Restructuring

For millennia usury (defined as any interest on a loan, not just interest above some prescribed rate) was condemned as immoral in almost every culture (and in some it still is). Even such great thinkers as Aristotle disapproved of the charging of interest, describing it as the “most unnatural” means of “getting wealth” because it “makes a gain out of money itself, and not from the natural object of it.”¹ In the United States, of course, compensating a lender for making a loan seems a completely natural and expected part of finance; and usury is a term that typically now only refers to the charging of interest in excess of that permitted by applicable law. But usury, however defined and regardless of the rate at which the concept kicks in, remains a subject of state specific opprobrium. Indeed, those states that proscribe usurious rates of interest typically declare the charging of usurious interest as being contrary to a fundamental public policy of the applicable state. And the penalties for violating these proscriptions can be severe, including in certain circumstances the forfeiture of the principal advanced.

Even a state like New York, which is popularly believed to be free of usury-related concerns, has severe penalties for loan transactions declared to be usurious. The rules for loans in an amount less than $2.5 million are actually quite complicated (and subject to several specifically defined exceptions depending on the nature of the borrower and the security for the loan), but in general if the loan is for an amount less than $250,000 the civil usury ceiling is 16% and charging interest in excess of 25% is a criminal offense. For loans of more than $250,000, but less than $2.5 million, the civil limit of 16% is not applicable but the 25% criminal limit remains applicable. It is only if a loan is for an amount of $2.5 million or more that usury limits, both civil and criminal, no longer apply (and a loan for $2.5 million that is to be advanced in installments by one or more lenders to a single borrower pursuant to a written agreement counts as being a loan for more than $2.5 million).² And states like Texas have usury limits that apply even to loans greater than $2.5 million (the current limit for written loan agreements is generally 18%, subject to some exceptions).³
But it is important to note that it is not just the stated rate that can count as interest, any other compensation for the “use, forbearance or detention of money,” such as fees, grants of equity, the amount of any debt of others assumed, or just about any other contractually extracted consideration tied to the loan, might well be counted as interest too (although Texas has certain specified statutory exceptions for equity grants, loan assumptions and other common lender add-ons for certain specifically defined types of loans⁴). And what constitutes a loan as opposed to an investment or purchase is a fact specific exercise. In general, any transaction that requires the absolute repayment of the funds advanced is subject to the risk of being re-characterized as a loan.
A recent Delaware Superior Court decision, Change Capital Partners Fund I, LLC v. Volt Electrical Systems, LLC, C.A. No. N17C-05-290 RRC (Del. Super. Ct. April 3, 2018), provides an opportunity to remind private equity and restructuring deal professionals and their counsel of the importance of considering state specific usury laws in structuring (or restructuring) transactions that are loans, or might be re-characterized as loans, as well as the importance of appropriately selecting the most favorable governing law that is available for such a transaction. In Change Capital Partners, Azadian Group, LLC (Azadian”) had entered into a Merchants Receivables Purchase and Security Agreement with Volt Electrical Systems, LLC (“Volt”), pursuant to which Azadian had agreed to purchase $472,500 of future receivables to be generated by Volt for a fixed purchase price of $338,000. Volt paid Azadian the fixed purchase price of $338,000, but Volt apparently only transferred $248,590 in receivables to Azadian, leaving Azadian short by $223,910 of untransferred receivables. Azadian thereafter transferred its rights under the receivables purchase agreement to Change Capital Partners, a private equity firm. Change Capital Partners then sued Volt for breaching the receivables purchase agreement by failing to transfer the additional $223,910 of Volt receivables.
In defense, Volt claimed that the receivables purchase transaction was actually a loan and that the interest charged on that loan (presumably the receivables to be transferred in excess of the $338,000 actually advanced) was a staggering 102%. Obviously, if true, the deemed interest rate was well above the maximum rate allowed under Texas law and, given that the amount of the alleged loan, $338, 000, would have been well below $2.5 million, that interest rate would have also been well above the 25% criminal usury rate under New York law. Volt further claimed that despite the fact that the receivables purchase agreement had a Delaware choice of law clause, that choice of law was invalid because (1) the receivables purchase agreement/loan was usurious under both Texas and New York law, both states with substantial relationships to the transaction and either of which would be the “default state,” whose law would govern in the absence of the contractual choice of Delaware law, (2) usury was contrary to the public policy of both Texas and New York, and (3) Delaware “recognizes that allowing parties to circumvent state policy-based contractual prohibitions through the promiscuous use of [Delaware choice of law] provisions would eliminate the right of the default state to have control over the enforceability of contracts concerning its citizens.” Upholding the Delaware choice of law clause was critical to eliminating further concern with Volt’s usury claims because Delaware, unlike Texas and New York, “provides no cap on interest rates, but instead allows interest to be charged in an amount pursuant to the agreement governing the debt.” In other words, if Delaware law applied any re-characterization of the receivables purchase transaction into a loan would have been irrelevant to the claim of usury as a defense to the enforcement of that agreement.
Ultimately the court rejected Volt’s efforts to override the Delaware choice of law clause because even though the court agreed that a usurious agreement would violate a fundamental public policy of both New York and Texas, Volt failed to show that either Texas or New York had a “materially greater interest” in the enforcement of the receivables purchase agreement/loan than did Delaware. The fact that Volt was Texas limited liability company based in Texas, and that the alleged loan was “originated and was funded by Azadian in New York” where “Azadian was headquartered,” was not deemed a materially greater interest for Texas or New York than the fact that Azadian was a Delaware LLC and the agreement contained a Delaware choice of law clause. Indeed, according to the court, “Title 6, section 2708(a) of the Delaware Code recognizes that a choice of law clause is a significant, material and reasonable relationship with [Delaware] and shall be enforced whether or not there are other relationships with [Delaware].”⁵
The choice of law for an agreement alleged to be a loan was deemed distinguishable from a prior case, Ascension Ins. Holdings, LLC v. Underwood, 2015 WL 356002 (Del Ch. Jan 28, 2015), where a Delaware choice of law clause was contained in an agreement respecting a non-compete by a California employee, in favor of Delaware corporation doing business almost entirely in California. California generally views non-competes as contrary to a fundamental public policy (similar to the view of New York and Texas respecting usury). But according to the court, “[a] loan is not akin to the non-compete clause in Ascension wherein the geographic scope of the non-compete necessarily invoked California.” And unlike a California-focused non-compete, “[t]here is no state, by virtue of the loan itself, that would clearly apply” absent the choice of Delaware law.
Blindly choosing New York law to apply to the receivables purchase agreement without considering the potential applicability of New York usury law may have resulted in a different outcome for the private equity firm assignee of Azadian’s receivables purchase transaction. It may be that the receivables purchase would not have been re-characterized and all would have been well, but by choosing Delaware law rather than New York, the issue became irrelevant. Never assume that New York is like Delaware with no usury limits just because most of the transactions that you have been involved with are for amounts in excess of $2.5 million. Sometimes private equity firms do in fact transact with portfolio companies or their management at levels less than $2.5 million, particularly in a situation where the portfolio company is in financial distress.⁶ Choosing Delaware law (coupled with a Delaware choice of forum clause)⁷ may be an appropriate default choice in such circumstances. After all, there is almost always an available Delaware entity to advance the funds pursuant to the agreed structure.