FREQUENTLY ASKED QUESTIONS

ABOUT TEXAS USURY LAWS

Scott G. Night
Haynes and Boone, LLP

February 14, 2006

 FREQUENTLY ASKED QUESTIONS ABOUT TEXAS USURY LAWS

Scott G. Night
Haynes and Boone, LLP

February 14, 2006

1. Are commercial loans subject to Texas usury laws?

In 1997, 1999, and 2005, the Texas Legislature passed several significant reforms that
provided relief under Texas’ usury statutes for commercial loans. Despite these reforms and
unlike many other states, commercial loans continue to be 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.1 In some instances, Texas usury laws
have discouraged lenders from making loans to borrowers in Texas.

In 2005, the Texas Legislature passed House Bill 955 (the “2005 Legislation”) that
included two sets of reforms to address certain recurring usury issues that lenders have
encountered in Texas. One set of reforms became effective on 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 contained in Senate
Joint Resolution 21 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 Article XVI, Section 11, of 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”)
set forth in the 2005 Legislation, 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

1
See choice of law discussion below.

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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.

2. What is the maximum lawful rate of interest in Texas?

Generally, the maximum rate of interest under Texas law is ten percent (10%) per
annum.2 If the parties do not agree to a specific rate of interest, then the statutes provide for
legal interest at the rate of six percent (6%) per annum on ascertainable amounts under accounts
and contracts commencing on the thirtieth (30th) day from and after the time when such amounts
are due and payable.3 Parties to a written contract may agree to a rate of interest not to exceed a
weekly, monthly, quarterly, or annualized ceiling based upon 26-week treasury bills, subject to
certain ceilings.4 The applicable ceiling will depend upon the type of loan and the agreement of
the parties.5 If the formula set forth in the statute for the applicable ceiling produces a rate that is
less than eighteen percent (18%), then the statute provides for a minimum usury ceiling of
eighteen percent (18%) per annum.6

The statute provides for the possibility of higher ceilings of twenty-four percent (24%) or
twenty-eight percent (28%), depending on the type of loan.7 The eighteen percent (18%)
minimum ceiling can generally be used for all written transactions (with the exception of home
solicitation transactions that are secured by a lien on the obligor’s homestead).8 The twenty-
eight percent (28%) maximum ceiling is applicable to business, commercial, or investment loans,
or extensions or renewals of such loans.9 The twenty-four percent (24%) maximum ceiling is
applicable to all other loans.10 The 2005 Legislation eliminated a $250,000 threshold for the
28% upper limit to apply for loans entered into after the effective date thereof. The Consumer
Credit Commissioner publishes a periodic Credit Code Letter which sets forth computations of
the ceilings.11 Although these ceilings are theoretically available, the eighteen percent (18%) has
been, and will likely remain, in effect for some time.
2.
TEX. FIN. CODE ANN. § 302.001 (Vernon Supp. 2002).
3.
Id. § 302.002.
4.
Id. § 303.001-.008.
5.
Id.
6.
Id. § 303.009.
7.
Id. § 303.009(b), (c).
8.
Id. § 303.009, 303.101.
9.
Id. § 303.009(c).
10.
Id. § 303.009(b).
11.
Id. § 303.011.

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 Generally, the proper usury ceiling under the statute is determined on the date the parties
enter into the contract. If the parties agree that at some future date the interest rate charged will
be or may be revised, then the subsequent change will be governed by the ceiling in effect at the
time the rate is altered. The ceiling with respect to a renewal or extension of a loan is the ceiling
in effect at the time of the renewal or extension, regardless of when the debt originated.12

3. What are the penalties in Texas for a usury violation?

A lender who contracts for, charges or receives interest in excess of that allowed by
Texas law is subject to statutory penalties for usury.13 Therefore, a lender does not have to
actually receive or collect usurious interest to be subject to the usury penalties. In general, the
lender must forfeit to the borrower three (3) times the amount of usurious interest contracted for,
charged, or received, plus reasonable attorneys’ fees.14 The 2005 Legislation eliminated the
minimum penalty equal to $2,000 or 20% of the principal amount of the loan for commercial
loans. If a lender with respect to a loan that is not a commercial loan charges and receives
interest greater than double the amount of interest allowed by law, then the lender must also
forfeit an additional penalty equal to all principal of, and interest on, the loan, plus reasonable
attorneys’ fees.15 The 2005 Legislation eliminated this penalty for so-called “double usury” for
commercial loans.

4. Our billing department goofed! We sent invoices to at least three (3) customers
charging them too much interest on their loans. The problem could be widespread.
What should we do?

A creditor may avoid usury penalties under certain circumstances. A lender has no
liability for a usury violation if the lender (a) within sixty (60) days after actually discovering a
violation, corrects the violation by taking whatever actions and by making whatever adjustments
are necessary to correct the violation, and (b) gives written notice to the obligor of the violation
prior to the obligor giving written notice to the lender or filing an action alleging a usury
violation.16

“Actually discovering” does not require reasonable diligence to discover the violation,
and therefore does not include situations where the lender should have discovered or known
about the violation.17 Actual discovery of a violation in an unrelated transaction, however, may

12.
Id. § 303.013.
13.
Id. CHAPTER 305.
14.
Id. § 305.001.
15.
Id. § 305.002.
16.
TEX FIN. CODE ANN. §305.103 (Vernon Supp. 2002).
17.
Id. § 305.103(b).

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be sufficient to find actual discovery in other transactions (including the related transaction) if
the violation is of such a nature that it is necessarily repeated in other transactions.18

One case interpreting the cure statute held that, to be effective, the notice must
acknowledge the existence of a usury violation and be accompanied by the adjustment or
correction required to comply with the usury laws.19 In this case, the lender made demand for
payment of the debt but excluded certain “fees” that would cause the loan to be usurious.20

Related to the cure statute is the provision in the statute that requires obligors to notify
creditors under certain circumstances prior to filing a usury claim. If a lender contracts for,
charges, or receives usurious interest, then the obligor must send notice to the creditor at least
sixty (60) days prior to filing suit seeking usury penalties.21 The 2005 Legislation extended the
pre-suit notice and cure period to situations where a creditor in a commercial loan has actually
received usurious interest. The notice itself must be sufficiently detailed for the creditor to
identify the alleged violation.22 If the lender corrects the violation within sixty (60) days, then it
is not liable for the violation.23 Prior to the 2005 Legistion, the notice was not required in the
case of a counterclaim.24 As a result of the 2005 Legislation, 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. This change applies only
to commercial loans.

5. Are commitment fees and other upfront fees interest?

A “bona-fide” commitment fee is not interest.25 In the case of a bona fide commitment
fee, the borrower is purchasing an option to obtain a loan at a future date. Therefore, the
commitment fee has distinct and separate consideration from the actual loaning of principal.26 It

18.
Id.
19
. In re Kemper, 263 Bankr. 773 (Bankr. E.D. Texas 2001).
20.
Id. at 784.
21.
Id. § 305.006(b).
22
Id.
23.
Id. §305.006(c).

24.
Id. § 305.006(d).
25.
Stedman v. Georgetown Sav. and Loan Ass’n, 595 S.W.2d 486 (Tex. 1979); Gonzales County
Sav. and Loan Ass’n v. Freeman, 534 S.W.2d 903 (Tex. 1976).
26.
Texas courts have consistently held that a lender may impose a separate charge or fee on a
borrower for any distinctly separate and additional consideration other than the simple lending of
money. Greever v. Persky, 165 S.W.2d 709, 712 (Tex. 1942).

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is unclear what constitutes a “bona-fide” commitment fee. Some factors to consider include
whether:

C The fee is payable prior to funding of the loan.

C The fee is payable whether or not the lender actually makes the loan.
C The commitment documentation actually binds the lender to make the loan.
C The reasonableness of the amount of the fee.
C Whether the borrower also reimburses the lender for its due diligence costs.

If the lender does not collect the fee until closing and does not actually commit to make the loan
in advance of closing, then the lender should consider the fee to be interest.

One case analyzed an initial facility fee and an annual facility fee charged in connection
with a revolving line of credit.27 The court analyzed prior Texas cases and held that neither fee
was a bona fide commitment fee.28 In this case, the initial fee was paid at closing and only if the
loan closed.29 With respect to the annual fee, the court reasoned that such fee was payable after
the lender committed to make the loan.30 Therefore, the annual fee could not be considered to be
a bona fide fee for separate and additional consideration.31 The annual facility fee in this case
should be distinguishable from an “unused” or similar fee where the lender has committed to
make advances in the future and the fee is calculated on the unused commitment.

6. Are prepayment penalties interest?

Unless the agreement between the borrower and the lender specifically states that the
borrower has the right to voluntarily prepay a loan prior to its stated maturity, the borrower does
not have such right.32 Some Texas courts have held that an additional fee charged for the
optional prepayment of a loan may not be considered interest.33 The penalty for prepayment is
not considered to be for the use, forbearance, or detention of money. Rather, the prepayment fee
is consideration for the termination of the use, forbearance, or detention of money. One case,

27.
In re Auto Int’l Refrigeration, 275 Bankr. 789, 802 (N.D. Tex. 2002).
28.
Id. at 802-04.
29.
Id. at 802-03.
30.
Id. at 804.
31.
Id. In October, 2002 the United States District Court for the Northern District of Texas affirmed
the bankruptcy court’s opinion on some matters and reversed and remanded on other matters.
Mims v. Fidelity Funding, Inc., 2002 U.S. Dist. LEXIS 19820 (N.D. Tex. 2002). Id. at 14-16.
The District Court affirmed the conclusion that the upfront and annual fees were interest.
32.
Cunningham v. McDonald, 83 S.W. 372, 373 (Tex. 1904); Boltz v. Graf, 43 S.W.2d 469, 470
(Tex. Civ. App. -- San Antonio 1931), aff’d, 68 S.W.2d 163 (Tex. Comm’n App. 1934, judgment
adopted).
33.
Southland Life Ins. Co. v. Egan, 86 S.W.2d 722 (Tex. 1935).

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however, has created an ambiguity with respect to prepayment penalties by analyzing such a fee
in the context of spreading and a savings clause.34

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.35 The statute
provides 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.36 The use of the term “election” implied that the prepayment
must be voluntary, rather than involuntary (e.g. payable upon acceleration following default).
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.

7. Are late fees interest?

There are several cases applying Texas law holding that late fees or charges in
non-lending transactions are not interest.37 Late fees or charges on past-due installments with
respect to loans and credit sales are, however, generally interest.38 In Dixon v. Brooks,39 the
court held that in order for late charges to be usurious, the late charges, when added to the other
interest on the loan, must exceed the total interest the lender could have contracted for, charged,
or received on the loan.40 Therefore, although late charges are interest, the lender may have the

34
Affiliated Capital Corp. v. Commercial Federal Bank, 834 S.W.2d 521 (Tex. App.-- Austin 1992,
no writ).
35.
TEX. FIN. CODE ANN. § 306.005 (Vernon Supp. 2002).
36.
Id. § 306.001(8).
37.
See Bexar Ice Cream Co. v. Swensen’s Ice Cream Co., 859 S.W.2d 402 (Tex. App. -- San
Antonio 1993) (late fees on franchise payments), overruled on other grounds by Barraza v.
Koliba, 933 S.W.2d 164 (Tex. App. -- San Antonio 1996); Maloney v. Andrews, 483 S.W.2d 703
(Tex. Civ. App. -- Eastland 1972, writ ref’d n.r.e.) (late fees under building lease); Apparel Mfg.
Co. v. Vantage Properties, Inc., 597 S.W.2d 447 (Tex. Civ. App. -- Dallas 1980, writ ref’d n.r.e.)
(late fees under building lease); Potomac Leasing Co. v. Housing Auth., 743 S.W.2d 712 (Tex.
App. -- El Paso 1987, writ denied) (late fees equipment lease); Rivera v. AT&T Corporation, 141
F. Supp. 2d 719 (S.D. Texas 2001) (“administrative fees” for late payments on cable bills); Forest
Point Venture #703 v. Forest Point Owners Assoc., 2001 Tex. App. LEXIS 6625 (Tex. App. --
Dallas 2001, n.r.h.) (condominium homeowners dues).
38.
Butler v. Holt Mach. Co., 741 S.W.2d 169 (Tex. App. -- San Antonio 1987, writ granted); Dixon
v. Brooks, 678 S.W.2d 728 (Tex. App. -- Houston [14th Dist.] 1984, writ ref’d n.r.e.).
39.
678 S.W.2d 728.
40.
Id. at 731.

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benefit of spreading such interest over the term of the loan.41 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.42

8. Can a lender “compound interest” or otherwise charge interest on accrued, but

unpaid, interest?

The phrase “compound interest” generally refers to the practice of accruing interest on
both the original principal of a loan and on the accrued, but unpaid, interest thereon. The
practice of compounding interest increases the effective interest rate with respect to the original
principal amount. Generally, Texas courts have held that a lender and a borrower may agree that
interest accrue on past-due interest.43

The loan documents may provide that accrued, but unpaid, interest is periodically added
to the principal of the loan and thereafter bears interest at the same interest rate that is otherwise
applicable to principal. Alternatively, the loan documents may provide that accrued, unpaid
interest also bears interest. Another approach is to provide for an “interest reserve” or similar
concept whereby principal is “advanced” under the loan to pay accrued interest.

Interest often compounds monthly or quarterly, but in some cases lenders may want to
compound as often as daily. There are no cases that expressly permitted compounding this often.
There may have been some support for this practice in the cases providing for pre-judgment
interest.44 The Texas Legislature, however, subsequently made changes in the Finance Code to
provide for simple interest prejudgment and post-judgment interest compounded annually.45

In absence of an agreement by the borrower, however, a lender should not unilaterally

accrue interest on accrued, but unpaid, interest or otherwise attempt to compound interest under
the loan. In William C. Dear & Assoc., Inc. v. Plastronics, Inc.,46 a vendor sent the vendee an
invoice that included a charge for interest at one percent (1%) per month compounded monthly.47

41.
But see Fisher v. Westinghouse Credit Corp., 760 S.W.2d 802 (Tex. App. -- Dallas 1988, no
writ).
42.
TEX. FIN. CODE ANN. § 306.006(1) (Vernon Supp. 2002).
43.
Bothwell v. Farmers’ & Merchants’ State Bank & Trust Co., 120 Tex. 1, 30 S.W.2d 289, 291
(1930); Shoberg v. Shoberg, 830 S.W.2d 149, 153 (Tex. App. -- Houston [14th Dist.] 1992, writ
denied).
44.
Allen v. Allen, 751 S.W.2d 567, 576-77 (Tex. App. -- Houston [14th Dist.] 1988, writ denied).
45.
TEX. FIN. CODE ANN. § 304.005(a) (Vernon Supp. 2002) (post-judgment interest compounds
annually); Id. § 304.104 (prejudgment interest in personal injury cases does not compound).
46.
913 S.W.2d 251 (Tex. App. -- Amarillo 1996, writ denied).

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The parties did not have an agreement as to a specified rate of interest. Therefore, under Texas
law at that time, the maximum lawful rate of interest was six percent (6%) per annum
commencing thirty (30) days after the debt became due.48 The court held that the vendor
charged more than twice the lawful rate of interest (i.e., more than twelve percent (12%) per
annum) due to the monthly compounding.49

9. My Dad’s best friend has asked him for a loan to acquire a piece of raw land and to
commence the development of a shopping center on the land. He needs $750,000 to
acquire the land and another $250,000 for initial development cost until he secures a
construction loan or other financing. He has promised my Dad that he will pay him
back the $1,000,000 in six (6) months together with interest at the local bank’s prime
rate. To “sweeten” the deal, he has further agreed to pay Dad fifty percent (50%) of
the net profits from the property.

Common Law Treatment of Equity Participations

The treatment of equity participations under Texas law prior to adoption of the Equity
Participation Statute described below was unclear. Texas statutes broadly define interest as the
compensation allowed by law for the use, forbearance, or detention of money.50 A lender may,
however, impose on a borrower an extra charge “for any distinctly separate and additional
consideration other than the simple lending of money.”51 Nevertheless, regardless of what the
parties call an amount in a loan transaction, if it is “in fact compensation for the use, forbearance
or detention of money [it] is, by definition, interest.”52 If a lender obtains an equity participation
from a borrower in addition to, or in lieu of, simple interest on a loan, then the lender is receiving
compensation from the borrower. In absence of independent consideration from the lender in
exchange for such compensation, the equity participation should be treated as interest under the
broad definition of interest under Texas usury law.

If a court finds that an equity participation is interest, then the next determination is what
is the value of that participation and the effect of such value on the total amount of compensation
that the lender is entitled to receive for the loan. Since equity participations involve future
considerations, such as a stream of payments or a share of profits upon sale of property,
determination of the value of the participation may often be difficult. In addition, such
participations are usually speculative and contingent upon the happening of future events.

47.
Id. at 253.
48.
TEX. REV. CIV. STAT. ANN. ART. 5069-1.03 (Vernon 1987). This provision is now found in the
Finance Code. See TEX. FIN. CODE ANN. § 302.002 (Vernon Supp. 2001).
49.
William C. Dear & Assoc., Inc., 913 S.W.2d at 254.
50.
TEX. FIN. CODE ANN. § 301.002(a)(4) (Vernon Supp. 2002).
51.
Greever v. Persky, 165 S.W.2d 709, 712 (Tex. 1942).
52.
Gonzales County Sav. & Loan Ass’n v. Freeman, 534 S.W.2d 903, 906 (Tex. 1976).

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 If the borrower transfers to the lender some form of property right or interest, then the
court should value such participation or interest at the time of the transfer or at the inception of
the transaction.53 At the inception of a transaction, the value of such property right or interest
may be small because of the speculative nature of the project. On the other hand, if the borrower
gives the lender the right to receive future payments, such as a share of rents or profits, then the
court might look at the actual payments the lender receives or is entitled to receive.54

There is some authority in Texas that a loan is not usurious where the borrower’s
obligation to pay amounts to the lender is uncertain or contingent.55 For example, in Beavers v.
Taylor,56 the borrower agreed to pay the lender consideration for the loan equal to varying
percentages of the borrower’s gross sales.57 The court held that since such payments were
contingent, the loan was not usurious, despite the fact that the actual payments ultimately
exceeded the applicable interest rate ceiling.58 Similarly, in Wagner v. Austin Savings and Loan
Association,59 the court held that the borrower’s assignment to the lender of eighty percent (80%)
of certain receivables was not usurious, where such receivables were subject to several
contingencies.60

This line of cases is often cited for the proposition that equity participations given to a
lender are not usurious if such participations are contingent, speculative, or difficult to value. In
one Fifth Circuit case, however, the court did not follow the Beavers line of cases by holding that
a borrower’s agreement to pay the lender twenty-five percent (25%) per annum on the balance of
the loan, but only if there were profits from the underlying project, was usurious.61 The court
relied on several cases subsequent to Beavers where the courts held that a contract is usurious if,

53.
See Thompson v. Hague, 430 S.W.2d 293, 296 (Tex. Civ. App. -- Fort Worth 1968, no writ)
(value of property determined at time it is received); Pinemont Bank v. DuCroz, 528 S.W.2d 877,
879 (Tex. Civ. App. -- Houston [14th Dist.] 1975, writ ref’d n.r.e.) (usury is determined at
inception of contract).
54.
See Thompson, 430 S.W.2d at 296.
55.
Beavers v. Taylor, 434 S.W.2d 230, 231 (Tex. Civ. App. -- Waco 1968, writ ref’d n.r.e.); Pansy
Oil Co. v. Federal Oil Co., 91 S.W.2d 453, 457 (Tex. Civ. App. -- Texarkana 1936, writ ref’d).
See generally, Annotation, Agreement for Share in Earnings of or Income from Property in Lieu
of, or in Addition to, Interest as Usurious, 16 A.L.R.3d 475 § 5[c] (1967).
56.
434 S.W.2d 230.
57.
Id. at 231.
58.
Id. at 232.
59.
525 S.W.2d 724 (Tex. Civ. App. -- Beaumont 1975, no writ).
60.
Id. at 731.
61.
Najarro v. Sasi Int’l, Ltd., 904 F.2d 1002 (5th Cir. 1990).

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under any contingency, it expressly entitles the lender to exact a greater amount of interest than
allowed by law.62 These cases did not involve a lender’s receipt of additional compensation such
as an equity participation. In addition, it seems that the lender in Najarro made a critical mistake
in having a stated rate of interest in excess of the applicable ceiling, even though such payment
was contingent on the borrower making a profit. By stating the interest on the loan in this
manner, the amount of interest on the loan, although contingent, became certain.

As a result of the different results in the various cases, and the lack of any recent
authority on this issue, lenders and their counsel have traditionally been concerned that a Texas
court would hold that equity participations are interest. Much of the concern focused on the
complexity of Texas usury laws and the many disturbing cases in Texas where courts that have
imposed harsh penalties on lenders. In addition, most people acknowledge that equity
participations, even at the inception of the loan, have some value. Otherwise, the lender would
not require such participations as a condition to the loan. The lender may even have appraisals
or other projections in its file showing that there was a clear expectation of future profits.
Finally, the ability to value contingent payments or interests through the use of expert witnesses
has arguably improved. Therefore, prior to the passage of the Equity Participation Statute,
lenders in Texas faced uncertain risks when taking equity participations in connection with loans.

Equity Participation Statute Treatment of Equity Participations

In 1997, the Texas legislature adopted revisions (herein referred to as the “Equity
Participation Statute”) to the Code to provide special treatment for “equity participations” for
certain qualified commercial loans. The legislature further amended these provisions in 1999. A
“qualified commercial loan” is: (a) a commercial loan not secured by real property of $500,000
or more ($250,000 or more if certain disclosure requirements are met), or (b) a commercial loan
secured by real property of $3,000,000 or more.63 A “commercial loan” is a loan that is made
primarily for business, commercial, investment, agricultural, or similar purposes and not for
personal, family, or household use.64 A lender pursuant to a qualified commercial loan may
contract for a rate or amount of interest that does not exceed the applicable rate ceiling.65 The
parties may contract for additional consideration for such loans such as options, warrants, or
other participations in income, revenues, production, or profits of the borrower or the collateral
without such amounts being considered interest.66

62.
Smart v. Tower Land & Inv. Co., 597 S.W.2d 333, 341 (Tex. 1980); Jim Walter Homes, Inc. v.
Schuenemann, 668 S.W.2d 324, 328 (Tex. 1984).
63.
TEX. FIN. CODE ANN. § 306.001(9) (Vernon Supp. 2002).
64.
Id. § 306.001(5).
65.
Id. § 306.101(a).
66.
Id. § 306.101(b). Section 306.101(b) provides as follows:

The parties to a qualified commercial loan agreement may contract for the following
charges:

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 Discussion

The Equity Participation Statute would apply to Dad’s loan so long as such loan is not
secured by the property. In such case, the net profits interest should not be interest and should
not cause the loan to be usurious. The Equity Participation Statute allows lenders in qualified
loan transactions to obtain net profits interests, assignments of interests in property, options and
warrants to purchase stock, and other similar interests. If the loan is secured by the property,
then the Equity Participation Statute would not apply to the loan. In such case, Dad is taking
some risk that the net profits interest will cause the loan to be usurious. Although the profits
interest is speculative and contingent, a Texas court may attempt to value such profits interest
and add such “value” to the total interest on the loan. Dad should evaluate the value of the
profits interest at the inception of the loan and make sure that such value, when added to the
other interest under the loan, does not render the loan usurious. In addition, the loan documents
should include a broad usury savings clause. If the net profits interest turns out to be valuable,
then Dad should also re-evaluate the amounts he has received in order to give effect to the
savings clause.

10. What is the rule established by the Alamo Lumber case?

(1) a discount or commission that an obligor has paid or agreed to pay to one or more
underwriters of securities issued by the obligor;

(2) an option or right to exchange, redeem, or convert all or a portion of the principal
amount of the loan, or interest on the principal amount, for or into capital stock or other equity
securities of an obligor or of an affiliate of an obligor;

(3) an option or right to purchase capital stock or other equity securities of an obligor
or of an affiliate of an obligor;

(4) an option or other right created by contract, conveyance, or otherwise, to

participate in or own a share of the income, revenues, production, or profits:

(A) of an obligor or of an affiliate of an obligor;

(B) of any segment of the business or operations of an obligor or of an affiliate of an

obligor; or

(C) derived or to be derived from ownership rights of an obligor or of an affiliate of

an obligor in property, including any proceeds of the sale or other disposition of ownership rights;
or

(5) compensation realized as a result of the receipt, exercise, sale, or other

disposition of an option or other right described by this subsection.

Id.

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 The basic rule in Alamo Lumber67 is 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.68 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.

11. A lender based in the State of Texas is making a loan to a corporation that is based
in Texas but organized under the laws of the State of Delaware. The proceeds of the
loan will be wired from Texas to the borrower’s bank in Texas. The borrower is
going to pay the lender back in Texas. Can the parties choose Delaware law to
govern the loan documents?

Choice of Law Statute

The Texas Business and Commerce Code (the “Texas Code”) allows parties entering into
certain transactions to choose, through a written agreement, the law that will govern (a) the
validity or enforceability of their agreement, or (b) the interpretation or construction of their
agreement.69 A “qualified transaction” includes any transaction pursuant to which a party pays
or receives consideration having an aggregate value of at least $1,000,000.70 In addition,
qualified transactions include transactions pursuant to which a party lends, advances, borrows, or
receives, or is obligated to lend or advance or is entitled to borrow or receive, funds or credit
with an aggregate value of at least $1,000,000.71

Under Section 35.51 of the Texas Code, with certain exceptions, the parties to a qualified
transaction may agree that the law of a particular jurisdiction governs a particular issue relating
to the transaction, including the validity or the enforceability of an agreement relating to the
transaction or a provision of the agreement.72 If the transaction bears a reasonable relation to the
chosen jurisdiction, then the laws of that jurisdiction (other than conflict of laws rules) shall
govern the particular issue regardless of whether the application of that law is contrary to a

67.
Alamo Lumber v. Gold, 661 S.W.2d 926 (Tex. 1984).
68.
Id. at 927. In Alamo Lumber, the lender agreed to renew and extend Mrs. Gold’s loan if she also
assumed her son’s debt to the lender. Id. at 926-27. The assumption of the son’s debt resulted in
interest on the renewal and extension of Mrs. Gold’s loan. Id. at 927.
69.
TEX. BUS. & COM. CODE ANN. § 35.51 (Vernon 2002).
70.
Id. § 35.51(a)(2).
71.
Id.
72.
Id. § 35.51(b).

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fundamental or public policy of the State of Texas or of any other jurisdiction.73 The parties to a
qualified transaction may also agree in writing that the law of a particular jurisdiction shall
govern the interpretation or construction of an agreement regardless of whether the transaction
bears a reasonable relation to that jurisdiction.74

The statute further provides that a transaction bears a reasonable relation to a particular
jurisdiction if the transaction, the subject matter of the transaction, or a party to the transaction is
reasonably related to that jurisdiction.75 In addition, Section 35.51 of the Texas Code contains
specific factual criteria, the presence of which will satisfy the “reasonable relation” test.76 These
criteria are as follows:

C A party to the transaction is a resident of that jurisdiction;

C A party to the transaction has its place of business or, if that party has more than
one place of business, its chief executive office or an office from which it
conducts a substantial part of the negotiations relating to the transaction, in that
jurisdiction;

C All or part of the subject matter of the transaction is located in that jurisdiction;

C A party to the transaction is required to perform a substantial part of its obligation

relating to the transaction, such as delivering payments, in that jurisdiction; or

C A substantial part of the negotiations relating to the transaction, and the signing of
an agreement relating to the transaction by a party to the transaction, occurred in
that jurisdiction.77

Common Law and the Texas UCC

If Section35.51 of the Texas Code does not apply, then either Texas common law or the
Uniform Commercial Code may apply. In DeSantis v. Wackenhut Corp.,78 the Texas Supreme
Court adopted the rule of Section 187 of the Restatement (2nd) of Conflicts of Law, which states
that the choice of the law of a particular jurisdiction by parties in a contract should be enforced
unless either (a) the chosen state has no substantial relationship to the parties or the transaction,
or (b) application of the law of the chosen state would be contrary to a fundamental policy of a

73.
Id.
74.
Id. § 35.51(c).
75.
Id. § 35.51(d).
76.
Id.
77.
Id. (emphasis added).
78.
793 S.W.2d 670 (Tex. 1990), cert. denied, 498 U.S. 1048 (1991).

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state that has a materially greater interest to the parties or the transaction than the chosen state.79
The Uniform Commercial Code, as adopted in the Texas Code, also provides that the parties to a
transaction may agree that the law of any state shall govern the transaction if the chosen state
bears a reasonable relationship to the transaction.80 This provision of the Texas Code should
generally apply to choice of law provisions in promissory notes, security agreements, and letters
of credit. In Admiral Ins. Co. v. Brinkcraft Dev., Ltd.,81 the Fifth Circuit enforced a contractual
choice of New York law in a promissory note made by a Texas borrower.82 The court relied
upon Section 1.105(a) of the Texas Code, rather than Section 187 and DeSantis, noting that
non-competition contracts (the subject of DeSantis) implicate a stronger Texas public policy than
usurious contracts.83 The court reviewed the contacts with New York, finding a reasonable
relationship between the parties, the transaction, and New York.84

Texas courts have also refused to honor the parties’ choice of law based upon the
conclusion that such choice of law was a “sham” or “subterfuge” to avoid Texas usury laws. For
example, one Texas court refused to honor the parties’ choice of Utah law in a loan transaction
and applied Texas law, making the loan usurious.85 In that case, the parties were all Texas
residents, the parties negotiated and executed the agreements in Texas, and all payments were
made in Texas.86 The only contact with the State of Utah was the borrower’s formation as a
partnership under Utah law.87 Such formation, however, was at the request of the lender as a
condition to the loan.88 The court concluded that the choice of Utah law was merely a subterfuge
to avoid Texas usury law and that the contacts with Utah were contrived “to cover the fact that
the transaction was between Texas entities.”89 The case was decided prior to enactment of
Section 35.51 of the Texas Code.

79.
Id. at 677-79.
80.
TEX. BUS. & COM. CODE ANN. § 1.105(a) (Vernon Supp. 2002).
81.
921 F.2d 591 (5th Cir. 1991).
82.
Id. at 594.
83.
Id.
84.
Id. See also Southwest Livestock and Trucking Co. v. Hargrove, 169 F.3d 317 (5th Cir. 1999)
(enforcing Mexican judgment on note notwithstanding such note being usurious under Texas
law).
85.
Cook v. Frazier, 765 S.W.2d 546 (Tex. App. -- Fort Worth 1989, no writ).
86.
Id. at 549.
87.
Id. at 549-50.
88.
Id.
89.
Id.

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 Discussion

If the loan described above is in the amount of $1,000,000 or more, then the provisions of the
Texas Code described above will govern whether the choice of Delaware law is enforceable.
Although the choice of law provisions described above are intended to provide the parties greater
freedom to choose the law that governs their transactions and agreements, there must still be a
reasonable relationship with the chosen state. In the facts described above, the relationship
between the parties, the transaction, and the State of Delaware are minimal. The transaction does
not satisfy any of the listed criteria that would create a reasonable relationship under the statute.
Therefore, it is unlikely that a court would enforce the choice of Delaware law other than with
respect to interpretation and construction of the underlying agreements. Similarly, the contacts
with the State of Delaware do not appear to be sufficient to satisfy the more stringent relationship
tests under Texas common law or under the reasonable relationship test under the Uniform
Commercial Code, as adopted in the Texas Code.

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