How lenders should calculate the cost of small-business loans is under debate in California, which last year passed
Lawmakers in Sacramento wanted to make it easier for small-business owners to comparison shop, but they left the intricate details of the disclosure regime to state regulators. Draft rules published late last month by the California Department of Business Oversight have drawn praise from some industry officials and criticism from others.
The California law applies only to nonbank lenders that make commercial loans of $500,000 or less. Many small-business owners have complained that high-cost loans from these companies carry misleading terms and have placed an unsustainable strain on their finances.
But the regulators who are charged with implementing the first-in-the-nation law face a vexing challenge: how to enable apples-to-apples comparisons when the types of financing that are available to small-business owners vary substantially.
Products covered under the law include term loans, lines of credit, factoring transactions, lease financing transactions and merchant cash advance products. Given the structure of some of the products, an upfront calculation of the annual percentage rate is impossible.
One example: a small business that uses a merchant cash advance pledges to pay a percentage of its future revenues to the finance company, so the ultimate cost of the transaction depends on how much revenue the merchant ultimately generates.
The regulations would deal with this problem by allowing disclosures that list an estimated APR in certain situations.
Some companies contend that the disclosure rules should not include APRs at all — they favor other methods of calculating total costs — but California regulators have so far rejected those arguments. Lenders that offer less expensive forms of credit are pleased with that decision.
“I think we’re very satisfied,” said Ryan Metcalf, head of U.S. regulatory affairs at Funding Circle, an online lender that favors an APR disclosure requirement. “We think small businesses got the better end of the deal.”
Gwendy Brown, vice president of policy and research at Opportunity Fund, a nonprofit business lender, said that borrowers may consider a range of financing options, including bank-issued credit cards, which are not covered by the California law. She argued that the way to create uniformity is by requiring the disclosure of an APR.
“It is the gold standard that has been used for over 50 years in the consumer context,” Brown said.
Funding Circle and Opportunity Fund are both members of the Responsible Business Lending Coalition, which developed a self-regulatory pledge called the Small Business Borrowers’ Bill of Rights in 2015.
The California proposal received a more mixed review from the Innovative Lending Platform Association, a trade association whose members include the online lenders OnDeck Capital and Kabbage. Back in 2016, that group developed a model disclosure box that includes APR as well as other metrics.
“We have long been in favor of APR disclosure,” noted Scott Stewart, the group’s CEO, calling the draft rules a step in the right direction.
But he criticized certain other aspects of the proposal. “It does not allow disclosure of additional metrics,” Stewart lamented.
Other industry voices were more critical. Scott Talbott, senior vice president of government relations at the Electronic Transactions Association, called the proposal too prescriptive. He noted that it would dictate the font sizes that lenders must use on disclosure forms.
Talbott also took issue with the inclusion of annual percentage rates in the proposal. Members of the Electronic Transactions Association include PayPal and Square, both of which offer financing to merchants under agreements that link repayments to sales volumes.
A Square spokeswoman declined to comment on the California proposal, and a PayPal spokeswoman did not respond to requests for comment.
For merchant cash advance providers, estimating APRs ahead of time will be problematic, said Scott Pearson, a lawyer at Manatt, Phelps & Phillips who has represented companies in that industry. He cited as an example restaurants that see their sales volumes fluctuate seasonally.
“Even though you can make a disclosure upfront by making a bunch of assumptions, the problem is that those assumptions are going to be unrealistic in many cases,” Pearson said.
The California proposal would require finance companies that make disclosures based on estimated sales projections to conduct annual audits to determine their accuracy. The draft rules spell out potential repercussions for those firms whose estimates do not prove accurate enough.
The California law will not take effect until the regulations are finalized, and it is unclear when that will happen. State officials have set a Sept. 9 deadline for public comment on the draft proposal.
Both supporters and critics of the law are tracking the development of the California regulations closely, in part because they believe other states are likely to use them as a template.
