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Protecting Small-Business Borrowers

As alternative financing for small businesses grows, so does the debate over regulation.

Under the law, commercial-credit borrowers are viewed differently from consumer borrowers. Business borrowers, deemed more financially savvy than the average consumer, are not protected under the majority of consumer protection laws. For instance, credit extended primarily for business purposes is not covered by the disclosure requirements of the Truth in Lending Act.

Lenders thus have a great deal of flexibility with respect to the information they provide borrowers and the way they disclose a product’s costs and features. As a result, borrowers have reported confusion in understanding the differences among various credit products and their costs, as noted in a Federal Reserve Bank of Cleveland report titled “Alternative Lending through the Eyes of ‘Mom & Pop’ Small Business Owners: Findings from Online Focus Groups.” In practice, some borrowers have found themselves in high-cost products with terms and conditions they did not understand or interest rates that were not affordable for their small businesses.

The Debate

Small-business advocates have called for disclosure rules that require lenders to describe their product terms and costs in clear and transparent language. They have also encouraged curbs on subprime lending and predatory practices that include stacking, namely, the practice of providing a merchant cash advance (MCA), a form of short-term funding, to a borrower who has an outstanding advance from another lender.

On the other hand, some industry proponents argue that regulatory intervention could stifle innovation and limit credit access for small-business customers who need financing to thrive. These observers assert that existing laws and regulations are sufficient to ensure that the market functions safely. (The accompanying table sets forth a non-inclusive list of applicable regulations.) They support industry efforts to self-regulate and have urged policy makers to allow market discipline to weed out the so-called “bad actors” that engage in high-cost or predatory lending.

Relevant Legislation

Regulation B of the Equal Credit Opportunity Act (ECOA)

This regulation prohibits discrimination in any aspect of a credit transaction, whether for consumer or business purposes, on the basis of

  • Race, color, religion, national origin, sex, marital status, or age (provided the applicant has the ability to enter into a contract)
  • Receipt of public assistance
  • The fact that the applicant has exercised any right under the consumer credit protection act

It also requires a creditor to notify the applicant of its decision within 30 days from receipt of a completed application.

Fair Credit Reporting Act (FCRA)

The FCRA stipulates that a creditor must notify a borrower if a personal consumer credit report is pulled in connection with a commercial transaction and an adverse action is taken based on that report.

Such “adverse action” includes a denial of credit, a modification of the requested terms, or a change in terms on an existing account.

Section 5 of the Federal Trade Commission Act (FTC Act)

Section 5 prohibits unfair or deceptive acts or practices in or affecting commerce and applies to both consumer and commercial transactions.

Such acts or practices include

  • Making misleading cost or price claims
  • Using bait-and-switch techniques
  • Offering to provide a product or service that is not available
  • Omitting material limitations or conditions from an offer
  • Selling a product unfit for the purposes for which it is sold
  • Failing to provide promised services

State laws regarding collection practices

Collection practices that may violate state laws vary from state to state and include

  • Making repeated collection calls in an attempt to harass a borrower
  • Calling borrowers at unreasonable hours
  • Making false allegations when attempting to collect from a borrower

Much of the debate about borrower protections centers on online alternative-finance companies that provide MCAs to small businesses. These products have a reputation for being expensive and are often marketed to borrowers with FICO scores in the low 500s. Furthermore, to grow their customer bases, some MCA providers rely on new business generated by brokers that have been a source of concern about misleading and unethical practices.

The Alternative Finance Industry

Online alternative lending is one of several segments that comprise the “fintech,” or financial technology, sector. New fintech entrants are using technology to serve the financial needs of businesses and consumers, bringing innovative solutions to payments, lending, and other financial services. These companies, many of them startups, boast double- or triple-digit annual growth rates supported by considerable venture capital investment.

Specific to small-business services, estimates suggest that at least 150 alternative-finance companies in the US alone focus on extending credit to small firms. These nonbank credit providers operate online and offer a variety of products such as loans and cash advances, as well as hybrid products that carry features of both. Marketplace-lending platforms, also known as peer-to-peer lenders, are among the largest and most well-known. Other lenders competing for small-business borrowers include MCA providers, direct lenders who keep loans on their balance sheets, and payment processors that lend to their business-account holders. These lenders appeal to business owners seeking alternatives to banks for a number of reasons including 1) the owner’s inability to qualify or belief that he or she will not be approved for traditional bank financing; 2) the faster, simpler application process; 3) the easier lending standards; and 4) the potential to obtain funding more quickly.

About Merchant Cash Advances

An MCA is a form of short-term funding typically offered to small-business borrowers who primarily accept credit card payments, for example, retail businesses or restaurants. An MCA is different from a traditional loan in that the small business, in essence, sells a portion of its future receivables: cash up front in exchange for a percentage of future sales. Unlike a traditional loan, an MCA has no fixed term for repayment of the advance, no minimum monthly payment, and, generally, no collateral or personal guaranty required. The cost is based on the “factor rate” applied to the advance, a rate which typically ranges from 1.2 to 1.4.

Here’s what happens in a typical MCA arrangement: The borrower agrees to repay the lump-sum cash advance by allowing the MCA provider to take a fixed percentage of the borrower’s daily debit and/or credit card revenue until the advance and associated fees are repaid. To pay back the advance, the borrower then authorizes the MCA provider to withdraw that fixed percentage of sales from the borrower’s merchant account through which credit and debit card receipts are processed. To determine the total amount owed, one multiplies the factor rate by the amount borrowed, for example, a $50,000 advance multiplied by a factor rate of 1.2 equals $60,000, the $50,000 advance plus the $10,000 fee.

However, the borrower may not realize that the factor rate is different from the annual percentage rate (APR) associated with traditional loans and credit cards in which the interest accrues on the declining principal amount as payments are made.

Given that the entirety of the interest is charged upon origination of an MCA, there is no cost savings associated with early repayment. In fact, the equivalent APR actually rises when the advance is repaid sooner. Assuming regular daily payments over the course of 12 months, the equivalent APR on this MCA would be around 40 percent; but if repaid in 6 months, the equivalent APR nearly doubles. Although such APRs are quite high, usury laws in most states apply only to consumer loans.

Borrower Protections

Small-business advocates have urged policymakers to consider regulatory intervention to protect alternative-finance-industry participants, especially borrowers. Some advocates promote the implementation of small-business-borrower protections similar to those in place for consumers. They note that in contrast to larger, established businesses with financial expertise on staff and long-term banking relationships, newer and smaller businesses often rely on the financial acumen of their owners and may have limited access to traditional credit. These small businesses increasingly are turning to a growing number of alternative-credit providers for their short-term financing needs.

However, there is evidence that some of the products are much more expensive than traditional credit and that their terms and conditions are not described clearly. Though industry leaders have argued that regulation would limit credit access to underserved small businesses, policymakers might seek to balance that risk with steps to ensure small-business credit is not merely available, but also affordable and easy to understand. The newness of the industry and the lack of regulatory structure have given rise to questions about what, if any, intervention is needed and what supervisory authority agencies might have over small-business credit providers. In July, the US Department of the Treasury issued a Request for Information (RFI) seeking input on the business models of online alternative lenders, the potential for these lenders to reach the underserved, and the need for changes to the regulatory framework to support safe growth in the industry. The RFI prompted over 100 responses from industry participants and borrower advocates.

In November, members of the US Senate Banking Committee issued a letter to Treasury and Small Business Association officials requesting greater clarity on the fintech industry, its role in the credit environment, and the need for greater transparency. Within it, the senators expressed particular interest in “understanding the opportunities, challenges, and risks in these emerging trends in small business capital.”

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