Usury

The concept of usury (defined as the lending of money with an interest charge—usually an exorbitant one) and its application to the lending function have generated significant head scratching and hand wringing over the years, especially in Arkansas. In fact, for much of recorded history, the lending of money at interest has simply not been considered a wholesome activity.

In some early Jewish and Christian communities, it was considered immoral to take advantage of a needy neighbor by adding interest at any rate to his already burdensome debts. To this day, some majority-Muslim countries observing the law of Sharia, as set forth in the Koran and the Sunna, prohibit lending at interest at any rate, based on the same rationale. However, Muslims who wish to abide by the letter of religious law while transacting business often resort to various fictions, primarily casting lending transactions as sales and leasebacks with options to purchase at a price reflecting the substance of the transaction.

As early as the ninth century in England, the taking of interest was frowned upon. Later, Parliament specifically authorized the practice in the reign of Henry VIII, but that enactment was short lived. Gradually, in many jurisdictions, the absolute prohibition gave way to a balancing between “reasonable” interest charges and unreasonable charges—that is, usury. Broadly speaking, extensions of credit at rates exceeding some standard set by the state have been termed “usurious” and the result “usury.”

American courts and legislatures have likewise sought to balance protection of borrowers with preservation of contractual rights, often by honoring subterfuge. The development of a rational, uniform, coherent legal framework took centuries. Real estate purchase money mortgages were given special status judicially, for example, the rationale being that the purchase of the real estate, which was mortgaged back to the seller, and the extension of credit were part of a single contractual transaction and, therefore, not subject to the limits on interest that would be applicable to the extension of credit alone (a distinction without a difference, certainly). The “time-price differential,” meaning use of a high “credit” price and a lower “cash” price, may have reflected the economics, but the structure also represented concealed interest, as did requirements of compensating balances.

Usury in Arkansas
When Arkansas was granted statehood in 1836, its first legislature set the limit for what was considered usury at eight percent, but it neglected to include any penalties for violations. By 1844, every state had some limit. By 1868, during Reconstruction, Arkansas joined the many using the ten percent limit and penalty. When Arkansas’s post-Reconstruction constitution was adopted in 1874 and enabled by statute, all such lending simply was capped at ten percent per annum simple interest, regardless of intent, manifest error, or refund. Violating that limit was given a moral flavor and draconian retribution—forfeiture of the remaining balance and any unpaid interest. That Arkansas limit and penalty were indeed intended to protect the state’s populace from the perceived threat of rapacious Eastern money lenders, who were commonly thought to gouge borrowers. But tools for evading or avoiding that limit soon arose. For years, many Arkansans relied on strategies such as use of pawn shops and payday lenders, which has involved post-dated checks and very high effective interest rates. (Significantly, one central Arkansas bank had a major pawn shop owner among its shareholders.)

As noted, courts and legislative bodies have vacillated for centuries over whether to limit interest charged, whether to prohibit its collection altogether, and how to calculate interest charged, sometimes straightforwardly and other times by permitting artificial fictions and outright evasions, such as those allowed by the Arkansas Installment Loan Act of 1951.

Arkansas judicial decisions expressly permitted the calculations associated with 360-day years (the standard accounting practice of recording interest on accounts payable using a year that consists of twelve equal thirty-day months) and the venerable Rule of 78 (which gives greater weight, when calculating interest, to months in the earlier part of a borrower’s loan cycle), both of which produced slightly higher effective interest rates. This concession was due to their longstanding use and the simplicity of calculations for small lenders. Lenders routinely added their overhead expenses in addition to actual interest, even though payments to third parties generally have not been considered interest. Computational devices at least bordering on evasion have included conditional sales cast as leases with options to purchase. In the 1950s, the Arkansas Supreme Court began to steadily chip away at such evasions and also their statutory equivalents, leaving small borrowers with very limited access to credit and resorting to even more onerous credit evasions.

The concept known as “indirect lending” has provided a source of liquidity to some Arkansas non-bank entities, such as automobile dealers. Typically, a customer fills out an application for a loan and sends it and a credit report to an out-of-state finance company. Generally, the dealer and the finance company will have already agreed on guidelines as to what the finance company will and will not approve. The approved contract of sale and any related documentation are then transferred to the finance company, which pays the dealer. Structured correctly, the actual extender of credit is the finance company, not the dealer, and, hence, the customer, the dealer, and the finance company can legitimately choose the law of the finance company’s domicile to govern the loan. This is the scenario for less desirable deals. For the “better” customers, the paper will be sold to an Arkansas bank, which is also regarded as the extender of credit. These transactions generate no usury concerns due to federal preemptions.

Such loans are frequently sold for less than the unpaid loan balance, which increases the return to the purchasing lender. That increase may or may not raise usury questions, but such transactions almost always rely on a continuing preemption, or a choice of law, so those questions are typically mooted. Likewise, commitment fees may increase yields for the lender, but true commitment fees do not alter the effective interest rate.

Federal preemptions have made a huge difference in the making of residential loans. The Depository Institutions Deregulation and Monetary Control Act of 1980 (DIDA) allows traditional, insured mortgage lenders to finance homes and apartment buildings at any rates dictated by the market, if they are secured by first mortgages.

Perhaps one of the most elaborate calculation devices under DIDA was the “wrap around mortgage,” typically used in multifamily loans, use of which required meeting several structural requirements and “wrapping around” an existing note and mortgage, with a second lien to produce the equivalent of a first mortgage securing the wrapped loan. Such structures never gained widespread use. Likewise, the concept of indexed principal, while intellectually appealing, never got off the ground.

The Federal Brock Act of 1974 preempted Arkansas rate limits on larger business and agricultural loans, but only for three years, in order to provide relief until the state revised its laws. Further, the rise of statewide and interstate branching and of bank holding companies ramped up competitive pressures on Arkansas banks.

The Financial Services Modernization Act of 1999 (FSMA) preempted state usury limits such as Arkansas’s and substituted therefor the home state limitations of banks branching into Arkansas pursuant to the federal Riegle-Neal Interstate Banking Act of 1994, as enabled by the Arkansas Interstate Banking and Branching Act. FSMA applied only to federally insured banks and essentially eliminated interest limits on loans over $2,000 and credit cards. Methods of calculation were largely irrelevant. National banks have been able to mirror rates available to other lenders. Federal preemptions ranging from the comprehensive to the narrowest focus have thus permitted Arkansas lenders to at least survive. For example, credit charges for purchases at the gasoline pump are preempted nationwide.

Over the years, bankers and legislators tried repeatedly to amend the Arkansas constitution to eliminate limits considered burdensome, without success. Alternative proposals were floated in 1970 in the drafting of a completely new constitution, but no consensus was reached among the delegates on that issue. In any event, the proposed new document failed at the polls. Only when there were reasonable indexed rates and voters had had experience with similar rates as a result of preemptions, such as those represented by FSMA, did the political climate improve.

With a pair of constitutional amendments—Amendment 60, adopted in 1982, and Amendment 89, adopted in 2010—the electorate changed how the state defined usury. First, Amendment 60 did away with the ten percent per annum ceiling set in the Arkansas Constitution and substituted an index tied to the Federal Reserve discount rate, but, for consumer loans, the ceiling was no more than seventeen percent per annum. It also dramatically reduced penalties for charging excessive interest. It did not purport to disturb existing federal preemptions, notably DIDA’s.

Then, Amendment 89 completely replaced Article XIX, Section 13 of the 1874 constitution, as amended by Amendment 60, substituting rates in these categories: 1) No limits on governmental bonds and borrowings of all kinds; 2) No limits on loans by insured banks headquartered in Arkansas, such as First Security Bank and Bank OZK; 3) No meaningful limits on loans by lenders that have branched into Arkansas and chosen to have the Arkansas loans governed by the laws of their home states, such as Regions Bank and Bancorp South Bank; and 4) All other loans calling for interest below seventeen percent.

Summary
Under the framework of state constitutional law, as amended; federal preemptions; and case law, notes secured by first mortgages on residential real property made by federally insured lenders are subject as to interest limits only to the market. Likewise, bonds and other debt instruments issued by units of government may bear interest at any rate agreed upon by the borrowing issuer and the purchaser of the bonds or other debt instruments. If such bonds are to be used for energy conservation progress, they may be secured by the savings.

Loans over $2,000 made by insured lenders headquartered in Arkansas, which would include virtually all car loans, have no meaningful ceiling. Loans under $2,000 but over $1,000 have a limit of twenty-four percent per annum. Loans under $1,000 have a limit of thirty-six percent per annum, primarily due to federal preemptions.

Out-of-state lenders may choose to have their lendings governed by the law of their home state if they meet a few simple rules. All other extensions of credit are subject to a limit of seventeen percent, calculated in accordance with existing case law and, in cases of violations, subject to the forfeiture of unpaid principal, essentially reviving the original 1874 remedy but at a higher limit.

So-called handshake loans still bear interest at six percent per annum, and pawn shops still simply ignore the issue of usury altogether. Perhaps more significantly, in 2018, US Bank, one of the country’s largest banks, announced that it was finalizing plans to offer existing customers versions of these small loans, for short terms, and allowing draws on the customers’ accounts for the balances, at maturity. Consumer groups immediately panned this program, as did a former bank executive who had been instrumental in running payday lenders out of Arkansas. He pointed out that it was unrealistic to think that a person so strapped that they had to resort to short-term small loans at high rates would be able to repay the loan within a short term. The dispute nationally appears to be over rolling over balances that cannot be paid or maturity into another loan, a significant bone of contention due to its higher potential cost to borrowers. Some payday lenders do not allow such roll-overs.

Nonetheless, with some prompting from regulators, banks, regulators, and some consumer groups do indeed intend for these products to directly compete with the payday lenders. Lenders such as US Bank and Southern Bancorp have banded together with consumer groups in a partnership called Bank on Arkansas that aims to reduce costs to consumers to ease them into the financial system and to avoid common dangers and misunderstandings. For decades, bankers in Arkansas tried various strategies to make enough income to justify administering such loans. Such programs usually were dependent on overdraft fees.

However complicated the Amendment 89 legal landscape may appear to be, when coupled with federal preemptions and indirect lending, Arkansas borrowers (and lenders) appear to have made their peace with interest rates that their ancestors would have found outrageous.

For additional information:
Bacon, Donald. “Indexed Principal: A Way around the Usury Laws.” Arkansas Law Review 31 (Spring 1977): 141–151.

Barrier, W. Christopher. “Usury in Arkansas: Bears and Borders and Buicks, Oh My.” Arkansas Lawyer 39 (Winter 2004): 22–26.

———. “Usury in Arkansas: Something Old, Something New.” Arkansas Lawyer 46 (Winter 2011): 28, 50, 51.

———. “Usury in Arkansas: The 17% Solution.” Arkansas Law Review 37 (1983): 572–611.

———. “Usury in Arkansas: Update and Countdown.” Arkansas Lawyer 16 (October 1982): 168–169.

Barrier, W. Christopher, and John O. Moore. “Usury in Arkansas: Millennial Pre-Emptions.” Arkansas Lawyer 35 (Spring 2000): 42–43.

Bray, Roy H., Jr. “A Partial Survey of Usury Laws in Arkansas.” Arkansas Law Review 6 (Winter 1951–52): 26–37.

Clark, Ronald M. “Interpretation of the Arkansas Usury Law: A Continuation of a Conservative Trend.” Arkansas Law Review 33 (1979): 518–528.

Collins, George B., and Virginia Harkey Ham. “The Usury Law of Arkansas: A Study in Evasion.” Arkansas Law Review 8 (Fall 1954): 399–419.

Falasco, Joseph R. “Who’s Getting Used in Arkansas: An Analysis of Usury, Check, Cashing, and the Arkansas Check-Cashers Act.” Arkansas Law Review 55 (2002): 149–176.

Galchus, Kenneth E., and Ashvin Vibhakar. “A Continuing History of Arkansas’s Usury Law: On the Verge of Extinction.” University of Arkansas at Little Rock Law Review 25 (Summer 2003): 819–834.

Galchus, Kenneth E., Charles G. Martin, and Ashvin P. Vibhakar. “A History of Usury Law in Arkansas: 1836–1990.” University of Arkansas at Little Rock Law Review 12 (1989–90): 695–737.

Jack, Donald T., Jr. “Usury—Recent Arkansas Developments Analyzed.” Arkansas Law Review 21 (Summer 1967): 224–243.

Matthews, Mary Beth. “Preemption of Arkansas Usury Law.” Arkansas Law Review 31 (Summer 1977): 325–334.

Mitchell, James E. “Usury in Arkansas.” Arkansas Law Review 26 (Fall 1972): 263–321.

Penick, Edward M. “The Impact of Usury Law on Banks in Arkansas.” Arkansas Law Review 8 (Fall 1954): 420–457.

“Usury: Issues in Calculation.” Arkansas Law Review 34 (1980): 442–492.

W. Christopher Barrier
Mitchell, Williams, Selig, Gates & Woodyard, P.L.L.C.