Usury has made quite a comeback from the dust heap of old law treatises to become a crucial concept that has shaped modern credit markets. It recently returned to public awareness in marketplace lending, where online lenders have avoided making loans in states comprising the Second Circuit, such as New York, due to an unfavorable usury decision. Now, light has been shed on subprime auto financing and an exception to usury laws that’s creating risk for an already shaky market.
Usury: It’s An Old Concept …
New York’s usury laws were put on the books as early as 1787 to protect desperate borrowers from being preyed upon by unscrupulous lenders who use that desperation as leverage.
These laws in their modern context were largely codified in the 1960s and have been rarely modified or updated to account for modern financial transactions. In general, New York’s civil usury statute sets an interest rate cap of 16% on loans of less than $250,000, while New York’s criminal usury state sets an interest rate cap of 25% on loans of less than $2.5 million. In addition to the risk that the loan may be unenforceable, the maker of a loan of less than $250,000 (such as the typical auto loan) may be liable for criminal fines, if the rate exceeds 25%, and civil penalties, if the rate exceeds 16%.
For New York’s usury laws to apply, the transaction must be considered a loan when viewed holistically and considered in its totality, rather than merely by the name or form which the parties have given it.
… But It’s Up To New Tricks
New York usury laws, however, do not apply to sales of merchandise on credit. This exception has allowed auto dealers to offer buyers financing through a form of agreement known as a retail installment contract (RIC). A RIC creates a security interest in favor of the dealer and it forms a contract for the bailment or leasing of a motor vehicle (which can be sold to a lender). Under the terms of New York’s Motor Vehicle Retail Installment Sales Act, a RIC is not viewed as a loan. The buyer pays compensation for the use of the vehicle with the option to own it following compliance with the terms of the RIC. As a result, auto loan financing often exceeds the usury limits for low-credit (read: subprime) borrowers.
What’s Legal Can Be Lethal to Market Health
There may be nothing illegal with dealer use of RICs, but it nevertheless spurs subprime market risk. As awareness of the usury issue grows, the practice may come under scrutiny by consumer rights groups and the courts, potentially leading to unfavorable decisions (read: losses) for lenders and investors, unless corrective action is taken. This was the case recently for marketplace lending after the Second Circuit came down with its decision in Madden v. Midland. The decision has the potential to render certain loans usurious, resulting in ABS investors requiring issuers to exclude from deals loans to borrowers residing in Second Circuit states (New York, Connecticut and Vermont).
Finally, even without judicial activism or corrective legislation, higher payment obligations for subprime borrowers means higher rates of default. Several smaller subprime auto lenders that hold the riskiest loans (pursuant to RICs) have had losses pile up and been driven into bankruptcy. Of course, higher interest rates are needed to compensate for high-risk borrowers and induce lenders to lend to otherwise underserved parts of the population, but the usury laws intended to protect consumers can be applied as guardrails that can keep the market from going off track.
James Serritella, a partner, and Massimo Giugliano, counsel, contributed to this post and are members of the Insolvency, Creditors’ Rights & Financial Products Practice Group of Davis & Gilbert.