The following is a case update prepared by Professor Dan Schechter, Loyola Law School, Los Angeles, analyzing a recent decision of interest:
A federal court in New York has held that despite a deeply discounted conversion price, a convertible note was not usurious because the stock option granted to the noteholder did not constitute “interest.” [Blue Citi, LLC vs. 5Barz International, Inc., 2018 Westlaw 4500870 (S.D.N.Y.).]
FACTS: A creditor held a convertible redeemable note, bearing interest at 10%. However, the note also contained a conversion option, under which the creditor could convert the outstanding principal and interest into shares of the issuer’s common stock. The conversion price was discounted at 60% of the stock’s lowest trading price during a 20 day “look back” period. Under the terms of the note, the issuer was required to deliver the converted shares within three days.
When the creditor made demand on the issuer, the issuer defaulted. Eventually, the parties entered into a settlement agreement, but the issuer defaulted again. The creditor brought suit seeking to compel the delivery of the shares. They were delivered after a considerable delay. The creditor then sought damages due to the devaluation of the shares in the interim between the due date and the date of actual delivery.
The creditor filed a motion for summary judgment, while the issuer sought to dismiss the action, claiming that the discount in the conversion price meant that the note was usurious and was therefore void ab initio. Under New York law, a note providing for more than 25% annual interest is void.
REASONING: The court ruled in favor of the creditor. The court noted that under New York law, there is a strong presumption against a finding of usury, and the debtor must establish usury by clear and convincing evidence. The court first concluded that the convertible nature of the instrument meant that this transaction was more like an equity investment, rather than a loan. As a fallback, the court held that the conversion option could not be characterized as usurious “interest:”
Interest is, by definition, a payment made with a degree of certainty and regularity; conversion options, by contrast, lack certainty, because they may or may not be exercised and because their value fluctuates depending on the prevailing market price of the shares . . . . Thus a conversion price is not an interest payment and, accordingly, does not fall under the protection of the usury laws.
The issuer then argued that the default rate was usurious, but the court noted that the weight of authority was to the contrary:
While the Second Circuit has not squarely ruled on the issue, the majority of district courts in this Circuit to have considered the issue have held that New York’s usury laws do not apply to default interest rates.
AUTHOR’S COMMENT: One would have thought that the courts of New York had long ago answered the question of whether convertibles are usurious; but that was apparently an unwarranted assumption. And although the court is correct that the weight of authority holds that the usury laws do not apply in this context, there is some contrary authority within the federal court system, and there is a dearth of state law decisions on point.
For discussions of cases dealing with related issues, see:
- 2011 Comm. Fin. News. 36, Note Bearing 32% Interest Rate Is Not Exempt from Usury Provision Because Individual Shareholder’s Nonrecourse Pledge of Stock Was Equivalent to Personal Guaranty.
- 2007 Comm. Fin. News. 67, Lender Cannot Invoke “Shared Appreciation” Exception to Usury Laws Because Additional Interest Is Not Really Contingent; Guarantor’s Waiver of Usury Defense Is Ineffective.
- 2006 Comm. Fin. News. 19, “Litigation Funding Agreement” Is Not Usurious Because Recovery Is Contingent.
- 2002 Comm. Fin. News. 21, Fees Charged in Loan Agreement (Including Commitment Fees, Facility Fees, Attorneys’ Fees , Collateral Monitoring Fees, Audit Fees, and Expense Reimbursement Fees) May Be Recharacterized As “Disguised Interest.”
These materials were written by Dan Schechter, Professor Emeritus, Loyola Law School, Los Angeles, for his Commercial Finance Newsletter, published weekly on Westlaw. Westlaw holds the copyright on these materials and has permitted the Insolvency Law Committee to reprint them.