BILL ANALYSIS
SENATE JUDICIARY COMMITTEE
Martha M. Escutia, Chair
2003-2004 Regular Session
SB 1406 S
Senator Ackerman B
As Amended April 29, 2004
Hearing Date: May 4, 2004 1
Corporations Code 4
GMO 0
6
SUBJECT
Usury Exemption
DESCRIPTION
This bill would clarify that:
a current exemption from the California Constitution's
prohibition against usury exempts only those persons who
meet both the requirements of having $2 million or more
in assets and borrowing $300,000 or more; and
the exemption applies only to persons who are in
compliance with the California Finance Lenders Law and
the Real Estate Law.
BACKGROUND
The California Constitution prohibits usury, but exempts
certain transactions and lenders from this provision. The
Constitution also allows the Legislature to exempt
additional transactions or classes of persons. The
Corporate Securities Act of 1968, as amended by AB 244
(Ackerman, Chapter 468, Statutes of 2000), exempts certain
evidences of indebtedness issued by an entity with assets
of more than $2 million, and certain evidences of
indebtedness of $300,000 or more under specified
circumstances. It does not "exempt a person from
application of the California Finance Lenders Law."
CHANGES TO EXISTING LAW
The California Constitution prohibits an interest rate of
(more)
SB 1406 (Ackerman)
Page 2
more than 7 percent per annum for the loan or forbearance
of payment for any money, goods, things in action, or
accounts on demand, but allows competent parties to
contract for consumer goods (e.g., for personal, family or
household purposes) at interest rates up to 10 percent per
annum and contracts for other than consumer goods at a rate
not exceeding the higher of 10 percent per annum or 5
percent per annum plus the prevailing Federal Reserve
interest rate, as specified. This is known as the usury
provision of the Constitution. [Article XV Section 1,
California Constitution.]
The usury provision allows exemptions for specified
contracts, such as loans made by a building and loan
association, by an industrial loan company, by a credit
union, by a licensed pawn broker or personal property
broker, by a licensed real estate broker and secured by a
lien on real property, by a bank, by a nonprofit
cooperative agricultural association that loans money or
assists a member in obtaining a loan under specified
conditions, or by a successor in interest to any loan
already exempted, and allows the Legislature to create, by
statute, other exemptions.
Existing law exempts from the usury provision evidences of
indebtedness issued or guaranteed by an entity with more
than two million dollars ($2,000,000) in assets, provided
the entity has a financial statement meeting this condition
within 90 days before the issuance of the indebtedness that
was prepared according to generally accepted principles or
in accordance with the rules of the Securities and Exchange
Commission. [Corporations Code Section 25118 (a).]
Existing law separately exempts from the usury provision
evidences of indebtedness (and the holders thereof) that
aggregate $300,000 or more or were purchased at an
aggregate discount price of $300,000 or more, or were
issued pursuant to a written commitment for the lending of
at least $300,000 or the provision of a line of credit of
$300,000 or more. [Corp. Code Sec. 25118(b).]
Existing law specifies that the exemptions described above
do not exempt a person from application of the California
Finance Lenders Law. [Corporations Code Section 25118(h).]
SB 1406 (Ackerman)
Page 3
This bill would instead require that the conditions of both
Section 25118(a) and Section 25118(b) must be present for
the exemption to apply. In effect, the usury exemption
would apply to an indebtedness, issuer, or holder of
indebtedness of $300,000 or more that is issued or
guaranteed by an entity with aggregate assets of $2 million
dollars or more. In addition, the exemption would apply
only to persons or entities who are in compliance with the
California Finance Lenders Law or the Real Estate Law.
COMMENT
1. Stated need for the bill
When Section 25118 was enacted, the legislation specified
its intent to affect only commercial loans. That bill
also declared its intent to not affect any other
provision of law that requires any person involved in the
(commercial) transaction from applicable licensing
requirements that protect parties from unfair, unlawful,
or deceptive acts or practices, or that affect the
availability of the exemption to a successor in interest
of the originating lender. [Section 1 of AB 244
(Ackerman), Chapter 468, Statutes of 2000.]
According to the author, Corporations Code Sec. 25118 was
written to enable small and start-up companies to obtain
short-term debt financing, including principally bridge
loans, without enduring the time and expense to obtain a
permit to sell a security under Corporations Code Section
25113 and to protect a lender against the state
Constitution's prohibition on usury.
Instead, the author states, this exemption to the usury
provision under Section 25118 is being used for long-term
real estate development transactions without compliance
with the state's Finance Lenders Law or Real Estate Law.
In addition, commercial borrowers who do not have the
assets or the ability to protect themselves have been
able to borrow $300,000 or more at high interest rates
because lenders have argued these borrowers do not need
to have $2 million in assets as required by Section
25118(a).
SB 1406 intends to cure this unintended result by
SB 1406 (Ackerman)
Page 4
requiring that a borrower have more than $2 million in
assets and borrow $300,000 or more to be exempt from the
usury provision of the California Constitution and that
persons using this exemption must comply with the state's
finance lenders law or real estate law.
2. Exemption "clarified": to borrow $300,000, one must
have assets of $2 million
When Section 25118 was enacted, there was considerable
debate over whether or not the exemption created would
constitute "legal loan sharking." This concern was
mollified by assurances that the exemption would only
apply where the transaction involved business persons who
are affiliated or who had "a preexisting personal or
business relationship" and the "capacity to protect their
own interests in connection with the transaction." [Corp.
Code Sec. 25118(f)(1) and (2).] Section 25118 applies
only to commercial transactions, and not to contracts for
the purchase of personal or household goods or services.
Apparently, even with the restricting provisions of
Section 25118(f), some small companies have found
themselves in trouble by taking out high-interest loans
in excess of their assets or capacity to pay.
Conversely, an entity that had $2 million in assets could
borrow any amount and enjoy the exemption from the usury
provision.
Subsequent amendments to Section 25118 did not address
this problem.
Under this bill, to be able to use the exemption under
Section 25118, a borrower must both: (1) have assets of
$2 million or more; and (2) borrow $300,000 or more.
This clarification clearly places the exemption in the
realm of commercial lending among persons who have the
capacity to take care of their own interests and avoids
the current problem of borrowers low on assets being able
to borrow amounts greater than $300,000 at high interest
rates.
Unless qualified under this exemption, an issuer of
evidence of indebtedness (i.e., promissory note,
SB 1406 (Ackerman)
Page 5
debenture, bond, other types of securitized paper) must
obtain a permit to sell a security or exempt itself under
Section 25113 or be exempt from the usury provision under
other exemptions (see Changes to Existing Law for listing
of other exemptions).
Because of the way this bill would amend Section 25118, a
business that has assets of $2 million or more would have
to borrow at least $300,000 in order to take advantage of
the exemption from the usury provision. For example: a
company with $2 million in assets only wants to borrow
$100,000 on a short-term basis to purchase a piece of
equipment quickly and pay higher than allowed interest
rates in order to do so. Under existing law, this company
can borrow this money at 30% interest rate if it wants
to, without the hassle of complying with Section 25113,
and the lender would be protected from the usury
provision. Under SB 1406, the company would either have
to borrow $300,000 to get into the exemption, or look for
a lender who would loan the money quickly at acceptable
interest rates, or, to pay the higher interest rate, the
company would have to obtain a permit under Section
25113. In any case, the ability of this company with $2
million in assets to obtain smaller loans at higher rates
would be hampered by the way SB 1406 is written.
In order to avoid this new unintended consequence, staff
recommends that the language of SB 1406 be clarified to
only require an entity that wants to borrow $300,000 or
more in a commercial transaction to have assets of at
least $2 million as described in Section 25118(a).
SHOULD THIS BILL BE SO AMENDED?
3. Exemption applies only to persons who comply with
relevant laws
This bill also would clarify the requirement under the
existing language of Section 25118(h) that the exemption
"shall not exempt any person from application of the
California Finance Lenders Law . . . ."
Apparently, this ambiguous language has allowed real
estate lenders to lend at prohibitive interest rates
without complying with either the finance lending law or
SB 1406 (Ackerman)
Page 6
the real estate law of the state. Further, it has
allowed lenders to lend money at usurious rates while in
violation of the California Finance Lenders Law, even
though the law applied to them.
The new language proposed for Section 25118(h) would
unambiguously make the exemption available only to
persons who are in compliance with the California Finance
Lenders Law or the Real Estate Law.
4. What about transactions concluded before January 1,
2005?
This bill would not affect any commercial transaction
executed prior to January 1, 2005. However, any
commercial transaction that may be renewed or
renegotiated and modified after that date may be subject
to this bill's provisions.
SHOULD THIS BE CLARIFIED?
Support: Commercial Real Estate Finance Forum; KPA Realty
LLC
Opposition: None Known
HISTORY
Source: Author
Related Pending Legislation: None Known
Prior Legislation: AB 244 (Ackerman, Ch. 468, Stats. 2000)
enacted Corporations Code Section 25118;
AB 2969 (Florez, Ch. 964, Stats. 2002)
modified requirements regarding financial
statements of borrowers with $2 million in
assets.
**************