Protect small businesses from predatory lending

If you knew what you were doing, would you sign a contract allowing a company to sue you and take your money whenever it wanted, with no proof, warning or legal recourse? Bizarre as it may seem, aggressive lenders are using precisely such agreements to terrorize and often bankrupt small businesses across the country.

It’s a practice that the government, and New York state in particular, should curb.

In a series of articles, Bloomberg News details how the revival of an obscure legal document has rearranged business lenders’ incentives to disastrous effect. Known as a confession of judgment, it’s supposed to act as a form of security on a loan, giving the lender the right to unilaterally drain a borrower’s bank account if the latter fails to pay. But for a particular group of unscrupulous lenders – who use the term “merchant cash advance” to skirt usury rules – it also creates an opportunity to profit by prematurely collecting debts.

This form of predation has found a lucrative base in New York, where state law is uniquely amenable to confessions of judgment. In a matter of days, a lender can get a county clerk to sign a judgment and a New York City marshal to confiscate cash from any bank with an office in the city – all before the borrower has a clue what’s going on. In this way, cash-advance companies have extracted hundreds of millions of dollars from thousands of small businesses over the past several years, afflicting the likes of car washes, real estate agencies and pizzerias nationwide. Even if documents are forged or defaults fabricated, fighting back can be useless: The judgments are extremely difficult to overturn, and businesses can be destroyed before their owners even get a chance to try.

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Most business owners would never sign such an agreement if they were aware of the potential consequences. All too often they aren’t: Small-business lending remains largely unregulated in the U.S., with no consistent requirements for clear disclosure of terms and interest rates. This gives predators the leeway they need to entrap unsophisticated borrowers, often with a promise of a larger loan that never materializes.

The best solution would be for Congress to pass a truth-in-lending law for small business, along the lines of the rules that already exist for consumer loans. This should include federal constraints on confessions of judgment – outlawing their use for new loans, or at least requiring that the borrower get a written recommendation from a lawyer before entering any such agreement (as California already does). It should also designate a federal regulator to apply the law to all lenders, no matter what they call themselves.

Granted, Congress isn’t likely to move quickly. In the meantime, New York needs to clean up its act. At the very least, that means placing its own constraints on confessions of judgment.

For a market economy to function, people must be free to make contracts. But there ought to be limits – and contracts that deprive small businesses of any semblance of due process lie outside them.

Bloomberg View editorial.