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Originally posted here. STATE OF MICHIGAN BILL SCHUETTE, ATTORNEY GENERAL USURY: Payment of interest with future revenues or profits. A financing agreement in which the borrower agrees to repay the principal with interest and a percentage of future revenues or profits will not violate usury laws so long as the lender’s profit is contingent, and… Read More »
Originally posted here. The current economic downturn has led to increased public scrutiny of lending practices. Michigan usury laws offer important protection to borrowers by capping the interest rate that lenders can charge. Whether one is a lender or a borrower, it is important to become familiar with the basic law and its many exceptions.… Read More »
Originally posted here.
STATE OF MICHIGAN
BILL SCHUETTE, ATTORNEY GENERAL
|USURY:||Payment of interest with future revenues or profits.|
A financing agreement in which the borrower agrees to repay the principal with interest and a percentage of future revenues or profits will not violate usury laws so long as the lender’s profit is contingent, and the parties contract in good faith and without the intent to avoid usury laws. Whether a particular financing agreement is lawful will depend on the true nature of the agreement as determined by the facts and circumstances surrounding the agreement.
Opinion No. 7283
May 4, 2015
The Honorable Joe Hune
Lansing, MI 48909
You have asked whether royalty financing violates Michigan’s usury laws. To answer this question, it is helpful to begin with a brief explanation of what constitutes royalty financing and usury.
Before discussing royalty financing, an understanding of common financing concepts, including the common financing practice of loans, is relevant.
“Financing” is defined as “[t]he act or process of raising or providing funds.” Black’s Law Dictionary (9th ed. 2009). A common form of financing is debt financing, whereby funds are raised by either issuing bonds or taking a loan from a financial institution. Id. “The hallmark of a loan is the absolute right to repayment.” Blackwell Ford v Calhoun, 219 Mich App 203, 209; 555 NW2d 856 (1996). In addition to the repayment of the principal of the loan, the lender almost always expects to receive compensation for the use of the money loaned. That compensation is termed interest. 15 Mich Civ Jur, Interest, § 1; Balch v Detroit Trust Co, 312 Mich 146, 152; 20 NW2d 138 (1945) (“Interest has been defined as ‘a charge for the loan or forbearance of money’”). In a basic loan transaction, the borrower receives a sum of money—the principal of the loan—and promises to repay the principal, over time, with interest.
With royalty financing, the borrower typically agrees to repay the principal with interest and a percentage of future revenues or profits—the royalty. See generally, 47 CJS, Interest & Usury, § 232 (2014); Anno: Agreement for share in earnings of or income from property in lieu of, or in addition to, interest as usurious, 16 ALR 3d 475. If revenues are low, it may be that no additional payment beyond the agreed interest will be necessary; but if revenues or profits are high, the total amount repaid will be higher.
“Usury is, generally speaking, ‘the receiving, securing or taking of a greater sum or value for the loan or forbearance of money, goods, or things in action than is allowed by law.’” Hillman’s v Em ’N Al’s, 345 Mich 644, 651; 77 NW2d 96 (1956), quoting 55 Am Jur, Usury, § 2. “Usury consists of several essential elements, generally enumerated as; (1) a loan or forbearance . . . of money . . . ; (2) an understanding between the parties that the principal will be repayable absolutely; (3) the exaction of a greater profit than is allowed by law; and (4) an intention to violate the law.” Mich Civ Jur, Usury, § 1. In determining whether usury exists, what matters is the “real nature of the transaction,” and not the particular form given it by the parties; the real nature must be determined from the facts and circumstances. Wilcox v Moore, 354 Mich 499, 504; 93 NW2d 288 (1958); Mich Civ Juris, Usury, § 2.
Unless an exception applies, Michigan’s usury statute generally prohibits a lender from charging a rate of interest greater than five percent, or, if agreed in writing, seven percent. MCL 438.31. Michigan’s criminal usury statute prohibits a lender, unless otherwise authorized by law, from receiving interest at a rate exceeding twenty-five percent. MCL 438.41.
As noted above, under a royalty financing arrangement, when the borrower has high revenues or profits, the lender’s total return on the loan—interest payments plus royalty payments—might exceed the law’s legal limit for interest. Given this possibility, you ask whether this type of financing arrangement violates Michigan’s usury laws.
While there has been little development in this area of the law in Michigan, numerous decisions by courts in other states provide guidance in answering your question.
Usury law is subject to various exceptions, including an exception developed at common law called the “interest contingency rule.” WRI Opportunity Loans II, LLC v Cooper, 154 Cal App 4th 525; 65 Cal Rptr 3d 205 (2007); 47 CJS, Interest & Usury, § 232; 16 ALR 3d 475; Restatement (First) of Contracts, § 527. As explained by the California Court of Appeals:
According to this rule, a loan that will “give the creditor a greater profit than the highest permissible rate of interest upon the occurrence of a condition [ ]is not usurious if the repayment promised on failure of the condition to occur is materially less than the amount of the loan . . . with the highest permissible interest, unless a transaction is given this form as a colorable device to obtain a greater profit than is permissible.” Thus, interest that exceeds the legal maximum is not usurious when its payment is “subject to a contingency so that the lender’s profit is wholly or partially put in hazard,” provided “the parties are contracting in good faith and without the intent to avoid the statute against usury.” [WRI Opportunity Loans II, 154 Cal App 4th at 534 (citations omitted).]
This rule has been followed by courts in New York and other states. See, e.g., Hartley v Eagle Insurance Co, 222 NY 178; 118 NE 622 (1918); Olwine v Torrens, 236 Pa Super 51; 344 A2d 665, 667-668 (Pa Super, 1975), and Dopp v Yari, 927 F Supp 814 (D New Jersey, 1996). To determine whether the rule applies, courts will “‘look to the substance rather than to the form’ of the transaction to determine whether the lender’s profits are exposed to the requisite risk.” WRI Opportunity Loans II, LLC, 154 Cal App 4th at 535 (citations omitted). In other words, whether this rule would exempt any particular agreement from being usurious will depend upon the particular facts and circumstances of each agreement.
For example, the facts and circumstances of a royalty financing agreement might show that the amount of the royalty payment, which is based on a share of the borrower’s revenues or profits, is not certain, but contingent: business revenues or profits may be less than the amount expected by the parties; they may be within that range; or they may exceed—or even greatly exceed—the range expected. In these instances, courts have determined that, so long as these payments result from a bona fide contingency—that is, the contingency incorporates a real element of risk and is not a sham devised to avoid the usury laws—these payments are not usurious even if they exceed the legal maximum of interest allowed. See Schiff v Pruitt, 144 Cal App 2d 493; 301 P2d 446 (1956), Thomassen v Carr, 250 Cal App 2d 341, 346–349; 58 Cal Rptr 297 (1967), and Beeler v H & R Block of Colorado, Inc, 487 P2d 569, 572 (1971), applying “interest contingency rule.”
However, where the facts and circumstances show that the risk to the lender’s profit is not sufficiently great, Teichner v Klassman, 240 Cal App 2d 514, 516–518; 49 Cal Rptr 742 (1966); Olwine, 344 A2d at 667-668, or where the arrangement would result in a return in excess of the legal rate regardless of risk, Whittemore Homes, Inc, 190 Cal App 2d 554; 12 Cal Rptr 235 (1961); Concord Realty Co v Continental Funding Corp, 776 P2d 1114 (Colo, 1989), the rule will not apply, and the legal limit will still be in force.
In Michigan, “the common law prevails except as abrogated by the Constitution, the Legislature, or this Court.” People v Stevenson, 416 Mich 383, 389; 331 NW2d 143 (1982). A review of the Constitution, statutes, and case law reveal no provision or decision expressly or impliedly abrogating application of the interest contingency rule. The only Michigan case found touching on this issue is Scripps v Crawford, 123 Mich 173; 81 NW 1098 (1900).
In Scripps, the defendant purchased the interest of an estate in a laundry business, and agreed with the estate’s administrator, Union Trust Company, to pay $1,500 for the estate’s interest and “one-half of the net profits that should be earned for five years. The agreement stated that this was to be ‘as interest on said loan, and compensation for the good will of the estate in the business . . . .’” Scripps, 123 Mich at 174. A number of disputes arose between different parties, and ultimately a claim was made that the defendant’s agreement with the Union Trust Company was usurious. Id. at 177. The Michigan Supreme Court disagreed, finding nothing unlawful about the arrangement:
We think the allowance of something for the good will of the business was legitimate, and there is nothing to show that either party understood that an unlawful rate of interest was contemplated. One-half of the prospective net profits was to be paid as interest and as a consideration for the good will. We must therefore hold that the claim of the Union Trust Company, as finally fixed by the agreement of the parties thereto, was a valid claim against [the defendant]. [Id.]
While the Scripps Court did not expressly discuss the interest contingency rule, it approved an agreement to use profits as payment on interest.
In OAG, 1979-1980, No 5740, p 877 (July 17, 1980), the Attorney General addressed several questions, including whether receipt by a lender of a percentage of profits as consideration for making a mortgage loan constituted interest on the loan so as to make the loan usurious, assuming the legal rate of interest is exceeded. The Opinion began its analysis by defining interest as “compensation paid for the use of money.” Id., citing OAG, 1975-1976, No 5085, p 717 (December 16, 1976). It then explained:
“[a]ny fee imposed upon the borrower, other than the reasonable and necessary charges, such as recording fees, title insurance, deed preparation and credit reports recognized in section 1(a) of the Usury Statute, supra, in exchange for the lending of money must be taken into consideration in determining the rate of interest being charged.” [Id., p 879, quoting OAG No 5085, p 717.]
The Attorney General then reasoned that in the situation presented, payment of a percentage of profits would constitute interest:
In the transaction described in your question, the fee imposed by the lender as consideration for making the loan would consist, in part, of a share in profits of the borrower’s business. Being part and parcel of the loan agreement, therefore, it is clear that such compensation constitutes interest on the loan. [Id., pp 879-880 (emphasis added).]
As support, the Attorney General quoted the following from Brown v Cardoza, 67 Cal App 2d 187, 192; 153 P2d 767 (1944) (citations omitted):
The law is well settled in most jurisdictions . . . that where there is a loan of money to be compensated for by a share in earnings, income or profits, in lieu of or in addition to interest, in determining whether the transaction is usurious the share of earnings, income or profits must be considered as interest.
Given this language, OAG No 5740 could be viewed as foreclosing royalty financing or rejecting the interest contingency rule. But that construction is overbroad. That Opinion stands for the following, narrow proposition that is consistent with decisions of the courts: a lender’s share in profits or revenues that are certainshould be considered as interest for the purposes of the State’s usury laws.
In this way, the facts and circumstances of a royalty financing agreement might show that the amount of the royalty payment, which is based on a share of the borrower’s revenues or profits, is a certainty; i.e., the revenue or profits are certain or almost certain to occur. This was the situation in Brown v Cardoza—the California case relied on by OAG No 5740. In Brown, the lender was to receive repayment of the loan with interest plus splitting the profits on the sale of certain property. Brown, 153 P2d at 768. As part of its analysis, the court considered whether this “splitting the profits” should be considered interest. Id. at 769. The court concluded that it should because, under the terms of the loan, as the contemplated “split” of the profits from the sale of the property, the lenders were receiving a sum certain “bonus” of $300. The very loan papers disclosed the certainty of this sum, and hence, the court found that this sum must be considered interest. Id. at 770. In such an instance, the conclusion of both Brown and OAG No 5740 is correct and consistent with the above discussion of the interest contingency rule—the payment of a share of profits that are certain constitutes interest, which would be usurious if the legal rate of interest was exceeded.
It is my opinion, therefore, that a financing agreement in which the borrower agrees to repay the principal with interest and a percentage of future revenues or profits, will not violate usury laws so long as the lender’s profit is contingent and the parties contract in good faith and without the intent to avoid usury laws. Whether a particular financing agreement is lawful will depend on the true nature of the agreement as determined by the facts and circumstances surrounding the agreement.