whiskey, among other potent potables. To handle the anticipated crush, the proprietor might also hire temporary bartenders.
When St. Patrick’s Day finally rolls around—thanks to the bulked-up inventory and extra help—the barkeep rakes in $100,000 and, soon afterwards, forwards the funding provider a grand total of $11,000 in receivables. The example of the pub-owner’s ability to parlay a short-term financing into a big payday illustrates that “commercial products—where the borrower is looking for a return on investment—are significantly different from consumer loans,” Hoffman says.
SBFA’s Denis observes that financial products like merchant cash advances are structured so that the provider of capital receives a percentage of the business’s daily or weekly receivables. Not only does that not lend itself easily to an annualized rate but, if the food truck, beautician, or apothecary has a bad day at the office, so does the funding provider. “It’s almost like the funding provider is taking a ride” with the customer, says Denis.
Consider a cash advance made to a restaurant, for instance, that needs to remodel in order to retain customers. “An MCA is the purchase of future receivables,” Denis remarks, “and if the restaurant goes out of business— and there are no receivables—you’re out of luck.”
Still, the alternative commercial-lending industry is not speaking with one voice. The Innovative Lending Platform Association—which counts commercial lenders OnDeck, Kabbage and Lendio, among other leading fintech lenders, as members—initially opposed the bill, but then turned “neutral,” reports Scott Stewart, chief executive of ILPA. “We felt there were some problems with the language but are in favor of disclosure,” Stewart says.
The organization would like to see DBO’s final rules resemble the company’s model disclosure initiative, a “capital comparison tool” known as “SMART Box.” SMART is an acronym for Straightforward Metrics Around Rate and Total Cost—which is explained in detail on the organization’s website, onlinelending.org.
But Kabbage, a member of ILPA, appears to have gone its own way. Sam Taussig, head of global policy at Atlanta-based financial technology company Kabbage told AltFinanceDaily that the company “is happy with the result (of the California law) and is working with DBO on defining the specific terms.”
Others like National Funding, a San Diego-based alternative lender and the sixth-largest alternative-funding provider to small businesses in the U.S., sat out the legislative battle in Sacramento. David Gilbert, founder and president of the company, which boasted $94.5 million in revenues in 2017, says he had no real objection to the legislation. Like everyone else, he is waiting to see what DBO’s rules look like.
“It’s always good to give more rather than less information,” he told AltFinanceDaily in a telephone interview. “We still don’t know all the details or the format that (DBO officials) want. All we can do is wait. But it doesn’t change this business. After the car business was required to disclose the full cost of motor vehicles,” Gilbert adds, “people still bought cars. There’s nothing here that will hinder us.”
With its panoply of disclosure requirements on business lenders and other providers of financial services, California has broken new legal ground, notes Odinet, the OU law professor, who’s an expert on alternative lending and financial technology. “Not many states or the federal government have gotten involved in the area of small business credit,” he says. “In the past, truth-in-lending laws addressing predatory activities were aimed primarily at consumers.”
The financial-disclosure legislation grew out of a confluence of events: Allegations in the press and from consumer activists of predatory lending, increasing contraction both in the ranks of independent and community banks as well as their growing reluctance to make small-business loans of less than $250,000, and the rise of alternative lenders doing business on the Internet.
In addition, there emerged a consensus that many small businesses have more in common with consumers than with Corporate America. Rather than being managed by savvy and sophisticated entrepreneurs in Silicon Valley with a Stanford pedigree, many small businesses consist of “a man or a woman working out of their van, at a Starbucks, or behind a little desk in their kitchen,” law professor Odinet says. “They may know their business really well, but they’re not really in a position to understand complicated financial terms.”
The average small-business owner belonging to NFIB in California, reports Kabateck, has $350,000 in annual sales and manages from five to nine employees. For this cohort—many of whom are subject to myriad marketing efforts by Internet-based lenders offering products with wildly different terms—the added transparency should prove beneficial. “Unlike big businesses, many of them don’t have the resources to fully understand their financial standing,” Kabateck says. “The last thing they want is to get steeped in more red ink or—even worse—have the wool pulled over their eyes.”
California’s disclosure law is also shaping up as a harbinger—and perhaps even a template—for more states to adopt truth-in-lending laws for small-business borrowers. “California is the 800-lb. gorilla and it could be a model for the rest of the country,” says law professor Hurley. “Just as it has taken the lead on the control of auto emissions and combating climate change, California is taking the lead for the better on financial regulation. Other states may or may not follow.”
Reflecting the Golden State’s influence, a truth-in-lending bill with similarities to California’s, known as SB-2262, recently cleared the state senate in the New Jersey Legislature and is on its way to the lower chamber. SBFA’s Denis says that the states of New York and Illinois are also considering versions of a commercial truth-in-lending act.
But the fact that these disclosure laws are emanating out of Democratic states like California, New Jersey, Illinois and New York has more to do with their size and the structure of the states’ Legislatures than whether they are politically liberal or conservative. “The bigger states have fulltime legislators,” Denis notes, “and they also have bigger staffs. That’s what makes them the breeding ground for these things.”
Buried in Appendix B of Treasury’s report on nonbank financials, fintechs and innovation is the recommendation that, to build a 21st century economy, the 50 states should harmonize and modernize their regulatory systems within three years. If the states fail to act, Treasury’s report calls on Congress to take action.
The triumvirate of Hurley, Oxman and Odinet report, meanwhile, that they are forming a task force and, with the tentative blessing of Treasury officials, are volunteering to monitor the states’ progress. “I think we have an opportunity as independent representatives to help state regulators and legislators understand what they can do to promote innovation in financial services,” ETA’s Oxman asserts.
The ETA is a lobbying organization, Oxman acknowledges, but he sees his role—and the task force’s role—as one of reporting and education. He expects to be meeting soon with representatives of the Conference of State Bank Supervisors (CSBS), the Washington, D.C.-based organization representing regulators of state chartered banks. It is also the No. 1 regulator of nonbanks and fintechs. “They are the voice of state financial regulators,” Oxman says, “and they would be an important partner in anything we do.”
Margaret Liu, general counsel at CSBS, had high praise for Treasury’s hard work and seriousness of purpose in compiling its 200-plus page report and lauded the quality of its research and analysis. But Liu noted that the conference was already deeply engaged in a program of its own, which predates Treasury’s report.
Known as “Vision 2020,” the program’s goals, as articulated by Texas Banking Commissioner Charles Cooper, are for state banking regulators to “transform the licensing process, harmonize supervision, engage fintech companies, assist state banking departments, make it easier for banks to provide services to non-banks, and make supervision more efficient for third parties.”
While CSBS has signaled its willingness to cooperate with Treasury, the conference nonetheless remains hostile to the agency’s recommendation, also found in the fintech report, that the Office of the Comptroller of the Currency issue a “special purpose national bank charter” for fintechs. So vehemently opposed are state bank regulators to the idea that in late October the conference joined the New York State Banking Department in re-filing a suit in federal court to enjoin the OCC, which is a division of Treasury, from issuing such a charter.
Among other things, CSBS’s lawsuit charges that “Congress has not granted the OCC authority to award bank charters to nonbanks.”
Previously, a similar lawsuit was tossed out of court because, a judge ruled, the case was not yet “ripe.” Since no special purpose charters had actually been issued, the judge ruled, the legal action was deemed premature. That the conference would again file suit when no fintech has yet applied for a special purpose national bank charter— much less had one approved—is baffling to many in the legal community.
“I suspect the lawsuit won’t go anywhere” because ripeness remains a sticking point, reckons law professor Odinet. “And there’s no charter pending,” he adds, in large part because of the lawsuit. “A lot of people are signing up to go second,” he adds, “but nobody wants to go first.”
Treasury’s recommendation that states harmonize their regulatory systems overseeing fintechs in three years or face Congressional action also seems less than jolting, says Ross K. Baker, a distinguished professor of political science at Rutgers University and an expert on Congress. He told AltFinanceDaily that the language in Treasury’s document sounded aspirational but lacked any real force.
“Usually,” he says, such as a statement “would be accompanied by incentives to do something. This is a kind of a hopeful urging. But I don’t see any club behind the back,” he went on. “It seems to be a gentle nudging, which of course they (the states) are perfectly able to ignore. It’s desirable and probably good public policy that states should have a nationwide system, but it doesn’t say Congress should provide funds for states to harmonize their laws.
“When the Feds issue a mandate to the states,” Baker added, “they usually accompany it with some kind of sweetener or sanction. For example, in the first energy crisis back in 1973, Congress tied highway funds to the requirement (for states) to lower the speed limit to 55 miles per hour. But in this case, they don’t do either.”
Open Banking — A U.S. Pipe Dream or Near-Term Reality?
December 18, 2018
Some alternative funders are anxious for “open banking” to become the gold standard in the U.S., but achieving widespread implementation is a weighty proposition.
Open banking refers to the use of open APIs (application program interfaces) that enable third-party developers to build applications and services around a financial institution. It’s a movement that’s been gaining ground globally in recent years. Regulations in the U.K., a forerunner in open banking, went into effect in January, while several other countries including Australia and Canada are at varying stages of implementation or exploration.
For the U.S., however, the time frame for comprehensive adoption of open banking is murkier. Industry participants say the prospects are good, but the sheer number of banks and the fragmented regulatory regime makes wholesale implementation immensely more complicated. Nonetheless, industry watchers see promise in the budding grass-roots initiative among banks and technology companies to develop data-sharing solutions. Regulators, too, have started to weigh in on the topic, showing a willingness to further explore how open banking could be applied in U.S. markets.
Open banking “is a global phenomenon that has great traction,” says Richard Prior, who leads open banking policy at Kabbage, an alternative lender that has been active in encouraging the industry to develop open banking standards in the U.S. “It’s incumbent upon the U.S. to be a driver of this trend,” he says.
The stakes are particularly high for alternative lenders since they rely so heavily on data to make informed underwriting decisions. Open banking has the potential to open up scores of customer data and significantly improve the underwriting process, according to industry participants.
“Open banking massively enables alternative lending,” says Mark Atherton, group vice president for Oracle’s financial services global business unit. What’s missing at the moment is the regulatory stick to ensure uniformity. Certainly, data sharing is gradually becoming more commonplace in the U.S. as banks and fintech companies increasingly explore ways to collaborate. But even so, banks in the U.S. are currently all over the map when it comes to their approach to open banking, posing a challenge for many alternative lenders. Many alternative lenders would like to see regulators step in with prescriptive requirements so that open banking becomes an obligation for all banks, as opposed to these decisions being made on a bank-by-bank basis. Especially since many consumers want to be able to more readily share their financial information, they say.
“It will create huge value to everyone if that data is more accessible,” says Eden Amirav, co-founder and chief executive of Lending Express, an AI-powered marketplace for business loans.
Some global-minded banks like Citibank have been on the forefront of open banking initiatives. Spanish banking giant BBVA is also taking a proactive approach. In October, the bank went live in the U.S. with its Banking-as-a-Service platform, after a multi-month beta period. Also in October, JPMorgan Chase announced a data sharing agreement with financial technology company Plaid that will allow customers to more easily push banking data to outside financial apps like Robinhood, Venmo and Acorns.
There are several other examples of open banking in action. Kabbage customers, for instance, authorize read-only access to their banking information to expedite the lending process through the company’s aggregator partners, says Sam Taussig, head of global policy at Kabbage.
Also, companies such as Xero and Mint routinely interface with banks to put customers in control of their financial planning. And companies like Plaid and Yodlee connect lenders and banks to help with processes such as asset and income verification.
Some banks, however, are more reticent than others when it comes to data sharing. And with no regulatory requirements in place, it’s up to individual banks how to proceed. This can be nettlesome for alternative lenders trying to get access to data, since there’s no guarantee they will be able to access the breadth of customer data that’s available. “As an underwriter, you want the whole financial picture, and if data points are missing, it’s hard to make appropriate lending decisions,” Taussig says.
The problem can be particularly acute among smaller banks, industry participants say. While the quality of data you can get from one of the money-center banks is quite good, “as you go down the line, it becomes a little less consistent,” says James Mendelsohn, chief operating officer of Breakout Capital Finance. For these smaller banks, the issue is sometimes one of control. There’s a feeling among some community banks, that “if I make it easier for my small business customers to get loans elsewhere, I’m done,” says Atherton of Oracle.
Absent regulatory requirements, alternative lenders are hoping that this initial hesitation among some banks changes over time as they continue to gain a better understanding of the market opportunity and as more of their counterparts become open to data sharing through APIs.
Open banking could be a boon for banks in that it would enable them to service customers they probably couldn’t before, says Jeffrey Bumbales, marketing director at Credibly, which helps small and mid-size businesses obtain financing. Open banking makes for a “better customer experience,” he says.
One challenge for the U.S. market is the hodgepodge of federal and state regulators that makes reaching a consensus a more arduous task. It’s not as simple here as it may be in other markets that are less fragmented, observers say.
Major rule-making would be involved, and there are many issues that would need attention. One pressing area of regulatory uncertainty today is who bears the liability in the event of a breach—the bank or the fintech, says Steve Boms, executive director of the Northern American chapter of the Financial Data and Technology Association. Existing regulations simply don’t speak to data connectivity issues, he says.
To be sure, policymakers have started to give these matters more serious attention, with various regulators weighing in, though no regulator has issued definitive requirements. Still, some industry participants are encouraged to see regulators and policymakers taking more of an interest in open banking.
A recent Treasury Report, for example, notes that as open banking matures in the United Kingdom, “U.S. financial regulators should observe developments and learn from the British experience.” And, The Senate Banking Committee recently touched on the issue at a Sept. 18 hearing. Industry watchers say these developments are a step in the right direction, though there’s significant work needed, they say, in order to make open banking a pervasive reality.
“We’re seeing the pace and interest around these things picking up pretty significantly,” Boms says. Even so, it can take several years to implement a formal process. “The hope is obviously as soon as possible, but the financial services sector is a very fragmented market in terms of regulation. There’s going to have to be a lot of coordination,” Boms says.
Another challenge to overcome is customers’ willingness to use open banking. Many small business owners are more comfortable sending a PDF bank statement versus granting complete access to their online banking credentials, says Mendelsohn of Breakout Capital Finance. “There’s a lot more comfort on the consumer side than there is on the small business side. Some of that is just time,” he adds.
Certainly sharing financial data is a concern—even in the U.K. where open banking efforts are well underway. More than three quarters of U.K. respondents expressed concern about sharing financial data with organizations other than their bank, according to a recent poll by market research body, YouGov. This suggests that more needs to be done to ease consumers into an open banking ecosystem.
The topic of data security came up repeatedly at this year’s Money20/20 USA conference in Las Vegas. How to make people feel comfortable that their data is safe is a pressing concern, says Tim Donovan, a spokesman for Fundbox, which provides revolving lines of credit for small businesses. Clearly, it’s something the industry will have to address before open banking can really become a reality in the U.S., he says.
Despite these challenges, many market watchers feel open banking in the U.S. is inevitable, given the momentum that’s driving adoption worldwide. Several countries have taken on open banking initiatives and are at varying states of implementation—some driven by industry, others by regulation. Here is a sampling of what’s happening in other regions of the world:
In the U.K., for example, the implementation process is ongoing and is expected to continually enhance and add functionality through September 2019, according to The Open Banking Implementation Entity, the designated entity for creating standards and overseeing the U.K’s open banking initiative.
At the moment, only the U.K.’s nine largest banks and building societies must make customer data available through open banking though other institutions have and continue to opt in to take part in open banking. As of September, there were 77 regulated providers, consisting of third parties and account providers and six of those providers were live with customers, according to the U.K. open banking entity.
In Europe, the second Payment Services Directive (PSD2) requires banks to open up their data to third parties. But implementation is taking longer than expected—given the large number of banks involved. By some opinions, open banking won’t really be in force in Europe until September 2019, when the Regulatory Technical Standards for open and secure electronic payments under the PSD2 are supposed to be in place.
In Australia, meanwhile, the country has adopted a phase-in process to take place over a period of several years through 2021. Starting in July 2019, all major banks will be required to make available data on credit and debit card, deposit and transaction accounts. Data requirements for mortgage accounts at major banks will follow by February 1, 2020. Then, by July 1 of 2020, all major banks will need to make available data on all applicable products; the remaining banks will have another 12 months to make all the applicable data available.
For its part, Hong Kong is also pushing ahead with plans for open banking. In July, the Hong Kong Monetary Authority published its open API framework for the local banking sector. There’s a multi-prong implementation strategy with the final phase expected to be complete by mid-2019.
Singapore, by contrast, is taking a different approach than some other countries by not enforcing rules for banks to open access to data. The Monetary Authority of Singapore has endorsed guidelines for Open Banking, but has expressed its preference to pursue an industry-driven approach as opposed to regulatory mandates.
Other countries, meanwhile, are more in the exploratory phases. In Canada, the government announced in September a new advisory committee for Open Banking, a first step in a review of its potential merits. And in Mexico, the county’s new Fintech Law requires providers to provide fair access to data, and regulators there are reportedly gung-ho to get appropriate regulations into place. Still other countries are also exploring how to bring open banking to their markets.
The U.S. meanwhile, is on a slower course—at least for now. More banks are using APIs internally and have been exploring how they can work with third-party technology companies. Meanwhile, companies like IBM have been coming to market with solutions to help banks open up their legacy systems and tap into APIs. Other industry players are also actively pursuing ways to bring open banking to the market.
As for when and if open banking will become pervasive in the U.S., it’s anyone’s guess, but industry participants have high hopes that it’s an achievable target in the not-too-distant future.
Thus far, there has been little pressure for banks to adopt open banking policies, says Taussig of Kabbage. But this is changing, and things will continue to evolve as other countries adopt open banking and as pressure builds from small businesses and consumers in an effort to ensure the U.S. market stays competitive, he says. Open banking “is going to happen in the near future,” Taussig predicts.
Velocity Capital Group (VCG) Secures $15 Million Series A Financing
December 11, 2018
CEDARHURST, NEW YORK—DECEMBER 10,2018–Velocity Capital Group recently secured another $15 million in financing. This will strengthen their ability to provide assistance to more small businesses and organizations. While the name might be new to some, Velocity Capital Group is no stranger to the business world. Servicing small businesses for over 7 years, there have been more than 15,000 clients who’ve received the financial boost they needed due to the available funding from VCG.
CEO/Principle Jay Avigdor couldn’t be happier to reach this point. Jay started the business in a small room of his home with only a laptop, and in just a short period of time has transformed VCG into a large and highly respected financial group that services organizations with speed and dedication. With an aim to merge the finance industry with technology, VCG aims to leave funding at your fingertips. To date, VCG is making strides as one of the fastest growing finance companies in the industry.
When businesses have financial demands, their situation is urgent and must be addressed immediately. Going through a lengthy process that could end up in a loss would be a waste of time, but with Velocity Capital Group, the relationship is taken seriously from the onset. With a staff of over 20 employees, VCG strives to get you what you need when you need it. A few of the industries that Velocity takes pride in assisting include:
- Accounting & Collection Agencies
- Construction, Machinery, Mechanics, & Manufacturing
- Electronic & Media/Entertainment
- Healthcare Services & Rehab Center
- Religious Organizations
- Restaurants & Retail
- Technology & Wireless
- AND MORE!
The $15 million funding access will help VCG build solid foundations and partnerships. With Velocity’s breakdown of available funding ($5mil in series A round & a $10 million line of credit), they’re able to provide more funding for more businesses. In fact, many customers have already stated that the VCG team is “resourceful” and “always available.” Others have even said that they “love the charity aspect” of Velocity, because they give back to aiding organizations monthly. Their attention and consistency prove that they are more than just the average financial group; they’re family! Winston Churchill said it best: “From what we get, we can make a living; what we give, however, makes a life.” Velocity Capital Group takes pride in giving to others so they can ultimately help others make a life.
Companies and small businesses are urged to contact Velocity Capital Group today and see what financial options are available. With urgency and compassion, the knowledgeable staff of Velocity is ready to build your business or brand. The funding is there, the foundation is there; all it takes is one step. That one step can be the greatest decision for success in business.
Velocity Capital Group is ready and able to serve you. For additional information, visit our website at www.velocitycg.com, send an email to info@velocitycg.com, or call 833-VCG-FUND (833-824-3863). We’re also available on social media outlets.
MCA Participations and Securities Law: Recognizing and Managing a Looming Threat
December 11, 2018Authors: Gregory J. Nowak and Mark T. Dabertin
Due to the high volume of relevant judicial decisions issued by New York courts over the past two years, the risk that enforceability of a merchant cash advance (MCA) contract1 might be successfully challenged as a disguised usurious loan has received ample attention in law firm white papers and published legal articles, including articles by Pepper Hamilton attorneys.2 Avoiding this risk of “loan re-characterization” is essential if the MCA industry is to achieve wider acceptance as a source of small business financing. But another risk—which we believe is largely unrecognized—could significantly throttle further expansion of MCA financing. This risk is that the funding structures MCA providers rely on to generate funding from third-party investors could be found to involve the issuance of unregistered securities. Unless an exception is available, that would be unlawful and could result in fines, penalties, defense costs and even rescission of the entire transaction, with the “issuer” being required to return investor capital.
Many MCA providers raise new funding by offering “participation interests” in their MCA contracts to third-party investors. These are usually structured in one of two ways. Under a “true participation,” the participant acquires the right to receive payments, and a resulting return on the participant’s investment, exclusively from the MCA provider. To this end, the participant receives no rights to enforce, nor any direct interest in, the underlying MCA contracts. Alternatively, the participation agreement may be structured so as to make each investor a pro rata “co-funder” of the underlying MCA contracts in an agreed-upon percentage (the “participation share”). Under this structure, the MCA provider’s contract with the merchant typically acknowledges the possible existence of “co-funders” in general terms, and does not require the merchant to ratify and accept named co-funders as they come into being. This add-on is usually accomplished through a novation to the MCA contract.
Under either of the above-described participation structures, the nature of the participant’s investment is purely passive, with no possibility for active involvement in the underlying MCA relationships. In fact, the participation agreement likely expressly prohibits such interference. The passive nature of a participant’s investment matters, because the presence of passivity, and the resulting reliance on the efforts of another party (i.e., the party offering the investment) to realize a profitable return, is a key factor for purposes of determining whether a security exists under the federal securities laws.
In SEC v. WJ Howey Co.,3> the U.S. Supreme Court established the following four-factor test for identifying the existence of a security: (1) an investment, (2) in a common enterprise, (3) with a reasonable expectation of profits, (4) to be derived from the entrepreneurial or managerial efforts of others. The facts of Howey concerned investments in an orange grove operation, where the investors were entirely dependent on the efforts of the orange grove manager/promoter to maintain the trees that the investor had invested in. In the case of an MCA participation structured as described above, all four Howey factors are arguably present. An investment is made with the expectation of realizing a profit. In addition, as discussed above, because that investment is passive in nature, its success hinges on the efforts of the MCA provider. Finally, at least one court has opined that the existence of common enterprise is inherent to any participation relationship.4
The Howey test, which seeks to identify the presence of an “investment contract,” is not the sole means for evaluating whether an investment constitutes a security. In Reves v. Ernst & Young, the U.S. Supreme Court recognized that the expansive definition of the term “security” under the Securities Act of 1933 and the Security Exchange Act of 1934 extends to other forms of “notes” besides investment contracts.5 In determining whether the “demand notes” at issue in Reves constituted a security, the court applied what is commonly known as the “close resemblance” test. Under this test, if the note in question bears a close resemblance to a type of note that has been judicially recognized as not involving a security, that note likewise will not be considered a security. For example, on its face, an MCA contract closely resembles “a short-term note secured by a lien on a small business or some of its assets.”6 However, in an MCA contract, the purchased future receivables provide the source of repayment of the advanced funds, as opposed to providing security for a lien.
This distinction is important. because in an MCA, the receivables do not yet exist, so there is nothing to lien. Rather, the MCA involves receivables to be created, presumably using the proceeds of the MCA to do so. Properly drafted MCAs sidestep all “note-like” characteristics, and make it clear that the MCA is a contract to purchase an asset (i.e., receivables) that are yet to be created. There is no sum certain for repayment – unlike a note, if the receivables turn out to be bad, the MCA provider has no recourse back to the merchant that created them. The receivables are not security for a loan; rather, the receivables are the property being forward purchased. MCAs are different in kind and extent from loans.
Notwithstanding the Howey test, and as noted above, it is possible to argue persuasively that an instrument that appears to be a security instead describes the terms of an individually negotiated contractual agreement. In this regard, in Marine Bank v. Weaver,7 the U.S. Supreme Court held that a contract between a bank and a married couple that called for the latter to pledge a certificate of deposit as security for a loan between the bank and an unrelated corporate borrower in exchange for the opportunity to share in the latter’s future profits did not involve a security. In doing so, the court distinguished the note in question from investments that fall within the “ordinary concept of a security. . . [which are offered] to a number of potential investors.”8 In contrast, the Court in Marine Bank found that the contested note created “a unique agreement [that was] negotiated one-on-one by the parties” and was therefore, “not a security.”9
In the absence of an applicable statutory exemption, the public offering of unregistered securities constitutes a criminal violation of the federal securities laws. Because securities can generally only be sold to the public by a registered broker-dealer, people who engage in selling such securities, as well as their related corporate actors, may be subject to monetary penalties for the resulting violations of law. An improperly structured MCA participation presents the risks that: (i) sales of participations made under the flawed structure could be declared void and subject to rescission; and (ii) both the MCA provider and its primary individual actors could be subject to criminal prosecution and resulting monetary penalties. In the remainder of this article, we discuss ways for effectively mitigating these risks.
Structuring the MCA participation so as to make each participant not merely a “co-funder” in name, but an actual party to each underlying MCA contract by means of a contract novation signed by the merchant and naming the individual participants, would arguably eliminate any risk that the structure might be deemed to involve the unlawful issuance of securities. Under this structure, each participant, at least in theory, could enforce the MCA contracts directly against the applicable merchants, without having to rely on the MCA provider. The main flaw with this option is that the MCA participation agreement necessarily prohibits such independent actions by the participant, because those actions could directly conflict with the economic interests of either or both the MCA provider or additional participants. Hence, any actual ability of the participant to be actively engaged in the underlying merchant relationships will be missing. As the number of participants increases to more than a handful, this structure – requiring as it does that the merchant ratify and accept every new participant as each participant is added, is unwieldy and becomes infeasible to administer.
One could also argue that including a requirement in the MCA participation agreements that the participant must evaluate independently the quality of each MCA contract before the purchase of the participation share precludes the existence of a common enterprise. However, unless each participant has its own series of MCAs, this distinction is unlikely to be of significance, because all participants are participating in the same MCA. Also, notwithstanding the obligation to conduct independent reviews, the MCA participant must still rely on the MCA provider to source qualified merchants. In addition, as noted above, the investor also must depend on the MCA provider’s success in collecting payments from merchants, which will determine whether a profitable return is achieved. Finally, where a pool of investors all share in the risks and benefits of a particular business enterprise (known in securities law as “horizontal commonality”), the resulting presumption of a common enterprise is extremely difficult to disprove.
In view of the above, we suggest that the best way to manage the risk that the participation structure might be viewed as involving the unauthorized issuance of securities is to embrace the substance, if not the precise letter, of the federal securities laws. Specifically, by structuring the participation in a manner that complies with the safe harbor from the requirement to register securities described in Section 506 of the SEC rules under the Securities Act of 1933. This entails: (i) only selling participations to accredited investors; (ii) describing the applicable risks (i.e., the risk factors) and potential conflicts of interest in an addendum to the participation agreement; (iii) making sure that all sales of participants are made on a one-to-one basis, with no general solicitation or marketing; and (iv) advising participants that the resale of their participation share may be subject to a one-year minimum holding period. (Of course, if the MCA pays off before the one year period and extinguishes the MCA, that is not an issue under this rule.)
We caution that the securities laws are both difficult to navigate and prone to divergent interpretations. The consequences of misinterpretation can be severe and could result in the rescission of existing participations and monetary penalties. Hence, this is not a DIY proposition.
Pepper Points
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The risk that an MCA participation structure could be found by a regulator or court to constitute the unlawful issuance of securities is under appreciated, and has serious consequences that could throttle the availability and growth of MCA financing.
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Although legal arguments can be made in support of the position that the most commonly used MCA participation structures do not involve the unlawful issuance of unregistered securities, none of those arguments is sufficiently persuasive to preclude the need for additional risk mitigation efforts.
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Mitigation plans for managing the risk that a given MCA participation structure involves should incorporate complying with the substance, and the precise letter, of the federal securities laws.
The federal securities laws are difficult to navigate and prone to divergent interpretations. The consequences of misinterpretation are severe and could include the rescission of existing participations and assessments of monetary penalties, including against individual actors.
Endnotes
1 An MCA is a business financing option that involves the advance of funds to a merchant, typically to assist the merchant in managing its short-term cash flow needs, in exchange for the sale of a specified percentage of the merchant’s future receivables at a sizeable discount. It is a relatively new offshoot of “factoring,” which likewise involves the purchase and sale of receivables at a discount in exchange for an advance of funds to a business, with the primary difference being that the receivables in the case of MCA financing are not yet extant. An MCA contract might be deemed a disguised usurious loan for many reasons, including the inclusion of a set term within which the advance must be repaid in full to avoid default. The most critical factor in this regard is whether the MCA provider is looking to the purchased receivables for repayment, or to the merchant itself or its individual owner(s); e.g., in the form of a financial guarantee given by the owner(s).
2 For a broader discussion of MCA financing, and the risk of re-characterization as a usurious loan, see: https://www.pepperlaw.com/publications/recent-litigation-illustrates-why-merchant-cash-advances-are-not-loans-2017-04-20/.
3 328 U.S. 293 (1946).
4 Provident National Bank v. Frankfort Trust Co., 468 F. Supp. 448, 454 (E.D. Pa. 1979) (By its “very nature” any participation involves a common enterprise.).
5 494 U.S. 56, 64 (1990) (“The demand notes here may well not be ‘investment contracts,’ but that does not mean they are ‘notes.’ To hold that a ‘note’ is not a ‘security’ unless it meets a test designed for an entirely different variety of instrument ‘would make the Acts’ enumeration of many types of instruments superfluous’ Landreth Timber, 471 U.S. at 692, and would be inconsistent with Congress’ intent to regulate the entire body of instruments sold as investments, see supra at 60-62”.).
6 Id. at 65.
7 455 U.S. 551 (1982).
8 Id. at 552.
9 Id.at 560. In Vorrius v. Harvey, 570 F. Supp. 537, 541 (S.D.N.Y. 1983), the court followed Marine Bank in finding that a contested loan participation agreement involved an individually negotiated contract versus a security. A key factor in that case, however, was the existence of a comprehensive federal regulatory scheme apart from the federal securities laws in the form of banking laws and regulations, which made application of the former unnecessary for purposes of protecting the interest of investors. No such alternative regulatory scheme exists in the case of the MCA industry, which is generally unregulated.
The material in this publication was created as of the date set forth above and is based on laws, court decisions, administrative rulings and congressional materials that existed at that time, and should not be construed as legal advice or legal opinions on specific facts. The information in this publication is not intended to create, and the transmission and receipt of it does not constitute, a lawyer-client relationship.
Dan DeMeo is Back in Action… at Lendr
November 15, 2018
Daniel DeMeo has been hired as Chief Revenue Officer by the Chicago-based funder, Lendr.
DeMeo has been working as an independent consultant for the last two years, according to LinkedIn. Prior to that he was the CEO of CAN Capital, a company he had dedicated himself to for nearly seven years until an internal account performance issue led to several senior executives taking an immediate leave of absence.
Under DeMeo, CAN enjoyed success as one of the nation’s largest non-bank small business financiers, partially attributed to the company’s major head start in pioneering merchant cash advance products when the company was founded in 1998. DeMeo even landed on the cover of AltFinanceDaily’s November/December 2015 issue, around the time when the company was widely believed to be planning an IPO.
It never happened.
The systems issue that toppled CAN’s top execs including DeMeo, brought the company to its knees, putting all new funding on hold for six months until it was saved by a capital infusion from Varadero Capital in July 2017. CAN Capital survived while DeMeo has notably since then kept a low public profile.
Now he’s back in action at Lendr, an ambitious funding company that offers MCAs, small business loans, equipment financing, and just recently, factoring.
“Dan is a highly strategic and thoughtful leader with broad perspective of the industry that enables him to understand specific challenges we face as a growing company,” said Tim Roach, CEO of Lendr. “Dan’s experience is a perfect addition to the team as we accelerate our growth plans, raise Lendr’s brand recognition, and further increase our market share.”
“I’m thrilled to be joining such a dynamic and progressive company,” said DeMeo. “Lendr has emerged as one of the leaders in the financial solutions space and we are poised to build strategic partnerships and alliances with those who share the same zeal in helping small- and medium-sized businesses grow.”
Lendr is setting its sights high. “We’ll be north of $100 million in our first year of factoring,” Lendr co-founder and CEO Tim Roach told AltFinanceDaily in September.
The company has also been showing off its technological and fundraising prowess as of late. This past March, they closed on a $25 million credit facility that’s expandable up to $50 million. That news was followed by the announcement of a new funding option made possible through virtual and physical debit cards.
Lendr has offices in Chicago and New York and employs over 45 people.
Prosper Tightens Credit and Introduces HELOCs
November 14, 2018
Today, Prosper announced its third quarter financial results, showing that originations were $640 million for the quarter, down from $822 million last year. And net loss was $19.8 million, an improvement of $7.2 million from the previous year. The lending platform also announced today that it will launch a new digital Home Equity Line of Credit (HELOC) product in 2019.
“As Prosper continues to focus on meeting investors’ return expectations, we have tightened credit and increased borrower rates this year in a rising interest rate environment,” said David Kimball, CEO of Prosper. “We have also focused our efforts and resources on expanding our business beyond personal loans with the development of a new home equity line of credit product.”
Prosper’s new HELOC product will be offered in conjunction with banks and the company is currently working with bank partners and welcoming new ones, according to a company spokesperson. She could not give the names of any of the bank partners, although she said that Prosper’s role will be to deliver cost estimates for the product in a matter of seconds, as opposed to weeks that it might take a bank to make a decision about eligibility and terms for a HELOC. As for the underwriting process, the bank will dictate the underwriting criteria and Prosper will execute on them.
“We are taking advantage of our expertise in consumer credit and personal loans to build a product that removes the complexity and time-consuming barriers in applying for a HELOC,” Kimball said. “For many of our customers, a HELOC could be a better choice for their financial needs and we’re thrilled to be working with our bank partners to render the traditional process obsolete with a new digital HELOC process that is simple, fast and painless.”
How will Prosper make money from these HELOCs? Prosper will charge the banks a fee for every deal that originates through Prosper’s platform, according to the company spokesperson. Founded in 2005 and based in San Francisco, Prosper makes personal loans from $2,000 to $40,000 to prime customers, with loan terms up to five years. At the Money 20/20 Conference in October, Kimball spoke about his openness and his approach to working with banks.
“You don’t go in the thinking [the bankers] are stupid,” Kimball said. “Assume that you have a really good partner.”
To date, over $13 billion in personal loans have been originated through the Prosper platform for debt consolidation and large purchases such as home improvement projects, medical expenses and special occasions.
National Funding Announces New President
November 5, 2018
Today National Funding announced that Joseph Gaudio has been promoted to President of the company, reporting directly to founder and CEO Dave Gilbert. Previously, Gaudio was Chief Operating Officer.
“I can’t think of a more exciting time to be a part of the business and the SMB lending industry,” Gaudio said. “I look forward to working closely with our talented senior leadership team to further our mission of helping small businesses across the U.S. secure the critical capital they need to grow their businesses.”
This announcement comes just weeks after National Funding acquired QuickBridge, another alternative lender based in California.
Prior to joining National Funding, Gaudio was the CEO of Superior Mobile Medics for five years. He led the sale of the company to Quest Diagnostics and then served as part of the integration of the acquisition for Quest.
“Since joining National Funding in 2017, Joseph has helped propel the company to one of the top 10 alternative SMB lenders in the nation, and has been a driving force during our rapid growth,” Gilbert said. “Joseph’s strategic thinking capabilities, strong business acumen and his more than a decade of industry experience geared towards the small to medium business market provides critical firepower as we build National Funding into the leading brand serving the financial needs of Main Street America.”
Founded in 1999, National Funding is based in San Diego and employs roughly 230 people. It now also owns QuickBridge, with headquarters in Irvine, CA and a small satellite office in New York. The QuickBridge name and most all of its 100 employees remained in the recent acquisition. National Funding has provided more than $3 billion in capital to over 40,000 businesses nationwide with loan volume expected to exceed $500 million this year.
SoFi CEO Ponders Opening Physical Locations
November 5, 2018
At Money 20/20 a few weeks ago, SoFi CEO Anthony Noto said that eventually the online lender will need to open some physical locations, not unlike ATM machines, for people who get paid in cash.
The notion of an online lender opening up physical locations sounds ironic. But it would not be the first time a company that started by providing an online solution then opened up physical locations. Amazon’s book stores, which first opened in New York in 2017, is a prime example. The e-commerce giant, which started as a uniquely online-only company, now has more than a dozen book stores. Similarly, Bonobos, which started as an online-only men’s clothing solution – that simplified shopping by avoiding physical stores – now has over 50 brick and mortar locations.
“A few years ago, being online and having a fast-growing Instagram was enough to drive market share away from main street and into our e-commerce stores,” according to a Forbes post this year, “but the amount of brands selling online is reaching such a high number that getting noticed is becoming harder and harder.”
While retail and lending are different businesses, the idea of getting noticed could apply to both.
With the increasing popularity of e-commerce and digital solutions to everything, including banking and lending, some have said that brick and mortar banking is on its way out. But data contradicts this. According to an American Banker story from March of this year, JPMorgan Chase said it intends to open as many as 400 new branches in Boston, Philadelphia and Washington, D.C. And Bank of America announced plans to add about 500 branches. On the other hand, according to the story, Wells Fargo closed 214 bank branches in 2017 and said it plans to close more than 1,000 by 2020.
But a survey released this year by J.D. Power, a research company, found that most customers prefer to open accounts and get financial advice in person.
The ultimate brick and mortar location in the world of lending is the payday lending store, which serves – or targets – the low end of the consumer market living paycheck to paycheck. Still, that is industry is alive and well, with about 12 million American taking out loans at physical stores like these, according to Finder.com. And online lenders like Elevate are actively trying to poach customers of these stores.
Lending professionals are using of brick and mortar spaces creatively these days. Brother James and John Celifarco recently moved their ISO shop to a storefront in Brooklyn, and many of their clients are neighboring small businesses.
“Obviously you can’t build an entire business on just these two streets,” John said, “but it’s extra business that we wouldn’t have had if we weren’t here.”
