Usury laws are the oldest and most controversial of all laws affecting loans of money. Deeply rooted in public policy, these laws attempt to prevent lenders from making oppressive bargains with inexperienced and vulnerable borrowers by limiting interest to maximum statutory rates. A lender who contracts for, charges or receives interest in excess of the maximum lawful rate commits “usury” and is susceptible to statutory penalties whether or not the loan is ultimately repaid. This article examines how usury law impacts asset-based commercial loans governed by Texas law.
Varying theories and attitudes toward usury have resulted in a hodgepodge of interest rate laws around the country. Some states have eliminated usury laws altogether and allow complete freedom of contract on interest rates. Other states regulate interest on consumer loans, but not business or commercial loans. Many states have usury laws for commercial loans, but only if the loan is less than a specified dollar amount. Maximum allowable rates of interest vary significantly under Texas law depending on the type of loan that is made, but Texas is among a small minority of states that imposes statutory interest rate ceilings on all loans, regardless of amount, and regardless of the consumer or commercial purpose of the loan, absent an exemption under the state constitution. This policy is the result of a state constitutional provision that allows the legislature to fix maximum interest rates on contracts, but imposes a maximum rate of 10% per annum in the absence of such legislation.
The Texas legislature has implemented the state constitutional provision by allowing lenders who make loans for commercial or business purposes to contract for, charge and receive interest up to 18% per annum, as long as the agreement is in writing. If a greater amount of interest is contracted for, charged or received the lender is susceptible to a statutory penalty of three times the excess amount plus attorneys fees. If more than twice the amount of interest allowed by law is charged and received, the lender is also liable for all principal, all interest, and all other amounts charged under the loan.
If an asset-based commercial lender is willing to accept a yield that will never exceed 18% per annum, precautions can be taken to avoid an inadvertent usury law violation if Texas law applies to the loan. Problems arise when the lender is careless or ignorant of the law, fails to monitor interest charged and received after the loan is made, or fails to recognize that fees charged in addition to stated interest can increase the risk of usury. Asset-based lenders who make loans governed by Texas law are wise to follow a few practical compliance steps to minimize or eliminate the usury risk.
The formula for analyzing whether a loan contract violates the usury law compares the amount of interest required to be paid under the contract for the full term of the loan against the amount of interest that the lender could have charged at the maximum lawful rate on the actual principal advanced and outstanding. Therefore, as an initial consideration, if a lender charges the stated interest rate under the note (which is almost always a rate well below 18% per annum) against the full stated principal of the note, instead of a lesser amount actually advanced to the borrower, the effective rate of interest is much higher than the note rate. If the effective rate exceeds 18% per annum, the contract becomes usurious.
Much litigation results over fees that are alleged to be interest in disguise. Under Texas law, the courts will look to the substance of a fee and not its label in ascertaining whether the fee is additional interest. Points, origination fees, and facility fees are vulnerable to characterization as interest because they serve no function other than to increase the lender’s yield. If a fee is intended to cover an expense for a service rendered, the substance of the fee may turn on whether the lender retains the fee for itself or requires the borrower to pay a third party for the services rendered. If the lender retains the fee for an internal expense, courts are likely to characterize that fee as interest. Internal overhead costs are recoverable under Texas law but only as a component of interest. A special statute allows banks to recover certain types of internal expenses with fees that are excluded from the scope of interest, but these fees cannot exceed the cost the bank reasonably expects to incur under the loan.
If a fee is paid to a third party for services rendered in good faith in connection with the loan, the fee is not ordinarily treated as interest. Fees paid for third party appraisals, third party collateral inspections, or outside attorney advice are generally excluded from interest. Nonetheless, if the lender receives a portion of the fee indirectly or is otherwise in collusion with the third party to evade the usury law, the fee can be characterized as a subterfuge for interest.
In some situations a lender can collect a fee directly without having that fee characterized as additional interest. This occurs when the lender collects a fee for a distinctly separate and additional consideration apart from the loan itself. For example, a bona fide commitment fee charged before a loan is made, providing an option to borrow money in the future, is not interest even if the borrower later invokes the option. If the lender is selling a service or property to the borrower, the fee charged is not additional interest on a loan made simultaneously to the borrower unless the fee is so exorbitant that it appears to be a subterfuge for additional compensation for the loan.
A usury risk can also arise if the lender requires the borrower, as a condition for a loan, to assume or pay another debt owed by another party to the same lender. If the borrower does not receive independent benefit from the assumption or payment of the third party loan other than the extension of its own loan, the entire amount of the additional debt assumed or paid may be characterized as additional interest. This is known in Texas as the Alamo Lumber problem.
Usury issues also arise when a lender desires to take an equity participation in the borrower, warrants, or a percentage of the borrower’s income or profits in addition to stated interest on a note. A special statute exempts the value of such property rights from statutory interest on a commercial loan if the loan is $250,000 or more (or $3 million or more if the loan is secured by real property), subject to certain disclosures if the loan amount is less than $500,000. In cases not covered by the statute, generally the value of the property interest must be determined at the inception of the loan and that value should be treated as additional interest unless the value is speculative or unascertainable and not so much in excess of the lawful rate as to indicate an intent to evade the usury law.
After a loan is made the lender should continue to monitor the transaction. Even if a loan is lawful at its inception, usury problems can arise if the lender grants a renewal or forbearance of a default in return for a fee. If a loan is prepaid voluntarily or accelerated after default, the term for analyzing the loan is cut short. Under these circumstances large fees charged at the inception of a loan that do not result in usury if spread over a multi-year loan term may result in the collection of usurious interest if the fees are spread over a shorter period. The lender should anticipate this contingency by including a well drafted “usury savings clause” in the loan agreement. This clause will typically state that if prepayment or acceleration results in the collection or charge of usurious interest, then the lender will rebate or credit the excess interest promptly upon the occurrence of that contingency. The lender can avoid statutory penalties if the contingency arises as long as the lender promptly implements the savings clause by providing the credit or rebate as the clause requires.
Default interest is also subject to a usury analysis under Texas law. Interest should not accrue after default at a rate in excess of 18% per annum by agreement. A special statute for commercial loans allows lenders to assess a delinquency charge on the amount of any installment or other amount in default for a period of not less than 10 days in a reasonable amount not to exceed 5% of the total amount of the installment.
A peculiar feature of Texas usury law is that a “charge” of usurious interest in the form of a demand letter, payoff quote, invoice or statement of account communicated to the borrower can result in usury penalties as if the borrower had agreed to the usurious charge. Penalties are applied even if the underlying loan contract is lawful and does not require the payment of the excessive charge. In this situation the unilateral act of the creditor alone invokes the penalty.
All is not lost if the lender discovers, after a loan is made, that usurious interest has been contracted for, charged or received. Texas statutes provide for limited circumstances to correct a violation unilaterally without incurring any penalties. Likewise, if usurious interest is contracted for or charged, but not received, the borrower is required to notify the lender of a usury violation and provide 60 days to cure before a lawsuit for penalties can be filed. If the lender cures the violation during the notice period then no penalties can be awarded. These notice and cure statutes provide valuable rights to the lender, but they can be easily squandered. If the borrower notifies the lender of a violation in writing before the lender unilaterally corrects the violation then the lender cannot correct the violation unilaterally. If the lender files suit to collect an unpaid loan without correcting a violation the borrower can file a counterclaim for usury penalties without providing notice or opportunity to cure. These statutes underscore the need for conducting a usury analysis after the loan is made and prior to bringing a collection action after default.
For many asset-based commercial lenders the cost of compliance with Texas usury law is frustrating. If the lender happens to be located outside of Texas, one solution is to avoid Texas law altogether by contracting for the law of the lender’s home state to govern the loan. A special Texas statute encourages this result if the loan is $1,000,000 or more and one of five factors establishing a reasonable relation to the selected state exists. The selection of another state law may be enforceable even if the loan does not qualify for this statute. A lender may also find assistance from federal law. One federal statute preempts state usury laws when a loan made by a qualified lender is secured by a first lien on residential real estate. Federal law also allows banks to “export” the interest laws of their home states to customers nationwide.
The Texas legislature is not unmindful of the uncertainties and costs involved in complying with usury laws. The trend in recent years is favoring commercial lenders. A bill proposed in the 2003 legislative session would have authorized a constitutional amendment to exempt business loans over $250,000 (or $7 million if secured by real property) from all state usury laws. This bill failed to become law, but after the session ended a legislative committee was charged with studying state usury laws in anticipation of further consideration of such legislation during the 2005 session. In the meantime, unless a new federal law intervenes with a blanket override, a commercial lender making an asset-based loan under Texas law, regardless of the amount of the loan, should be cognizant of the risks associated with usury law and take proper precautions to minimize or eliminate those risks.