One of the major decisions a business investor must make is how to structure his or her investment in a small business. Sometimes, investors will simply purchase an equity position in the business. For example, an investor might acquire a membership interest in a limited liability company (LLC) or become a stockholder in a corporation in exchange for a cash contribution. At other times, circumstances may require that at least a portion of the investment be structured as a loan (either secured or unsecured) with interest payments to be made by the borrower to the investor.
While there are myriad reasons that an investor might choose one form of investment over the other (e.g., tax issues, control of the company, reducing risk of loss, etc.) the impact of California’s restrictions on usurious loans must be carefully considered. Failure to properly structure a loan can have significant consequences—if the interest rate on the loan is in excess of the legal limits, the loan agreement is illegal and the borrower may not have to pay any interest whatsoever. Even worse, if the borrower actually pays interest at a usurious rate, the lender may be liable for treble the amount of interest paid!
California’s usury laws are not simple. While there are numerous exemptions to their application, they are replete with traps for the unwary. This blog post will discuss the origin of the usury laws, the statutory exemptions and their application to particular transactions. This article, however, is not intended as a definitive discussion of the legal or practical issues in determining whether a particular transaction is usurious. If you are considering making a business investment that is, in whole or in part, structured as a loan, you should consider consulting with an attorney that is well versed in the usury law.
What is Usury?
California law specifies the maximum interest rate that can be charged in a loan transaction or forbearance. A “forbearance” can take many forms but, in general, it is an agreement to delay enforcing rights that a lender has under a promissory note in the event of a default. There is no national usury law. Each state either sets its own rate or may have no limitation at all.
What are the Rationales For and Against Usury Laws?
Usury laws are intended to protect potential borrowers from themselves and unscrupulous lenders. That is, desperate borrowers will agree to any interest rate when they need money. While some may argue that government should have no role in setting interest rates in private transactions, California has opted to impose such restrictions. Others argue, however, that such restrictions are counterproductive in that imposing interest rate restrictions in times of high inflation and tight money, reduces the number of lenders willing to offer loans at or below the legal limit.
Current California Restrictions Relating to Usury
The California Constitution sets the maximum interest that can be charged to borrowers. Specifically, for loans in which the proceeds are primarily for “personal, family or household purposes” the maximum rate is 10% per annum. For all other uses, the maximum rate is the higher of (a) 10% or (b) 5% plus the Federal Reserve Bank of San Francisco (“FRBSF”) discount rate on the 25th day of the month preceding the making of the loan. As a practical matter, since the onset of the Great Recession in 2008 and the reduction in the discount rate set by the FRBSF, the maximum permissible interest rate has been 10%. Of course, if the economy continues to improve it is possible at some point that the 5% rate plus the FRBSF discount rate may exceed 10%.
When is a Loan Deemed Usurious?
A loan is deemed usurious if there is a probability that amounts in excess of that permitted by law will be paid over the life of the loan. Unless they fall within an exemption (see below) shared appreciation loans and participation in profit arrangements may violate usury limitations. Similarly, loan origination fees may be deemed usurious if they exceed the lender’s actual origination costs (i.e., they are considered “disguised interest”).
Who is Exempt from the Usury Law?
There are numerous exemptions from California’s usury law. For example, institutions in the business of lending money, including building and loan associations, industrial loan companies, credit unions, licensed pawnbrokers and personal property brokers, banks and specified nonprofit organizations engaged in lending money for agricultural purposes, are exempt. Similarly, there are various statutory exemptions, including certain shared appreciation loans, certain ERISA loans, and loans made by institutions engaged in the trust business when acting as a fiduciary.
For the typical investor that is considering making a loan, the two most important and useful exclusions from application of the usury laws, are the so-called “purchase money mortgage” sales agreement and the real estate broker exemption.
What is a Purchase Money Mortgage?
A Purchase Money Mortgage is a loan made by the seller of property to the buyer that is secured in whole or in part by said property. Such loans are not subject to the usury law. For example, a seller of either personal or real property might be willing to sell at a price of $100,000 if paid in cash or $125,000 if paid over time. Assuming that the buyer elects to pay $125,000 over time, if the loan is secured by the property being purchase, it is considered a purchase money mortgage that is exempt of the usury law. Similarly, the loan would not be usurious if the purchase price was $100,000 but the secured promissory note included a 20% interest rate on the unpaid principal balance.
The real estate broker exemption
Any loan made or arranged by any person licensed in California as a real estate broker and secured in whole or in part by liens on real property is exempt from the usury law. (See California Civil Code section 1916.1.) A loan is “made” by a broker when he acts as a principal in the transaction, whether or not he is acting within the course and scope of his real estate license. A loan is “arranged” by a real estate broker when he acts for another, not for himself, and must receive or expect compensation. Arranging includes “soliciting, negotiating or arranging the loan for another.”
What about Unconscionable Contracts?
Even if the loan is not usurious, the contract may be void if the interest rate is excessive. For example, if a licensed real estate broker made a loan secured by real property but charged 200% interest, it is likely that the court would find the contract unconscionable and refuse to enforce its terms. In one recent case, the court reduced the rate to what it determined was “commercially reasonable.”
Loans Made in Another State—Conflict of Law
What happens if a contract is entered into in a state that does not have a usury limitation but is secured by California real estate? Are the terms of the loan enforceable? Will the Courts permit a foreclosure in the event of a default in payment of excessive interest?
The answer: It depends.
California follows a rule of validation. That is, if two states have a substantial relationship to a contract and the interest rate is usurious under the laws of one state but not the other, it applies the laws of the state that would permit the interest charge unless the interest rate is “greatly in excess” of the rate permitted by the general usury law of the forum state.
While California has strict usury laws, there are multiple exemptions that may apply. The exemptions, however, contain traps for the unwary. If you are contemplating making a loan, you are well advised to seek legal counsel to review the promissory notes and related documents to ensure that they comply with California’s usury law.