DISPATCHES FROM THE TRENCHES:Usury and Choice of Law Considerations
BY KENNETH WEINBERG
Usury laws vary from state to state, which can make a lease or loan more complicated when the lessor is in one state and the lessee in another. Kenneth Weinberg discusses how this has played out so far in the courts, with favorable rulings for a lessor often depending not only on who files first, but where they file from.
In certain segments of our industry, the interest rate charged for the advance of loan proceeds may exceed the rates allowed under the usury laws of the state where the borrower or lessee may be located. It is important to remember that leases with bargain purchase options, mandatory purchase requirements, economic life issues or certain other select attributes may be viewed as the functional equivalent of a loan for a variety of legal purposes, including the potential application of usury laws. Of course, equipment finance agreements or other documentation clearly designated as loans should always be viewed as providing for payments of principal and interest.
A recent case provides a good example of one arrow in the quiver of financiers who face claims that they have violated usury laws: Onset Fin v. Victor Valley Hosp. Acquisition.1 In this case, the finance company entered into three schedules incorporating the terms of a master lease. When it sued the lessee in Utah for failing to pay amounts due under the schedules, the lessee countered with various claims, including a claim that the implicit rates used to calculate rentals due under the leases were usurious. The finance company was located in Utah, where the implicit rate was not usurious, and the lessee was located in California, where the rate was usurious.
The leases in question had some interesting terms, including a requirement, in some instances, that the lessee lease new equipment as a condition to its right to return the existing equipment. A lease versus loan analysis would certainly have been interesting and relevant, since a true lease should not be subject to usury laws given that the payments due under such an arrangement constitute rent for the use of the equipment and not the repayment of principal or interest. However, the court did not address this issue, instead handling the matter solely through a choice of law analysis.
Many financiers receive at least some comfort from choice of law concepts. Such financiers commonly contend that, to the extent the interest due under the applicable financing documents is not usurious under the laws of the chosen state, a more restrictive usury rate in the jurisdiction where the lessee/borrower is located (or which is otherwise applicable) is not relevant to the transaction so long as the choice of law provision is valid and enforceable under the laws of all states in question.
Choice of Law Rules
The court in this case noted that the effect of a contractual choice-of-law clause would be determined under the choice-of law rules in the forum state (in this case Utah), and that Utah law allows the state chosen by the parties to govern their contractual rights and duties unless either:
(a) the chosen state has no substantial relationship to the parties or the transaction, and there is no other reasonable basis for the parties’ choice, or
(b) application of the law of the chosen state would be contrary to a fundamental policy of a state which has a materially greater interest than the chosen state in the determination of the particular issue, which would be the state of the applicable law in the absence of an effective choice of law by the parties.
It may be worth noting that the test cited by the court is consistent with the Restatement of Conflicts of Laws (2d) (the Restatement). The approach taken under the Uniform Commercial Code (the UCC) should have also been mentioned given that the UCC applies to the transactions in question irrespective of whether or not they were true leases governed by Article 2A of the UCC or secured financings governed by Article 9.
The key language is currently found in UCC §1-301, part of the “General Provisions” of the UCC. The Uniform Law Commission, which promulgates drafts of the UCC for enactment, proposed the following language in 2001 (the Proposed Provision):
Except as otherwise provided in this section ... an agreement by parties to a domestic transaction that any or all of their rights and obligations are to be determined by the law of this state or of another state is effective, whether or not the transaction bears a relation to the state designated; … An agreement otherwise effective under [this section] is not effective to the extent that application of the law of the state or country designated would be contrary to a fundamental policy of the state or country whose law would govern in the absence of agreement under [this section].
However, the vast majority of states enacted the various changes to Article 1 of the UCC rejected the Proposed Provision and, instead, retained the test from the older version of the UCC which had been located in UCC §1-105 (the Older Provision) and which provides:
Except as provided hereafter in this Code section, when a transaction bears a reasonable relation to this state and also to another state or nation the parties may agree that the law either of this state or of such other state or nation shall govern their rights and duties. Failing such agreement this title applies to transactions bearing an appropriate relation to this state.
The reaction was so strong that the Uniform Law Commission subsequently promulgated a substitute version of UCC §1-301 effectively reinstating the Older Provision. As a result, the Older Provision is now the law in almost all (if not all) states, including the states in question in this case (Utah and California). The key difference between the two approaches is that the Proposed Provision would have allowed for a given state’s laws to be chosen regardless of whether the transaction had any relationship to the chosen state unless such choice would violate a strong public policy of the state whose law would have governed absent the choice of law provision. The Older Provision requires a “reasonable relation” but does not explicitly provide for a public policy exception (although, it may very well still be applicable).
Matters are further complicated by the fact that in some states, Utah being one, the Older Provision is the applicable law, but the statute includes the official commentary meant to accompany the Proposed Provision.2
Application of the Substantial Relationship Analysis
In the current case, the finance company noted that Utah had a substantial relationship to the case because: (1) the finance company was a Utah corporation with its principal place of business in Utah; (2) the contracts were delivered to the finance company in Utah; (3) the finance company signed and accepted the contracts in Utah; (4) all payments were made to the finance company or its assignees in Utah; and (5) the finance company negotiated the terms of the contracts on the phone and via email from its office in Utah.
The lessee made essentially the same arguments in favor of California law applying and also claimed that since the goods it purchased were located in in California, that state had a greater relationship to the case. The court noted that it need only find that Utah has a substantial — not a greater — relationship to the transaction and the parties and held that in this case, it did.
Public Policy Analysis
The lessee then argued, as expected, that applying Utah law would violate a fundamental policy of the state of California. The court disagreed, quoting a California court which stated that the courts “have uniformly enforced contracts allowing interest rates above the limit under California law where there is shown a substantial relationship between the contract and the state which is referenced in the choice-of-law provision.”
Although the finance company won this battle, and should be commended for filing quickly in Utah, the result may not always be the same.
For example, the court in this case did not even consider the extent to which the interest rates in the contracts exceeded the rates allowed in California. Although the California cases cited in the Palm Ridge case imply otherwise, some courts focus on the rate difference.3
Also, the court focused on the public policy in California solely relating to the interest rate. What about California’s policies surrounding the licensing of lenders doing business in the state (and the underlying rationale for such licenses)?
Lastly, what would have happened if the lessee had filed suit in California first, or even afterwards in California with a well-crafted complaint that was persuasive enough to cause the California court to exercise jurisdiction? Would the California court have applied law other than the public policy related cases referenced in the Utah decision?
The key point here is, although applicable laws, the UCC in particular, make it reasonable for a lender/lessor to rely on the choice of law provision in its documents if the chosen state’s law bears a reasonable relationship to the transaction (such as the law of the lender’s/lessor’s home state), language in the Restatement, prior case law and official commentary relating to the Proposed Revision all provide courts with some flexibility to make a public policy exception when the rate permitted by the laws of the state chosen by the contract is greatly in excess of the rate allowed in the otherwise-applicable state. Accordingly, there remains some risk of a court not honoring a choice of law provision, even more so when there is a significant difference between the contract rate of interest and the state usury rate. •
12018 U.S. Dist. LEXIS 58494; 2018 WL 1662611 (U.S. Dist. Ct, Utah 2018)
2Palm Ridge v. Ahlers, No. EDCV0800652SGLOPX, 2008 WL 11339594, at *2 (C.D. Cal. June 23, 2008)
3See e.g. In O’Brien v. Shearson Hayden Stone, 586 P.2d 830 (1978), supplemented, 605 P.2d 779 (1980). In a class action suit over margin interest rates, the court examined the Restatement rule and determined that, as to a portion of the plaintiff class, Washington law would have applied but for a New York choice of law in the brokerage contracts, and that the court would not apply New York law due to the disparity between the 25% rate in the contract and Washington’s 12% limit, which was deemed a “fundamental policy.”