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2005 TEXAS USURY REFORM

December 1, 2005 Finance Code Amendments Relating to Commercial Loans

Background In Texas, a lender who contracts for, charges, or receives interest in excess of the amount allowed by law can be subject to harsh penalties. In 1997 and 1999, the Texas Legislature passed several significant reforms that provided some relief to lenders under Texas' usury statutes. Despite these reforms and unlike many other states, commercial loans are still subject to Texas usury laws. Texas usury laws can affect the ability of lenders to structure loans in certain ways and, as a result, have led some lenders to look for ways to avoid Texas law. In some instances, Texas usury laws have discouraged lenders from making loans to borrowers in Texas. In 2005, the Texas Legislature passed two sets of reforms to address certain recurring usury issues that lenders have encountered in Texas. One set of reforms became effective September 1, 2005 and was not dependent upon the passage of an amendment to the Texas Constitution. The second set of reforms required the passage of an amendment to the Texas Constitution that went to the voters on November 8, 2005. The Texas Constitution grants the Legislature the authority to define interest and fix the maximum rates of interest but does not authorize the Legislature to create exemptions for particular types of loans. The proposed amendment to the Texas Constitution would have authorized the Texas Legislature to define interest rates and other terms for large commercial loans. Proposition 5, together with the proposed amendments to the Texas Finance Code (the "Code"), would have exempted from Texas usury laws commercial loans of $500,000 or more (if not primarily secured by real property) and $7,000,000 or more (if primarily secured by real property). Unfortunately for commercial lenders in Texas, the public rejected the proposed constitutional amendment. Proponents for the amendment argued that the changes would encourage lenders to locate their headquarters in Texas (instead of other states where such lenders could import the local law in order to avoid Texas usury laws) and allow greater freedom to structure loans in Texas. Opponents, on the other hand, argued that the changes would remove safeguards that are intended to protect borrowers in Texas. Effective Reforms Although the proposed constitutional amendment failed, the 2005 Legislature passed various other usury reforms that became effective September 1, 2005 and that were not dependent upon passage of the amendment to the Texas Constitution. These reforms included the following: Definition of Interest. The legislature clarified the definition of "interest" to exclude amounts otherwise defined in the Code to not constitute interest or otherwise permitted in addition to interest in connection with an extension of credit. Pre-Suit Notice. In 1997, the Texas Legislature amended the Code to require that a borrower has to notify a creditor who has contracted for or charged usurious interest at least sixty (60) days before filing a suit alleging usury, during which time the creditor has an opportunity to correct the violation and avoid any penalties. The 2005 legislation

This alert is for informational purposes only and is not intended to be legal advice. Transmission is not intended to create and receipt does not establish an attorney-client relationship. Legal advice of any nature should be sought from legal counsel. For more information about Haynes and Boone and our practices, please visit www.haynesboone.com ©2005 Haynes and Boone, LLP

extended the notice and cure period to situations where the creditor has received usurious interest. In addition, the Code now requires a sixty (60) day abatement period when the borrower files a counterclaim alleging usury to allow the plaintiff creditor an opportunity to correct the violation and avoid any penalties. These changes apply only to commercial loans. Elimination of Alamo Lumber. In Alamo Lumber v. Gold, 661 S.W.2d 926 (Tex. 1984), the Texas Supreme Court held that if a lender, as a condition to a loan and as consideration for making it, requires the borrower to assume or pay in whole or in part the debt that another person owes to the same lender, then the amount of the debt assumed or paid will be considered as interest in determining whether or not the loan is usurious. Subsequent cases have limited the rule in Alamo Lumber, but lenders in Texas nevertheless have been concerned that a court would extend the rule to apply when a lender requires that a borrower provide collateral or a guaranty to secure another person's loan. This rule has limited lenders' efforts to structure, restructure or consolidate loans with multiple obligors. The 2005 legislation added a new Section 306.007 to the Code that provides that a lender may require an obligor with respect to a commercial loan to assume, pay, or provide a guaranty of another person's existing or future obligations and that the amount of the debt assumed, paid, or guaranteed does not constitute interest. Late Charges. In 1997, the Texas Legislature amended the usury statutes to permit the parties to a commercial loan to agree to a delinquency charge, in addition to other interest authorized under the statutes, on the amount of any installment or other amount in default for a period of not less than ten (10) days in a reasonable amount not to exceed five percent (5%) of the total amount of the installment. The 2005 legislation eliminates the

requirement that the late fee be in a reasonable amount, but retains the five percent (5%) limitation. Prepayment Penalties. In 1997, the Texas Legislature amended the usury statutes to allow parties to a commercial loan to agree to a charge for prepayment, which charge is not interest. The statute provided that a "prepayment charge" is compensation that is paid or payable solely as a result of, or as a condition to, the payment or maturity of all or a portion of the principal amount of a loan before maturity as a result of any election made by the obligor to pay all or a portion of the principal amount before maturity. The use of the term "election" implied that the prepayment must be voluntary, rather than involuntary (e.g. payable upon acceleration following default) in order for the amount of the penalty to be excluded as interest. The 2005 legislation amended this section of the Code to provide that, with respect to a commercial loan, any prepayment premium, make-whole premium, or similar fee or charge, whether upon the voluntary or involuntary prepayment or acceleration of the loan, does not constitute interest. Penalty Reforms. Pursuant to the Code prior to the 2005 amendments, a lender who contracted for, charged, or received interest that exceeded the amount authorized by applicable law was liable to the obligor for an amount equal to the greater of: (a) three (3) times the amount computed by subtracting the amount of interest allowed by law from the total amount of interest contracted for, charged, or received; and (b) $2,000.00 or twenty percent (20%) of the amount of the principal, whichever is less. In addition to the basic penalty, if a lender charged and received interest which was in excess of double the amount of interest allowed by law, then such lender was

This alert is for informational purposes only and is not intended to be legal advice. Transmission is not intended to create and receipt does not establish an attorney-client relationship. Legal advice of any nature should be sought from legal counsel. For more information about Haynes and Boone and our practices, please visit www.haynesboone.com ©2005 Haynes and Boone, LLP

liable for an additional penalty equal to: (a) the principal amount on which the interest is charged and received; and (b) the interest and all other amounts charged and received. The 2005 legislation amended the penalty provisions to eliminate the minimum penalty for commercial loans. In addition, the amendment eliminates the penalty for socalled "double usury" for commercial loans and such penalty now only applies to loans for personal, family, or household use. Compensating Balances. Under existing case law, the amount of a loan might be reduced for usury purposes by the amount of deposits the lender requires the borrower to keep with the lender. Compensating balances typically arise when a lender

requires such deposits and does not disburse the full loan amount to the borrower or where the borrower has no or limited access to such deposits. New Section 276.003 of the Code provides that proceeds of an extension of credit made for business, commercial, investment, or similar purposes that the obligor uses to establish collateral in the form of deposits, certificates of deposit, or other accounts with the lender do not constitute a reduction in the amount of the proceeds of the extension of credit for usury purposes.

If you have any questions regarding the foregoing or for assistance with issues regarding Texas usury laws, then please feel free to contact any of the attorneys listed below.

Scott G. Night (214) 651-5498 [email protected] Kenneth R. Rogers (214) 651-5951

Terry W. Conner (214) 651-5604 [email protected] Karen S. Nelson (214) 651-5648 [email protected] Laurie G. Lang (214) 651-5667

Sue P. Murphy (214) 651-5602 [email protected] Paul H. Amiel (214) 651-5605

[email protected]

Albert Tan (214) 651-5022

[email protected]

Timothy E. Powers (214) 651-5610

[email protected]

Steven A. Waters (210) 978-7406

[email protected]

Joseph A. Vilardo (713) 547-2228

[email protected]

Theresa Einhorn (713) 547-2078

[email protected]

[email protected]

[email protected]

This alert is for informational purposes only and is not intended to be legal advice. Transmission is not intended to create and receipt does not establish an attorney-client relationship. Legal advice of any nature should be sought from legal counsel. For more information about Haynes and Boone and our practices, please visit www.haynesboone.com ©2005 Haynes and Boone, LLP

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