Not Just Cookies, a wholesale and e-commerce bakery in Chicago is on a growth spurt. Johnathon Bush, the company’s founder and baked goods aficionado, is opening up more sites in Chicago and soon New York to more quickly distribute his brownies, cookies, and pies to dessert-hungry customers.
But his company’s expansion wasn’t without growing pains when in 2019 Bush took on two merchant cash advances to help meet payroll and pay rent on the brick-and-mortar store he operated out of at the time.
“You’re under tremendous pressure because you have people who are depending on you. So you are in a very bad bind and you are desperate” while exploring financing options, Bush said. A broker steered him toward the merchant cash advance companies even though he would have qualified for lower-cost options, Bush said he later learned.
The funds were delivered fast but came with significant fees on top of the financing rate that weren’t well disclosed, he said. He also felt misled about the interest rate initially offered to him, which didn’t seem to match how much money the company was taking from his accounts on a daily basis.
“There was no transparency at all,” Bush said.
De Facto National Standards
Soon, merchant cash advance companies as well as prominent fintech lenders like PayPal Inc. and Lending Club Corp. could be required by state authorities to provide far more transparency to small business borrowers.
Regulators in California and New York have proposed requirements for online lenders to disclose the cost of the financing small business borrowers apply for, such as interest rates and fees. Lawmakers in Connecticut, New Jersey, and North Carolina have introduced similar legislation.
Once in place, potentially as soon as Jan. 1, 2022 in New York, the state rules could create de facto national standards that small business borrowers have been without due to a gap in federal law.
Better disclosures and more transparency would help entrepreneurs avoid the financing that comes with the sort of aggressive, high-cost repayment Bush experienced as soon as he took the advance.
“It probably will save a good number of small businesses,” he said.
Proponents of the states’ regulatory efforts say the need for better disclosures is ripe as small businesses struggle to get back on their feet after the Covid-19 pandemic.
“The hope is the standard can bounce small businesses out of the hole they’ve been in more easily and not fall back into taking loans they didn’t fully understand,” said Armen Meyer, head of public policy at Lending Club.
State financing disclosure laws could save small businesses in California $2.9 billion and those in New York $1.75 billion annually, according to estimates by the Responsible Business Lending Coalition. The group includes online lenders Funding Circle and Lending Club, along with community development lenders and small business organizations.
As two of the largest markets in the U.S. to move first on the issue, California and New York’s regulations will “set a benchmark for disclosure practices for all potential borrowers,” said Jonathan Pompan, co-chair of the Venable LLP’s Consumer Financial Services Practice Group.
“At the federal level, a substantial focus has been on consumer borrowing and not small business,” Pompan said. That’s left a gap for many commercial borrowers, many of whom are individuals and minorities. “There’s no small business protection bureau,” he said.
Online lenders have become an important source of funding for many small businesses. They were the third most common source of finance for small businesses over the past five years, according to a 2021 report from the Federal Reserve.
Medium- or high-credit risk business borrowers were more likely to turn to online lenders for financing compared to low-risk borrowers, the report found. Black-owned businesses said credit availability would be their toughest challenge coming out of the pandemic, according to the report.
The Responsible Business Lending Coalition has been lobbying state governments for several years to bring more transparency to the market through standardized disclosures.
Its vision is modeled after the Truth in Lending Act, a federal law that requires use of an annual percentage rate and other cost disclosures for consumer loans. No similar federal law exists for small business borrowers.
“It creates information symmetry in the market for borrowers to comparison shop, which then forces lenders to compete on price,” said Ryan Metcalf, Funding Circle’s U.S. head of public policy and regulatory affairs and spokesman for the coalition.
“Today, that doesn’t exist. There is no single metric for borrowers to compare products, terms, and pricing, and these disclosures using annual percentage rate is the way to do that,” Metcalf said.
Some finance providers, including PayPal, Square Inc., and Stripe, as well as merchant cash advance companies, worry their products could be at a disadvantage—real or perceived—depending on the disclosure metrics states want to put in place.
Financing products that are paid back at variable rates, based on measures such as a merchant’s volume of sales, can be hard to predict at the time of financing, companies say. An annual or monthly metric doesn’t accurately reflect the true cost of their financing, they say.
Others say a requirement to express both interest rates and fees in a single APR disclosure would mislead borrowers about the cost of capital. Financial Innovation Now, a trade group representing Amazon.com Inc., Intuit Inc., and Apple Inc., as well as PayPal, Square, and Stripe, asked California’s Department of Financial Protection and Innovation to let companies disclose rates and fees separately.
Otherwise, APR disclosures will “bear no relation to the true cost of credit” and may make comparison-shopping “a bewildering experience,” the group said.
Without provisions that take account of their different business models, California and New York’s rules won’t be viewed as a national standard for a segment of the commercial lending industry, said Katherine Fisher, co-chair of Hudson Cook LLP’s business funding practice group.
“My hope is state legislatures will not wholesale adopt the New York and California models, and instead will consider what disclosures are likely to be the most accurate and helpful for small businesses,” she said.
New York’s draft proposed rules, issued Sept. 21, would require disclosures for financing under $2.5 million. It also provides methods for calculating finance charges and APR. The disclosure requirements would go into effect Jan. 1, 2022, under New York statute.
California’s rules have taken more than a year to implement, but the lending community expects that state to soon wrap up its own rulemaking to keep pace with New York.
Disclosures there would be required for any financing below $500,000. They also propose requiring lenders to calculate and provide an APR or other metrics for displaying the costs of financing.
Meanwhile, the Consumer Financial Protection Bureau is emerging as a potential player in small business finance disclosure.
Rohit Chopra, who was confirmed as the CFPB’s new director earlier this month, is widely seen as an aggressive enforcer of consumer lending laws and the agency’s broad Dodd-Frank Act powers against unfair and deceptive acts and practices.
Chopra took aim at online commercial lenders as a Democratic member of the Federal Trade Commission. As a commissioner, he called for the FTC to “closely scrutinize” the marketing claims of certain merchant cash advance providers that functioned more like installment lenders, which are subject to federal anti-discrimination laws and the Equal Credit Opportunity Act.
The CFPB is already developing ways to measure fairness in small business lending, and has embarked on a data-collection effort to better understand the financing terms women and minority small business borrowers receive.
“The open question then is, what’s next after that, and how will that data be used by policymakers and the bureau itself,” Venable’s Pompan said.
The RBLC is hoping California and New York’s regulations will be models for possible CFPB requirements on small business loan disclosures.
“It’s a natural extension from what business borrowers should expect and what lenders should do,” Meyer said.