[author: Sarah Schofield]

On March 15, 2022, the U.S. Court of Appeals for the Second Circuit vacated a district court’s denial of a borrower’s motion to dismiss lender claims. Applying the New York Court of Appeals’ guidance from certified questions, the Second Circuit held that an option permitting a lender to convert an outstanding balance to shares of stock at a fixed discount could constitute “interest” for purposes of New York’s criminal usury law and that a loan agreement involving convertible debt violating the usury law would be void ab initio.

Adar Bays, LLC loaned $35,000 to GeneSYS ID, Inc. The loan agreement and convertible note governing the transaction set a one-year term for repayment at an annual interest rate of 8% and gave Adar Bays the option to convert the outstanding balance into shares of GeneSYS common stock at a set price. Several months later, Adar Bays attempted to exercise its conversion option as to $5,000 of the loan balance, but GeneSYS refused to honor the election. Adar Bays sued GeneSYS for breach of contract, and GeneSYS moved to dismiss on the ground that various components of the note were usurious under New York law, including that the liquidated damages provisions constituted “hidden interest” that increased the note’s true interest rate beyond 25%, the level New York law deems criminally usurious. The district court denied the motion and held that the interest rate was not usurious and that, even if the loan were usurious, it would not necessarily be void ab initio.

On appeal, the Second Circuit certified both issues to the New York Court of Appeals, which disagreed with the district court and characterized the conversion option as interest under the New York usury statute and declared loans made in excess of the statutory usury rate void ab initio. The Second Circuit instructed that the interest rate analysis “is the bread and butter of trial courts,” and directed that the district court should decide the issue. The Second Circuit also indicated that if the district court finds the note usurious, then it should follow the Court of Appeals’ clear directive and deem the convertible note void ab initio.

The case is Adar Bays, LLC v. GeneSYS ID, Inc., No. 18-3023 (2d Cir. Mar. 15, 2022). Adar Bays is represented by Garson, Segal, Steinmetz, Fladgate LLP. GeneSYS is represented by Phillipson & Uretsky, LLP. The order is available here.