New York Court of Appeals Rules Business Convertible Loans May Be Subject to Usury Laws | Knowledge
A recent New York Court of Appeals ruling may affect lenders who use convertible loans when lending to corporate borrowers. The decision in Adar Bays, LLC v GeneSYS ID, Inc., considers that the conversion price of a convertible option can be considered to be interest and therefore may fall under the criminal usury laws of New York. Therefore, loan companies must take appropriate steps to ensure that the value of their convertible loan rates is below the interest rate cap set by New York’s criminal usury laws or risk that the entire loan – both interest and principal – will be canceled and therefore entirely uncollectible.
In Adar berries, the United States Court of Appeals for the Second Circuit certified two questions to the New York Court of Appeals:
- “That a share conversion option which allows a lender, in its sole discretion, to convert any outstanding balance into shares at a fixed price is to be considered interest for the purpose of determining whether the transaction violates criminal law of NY § 190.40, the criminal law of usury.
- “If interest charged on a loan is found to be criminally usurious under NY Criminal Law § 190.40, let the contract be void ab initio pursuant to NY Gen. Oblig. Law § 5-511.
(Majority at 1-2). The State High Court answered both questions in the affirmative. As a result, the business loan in question may be considered void and unenforceable, and GeneSYS, the borrower, may be awarded for both interest and principal.
Facts and history of the proceedings
The case concerns a loan of $ 35,000 made by Adar Bays to GeneSYS which included an option for Adar Bays to convert the outstanding balance of the loan into shares of GeneSYS at a discount of 35%. Adar Bays could exercise the option from 180 days after the ticket was issued.
Six months and four days after the note was issued, Adar Bays sought to convert $ 5,000 of debt into 439,560 shares. At the time, GeneSYS stock was trading at $ 0.024 per share, for a conversion price of $ 0.011. GeneSYS denied Adar Bays’ request, after which Adar Bays filed an action in the United States District Court for the Southern District of New York. GeneSYS decided to reject it, arguing that the loan violated New York’s usury law which capped interest at 25%. The motion was dismissed and the district court awarded summary judgment to Adar Bays and $ 92,308 in damages.
On appeal, the Second Circuit noted that while most federal district courts had ruled that similar conversion options did not constitute interest under New York usury laws, some courts in New York State York had factored in the value of future contingent payments when valuing the usury defenses. Additionally, the Second Circuit ruled that New York law was unable to determine whether a loan made to a corporation would be void or subject to reform, even if the rate was deemed usurious. Due to this lack of clarity, the Second Circuit certified both questions to the Court of Appeal.
Decision of the Court of Appeal
In its decision, the Court of Appeals answered the second question first, telling the long story of the ban on usury in New York (both the state and the colony). Most relevant here, the court clarified that the 25% interest rate cap on loans (“criminal usury”) applies to business loans, and therefore is not prohibited for a business. borrower to invoke the defense of criminal usury in a civil action. If a borrower proves the defense of criminal usury in a civil action, the usurious loan is deemed null and unenforceable for both principal and interest. As the court said, “Loans proven to violate the law on penal usury are subject to the same consequence as any other usurious loan: the total invalidity of the loan instrument”. (Majority at 15-16 years old).
On the first question, the court specifies that “to assess whether the interest on a given loan has exceeded the legal usury ceiling, the value of the convertible options at variable prices must be included in the determination of the interest”. (Majority at 16). This value is a question of fact measured at the time of contracting.
As a preliminary matter, the court determined that the transaction in question was a loan and not, for example, a purchase of shares, which is not subject to usury laws. Although the conversion option was a significant part of the consideration received by Adar Bays for the loan, the court ruled that its mere presence did not turn the loan into an investment in shares. In addition, the court ruled that loans that include an option to convert debt into shares are still loans, for the purposes of usury laws, because they are simply loans with an option to repay the property ( i.e. in actions).
Next, the court considered the principles for evaluating a criminal usury defense when it came to possible future options. First, it ruled that the fact that a future fixed-price conversion option could result in a usurious rate does not render the loan usurious on its face. Usurious intention is rather a question of fact which must be assessed at the time of negotiation, and not a posteriori.
Finally, the court provided some rules for investigators to determine the value of a convertible option. First, the value of a convertible option should not be discounted based on the risks inherent in any lending transaction. For example, a borrower may go bankrupt and be unable to pay the loan – this risk exists regardless of the loan terms and is built into the statutory usury limit. Second, when a lender has contractually protected itself against a certain risk, that risk does not negate the value of the convertible option. Here, for example, Adar Bays had included provisions to protect themselves if GeneSYS were deregistered. Thus, the possibility of delisting had no effect on the value of the convertible option.
The court did not approve any particular methodology for determining the value of stock conversion options, ruling only that it is “confident that convertible options are not so speculative that, in law, they cannot be valued” . (Majority at 23-24).
The Court of Appeals ruling makes it clear that business loans with convertible options could violate New York usury laws. Corporate lenders should prepare borrowers who default on such loans to raise criminal usury as a defense in civil actions. Lenders will be well advised to heed the concerns raised by dissent that “stock options to convert debt to equity at a fixed discount must [now] be treated as interest rates per se in all cases. (Dissent at 6). Dissent fears that the majority approach places the onus on lenders to refute the defaulting borrower’s valuation model, which would lead to costly litigation.
Loan companies should also consider keeping a record of their calculations of the value of a conversion option at the time a loan is made, to demonstrate that the expected interest rate on the loan is less than the usury rate. 25% criminal. As the court explained, the actual and realized value of a conversion option is not the relevant figure for courts considering a criminal usury defense. Rather, the intention of the parties at the time of negotiation is the relevant investigation for investigators. Where a lender can use good faith to avoid usurious rates, through contemporary modeling or analysis to justify or assess the expected returns of the loan containing variable price conversion options, courts are likely to note an absence of usurious intention.