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.”
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%.
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.
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.
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.
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.
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 email@example.com.
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