Don't Get Used By Usury Laws

Originally published by The Deal Online

As difficult economic times continue, it is no surprise that private equity and venture capital firms are seeing many of their portfolio companies struggle. Some of these businesses need or likely will need additional cash infusions to meet near-term expenses. With banks still reluctant to lend, the portfolio company might have nowhere else to turn but to its current PE or VC owners. The PE/VC owners -- not wanting to lose their existing investment and perhaps believing that the company can, with only a modest infusion of cash, get past its current problems and achieve long-term growth and prosperity -- might be willing to front the company some needed cash.

The terms of any such loan the PE/VC owners might be willing to make in this type of situation will of course vary widely depending on the circumstances. However, it would not be shocking to envision a PE or VC lender asking for an up-front fee, and maybe a recurring administrative fee as well. The lender might also require the company to issue it warrants, preferred stock or other securities in exchange for the loan. While these terms may seem straightforward and reasonable, there is a potential legal trap lurking: If New York State law is applied to the transaction, and if the effective interest rate (which, depending on the terms, might include the fees, securities and other consideration paid to the lender on top of the nominal interest) exceeds 25% per year, the transaction might be in violation of New York's laws against usury.

That's right -- your friendly PE or VC lender, in trying to help out a troubled business, may have just broken the law. Not only that, the law in question is a criminal statute, violations of which constitute a Class B felony.

New York, like most other states, has had on its books laws against usury, or the charging of excessive interest, since the 19th century. There are separate civil and criminal usury statutes. These laws were passed to protect borrowers from loan sharking and other unscrupulous tactics. As one New York court put it, the statutes are intended "to protect desperately poor people from the consequences of their own desperation." New York's usury statutes have many exceptions, some of which are intended to differentiate the truly helpless, who are deemed in need of the laws' protections, from more sophisticated parties, who presumably can fend for themselves. However, these distinctions are imperfect...