Does this debt come with all the bells and whistles?

In today’s world, the buying and selling of distressed debt is a common occurrence. When buying promissory notes or other negotiable debt instruments, buyers (i.e., future holders of the note) may overlook whether they can actually charge the interest rate(s) stated in the instrument once it has been assigned. At least under Tennessee law, the maximum allowable interest rate that may be charged depends on the person/entity charging it. However—and good news for the debt market—under Tennessee law a buyer of debt may charge the applicable rate(s) stated in the negotiable debt instrument as long as the rate(s) could legally be charged (i.e., non-usurious) by the original holder of the debt instrument.

Many states are like Tennessee in that the legislature sets different maximum allowable interest rates for the various categories of lenders (i.e., usury rates).¹ The interplay between usury rates and the purchasing of a negotiable debt instrument is highlighted in the case of J&B Investments, LLC v. Surti, 258 S.W.3d 127 (Tenn. Ct. App. 2007).

In that case, J&B purchased a $1.5 million promissory note originally held by a state-chartered bank (“State Bank”). The note contained a provision allowing State Bank to charge a maximum allowable interest rate of 24%. The maker of the note defaulted and the holder accelerated the debt and increased the interest rate to 24%. After default, J&B sued the guarantors for payment of the outstanding obligations under the note.²

The threshold issue in the case was whether Tennessee law allowed State Bank—which originally held the debt—to charge 24% default interest without violating Tennessee’s usury laws. The Tennessee Court of Appeals found that the 24% interest rate was not usurious because state-chartered banks can charge the maximum allowable interest rate that a national bank can charge. However, what makes J&B significant is that because the court found that the note was not usurious in the hands of State Bank, J&B—the assignee and subsequent holder—was allowed to charge the same rate of interest as State Bank.

In order to appreciate the court’s holding, it is important to understand that under Tennessee law not all lenders are treated the same. Financial institutions operating in Tennessee can be lumped into three broad categories: (1) nationally-chartered financial institutions; (2) Tennessee state-chartered financial institutions; and (3) out-of-state-chartered financial institutions. Tennessee state-chartered financial institutions are further divided into subcategories such as banks, credits union, and industrial loan and thrift companies. As it pertains to the subcategories, the Tennessee legislature dictates the maximum allowable rate that each state-chartered financial institution may charge to their borrowers.

In the late 1960’s, the Tennessee legislature found that national banks—those banks controlled by the federal Office of the Comptroller of Currency—might gain a competitive advantage over Tennessee state-chartered banks if the national banks were allowed to charge higher interest rates. Thus, Tennessee Code Annotated § 45-2-601, a.k.a. the “Wildcard Statute,” was enacted to allow Tennessee state-chartered banks to have the “same powers” as national banks. Moreover, the Tennessee legislature also expressly allows state-chartered banks “to make loans upon the same terms and at the maximum effective interest rates as loans are authorized and credit extended by national banks in this state.” T.C.A. § 45-2-1108.

In the same line, Congress allows national banks to charge interest at the highest rate allowed by law in the state in which the national bank is located.³ See 12 U.S.C. § 85. In Tennessee, lenders categorized as industrial loan and thrift companies are allowed to charge a maximum interest rate of 24%. Thus, a national bank located in Tennessee can charge 24% interest, and therefore, because of the Wildcard and other accompanying statutes, a state-chartered bank may charge the highest applicable rate a national bank can charge, which is 24%.

As it relates to out-of-state-chartered banks that are federally insured, they may charge interest rates up to the maximum allowable rate a national bank charges in the state in which the out-of-state bank is located. So, if the out-of-state bank is located in Tennessee, it may charge up to 24%.

With all this in mind, J&B is important because the court held that J&B—as the assignee of the promissory note—was allowed to charge interest at a rate of 24% because State Bank—the original holder of the note—could charge interest at the highest rate a national bank could charge. This means that any assignee of a promissory note can charge the highest non-usurious interest rate stated in the note that the original holder of the note could have charged. The assignee can charge the highest rate despite the fact that if the assignee was the original holder of the note the interest rate would be usurious.

Despite the holding in the J&B case, there still remains some lingering issues for those purchasing debt. Specifically, the Tennessee Court of Appeals’ holding does not clarify the situation where a promissory note is drafted to state that the default rate shall be the “maximum rate allowed by law,” but declines to specifically reference that rate. For example, the original holder of the note is a Tennessee state-chartered bank, which subsequently assigns the note to a Tennessee LLC. Under Tennessee law, the LLC can only charge interest at the applicable formula rate.⁴ If the maker of the note defaults after assignment and the Tennessee LLC decides to implement the default rate, what is the maximum rate that can be applied; the state-chartered bank rate of 24% or the formula rate of 7.25%? J&B’s holding may assist an argument that 24% should apply. Of course, buyers of debt should carefully review the provisions of the negotiable debt instrument to confirm that they are allowed to take advantage of all the provisions to which the assignor was entitled.

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¹Although not all states have usury laws, statutory prohibitions preventing lenders from charging oppressive interest rates date back to at least Henry VIII’s time. Depending on applicable state law, the punishment for charging a usurious interest rate could be statutorily defined damages, voiding the principal, and/or returning the collected usurious interest.

²The maker of the note filed for chapter 11 bankruptcy protection prior to J&B’s suit. The bankruptcy plan provided that J&B would be paid the full amount of its claim, however the court reduced the amount of interest on the claim to the pre-default interest rate of 8.5% rather than allowing the claim to include interest at the 24% default rate. J&B sued the guarantors in state court to recoup, amongst other things, the difference in the interest accrued under the default rate and non-default rate.

³“Located” is a term of art, and for the purposes of determining the applicable maximum non-usurious interest rate, deciding where a bank is located can be difficult and should be conducted with the assistance of legal counsel.

⁴As of November 21, 2012, the formula rate for Tennessee was 7.25%.