Hybrid debt/equity transactions: do they intersect with the usury laws?

• Author: Matlow, Daniel W.
• Position: Florida

One of your regular clients, Carey Capital, asks you to spend a few minutes to look over the terms of a deal in which he plans to make a small investment. You review his handwritten notes. The material terms are straightforward and seem innocuous: "Mr. Capital agrees to lend Sally Sweat $25,000 to fund the start up of an Internet business.... Ms. Sweat agrees to repay the loan at a 10 percent interest rate.... Mr. Capital will keep the partnership books, assist in the office, and provide Ms. Sweat with business advice.. Ms. Sweat will run the day-to-day operations.... Mr. Capital is entitled to 10 percent of the partnership's profits." The agreement is unremarkable, a small loan rolled into a partnership agreement. Your biggest concern is whether Ms. Sweat or the Internet company has any assets that can stand as security for the loan. Hopefully, you do not overlook the usury laws when advising Mr. Capital.

Overview of Usury Law

Usury has ancient roots. (1) The Old Testament commands that "[t]hou shall not lend upon usury to thy brother" (2) or "take usurious interest from him." (3) Early Judeo-Christian communities regarded the practice of charging interest an immoral sin. (4) Aside from prohibiting usury in particular religious traditions, usury was condemned by the Roman Republic in 340 B.C. when anti-usury laws were enacted. (5) As the Florida Supreme Court long ago explained, "[t]he very purpose of statutes prohibiting usury is to bind the power of creditors over necessitous debtors and prevent them from extorting harsh and undue terms in the making of loans." (6)

Florida's usury laws, set forth in F.S. Ch. 687, prescribe a maximum rate of interest of 18 percent on loans of less than $500,000. (7) On loans that exceed $500,000, the maximum legal rate of interest is 25 percent. (8) Significantly, it is a criminal offense--misdemeanor or felony--to provide loans which have effective interest rates of 25 percent or more, but less than 45 percent. (9) Interest rates that exceed 45 percent are punishable as a third degree felony. (10)

The consequences of a usurious loan are severe. First, the loan may become unenforceable in whole or in part. If a loan is deemed usurious, the lender forfeits all interest charged. (11) With respect to loans deemed to be criminally usurious, in addition to forfeiting the interest, the entire debt becomes unenforceable. (12) Second, with respect to loans deemed usurious or criminally usurious, the lender may be liable to the borrower for damages in the amount double the amount of interest taken. (13) Third, with respect to any usurious loan, the lender may be liable for the borrower's attorneys' fees. (14)

In determining whether a loan is usurious, the court considers the substance of the transaction, rather than its form. (15) In its examination of the transaction, the court will deem certain lender charges as interest. (16) When the interest rate and lender charges are considered in tandem, and the latter is deemed interest, the charge must be valued as of the date received and spread over the term of the loan, advance of money, or line of credit. (17) Accordingly, when the court construes the lender charges and the stated interest rate on the loan together, the effective interest rate is often excessive and violates Florida's anti-usury statutes. Despite the confusion over lender charges, the usury statutes fail to exhaustively enumerate what charges should be deemed interest and in what circumstances. Without guidance from the legislature, it is difficult for investors and lenders to anticipate the potential consequences of their agreements. (18)

Attorneys must be aware of the anti-usury statutes and the judicial construction when advising clients. Although the statutes do not enumerate the lender charges that are considered interest, it is significant that the courts, in certain circumstances, have recharacterized equity interest in a partnership as interest. As such, attorneys must be careful not to violate the usury laws when drafting loan and partnership agreements.

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Recharacterization of Equity Share as Interest

Turning to the hypothetical scenario set forth in the introduction, there is very little Florida case law as to whether a lender's equity share should be deemed interest in a hybrid debt/equity investment. (19) In Jersey Palm-Gross, Inc. v. Paper, 658 So. 2d 531 (Fla. 1995), a real estate partnership sought to develop its property located in West Palm Beach to construct a multi-tenant office building. (20) The lots were valued at $1.7 million, but were encumbered by a $1.1 million purchase money mortgage that was nearly due. (21) The partnership secured a loan from a bank to satisfy the purchase money mortgage, and the remaining funds were to be applied to the construction project. (22) Despite the bank loan, the partnership was $200,000 short. (23) In seeking to bridge the gap, the partnership approached Walter Gross, a real estate developer, and suggested that he become an equity partner in the partnership for $200,000. (24) Gross agreed to lend the $200,000, but initially refused the partnership offer. (25) When the loan documents were presented to the borrowers, however, Gross had included a demand for 15 percent ownership interest in the partnership. (26) With...