These are challenging times for lenders. Problems sourcing funds coupled with heightened risk in volatile markets make finding good customers and hurdling profit expectations difficult. While New York State's usury laws do not affect most business transactions, lenders should remain aware of potential pitfalls when pricing loans because running afoul of the rules could result in loss of principal and interest for civil usury or even criminal penalties. Warrants, success fees, consulting fees and other fees may be appropriate, but if used to disguise interest, lenders may be inviting trouble. This was illustrated in Funding Group, Inc. v. WaterChef, Inc. , (852 N.Y.S.2nd 736, 740-42 (N.Y. Sup. Ct. 2008)), where a New York State Supreme Court found that a corporation could assert the defense of criminal usury, in part because lender took stock valued at amounts exceeding the usury limits as compensation for a loan.
The maximum rate of interest in New York is 16 percent per annum. See, N. Y. Gen. Oblig. Law ("GOL") § 5-501 (2009). Under GOL and New York Limited Liability Company Law, corporations and limited liability companies generally cannot use the civil usury defense . See , GOL § 5-521; N.Y Ltd. Liab. Co. § 1104 (2009).Criminal usury defenses, on the other hand, may be available. Loans to corporate borrowers of $250,000 or more are subject to a maximum interest rate of twenty-five percent per annum; but for loans of $2,500,000 or more, there is no limitation on the maximum rate of interest. See, GOL § 5-501(6)(a) and (b) and N.Y. Penal Law § 190.40 and § 190.42 (2009). GOL § 5-511(a) provides that transactions violating GOL § 5-501 are void and some lenders may be subject to forfeiture of principal and interest or, in the case of a savings bank, a savings and loan association or a federal savings and loan association, a borrower may be able to recover twice the interest paid.
There are a number of exceptions to the usury rule. For example, GOL provides that loans secured in accordance with Article 9 of the UCC, including discretionary or mandatory advances in the amount of $100,000 or more, are not subject to usury limitations, if on the date when the interest is charged or accrued, such interest is not greater then eight percentage points over the prime rate. See , GOL § 5-526(1).
But attempts to disguise interest may put a loan in jeopardy. See e.g., In re Rosner , 48 B.R. 538, 550-51 (Bankr. E.D.N.Y. 1985) (concluding consulting fee was usurious since fee was really compensation for making loan).
WaterChef extends to other types of compensation. In WaterChef, lender agreed to lend WaterChef, Inc. $25,000 for forty-five (45) days at ten percent per month. WaterChef agreed to pay interest in advance in the form of 75,000 shares of convertible preferred stock valued at five cents a share. As an incentive, lender was also issued additional shares of preferred stock convertible to 150,000 shares of WaterChef common stock. WaterChef agreed that if it failed to timely repay the loan, it would give lender a call on additional shares of convertible preferred stock to yield at least 500,000 shares of common stock upon conversion, and if the price of WaterChef common stock fell below five cents per share, WaterChef would issue additional shares, so the total number of shares held by lender would have a value of $25,000. If payment was made more than four (4) business days after loan maturity, WaterChef would be required to issue additional shares of convertible preferred stock so as to yield 600,000 shares of WaterChef common upon conversion.
The loan was made on April 1, 2003, and when WaterChef failed to timely repay the loan, it was sued by lender. In defense of lender's claims, WaterChef claimed usury.
The Court pointed out GOL's bar on corporations asserting civil usury defenses but said the defense of criminal usury was available. The Court found, despite lender's claims to the contrary, that besides the initial 120 percent interest rate, the agreement to take stock amounted to interest. There was nothing about the transaction that characterized it as anything other than a loan.
In dismissing the complaint, the Court found the loan to be usurious under § 190.40 of the Penal Law, but citing dicta from In re Venture Mortgage Fund, L.P. (282 F.3rd 185 (2nd Cir. 2002)), it noted that there is no authority for voiding a loan that violates the criminal usury law. WaterChef serves as a reminder that lenders should not to try to disguise interest as something it is not.
Published May 4, 2009.
