Fed Rate Change Puts Usury Limit in Legal Limbo

If Arkansas' constitutional restriction on usury wasn't problematic enough, a change last week in the Federal Reserve's monetary policy has left the state without a clear definition of the allowable interest rate that can be charged by non-bank lenders.

On Thursday, the Fed followed through with an announced plan to eliminate its traditional "discount rate" — the rate at which it made short-term loans to member institutions — and replaced it with a two-tiered credit program.

Unfortunately, Amendment 60 to the Arkansas Constitution defines usurious lending as anything more than five percentage points above the Federal Reserve's discount rate — a benchmark that no longer exists. And state law also ties the rates on school and municipal bond issues to the discount rate.

Federal legislation has exempted most mainstream lenders — in-state

and out-of-state banks, thrifts and federal credit unions — from the most restrictive usury limit in the country. But state agencies, school districts, cities and counties that issue bonds, pension plans that make loans as part of their investment portfolio, and retailers who want to "tote the note" are still bound by the limit — whatever it is.

"My people want to know something definitive because there are penalties involved, and if there's litigation, it could be class action," said Dennis Jungmeyer, executive director of the Arkansas Automobile Dealers Association. "On the other hand, I don't think anybody can make a determination outside the court system, and that will be both time consuming and expensive."

The question could only be completely settled by a constitutional amendment, which couldn't be voted on by the public until November 2004 at the earliest. In the meantime, lenders are looking for an interim answer, and the most likely one seems to be to substitute the Fed's new "primary credit" rate for the outmoded discount rate.

The primary credit rate is the lower of the two new rates created by the Fed's new "Regulation A," and it is the one available to generally sound institutions. It was set Thursday at 2.25 percent, 1.5 percentage points above the final level of the discount rate — and that is excellent news for financiers who were previously limited to 5.75 percent interest rates.

Robert Hopkins, manager of the Federal Reserve Bank of St. Louis' Little Rock Branch, said the Fed considers the primary rate to be the "functional equivalent" of the former discount rate. But the Fed's opinion has little to do with the application of state law.

More important, then, is an opinion issued Dec. 31 by outgoing Attorney General Mark Pryor at the request of Mac Dodson, president of the bond-issuing Arkansas Develop-ment Finance Authority. While the AG didn't come up with what Arkansas Bankers Association Director Ken Hammonds called "the final-final word," the opinion did suggest that using the primary credit rate would make sense.

"Until such a definitive resolution of these issues is forthcoming, it is my opinion ... that the approach most consistent with Arkansas precedent would be to interpret the phrase 'Federal Reserve Discount Rate,' as used in Amendment 60, as being equivalent to the 'primary credit' rate that is created by the new Regulation A," Pryor said in the opinion, which was researched and written by Assistant Attorney General Suzanne Antley.

Legal Obsolescence

The precedent for such legal obsolescence on which Antley based her argument dates back to 1982, when the state Supreme Court dealt with the fact that the state constitution called for five State Highway Commissioners from separate Congressional districts — even though the number of Congressional districts in Arkansas dropped to four after the 1970 Census.

In that case, the Supreme Court solved the problem "by looking to the intent and purpose" of Amend-ment 42, which was to create statewide representation on the Highway Com-mission even when strict compliance was impossible.

"If the [Supreme Court] were to take such an approach to the interpretation of Amendment 60," the AG's opinion concluded, "I believe that it would conclude that the intent and purpose of Amendment 60 would be best effectuated by relying on the new 'primary credit' rate to calculate the usury limit in Arkansas."

Dodson said he was pleased with the AG's opinion, primarily because it would allow ADFA some upward rate flexibility on the few occasions when it issues taxable bonds.

"The problem we have had in the past is, in some instances, we couldn't sell the bonds because our maximum rate was below market rate and no one would buy the bonds," he said.

Still, Dodson said he'll be seeking the advice of bond counsel on a case-by-case basis.

One such lawyer, Paul Benham of the Friday Eldredge & Clark firm in Little Rock, said he disagreed with some of the AG's logic but "I agree with the conclusion of the Attorney General ... and I think most of the lawyers who deal in this area do as well."

Amendment 60 is the only part of the state constitution affected by the elimination of the discount rate, but there are several parts of Arkansas Code that cap interest rates on school and municipal bonds at five percentage points above the Federal Reserve's "discount rate on 90-day commercial paper" — a benchmark that hasn't existed for several years.

Benham said his firm has drafted proposed legislation to fix that language with regard to municipal bonds, and late last week he was shopping around for a legislator to introduce it in the upcoming session.

He was not drafting a proposed replacement for Amendment 60, as he had in vain for the 1990 General Election.

"We are either the silliest state or the most protected state in the nation because of our usury law ... or maybe we're both," Benham said.

He thinks the chances of persuading the voting public to dump the existing usury law are slim because the credit environment has changed dramatically since the high-interest days of 1980, when voters approved Amendment 60 to replaced the constitution's flat 10 percent limit on interest.

"At the time, people faced the possibility of not having credit available," he said. "Now people are generally able to get credit at a price, somewhere."

But Amendment 60 was flawed, he said, even before the reference to the discount rate was rendered meaningless.

"What we didn't do was choose a benchmark or reference that was actually reflective of the cost of money," Benham said. "If I could have a perfect world, I would love to change Amendment 60 to have a benchmark that refers to Treasury bills or something, but that's very confusing for the guy on the street."

Rep. Roger Smith, D-Hot Springs, said he might be interested in introducing an amendment to replace Amendment 60, even though he's been warned that it would be a political loser.

"I don't like anything that holds us back, and I think our usury laws have been a problem in a number of areas," Smith said last week. "I want to explore it. I want to know, first of all, do we have a problem? And if we do, I want to solve it."

Smith thinks the Fed's elimination of the discount rate might be a blessing in disguise.

"It takes a crisis to get people's attention, and maybe this is just what we needed to make us take some action," he said.

Congress to the Rescue?

Auto dealer lobbyist Jungmeyer, who leads a group that calls itself the Arkansas Fair Credit Coalition, said Rep. Mike Ross, D-Ark., will make another attempt in the new session of Congress to get non-bank lenders (not including payday lenders) exempted from the state's constitutional usury limit.

The proposal is characterized as "technical corrections" to the Gramm-Leach-Bliley Act of 1999, which allows banks chartered in Arkansas to match the interest rates that their interstate competitors can "import" from their home states. Ross' amendment would extend the relief the 1999 act offered banks to non-bank lenders.

An identical attempt in the last Congress failed, in part because Sen. Paul Sarbannes, D-Md., who chaired the Senate Banking Committee, was hesitant to meddle in a state-specific issue. The new Republican-controlled Senate may be more receptive, Jungmeyer said.

"We have to wait for them to get in and find their seats," he said.

Lunsford Bridges, CEO of Metropolitan National Bank in Little Rock and a member of the board of directors of the Federal Reserve Bank at St. Louis, said it may be necessary to let Congress do what the voters of Arkansas have been loath to do, which is remove the state's restrictive cap on interest charges.

"Having seen how the Arkansas banks have operated under the new law ... and that the public has not been hurt in any way, there's no reason that Congress shouldn't go on and give relief to everyone in the state and in states operating under laws similar to it," Bridges said.

"Banks haven't jumped up on rates — we can't. The marketplace is controlling the rates. And I think that Congress ought to go on and enact a law that would eliminate the Arkansas problem altogether."

The good intention of the usury limit is backfiring, Bridges said.

"Arkansas has potentially a powerful engine, but we're operating it with a governor on it that keeps it running very slowly. And I refer to the usury limit as a governor. We've got to remove that governor and let it run at the same speed as every other state in the country.

"We've got the most restrictive law in the land, and it is holding this state back. If a municipality or a school district can't finance their needs with a bond issue, that is a real problem," he said.