in a Adar Bays, LLC v. GeneSYS ID, Inc., the New York Court of Appeals (the “Court”) held that the transfer price in the convertible option could be classified as interest and therefore likely to fall within the territory of the criminal usury laws of New York.
In 2016, Adar Bays provided GeneSYS with a $35,000 loan against a note with a one-year maturity and eight percent interest. This note contained an option for Adar Bays to convert, in whole or in part, the amount of the debt into shares of GeneSYS stock at a 35% discount from the lowest publicly traded price in the 20 days prior to the conversion request. Six months and four days after the bond was issued, Adar Bays sought to convert $5,000 of debt into shares of GeneSYS stock. This request was denied and litigation began with Adar Bayes alleging breach of contract by GeneSYS and GeneSYS to dismiss the case on the grounds that the loan violated New York’s criminal usury laws.
The Federal District Court rejected GeneSYS’ argument that the contract should be deemed void because the loan interest rate exceeded the criminal usury rate of 25%. Upon a favorable ruling in Adar Bays’ favour, GeneSYS appealed and on appeal the Second Circuit noted that many federal district courts did not classify similar transfer options as interest under New York’s usury laws but some New York state courts included future contingent payments in the analyses. With this distinction in mind, the Second Circuit endorsed two questions to the Court:
- whether the stock transfer option permits the lender, in its sole discretion, to convert any outstanding balance into shares of stock at a fixed discount, which shall be treated as interest for the purpose of determining whether the transaction violates New York Criminal Code § 190.40, the criminal usury law; And
- If the interest charged on the loan is determined criminally usurious under NY § 190.40, whether the contract is essentially void according to NY Gen. Obligation. Law § 5-511.
The court decided both questions in the affirmative.
The Court began with the second question and provided a comprehensive analysis of New York’s civil and criminal usury laws, as well as the history of New York’s usury laws. The court examined the interaction between civil and criminal usury laws and held that while civil laws do not provide companies with a defense of usury, a violation of criminal usury laws can be used by a company as a defense in a civil case. Furthermore, while criminal usury laws do not expressly state that usurious loans are void and unenforceable as civil laws do, the Court has held that it was the intent of legislatures that a violation of criminal usury laws results in the loan, whether it is principal or interest, being void. and unenforceable.
Of added importance, the court made clear that loans over $2.5 million are not subject to New York’s usury laws.
In analyzing the first question, the Court held that “New York law requires that the value of the transfer option, like all other property exchanged for the loan, be included in the determination of the interest rate on the loan for purposes of usury laws, to the extent reasonable, when such value is measured at the time of contract. The hypothetical possibility that the future exercise of the floating rate conversion option would result in a return in excess of 25% does not make the loan ostensibly usurious.”
New York is one of the most popular governing laws for loan documents, due in large part to the fact that there are no usurious restrictions for loans over $2.5 million. However, lenders should be aware of potential usury issues with stock options related to loans under $2.5 million. The court ruling indicates that going forward with corporate loans will be considered with a greater level of scrutiny and that defaulting borrowers are likely to file a criminal defense of usury in a civil action arising from loan default.
Moreover, it is advisable that, in the future, lenders keep a detailed ledger going forward detailing their accounts in case the value of the conversion option is questioned. Since the court held that the analysis was based on the intent of the parties at the time of entering into the loan, the lender must prove its intent that the expected interest rate found on the loan does not exceed 25% so as not to conflict with criminal usury laws. Practitioners may also wish to consider including the usury clause which states that the transfer price is considered adjusted to the minimum required to ensure that the interest considered is not usurious.
Finally, while New York law is often seen as the default governing law for loan documents, lenders may want to consider other state laws to the extent that party locations allow. State usury laws vary widely from state to state, so lenders may be able to rely on a law that governs them with more flexibility to avoid usury traps.