[FINANCE] DD 10/11/06 Court specifically enforces option agreement with usurious terms, but voids the interest - optionee rides free.

Daily Development for Wednesday, October 11, 2006
by: Patrick A. Randolph, Jr.
Elmer F. Pierson Professor of Law
UMKC School of Law
Of Counsel: Blackwell Sanders Peper Martin
Kansas City, Missouri

OPTIONS; SPECIFIC PERFORMANCE; USURY:  Court may award specific performance of a lease option to purchase the property with financing at a usurious interest rate.  Tenant, however, does  not waive the issue of usury by seeking specific performance. 

Van Carr Enter. v. Hamco, Inc., 2006 Westlaw 649985 (Ark. 3/16/06). 

The parties entered into a commercial term lease agreement with an option to purchase the building, exercisable at any time during the period of the lease.  If tenant elected to purchase the building, landlord agreed to finance the purchase at an interest rate of 7% for 5 years and thereafter at 6% above the Federal Discount Rate (FDR) for 15 years.  On the date of the lease, the FDR was 1.25%. 

Article 19, Section 13 of the Arkansas Constitution provides that the maximum lawful rate of interest on any contract cannot exceed 5% above the FDR at the time of the contract, and any contracts having a rate of interest in excess of the maximum lawful rate shall be void as to the unpaid interest. 

During the term of the lease, landlord entered into two separate leases with a subsidiary of landlord for two different suites in the building, both at below market rent.  Four months prior to the expiration of tenant’s lease, tenant gave written notice to landlord of tenant’s intent to exercise its option to purchase.  Three months later, landlord mailed a notice to tenant stating that tenant could either purchase the building subject to the current leases or sign a new lease for five more years. 

Tenant filed suit alleging breach of contract and seeking specific performance under the lease option.  Landlord countered that the contract contained an unlawful rate of interest and was illegal on its face. 

The circuit court declared that the interest rate under the contract was usurious and void but awarded specific performance of the remaining provisions of the contract.  Thus the tenant could make payments over the twenty year term, as agreed, but was not required to pay any interest. 

Tenant also sought equitable compensation for the difference between the lease rents on the “sweetheart” leases to landlord’s affiliates that now bound the property, but the trial court refused such compensation.  Instead the trial court simply cancelled the leases, since the option agreement provided that the optionor landlord would convey title free and clear of all liens and encumbrances that might affect the title to the property. 

On appeal, the Supreme Court affirmed the circuit court’s decision and rejected landlord’s argument that tenant should be estopped from asserting that the interest rate in the contract was usurious because tenant waived the issue by seeking specific performance of the contract.  The Court reasoned that because the contract at issue is void as to the unpaid interest under Arkansas law, a borrower cannot waive a usury defense by simply requesting specific performance of the remaining clauses of the contract.

Comment 1: We haven’t seen many usury issues in recent years.  Many states have abolished usury in commercial contracts.  But a few states have usury protection embedded in their Constitutions, including Texas and Arkansas.   If, as we now expect, interest rates begin to creep up, the issue may arise again.  Here, of course, usury was based upon the spread bargained by the parties, and not the absolute rate. 

Is this an appropriate case to deny specific performance and leave the penalty to his remedy in damages?  Note the draconian penalty resulting from specific enforcement - the tenant gets the property for a song - payments over twenty years at no interest.  The court considered equitable factors such as whether the tenant or the landlord dictated the terms of the sale.  It found there was no evidence that the tenant in fact controlled the deal.  It apparently was simply bargained, and the landlord, obviously, needed better advice for that bargain.

Comment 2: Note that the leases were knocked out because of specific language in the option itself, binding the optionor to transfer the title free and clear.  What if that language wasn’t there?  Was the landlord free to encumber the property with leases?  

If the lease option was properly recorded, then tenants entering into leases subsequent to the lease option would be bound by the optionee’s rights, so one assumes the optionee could avoid those leases.  But what if, as is often the case, the tenant/optionee did not record the lease?  Is its possession notice to the world of its purchase option?  Note that the other tenants would be leasing other space in the building.  Are they required to check with other tenants to see if they have option rights in the space they are renting?  Hmmm.  The editor guesses that they are not.  But there are a few cases where tenants renting space in a shopping center are held on notice of exclusive use clauses contained in the leases of other tenants.  Are such clauses more likely to be found than purchase options, so that the inquiry duty is higher?  The editor thinks not. 


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