The Legal Aspects of 605 Loans

The global financial landscape is a pressure cooker. From the lingering aftershocks of the pandemic to rampant inflation, supply chain snarls, and geopolitical instability, businesses are caught in a relentless search for capital. Traditional lending avenues, with their stringent requirements and slow-moving machinery, often fail to meet the urgent needs of modern enterprises. In this high-stakes environment, alternative financing has surged, and among the most potent, yet legally intricate, instruments are what industry insiders refer to as "605 Loans." This term, while not a formal statutory classification, has come to represent a class of sophisticated, often revenue-based or cash-flow-secured financing arrangements that operate in a complex legal gray area. Understanding the legal architecture of these loans is not just an academic exercise; it is a critical survival skill for founders, CFOs, and their legal counsel.

Deconstructing the "605 Loan": What Are We Really Talking About?

Before diving into the legalities, we must define our subject. The term "605 Loan" is a piece of industry jargon, not a code section. Its origins are debated, but it generally points to a financing structure where the primary underwriting focus is on a company's recurring revenue, cash flow, or specific asset performance, rather than traditional metrics like hard collateral or years of profitability.

Core Characteristics of a 605-Style Financing

These arrangements are typically characterized by several key features. First, they are often structured as Revenue-Based Financing (RBF) or Merchant Cash Advances (MCAs), where repayments are a fixed percentage of daily or monthly revenue. Second, they frequently involve a Confession of Judgment (COJ), a powerful and controversial legal clause where the borrower pre-emptively waives their right to defend themselves in court. Third, security is not always a traditional mortgage on property; it can be a UCC-1 financing statement filed against all of a company's assets, or a specific lien on intellectual property or accounts receivable. Finally, the "cost of capital" is often expressed as a factor rate rather than an interest rate, which can sometimes obscure the true Annual Percentage Rate (APR), pushing it into territory that might be considered usurious under some state laws.

Why the "605" Moniker?

The "605" is believed to be a reference to the higher-risk, non-conforming nature of these loans, placing them outside the "prime" lending box. It signifies a deal that is too complex, too risky, or too unconventional for a standard bank loan. It exists in the vibrant, but less regulated, space of private credit and alternative lenders.

The Legal Hot-Button Issues: A Minefield for the Unwary

The legal framework governing 605 Loans is a patchwork of state and federal laws, creating a landscape ripe for litigation and regulatory scrutiny. For any party involved, navigating this minefield requires a keen eye on several explosive issues.

Usury and the True Cost of Capital

This is arguably the most significant legal threat to lenders in this space. Usury laws, which set caps on allowable interest rates, are primarily state-based. A loan with an effective APR of 40% might be perfectly legal in one state but criminally usurious in another. The legal battleground here revolves around characterization. Lenders structure deals as "purchases of future receivables" (as in an MCA) or apply "origination fees" and "servicing fees" to argue that the transaction is not a "loan" and therefore not subject to usury caps. Courts across the country are deeply divided on this issue. A New York court might uphold the "true sale" theory of an MCA, while a California court may "recharacterize" the same transaction as a loan, potentially voiding the entire contract and requiring the lender to refund all payments made. For borrowers, challenging a 605 Loan on usury grounds is a high-risk, high-reward litigation strategy.

The Controversial Power of Confessions of Judgment

The Confession of Judgment is a legal nuclear option for lenders. By signing a COJ, a borrower waives their right to notice and a hearing. If the lender declares a default, they can present the COJ directly to a court clerk and obtain a judgment instantly, often before the borrower is even aware that legal action has been taken. The borrower's bank accounts can be frozen, and assets seized, without any opportunity to present a defense, such as arguing that the lender breached the agreement first. While COJs are permissible in commercial contexts in many states, their use in 605 Loans has drawn fierce criticism and regulatory action. The CFPB and state attorneys general have targeted the predatory use of COJs, particularly against small businesses that may not have had independent legal counsel review the documents. New York, a traditional hub for filing COJs, has recently tightened its rules, but they remain a potent and legally fraught tool.

UCC-1 Filings and the Battle for Priority

When a lender files a UCC-1 financing statement, it puts the world on notice that it has a secured interest in the borrower's assets. This becomes a critical issue in a bankruptcy or if the company seeks additional financing. The legal complexity arises around "priority" – who gets paid first if the company fails? A 605 lender's broad UCC-1 filing can effectively block a company from obtaining traditional venture debt or a bank line of credit. Furthermore, the specific terms of the "security agreement" can grant the lender sweeping control, including the right to seize not just inventory and equipment, but also the company's intellectual property, its very lifeblood. Disputes often erupt over the perfection of these liens and the scope of the collateral described.

605 Loans in the Context of Contemporary Global Crises

The legal risks associated with 605 Loans are magnified when viewed through the lens of today's global economic turmoil.

Supply Chain Finance and the Hidden Pitfalls

As companies struggled to pay suppliers amid supply chain disruptions, many turned to supply chain finance solutions, some of which bear the hallmarks of 605 structures. A company might use a financier to pay its suppliers early, with obligations tied to its own revenue. The legal danger here is the potential for these arrangements to be reclassified as corporate debt on the balance sheet, violating loan covenants with senior lenders and triggering cross-default provisions. The fallout from the Greensill Capital collapse is a stark reminder of how opaque supply chain financing can lead to catastrophic legal and financial consequences.

The Tech Winter and Down-Round Disasters

The recent "tech winter," with its plummeting valuations and frozen IPO markets, has forced many startups to seek 605-style bridge loans to extend their runway. These loans often come with punishing terms and warrants for equity. The legal conflict arises during a "down round" of equity financing. The terms of the 605 Loan may include "anti-dilution" provisions or specific liquidation preferences that clash with the terms demanded by new venture capital investors. Untangling this web of conflicting rights and priorities can scuttle a crucial funding round and lead to intense shareholder litigation.

ESG and the Question of Ethical Lending

The global push for Environmental, Social, and Governance (ESG) standards is now colliding with the world of high-cost private credit. Can a lender that funds a fossil-fuel enterprise or one that uses aggressive, borderline-predatory collection tactics like COJs truly claim to have a strong "S" and "G" framework? There is a growing risk of "ESG-washing" litigation, where stakeholders sue companies or their financiers for misrepresenting their ethical commitments. A 605 Lender that publicly touts its support for small business while simultaneously deploying Confessions of Judgment against them is creating a significant legal and reputational vulnerability.

Best Practices for Navigating the Legal Terrain

For all their risks, 605 Loans fill a vital need. The goal is not to avoid them entirely, but to engage with them intelligently and with robust legal safeguards.

For Borrowers: Vigilance and Scrutiny

The number one rule for any business considering this type of financing is: get an experienced lawyer. Do not rely on the lender's explanation or boilerplate documents. Scrutinize the total cost of capital and calculate the implied APR. Negotiate aggressively to remove or modify the Confession of Judgment clause. Understand the scope of the UCC-1 filing and seek to narrow the definition of collateral. Crucially, model various downside scenarios to understand what a default would truly mean for the company's survival.

For Lenders: Compliance and Sustainability

Prudent lenders in this space must invest heavily in legal compliance. This means conducting rigorous state-by-state usury analysis before issuing any credit. It means moving away from the reflexive use of Confessions of Judgment and adopting more transparent and equitable collection practices. Clear, plain-English disclosures about the cost and structure of the financing are not just good practice; they are a defense against claims of deception and a key to building a sustainable, reputable business in the long term. The "lender-beware" era is dawning.

The world of 605 Loans is a testament to financial innovation meeting real-world desperation and opportunity. It is a domain where the law is constantly playing catch-up, creating a dynamic and perilous environment. In an era defined by economic uncertainty, the parties who thrive will be those who respect the legal complexities not as obstacles, but as the fundamental rules of the game. The difference between a strategic capital infusion and a corporate death sentence often lies in the fine print.