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By Steven R. Harmon
California’s new usury exemption should provide a quick, inexpensive
method for small private companies to obtain debt financing
that meets the exemption requirements.
California Assembly Bill 244, which went into effect on January
1, 2001, should significantly ease the regulatory burden imposed
by California’s usury law on companies seeking to arrange
some types of debt financing. A.B. 244 should be particularly
helpful to private California-based companies that must rely
on debt financing to bridge the gaps between rounds of equity
financing, such as stock investments by “angels” or venture
capitalists.
In shepherding A.B. 244 to passage, the State Bar of California’s
Business Law Section stated that its purpose was to “make
it easier for small companies to obtain debt financing” in
cases where the companies “would be unable to obtain loans
from traditional institutional lenders in a timely manner.”
“Usury” Defined
Article XV of the California Constitution prohibits “usury”,
which is a loan or forbearance of money, goods or things at
a rate of interest that exceeds specified levels. Under state
law, a borrower that pays interest in excess of the usury
limits may sue the lender for treble damages, and the lender
may be guilty of a felony. The constitutional usury limit
applicable to most business transactions (those not “primarily
for personal, family, or household purposes”) equals the Federal
Reserve Bank of San Francisco’s discount rate (the rate charged
to Fed member banks) plus 5% per year, but the limit can never
drop below a floor of 10% per year. As of May 15, 2001, because
of a low discount rate (4.0% per year), the maximum rate was
10%.
Usury Exemptions
California law provides several exemptions from the prohibition
on usury. The State Constitution exempts certain transactions
and lenders (such as banks and credit unions) from its provisions
and also authorizes the California legislature to create additional
exemptions by statute. Prior to A.B. 244, statutes on the
books exempted “evidences of indebtedness” (e.g., promissory
notes or bonds) in few circumstances, such as:
(1) where the debt has certain minimum Standard & Poor’s
or Moody’s ratings,
(2) where the issuer has any securities listed on a national
securities exchange or NASDAQ, or
(3) where the issuer is a reporting company under the federal
Securities Exchange Act of 1934 and meets certain financial
condition minimum requirements.
Additionally, private companies, who generally cannot meet
the requirements of the foregoing exemptions, can issue debt
exempt from usury regulation by issuing the debt pursuant
to a “qualification,” which usually requires the company to
obtain a permit for the issuance of securities from the state
Department of Corporations, with significant associated costs
and delays. Primarily with these private companies in mind,
A.B. 244 was passed to create an additional usury exemption.
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Applying the New Exemption
The new usury exemption, found in California Corporations
Code Section 25118, provides that evidences of indebtedness,
and persons or companies who purchase or hold them, are exempt
from the usury prohibition in two instances:
(1) if the company issuing the debt (or a guarantor affiliated
with the issuer) has at least $2 million in total assets,
according to its most recent financial statements, or
(2) if the debt is at least $300,000 at the time of issuance,
or is issued pursuant to a written commitment or line of credit
of at least $300,000.
In addition, for either exemption to apply, one of the following
must apply:
(1) the lender and the issuer or guarantor of the indebtedness
(or any of their officers, directors or controlling persons)
must have a preexisting personal or business relationship,
or
(2) the lender and the issuer, or the lender and the guarantor,
by virtue of their own business and financial experience or
that of their professional advisers, could reasonably be assumed
to have the capacity to protect their own interests in connection
with the transaction.
The new exemption explicitly does not apply if:
(1) the borrower is an individual, a revocable trust having
at least one individual as a trustor, or a partnership having
at least one individual as a general partner (or the debt
is guaranteed by any of the foregoing), or
(2) the loan is primarily for personal, family, or household
purposes.
The statute explicitly states that it does not exempt any
person from the California Finance Lenders Law, which governs
licensing requirements for lending and loan brokering activities.
Hence, while the exemption eliminates usury regulation as
an impediment to certain transactions, it does not create
new classes of potential lenders or loan brokers who are wholly
exempt from regulation.
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Quick, Inexpensive Method
The new exemption should facilitate the bridge loan transactions
often entered into by expanding private companies. Bridge
loan transactions often encounter usury problems when a non-bank
lender (such as a prospective equity investor) insists that
the borrower agree to interest rates that are at or near the
prevailing interest rate ceiling. Lenders to private growth
companies tend to
require high rates, at least in part, because of the collection
risks associated with private growth companies. Further exacerbating
the usury problem is the fact that bridge loan terms typically
provide that principal (and sometimes interest) on the loan
is convertible into the borrower’s stock (sometimes at a discount
from fair market value), and often the lender is issued a
warrant (a
right to buy the borrower’s stock in the future) as a “sweetener”
in order to induce the loan. If the conversion feature of
the note and/or the warrant has some additional value that,
when added to the nominal interest rate on the note, exceeds
the existing usury interest rate ceiling, a usury exemption
is needed in order to facilitate a legally enforceable transaction.
For bridge loan transactions that can meet the Section 25118
requirements, the exemption should provide a quick, inexpensive
method for small private companies to obtain capital, permitting
them to avoid the added cost of filing a securities qualification
permit (with fees up to $2,500, not to mention attorneys’
fees associated with preparing the filing), and the delay
that waiting for permit issuance might entail.
Opening the Field of Lenders
An additional feature of the new exemption is responsive to
the convention that, as in venture capital financing transactions,
the borrower is expected to pay the lender’s reasonable attorneys’
fees. The exemption specifically provides a clarification
that, with respect to the lender, the “capacity to protect
their own interests” test, described above, can be satisfied
by the lender’s “professional advisor”, including the lender’s
attorney, even if that attorney is compensated by the borrower
or guarantor. This clarifying language ensures that a transaction
will not be disqualified from the new exemption on the basis
of the potential conflict of interest created by lender’s
counsel being compensated by the borrower. This opens up the
field of possible lenders to include high net-worth individuals
who may not have lending experience but are represented by
counsel.
In Summary
California’s new usury exemption should allow bridge loan
transactions to be completed more quickly and with lower transaction
costs. This represents a substantial improvement in the regulatory
environment for California private companies that must finance
their operations through bridge loans.
This Update provides general information only. For more information
regarding the specifics of this Update, please contact Steve
Harmon of our Business & Technology Practice Group at
(925) 937-3600 or e-mail sharmon@mmblaw.com.
This Update is produced and copyrighted by Morgan, Miller
& Blair. Any use or reproduction of the Update or its
contents without Morgan, Miller & Blair's prior express
written consent is strictly prohibited. This published material
constitutes neither legal advice nor exhaustive legal study.
Applicability to any particular situation is dependent on
a fact-by-fact analysis.
© 2000 Morgan, Miller & Blair. All Rights Reserved.
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