DIP Em and Dump Em: Small Business Chapter 11 Cases and MCA Lenders

Written By: Steven Kurtz, Partner, Levinson Arshonsky Kurtz & Komsky, LLP

First, one must give credit where credit is due. This catchy phrase was coined by Lewis Merrifield of 1st Commercial Credit to describe financing a factor client in a Sub-Chapter V Chapter 11 case when saddled with merchant cash advance debt. This is known as a Debtor-in-Possession or DIP Financing. This Bankruptcy process allows the factor to finance its client and assists the factor client in formulating a plan to pay merchant cash advance lenders in bankruptcy dollars, which is often pennies on the dollar.  This is also a loosely based sequel to an earlier article published by the IFA in May 2020.  

A small business Chapter 11 case, known as a Sub-Chapter V is a badly needed amendment to the Bankruptcy Code.  Recognizing that most business Chapter 11 cases fail, Congress in 2019 passed the Sub-Chapter V Amendments, which made the Chapter 11 process much easier to succeed.  Before the Sub-Chapter V legislation, a Chapter 11 Debtor had to deal with a creditor’s committee, the Office of the U.S. Trustee, prepare a disclosure statement (best described as a prospectus), formulate a Chapter 11 plan, file expensive first day motions, and satisfy what is known as the absolute priority rule. The absolute priority rule is complex, but basically means that a chapter 11 business owner (the equity holder, who is at the bottom of the “pile”) must in order to retain its interest in the business, pay in full all classes of creditors above her, or put in “new value” (money) in order to pay less than the full claim and keep the business. Small businesses who were strapped for cash, had a hard time reorganizing in traditional Chapter 11 cases.  The traditional Chapter 11 plan often led to complex “plan fights” and the system did not suit a small business who needed relief.  

Congress originally enacted the Sub-Chapter V process as an experiment.  Basically, the Sub-Chapter V cases work as follows:  if you have $7,500,000 or less in total debt, and you are not in the business of owning real estate, you can elect to file the Sub-Chapter V case. The process is simplified and does not require a disclosure statement, but just a plan. The plan must be filed within four months of the case filing. The Debtor need not satisfy the absolute priority rule which is critical. This means that if the debtor can propose a feasible plan, it will pay “free cash” to its creditors over the life of the plan (five years typically). There are no U.S. Trustee fees which are calculated as a percentage of the case size.  There is a Sub-Chapter V trustee who is involved with and has a say in the case and administers the plan payments. There is also no creditors committee unless it’s by court order. The debt limits were originally $2,725,625 but went to $7,500,000 as part of a series of COVID relief legislation and there is a proposal to keep this number for a few more years.  Hopefully, this number is permanent as this process will enable more honest small businesses who get in trouble to successfully reorganize, which is an essential component of capitalism. 

So, let’s discuss the “DIP em and dump em” process. As most of you know, the underwriting criteria for a merchant cash advance lender, aka “MCA hole”, is that the borrower must have an email address, a bank account to debit, and a pulse. The typical MCA lender “buys” future income/receivables at a discount, such as purchasing $250,000 in future income for $185,000.  The loans are paid back by daily debits for a set percentage, and the loan is typically loaded with fees. It takes a quant person to accurately calculate the interest rate, but the rates typically exceed a 100% annual percentage rate and there are websites that can do the math better than me. When MCA lenders file their financing statements, they typically are behind another lender or factor, and MCA lenders often pile on top of each other.  MCA lenders like to be behind factors and frequently time their debits to hit right after the factor advances.  While MCA loans are easy to get, they often lead to a cash crunch and ultimate failure. An MCA loan is the business equivalent of fentanyl. It may provide an immediate high through cash relief, but ultimately kills.  

The DIP em and dump em strategy works best when you are the factor or lender in a first position, but it’s not required depending on the type of business. First thing is to confirm is whether the business is a viable operation that can survive if it did not have that crushing MCA debt. After paying your financing/factoring costs and after meeting operational expenses, does it have a positive cash flow, or maybe show one on paper?  If the answer is yes, you can think about going further. The next step is to evaluate the type of business and what are the liens behind you.  If the business is one with inventory, then what is the value of the inventory?  Your collateral with the most value is likely the accounts and the inventory. Is there equity behind you on the inventory or even the accounts (which you may own as the factor). The most likely answer is no, and almost certainly no for the MCA lenders No 2 and beyond. These MCA lenders financed “air”.

In Bankruptcy Court, one looks to state law to determine an interest in property, which for factors, lenders and MCA lenders is Article 9. One must have a security agreement that grants a lien in the collateral. That’s easy. The critical issue is whether the MCA loan document attaches to after acquired collateral, which not all of them do. Under UCC Sec. 9-204 you do not get after acquired property unless you state so, which all of you do. A security interest in collateral always applies to proceeds, which is basically whatever is received upon the sale, lease, or other disposition of your collateral. For inventory, that’s easy- the proceeds are either the money received from a sale of the collateral, or the accounts generated from the sale. For accounts generated from transportation or staffing, where you don’t have inventory, but instead have customers, the only real collateral would be the accounts, which presumably you are in first. Money in a bank or deposit account, requires a deposit account control agreement to perfect a security interest in the bank account funds. So, the MCA lender is not perfected against any monies in a deposit account and a holds junior lien.  

Bankruptcy courts can value a lien and bifurcate the lien into a secured and unsecured portion. Under Sec. 506 (c) of the Bankruptcy Code, the secured party is secured up to the value of its collateral and unsecured for the balance.  If the MCA lien has some value, then it must be examined in light of Bankruptcy Code Sec. 552, which allows the lien to attach to proceeds if the agreement so provides and if there are proceeds. In inventory deals, there may be proceeds that attaches to the potential equity the MCA lender may hold. In other deals, such as transportation or staffing, there will be no proceeds to address, only a junior lien against accounts and an unperfected lien against deposit accounts.  If for some reason there is equity, as will be discussed, courts can grant a replacement lien to adequately protect the creditor. Other tools that may be used against an MCA lender in keying up a “DIP em and dump em” fight, is when the MCA lender perfected its lien. Many MCA lenders don’t perfect their collateral unless there’s a default as they don’t want to be discovered.  Under Bankruptcy Code Sec. 547(C)(3), a secured party should perfect its collateral within 30 days of the lien attaching, and if it does not do so and perfects within 90 days of a bankruptcy filing, it faces a preference claim for improving its position from unsecured to secured within the 90-day preference period. Finally, just showing the math and the annual interest rate for the MCA lender won’t usually look so good in a small business case where the court wants to see a good and honest debtor succeed and reorganize.  

When a Chapter 11 case is initially filed, the debtor usually files its first day motions which include use of cash collateral, financing motions, paying employees, and paying critical vendors. A Sub-Chapter V Case is similar.  Financing a Chapter 11 debtor requires court approval. That’s the first part, “DIP em”. You seek authority to continue your financing already in place through a DIP financing motion. The DIP financing motion can point out the effective rate of returns on the MCA lenders and offer them “replacement liens” to the same validity, priority and extent it had pre-petition. For a junior MCA lender, that’s the kiss of death. Most MCA lenders don’t participate in the first day motion process, especially when they are junior. They will have received notice, but since they are being offered replacement liens, even if the replacement lien is just “air”, there is really not much they can do nor will they garner a lot of sympathy.

The next step is the “dump em”. Sub-Chapter V cases move quickly, and a plan is required to be filed in four months.  As discussed, there are tools to value the MCA lender’s lien, which will typically be unsecured. The debtor must formulate a feasible plan, which is typically tied into projecting a positive cash flow. It need not pay the MCA lenders the full claim, or even near the full claim. While this is an oversimplification of the Sub-Chapter V plan confirmation process, the net result is that a confirmed plan will pay MCA lenders bankruptcy dollars and effectively kill their secured claims. Couple a plan with a potential third-party injunction, which can happen sometimes, and the guarantor can be protected too.  

The Sub-Chapter V legislation is friendly to small business debtors and is a good place for factors to transact business. Your factor client is in a fishbowl, has protections, is subject to the automatic stay which prevents the MCA lenders and other creditors from pursuing their claims. The DIP financing often comes with very good protections in your favor. The process allows for a complete clean up of the debtor’s balance sheet leaving you as the only secured party. Once the plan is confirmed, which will happen for honest debtors who propose a feasible plan, you have a rehabilitated factor client/borrower. While this is a somewhat simplistic explanation, the process can and does work. Good luck with your “DIP em and dump em” clients.  

The views expressed in the Commercial Factor website are those of the authors and do not necessarily represent the views of, and should not be attributed to, the International Factoring Association.