October 20, 2021
Usury: Toxic Converts Prove Toxic to Lender
The New York Court of Appeals recently determined that the conversion price of convertible debt can be considered interest under New York’s criminal usury laws and that convertible debt that’s found to be usurious is void ab initio. This Sidley memo reviews the Court’s decision, in Adar Bays LLC v. GeneSys ID, Inc., (NY; 10/21), which involved a toxic convert issued by a small public company. As this excerpt from the Court’s opinion makes clear, the terms of this particular death spiral were – how shall I put this? – familiarly egregious:
On May 24, 2016, Adar Bays loaned GeneSYS $35,000. In exchange, GeneSYS gave Adar Bays a note with eight percent interest that would mature in one year. The note included an option for Adar Bays to convert some or all of the debt into shares of GeneSYS stock at a discount of 35% from the lowest trading price for GeneSYS stock over the 20 days prior to the date on which Adar Bays requested a conversion. Adar Bays could exercise its option starting 180 days after the note was issued and could do so all at once or in separate partial conversions.
The note included additional provisions favorable to Adar Bays. Although GeneSYS could prepay the note within the first 180 days, prepayment would incur significant penalties exceeding 100% of the face of the note and, after Adar Bays’ conversion right ripened, prepayment was prohibited. If GeneSYS went bankrupt or failed to maintain current filings with the U.S. Securities and Exchange Commission (“SEC”), the interest rate would increase to “24 percent per annum or, if such a rate is usurious then at the highest rate of interest permitted by law.” The note further provided for events that would automatically result in an increase in the principal owed. For example, if GeneSYS were delisted from any stock exchange, the principal would increase by 50% and if Adar Bays lost its bid price in a stock market, the principal would increase by 20%.
The 2nd Circuit certified two questions to the Court of Appeals. First, whether conversion option that permits a lender, in its sole discretion, to convert any outstanding balance to shares of stock at a fixed discount should be treated as interest for the purpose of determining whether the transaction violates NY’s criminal usury statute. Second, if the interest charged under the agreement is usurious, whether the contract is void ab initio. As this excerpt from the Sidley memo explains, the Court answered both these questions in the affirmative:
In its ruling, the Court of Appeals answered the second question first, recounting the long history of the prohibition on usury in New York (both the state and the colony). Most relevant here, the court clarified that that the 25% interest rate cap on loans (“criminal usury”) applies to corporate loans, and thus a corporate borrower is not precluded from raising the defense of criminal usury in a civil action. If a borrower proves the defense of criminal usury in a civil action, the usurious loan is deemed void and unenforceable for both the principal and interest. As the court puts it, “loans proven to violate the criminal usury statute are subject to the same consequence as any other usurious loans: complete invalidity of the loan instrument.” (Majority at 15-16).
On the first question, the court makes clear that “in assessing whether the interest on a given loan has exceeded the statutory usury cap, the value of the floating-price convertible options should be included in the determination of interest.” (Majority at 16). This value is a question of fact measured at the time of contracting.
The memo cautions that, as a result of the decision, corporate lenders should expect defaulting borrowers to assert criminal usury as a defense, and says that they would be “well advised to heed the concerns raised by the dissent that “‘stock options to convert debt to equity at a fixed discount must [now] be treated as per se interest rates in all cases.'”
By the way, it turns out that I’m utterly incapable of spelling the word “usury” correctly. When I originally posted this memo on our sites, I spelled the word “u-s-e-r-y.” Fortunately, our new colleague Emily Sacks-Wilner came to my aid and had our webmaster fix it. The thing is, I did exactly the same thing the last time I blogged about usury. One of our members bailed me out on that occasion.
– John Jenkins