Investment or Loan? Beware of Usury

New York has the harshest[1] usury laws in the country. Unlike many other jurisdictions where the penalty for making a usurious loan is the loss of interest, New York penalizes a usurious lender by forgiving the principal as well. However, because New York recognizes that sophisticated commercial borrowers may have good reason to obtain loans at usurious rates, New York usury laws only apply to loans of less than $2.5 million, so most commercial lenders need not worry.

The New York Court of Appeals (the highest court in New York) recently addressed an interesting usury matter. Keep in mind that federal courts ruling on state law must be guided by state court rulings. When questions arise for which there is no authoritative guidance the question is referred to the state’s highest court.

The underlying action was brought by Adar Bays, LLC, against GeneSYS ID, Inc. (publicly traded on the OTC) to collect on a Convertible Redeemable Note (Note) issued in connection with a $35,000 loan from Adar Bays to GeneSYS which had defaulted. The Note permitted Adar Bays to convert any outstanding loan balance into GeneSYS common stock at a 35% discount from the stock’s market price. The primary issue presented was whether this conversion option meant that the Note’s interest rate exceeded the 25% cap set by New York’s criminal usury law.

The United States District Court for the Southern District of New York granted summary judgment in favor of Adar, ruling that under New York law, the Note’s conversion option did not result in a criminally usurious interest rate. GeneSYS appealed to the Second Circuit.

Because the resolution of the issues before it turned on questions of state law for which no controlling decisions of the New York Court of Appeals exist, The Second Circuit certified two questions to the New York Court of Appeals:

    1. Whether a stock conversion option that permits a lender, in its sole discretion, to convert any outstanding balance to shares of stock at a fixed discount should be treated as interest for the purpose of determining whether the transaction violates … the criminal usury law.
    2. If the interest charged on a loan is determined to be criminally usurious …, whether the contract is void ab initio …

In considering the matter, the Second Circuit noted that

[w]hen a note is not usurious on its face, usury is not presumed and the debtor must prove all the elements of usury, including usurious intent.

The Second Circuit went on to recognize that

New York courts … have generally rejected the view that a conversion option with a discounted rate should be treated as interest.

The New York Court of Appeals started with an extensive history of New York’s usury laws dating back to colonial times and continued through the present.

When determining whether a transaction is a loan, substance—not form—controls… Several factors help distinguish loans from equity purchases and joint ventures, which are not subject to the usury laws. First, parties who are not directly exposed to market risk in the value of the underlying assets are likely to be lenders, not investors… Additionally, context, such as whether a party applied to the other for a loan or had outstanding, separate transactions, helps to distinguish between intent to borrow and intent to engage in a joint transaction or exchange money for some other reason.

The Court noted that Adar Bays was a lender; GeneSYS executed a note where it promised to repay the loaned principal plus interest by the maturity date. It further noted that by having a floating-price conversion option, the lender avoided any share-price risk that an equity investor or joint venturer would bear. Specifically, Adar Bays would always receive more stock than the converted principal could have purchased on the open market at the then current trading price.

From colonial times to present, the legislature has defined interest to include the value of all goods and promises exchanged in consideration for a loan in the usury analysis. The earliest usury prohibition in the colony of New York set out the modern and broad language prohibiting the “direct[] or indirect[]” taking of usurious interest.

In rendering its decision, the Court made it clear that it was not holding that convertible stock options are per se usurious.

We have not been asked how to determine the value of stock conversion options here and do not endorse any particular methodology. Nonetheless, we are confident that convertible options are not so speculative that, as a matter of law, they cannot be valued. The valuation of options is widespread and is the foundation on which hedge funds operate.

However, floating rate convertible options will be more closely scrutinized to assess whether the balancing of the risks associated render the transaction an investment or a loan.

One reading the decision should be sure to review the dissent, which expressed concerns with multiple examples of the dangers that might result from the Court’s ruling, to which the majority responded:

The dissent worries, essentially, that usurers making loans of less than $2.5 million with floating-price conversion options will move their operations to other states, and perhaps some legitimate lenders of such loans who are close to the edge will do likewise. If so, that result is in harmony with our legislature’s unbroken intent over many centuries: the strict protection of more vulnerable borrowers from extortionate rates. As it has done before, our legislature can freely adjust the usury laws if the dissent’s parade of horribles turns out to be something more than phantasm.

Inasmuch as much of today’s commercial lending is derived from non-bank and nontraditional lenders whose objectives are different from those of traditional banks, consideration must be given when structuring such transactions to mitigate the lender’s risks and better assure that its investment will be best protected.

Adar Bays, LLC v GeneSYS ID, Inc. (__ NY. 3d ____ October 14, 2021)

See also, Adar Bays, LLC v GeneSYS ID, Inc. (962 F3d 86, 2d Cir. 2020)

[1] ‘New York’s voiding of usurious contracts “can be harsh,” perhaps especially in comparison to other states’ laws, but the penalty reflects the legislature’s consistent condemnation of the ‘evils of usury’” (Seidel v 18 E. 17th St. Owners, 79 NY2d 735, 740-741 [1992]).

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