New York Court of Appeals Rules Corporate Convertible Loans May Be Subject to Usury Laws

A recent decision from the New York Court of Appeals may affect lenders who use convertible loans when lending to corporate borrowers. The decision in Adar Bays, LLC v. GeneSYS ID, Inc., holds that the conversion price in a convertible option can be considered interest and thus may fall under the purview of New York’s criminal usury laws. Accordingly, corporate lenders must take appropriate steps to ensure that the value of their convertible loan rates is less than the interest rate cap set by New York criminal usury laws or risk that the entire loan — both interest and principal — will be voided and thus entirely uncollectible.
  
In Adar Bays, the U.S. Court of Appeals for 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 N.Y. Penal Law § 190.40, the criminal usury law.
2. “If the interest charged on a loan is determined to be criminally usurious under N.Y. Penal Law § 190.40, whether the contract is void ab initio pursuant to N.Y. Gen. Oblig. Law § 5-511.”

(Majority at 1-2). The state high court answered both questions in the affirmative. As a result, the corporate loan in question may be deemed void and unenforceable, and GeneSYS, the borrower, could be off the hook for both the interest and principal.

Facts and Procedural History

The case concerns a $35,000 loan made by Adar Bays to GeneSYS that included an option for Adar Bays to convert the outstanding loan balance into shares of GeneSYS stock at a discount of 35%. Adar Bays could exercise the option starting 180 days after the note 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 of stock. At the time, GeneSYS stock was trading at $0.024 per share, for a conversion price of $0.011. GeneSYS refused Adar Bays’ request, after which Adar Bays sued in the United States District Court for the Southern District of New York. GeneSYS moved to dismiss, arguing that the loan violated New York’s usury law that capped interest at 25%. The motion was denied, and the district court granted summary judgment to Adar Bays and $92,308 in expectation 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’s usury laws, some New York state courts had taken into account the value of future, contingent payments when evaluating usury defenses. Further, the Second Circuit found New York law unsettled as to whether a loan made to a corporation would be void or subject to reformation, even if the rate were determined to be usurious. Due to this lack of clarity, the Second Circuit certified the two questions to the Court of Appeals. 

Court of Appeals Decision

In its ruling, the Court of Appeals answered the second question first, recounting the long history of the prohibition on usury in New York (both the state and the colony). Most relevant here, the court clarified that that the 25% interest rate cap on loans (“criminal usury”) applies to corporate loans under $2.5 million, and thus a corporate borrower is not precluded from raising 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 void and unenforceable for both the principal and interest. As the court puts it, “loans proven to violate the criminal usury statute are subject to the same consequence as any other usurious loans: complete invalidity of the loan instrument.” (Majority at 15-16). 

On the first question, the court makes clear that “in assessing whether the interest on a given loan has exceeded the statutory usury cap, the value of the floating-price convertible options should be included in the determination of interest.” (Majority at 16). This value is a question of fact measured at the time of contracting. 

As a threshold matter, the court determined the transaction in question was a loan and not, for example, an equity purchase, which is not subject to usury laws. Although the conversion option was an important part of the consideration Adar Bays received for the loan, the court held that its presence alone did not turn the loan into an equity investment. Further, the court held that loans that include an option to convert debt into stock are still loans, for the purpose of usury laws, as they are simply loans with the option of repayment in property (i.e., stock).  

Next, the court looked at principles for assessing a criminal usury defense when dealing with contingent future options. First, it held that the fact that a fixed-price future conversion option may result in a usurious rate does not make the loan usurious on its face. Rather, usurious intent is a question of fact that must be assessed at the time of the bargain, not ex post.

Last, the court supplied a few rules for fact finders when figuring out the value of a convertible option. First, the value of a convertible option should not be discounted based on risks inherent to any loan transaction. For example, a borrower may go bankrupt and be unable to pay the loan — this risk exists regardless of the terms of the loan and is built into the statutory usury cap. Second, where a lender has contractually insulated itself from a certain risk, that risk does not discount the value of the convertible option. Here, for example, Adar Bays had included provisions to protect itself if GeneSYS were delisted. Thus, the possibility of delisting had no effect on the value of the convertible option. 

The court did not endorse any particular methodology for determining the value of stock conversion options, only holding that it is “confident that convertible options are not so speculative that, as a matter of law, they cannot be valued.” (Majority at 23-24). 

Conclusion 

The Court of Appeals’ ruling provides clarity that corporate loans with convertible options could run afoul of New York’s usury laws. Corporate lenders should brace themselves for defaulting borrowers of such loans to raise criminal usury as a defense in civil actions. Lenders will be well advised to heed the concerns raised by the dissent that “stock options to convert debt to equity at a fixed discount must [now] be treated as per se interest rates in all cases.” (Dissent at 6). The dissent fears that the majority’s approach will place the burden on lenders to rebut a defaulting borrower’s valuation model, inviting costly litigation. 

Corporate lenders 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 loan’s expected rate of interest is below the criminal usury rate of 25%. As the court explained, the actual, realized value of a conversion option is not the pertinent number for courts considering a defense of criminal usury. Rather, the intent of the parties at the time of the bargain is the relevant inquiry for fact finders. Where a lender can show a good faith effort to avoid usurious rates, through contemporaneous modeling or analysis to justify or evaluate the expected returns from the loan containing floating-price conversion options, courts are likely to find a lack of usurious intent.