Square Peg, Round Hole: MCA Disclosures Under the California Commercial Financing Disclosure Regulations

In the third in our series on the California Commercial Financing Disclosure Regulations, we focus on the disclosure requirements for merchant cash advances (MCAs).

Background

In previous client alerts, we discussed the California Commercial Financing Disclosure Law enacted in September 2018 (the “Act”), provided a high-level overview of the recent final regulations implementing the Act, and took a deeper dive into the content and format requirements. In this alert, we focus on disclosures, APR and finance charge calculations, and estimates for MCAs.

Scope

The Act applies broadly to sales-based financing transactions, including MCAs, made to California recipients. Specifically, the definition of sales-based financing covered by the Final Regulations includes MCAs if they meet one of two requirements:

• The funding is repaid as a percentage of sales or income in which the payment amount is impacted by the volume of sales made or income received; or
• The agreement includes a true-up mechanism.[1]

A true-up mechanism is defined as a contractual term by which the financer receives periodic payments based on an amount(s) specified in the contract and the contract allows for adjustments to the payment amount or amounts paid so that the amount paid is closer to the split rate in the contract. The split rate is the percentage used to calculate payment amounts or the true up.[2]

Note that this definition of sales-based financing transactions is broad enough to include not only MCAs, but also loans or other transactions that meet on of the two criteria above.[3]

MCA Disclosure Requirements

We discussed the general disclosure requirements that apply to all types of commercial financing (such as font size, use of columns, etc.) in our previous client alert. For MCAs specifically, the Final Regulations require a three-column by nine/ten-row table containing the following information using the following font sizes and column widths, with annotations in red:

Applicable law requires this information to be provided to you to help you make an informed decision. By signing below you are confirming that you received this information.

Date: _____________                                 Recipient Signature:  [5]

Estimated APR and Finance Charge Computations

The DFPI has consistently elected to require disclosure of an APR for MCAs, rejecting other measures such as Annualized Cost of Capital.[6] In response to comments that APR will confuse recipients of financing like MCAs for which the provider does not charge interest, the DFPI opted for a statement in the disclosures that the cost is based on fees rather than interest.[7]

The Final Regulations require calculation of the APR for MCAs pursuant to the closed-end APR calculation methodology set forth in Appendix J of Regulation Z. The APR calculation must include all finance charges included in Regulation Z plus the discount taken on the face value of the accounts receivable.[8]

The Final Regulations specify what estimates must be made in order to calculate APRs for transactions such as MCAs for which APRs have not historically been computed. The DFPI acknowledged that for these transactions, the disclosed APR and effective APR may vary substantially. The agency rejected comments questioning the effectiveness of the disclosures and ability to compare costs across different financing options, finding it sufficient to require a statement in the disclosures that the estimate may vary from the effective APR.[9]

Estimated Monthly Sales Calculations

The Final Regulations set out two permissible methods for estimating the recipient’s future sales for use in calculating the APR.

The Historical Method is specific to the recipient, with calculations based on the recipient’s historical average sales. The Final Regulations give the provider flexibility in determining the historical period to review as long as it is between four and 12 months and is the same number of months for all transactions or by recipient industry or financing amount.[10] The Final Regulations also include provisions intended to add flexibility, for example, to allow providers to account for outlier months with unusually low sales due to an uncommon business interruption that is unlikely to occur during the performance of the contract.

The DFPI agreed with commenters that use of different lookback periods by providers will result in very different disclosures for the same financing. In the DFPI’s view, required disclosure of average monthly income used to calculate disclosed terms will provide the information recipients need to understand why two identical products from different providers have significantly different estimates of cost of financing.[11]

The Underwriting Method is specific to the provider, with calculations based on the provider’s internal estimated sales projection using the “best information reasonably available” to the provider.[12] Every four months, providers choosing this Method must audit their commercial financings that have paid off as agreed over the period to assess how closely the APR disclosed based on the estimated sales projections aligns with the actual APR based on the actual sales.

If the weighted average of the APR spread found in the last three, five, or seven audits exceeds certain thresholds, the provider is barred from using the Underwriting Method for two years and must use the Historical Method instead. The DFPI added the seven-audit average and raised the acceptable weighted averages for the audits as compared to earlier drafts based on comments that the thresholds were too limiting.[13]

Estimated Payments and Reasonably Anticipated True-Ups

To calculate estimated payments and reasonably anticipated true-ups, the provider must use the estimated monthly sales calculated using either the Historical Method or the Underwriting Method and must account for specified payment amounts, changes to the split rate over time, any required minimum payment due, payments required when a payment or series of payments falls below a threshold specified in the MCA, and any other finance charges that can be “reasonably anticipated” (the “Relevant MCA Terms”). In calculating estimated monthly cost, finance charge, term, and APR, the provider must use one of the two specified methods and must account for each of the Relevant MCA Terms plus any “reasonably anticipated” true-ups.[14]

In responding to comments, the DFPI clarified that providers are not required to include charges due to a recipient’s unanticipated default. Instead, this provision requires the provider to include charges it anticipates recipients will have to pay based on the provider’s calculations of anticipated monthly sales income or receipts. The DFPI acknowledges that it is not typical for MCA providers to structure agreements in this way, but claims it “cannot assume that such products are not currently offered or will be offered in the future.”[15]

In the Final Regulations, the DFPI defines “reasonably anticipated true-up” as a true-up the provider has a “reasonable basis to expect will be made during the term of the contract, accounting for past performance of similar contracts (both those made to the recipient and other similar recipients) and the policies and procedures of the financer.”[16] In the Response to Comments, the DFPI explains that a financer should rely on its calculations of future revenue and past experience regarding how often true-ups occur to determine whether a true-up is “reasonably anticipated.”[17] The DFPI acknowledges that MCA providers may structure their products such that true-ups cannot be “reasonably anticipated,” but again asserts that it “cannot assume that such products are not offered or will not be offered in the future.”[18]

Moving Toward Compliance

In response to comments, the DFPI repeatedly downplayed the costs imposed on MCA providers of having to calculate APR and the other data points in the disclosure scheme. According to the DFPI, “calculating an APR based on estimated payments is not a complicated task for individuals with minimal training and can be accomplished in widely available spreadsheet programs.”[19] The DFPI does not cite to any evidence supporting this assertion. Instead, the agency has proposed to expand the scope of its UDAAP authority over MCA providers to small businesses. While downplaying the costs, the DFPI asserts that the MCA disclosures will provide benefits to recipients, who will be “better able to comparison shop for financing.”[20] This remains to be seen, including based on the DFPI’s acknowledgment that differences in estimates, including the time period used for those estimates, will result in very different disclosures of the costs of credit for the same MCA product.

MCA providers should start planning to comply with the new disclosure requirements, which will become effective on December 9, 2022.

Watch for our final alert on commercial financing, which will analyze the status of commercial financing disclosure laws in other states.

[1] Cal. Code. Regs. tit 10, § 900(a)(28).

[2] Cal. Code. Regs. tit. 10, § 900(a)(34), (a)(31).

[3]See California Department of Financial Protection and Innovation, Response to Comment 1.2.18, Final Statement of Reasons at 38 (PRO 01/18) (stating that the definition of sales-based financing does not require that the recipient’s payment obligation be contingent on the recipient’s income or sales volume (e.g., an MCA), but includes transactions (with or without minimum payment amounts) where the payment amount increases or decreases based on income or sales volume (e.g., closed-end loans with sales-based repayment terms)).

[4] See discussion of “reasonably anticipated true-ups” below.

[5] Disclosures specified in Cal. Code. Regs. tit. 10, §§ 901, 914.

[6]See, e.g.,Response to Comments 1.1.2, 1.2.2, 1.2.16, 1.4.2, 3.5.1, Final Statement of Reasons at 27, 29, 36, 44, 140.

[7] Response to Comment 1.2.15, Final Statement of Reasons at 36.

[8] Cal. Code Regs. tit. 10, §§ 940(a), 943(a).

[9] Response to Comment 1.4.8, Final Statement of Reasons at 48.

[10] Cal. Code Regs. tit. 10, § 930(b).

[11] Response to Comments 1.2.23, 1.4.8, Final Statement of Reasons at 41, 48.

[12] Cal. Code Regs. tit. 10, § 931(a). The DFPI explained that this standard comes from Regulation Z, 12 C.F.R. § 1026.17(c), providing some framework for the meaning of the term. Response to Comment 1.11.16, Final Statement of Reasons at 71.

[13] Final Statement of Reasons at 21.

[14] Cal. Code Regs. tit. 10, § 942(b).

[15] Response to Comment 1.2.12, Final Statement of Reasons at 33.

[16] Cal. Code Regs. tit. 10, § 900(a)(25).

[17] Response to Comment 1.2.13, Final Statement of Reasons at 34–35.

[18] Response to Comment 1.4.4, Final Statement of Reasons at 45.

[19] Response to Comment 1.2.14, Final Statement of Reasons at 35–36.

[20]Id.