Avoiding Usury Traps in Business Lending Arrangements
There are a variety of economic and non-economic factors that can negatively impact cash flows for businesses of all sizes across various industries. Currently, the ongoing labor and supply-chain constraints, coupled with record-high inflation and rising interest rates, are making it more difficult for businesses to cover their operating costs and maintain profitability.
While there are specific strategies businesses can implement to try to improve cash flows, some may find that, despite their best efforts, they need financing to provide immediate liquidity. Regardless of whether financing comes in the form of a traditional lending arrangement through a bank or perhaps a private lender, or some other form of alternative financing, business owners should familiarize themselves with state usury laws to understand the requirements to properly account for any such alternative financing arrangements. One such arrangement involves the transfer of financial assets, which is governed by the Financial Accounting Standards Board (FASB) in its Accounting Standard Codification 860 - Transferring and Servicing of Financial Assets (ASC 860). It should be noted that while this codification is accepted accounting guidance, it specifically indicates the need for certain legal determinations.
State Usury Laws
Each state has its own statute for determining whether the interest rate a lender charges a borrower on a loan or other financial transaction is “usurious,” or unreasonably excessive and higher than the rate allowed by law. While the limits of these rates differ from state to state, those deemed usurious may be punishable by civil or criminal penalties, ranging from a lender’s forfeiture of loan interest and/or principal to civil and/or criminal fines or prosecution.
In these matters, borrowers must not only demonstrate that the interest rate charged on the transfer of financial assets is usurious, they must also demonstrate that an actual lending relationship exists (with a loan and an interest charge) rather than another type of financial arrangement, such as a sale, factoring arrangement or securitization. While it may appear easy to identify a loan from a sale, there are myriads of unconventional transactions that blur the lines between the two, making it more difficult to identify one from the other and seek legal remedy for usury claims.
Sale Versus Loan
It is not uncommon for businesses seeking immediate cash flow to sell their receivables to a third party, often at a discount. Some arrangements require a subsequent repurchase of those same assets at a premium. Whether these transactions qualify as sales or loans, however, depends on several factors, including, but not limited to, the language of the receivables purchase agreement, whether the agreement is with or without recourse and the way in which the seller recognizes the transaction in its accounting books and records.
Accounting for Sale Versus Loan
Under FASB ASC 860, transfers of financial assets, including accounts receivables, which convey to one entity a right to receive cash or another financial instrument from a second entity or to exchange other financial instruments may be treated as either:
- a sale in which the transferor (seller) “derecognizes” the transferred assets, removing them from its balance sheet, while the transferee (purchaser) accounts for the transfer as a purchase of financial assets, or
- a secured borrowing, in which the transferor (seller) retains the financial asset(s) on its balance sheet (as pledged collateral), reflects a financial obligation (payable) to the transferee (purchaser) who, in turn, records its own financial asset (receivable) on its balance sheet.
Moreover, the codification requires that transfers of assets that convey control over those assets (i.e., the seller cedes control over the asset to the purchaser) should be treated as a sale only when ALL the following conditions are met:
- The transferred financial assets are isolated outside the reach of the transferor(seller) and its creditors.
- The transferor (seller) does not maintain effective control over the transferred financial assets or third-party beneficial interests related to those transferred assets; and
- The transferee (purchaser) has the right to pledge or exchange the assets (or beneficial interests in those assets) it received, and no condition constrains both the transferee (or third-party holder of its beneficial interests) from taking advantage of its right to pledge or exchange the asset and provides more than a trivial benefit to the transferor (seller).
Therefore, if a purchase and sale agreement entitles or obligates the seller to repurchase or redeem the transferred asset, the transfer would be accounted for by both parties as a secured borrowings rather than a sale of assets and as such, could subject the transaction to applicable usury laws.
It is critical businesses consult with their financial and legal advisors before entering into any financing arrangement (whether traditional or alternative) to ensure the terms of the underlying agreement will result in the desired outcome, and they do not fall victim to any unintended consequences.
 The applicable usury law can be based on either the location of the lender, the borrower, or the business in question.