SDNY Backs RICO Claims Against Revenue-Based Finance Companies | Hudson Cook, LLP

In the past two months, the U.S. District Court for the Southern District of New York has issued three adverse rulings against revenue-based financing providers. In each case, the court upheld federal claims under the federal Racketeer Influenced and Corrupt Organizations (“RICO”) Act against the finance companies or their officers. Each decision provides guidance on how to mitigate risk by updating contracts or adopting best practices. Revenue-based financing providers must ensure that merchants can obtain reconciliations and that the daily or weekly payments disclosed in the contract represent a good faith estimate of the merchant’s future revenue. A summary of the latest court decision, Lateral Recovery LLC v Queen Funding, LLC, 2022 US Dist. LEXIS 129032 (SDNY July 20, 2022) appears below:

Case summary

Lateral Recovery, LLC sued Queen Funding, LLC, Yehuda Klein and “John and Jane Doe Investors” claiming that they violated RICO by engaging in wire fraud and collecting illegal debts. Defendants moved to dismiss RICO’s claims and the court dismissed the motion.

Queen Funding entered into seven Futures Purchase Agreements (the “Agreements”) with a trader in 2017 and 2018. Each Agreement required the Trader to pay a fixed amount each day, which the Agreements stated represented an “estimate in good faith” of 13% of the merchant’s claims. Over a two-year period, Queen Funding advanced approximately $6,500,000 in cash and collected approximately $10,500,000 in daily payments.

Wire Fraud Claim: Under RICO, “wire usage” includes e-mail communication and money transfers. The complaint alleged that Queen Funding and its owners used email to “create, underwrite, administer and collect” contracts. Queen Funding and its owners would also have collected amounts due under the contracts through ACH interstate electronic debits.

The complaint alleged that the following misrepresentations appearing in the seven contracts satisfied the fraudulent element of wire fraud:

  • Alleged misrepresentation 1: The transaction is not a loan. The complaint alleged that the transactions were loans because, notwithstanding a “reconciliation provision”, the contracts required fixed daily payments, included a security interest in all trader receivables and a personal guarantee from the individual owners, and Queen Funding relied on the creditworthiness of the merchant rather than the merchant’s customers who owed the receivables.
  • Alleged misrepresentation 2: The daily payment is a good faith estimate of the trader’s receivables. All seven contracts stipulated that the merchant’s daily payment amount was 13% of the merchant’s expected monthly receivables. However, the daily payment amount ranged from $4,999 to $49,900.
  • Alleged misrepresentation 3: The fixed daily payment is at the convenience of the merchant. The complaint alleged that the fixed daily payment was intended to secure payment from Queen Funding and would not bear the credit risk of the receivables purchased.
  • Alleged misrepresentation 4: The contracts stated that Queen Funding’s automated ACH program is “labour-intensive” and not an automated process, requiring MCA to charge an “ACH program fee” or “fee origin” exorbitant. The complaint alleged that Queen Funding performed little to no due diligence and that the actual costs of ACH withdrawals were a fraction of the fees.

Recovery of an illegal debt: RICO defines “illegal debt” as debt that (1) is unenforceable in whole or in part due to usury with interest at least twice the enforceable rate and (2) was incurred under “the activity of lending money”.

The court explained that in determining whether a contract is a loan, the courts consider whether the lender “is absolutely entitled to reimbursement in all circumstances” and whether “the principal sum advanced is absolutely repayable”. The court considered the following four factors and concluded that the complaint sufficiently alleged that the contracts were loans:

  1. Reconciliation. The contracts included a reconciliation clause guaranteeing that the merchant’s daily payments were 13% of the merchant’s revenue. The court noted that “in theory” this suggested the contracts were not loans, as Queen Funding bears the risk of loss if the receivables are not paid. However, the plaintiff alleged that the reconciliation clause was a “sham” because:
    • Queen Funding had no reconciliation service, did not perform reconciliations, and never refunded a merchant’s money as required by its reconciliation provision.
    • Queen Funding’s obligation to provide a reconciliation was dependent on the trader providing the documents requested by Queen Funding “in its sole judgment” and “sole and absolute discretion”. Accordingly, the court found that Queen Funding had the absolute ability to nullify any obligation of reconciliation.
    • The contracts described the reconciliation as “a courtesy, and that [the funder] is not required to provide it.”
    • The contracts stated that Queen Funding had no obligation to reconcile “if the merchant fails to provide the requested documents within five (5) business days of the end of a calendar month”.
  2. Indefinite period. The contracts stipulated that they had an indefinite duration. However, the court held that a term could be easily calculated by dividing the amount owed by the merchant by the amount of daily payments, and that failure to make daily payments would not extend the term indefinitely because the contracts provided that ‘a default would occur if two daily payments have not been made during the term of the agreement and the trader has not contacted Queen Funding in advance.
  3. Remedies in the event of bankruptcy. The court found that a “Default Protections” section made payment due immediately and allowed seizure of collateral in the event of default and that the personal guarantee provision effectively protected Queen Funding from the risk of loss if the trader were to edge of bankruptcy or bankrupt.
  4. ACH Rejected as Fault Event. Under the Contracts, an “Event of Default” occurs if “the ACH debit attempt of the Specific Daily Amount is rejected twice during the term of [the Merchant Agreement] and the merchant does not contact the funder until the ACH debit is rejected.” In such cases, payment became immediately due and Queen Funding was entitled to seize the collateral, including any collateral held by the guarantor Also for this reason, Queen Funding involved no “true transfer of risk”, and therefore “the economic substance of the transaction was a loan, not a purchase of receivables”.

Lateral Recovery LLC v Queen Funding, LLC, 2022 US Dist. LEXIS 129032 (SDNY July 20, 2022). The other two cases are Haymount Urgent Care PC vs. GoFund Advance, LLC, 2022 US Dist. LEXIS 112768 (SDNY June 27, 2022) and Fleetwood Servs., LLC v Ram Capital Funding, LLC, 2022 US Dist. LEXIS 100837 (SDNY June 6, 2022).