Default fees in Merchant Cash Advance (MCA) agreements have come under increasing judicial scrutiny. Courts, including in Specialty Capital LLC v. Hall Academy of Child Growth and Development LLC, have consistently held that such fees may constitute unenforceable penalties rather than valid liquidated damages. Here’s why these fees often fail to meet enforceability standards:
1. Failure to Estimate Actual Damages
To qualify as enforceable liquidated damages, default fees must reflect a reasonable advance estimate of damages that are difficult to calculate at the time of the agreement. In Specialty Capital, the court emphasized that the plaintiff did not attempt to demonstrate that the fees were a reasonable estimate of actual damages. Without this justification, the fees are deemed punitive rather than compensatory.
2. Disproportionality to Actual Losses
Courts look for proportionality between the agreed-upon fee and the actual damages resulting from a breach. If the default fee is grossly disproportionate to foreseeable losses, it is considered an unenforceable penalty. In the case at hand, the court noted that the damages upon breach—namely, the amount remaining on the agreement—were readily ascertainable. This clarity negated the need for an inflated penalty disguised as liquidated damages.
3. Penalties vs. Just Compensation
Enforceable liquidated damages aim to provide just compensation for a loss. As explained in Truck Rent-A-Center, Inc. v. Puritan Farms 2nd, Inc., penalties that are “plainly disproportionate to real damages” are designed to compel performance out of fear rather than to compensate the injured party. Such provisions undermine fairness in contractual dealings and create the potential for financial exploitation.
4. Judicial Precedent on Penalties
Recent cases have consistently struck down excessive default fees in MCA agreements. For instance:
- Forever Funding LLC v. S.F. Meats, Inc. and Irwin Funding, LLC v. Dexter Young Cattle Feeding reinforce the principle that fees must reflect actual losses to be enforceable.
- Newco Capital Group VI LLC v. La Rubia Restaurant Inc. reaffirmed that penalties disguised as liquidated damages are invalid, limiting recovery to proven actual damages.
5. Limiting Recovery to Proven Damages
When a default fee is found to be an unenforceable penalty, the recovery for breach is limited to actual damages that the plaintiff can prove. This ensures that compensation aligns with the real harm suffered rather than granting a windfall to the plaintiff.
Default fees in MCA agreements often fail the enforceability test because they are punitive rather than compensatory. Courts emphasize that such provisions must bear a reasonable relationship to actual damages and cannot simply serve as leverage to enforce compliance. For businesses, this highlights the importance of structuring agreements with enforceable and equitable terms. For merchants, it offers a pathway to challenge oppressive fee structures that lack legal justification.
