This story begins in 1994, when Ronald Sexton negotiated a deal with Bluebonnet Savings Bank to purchase 43 acres of unimproved land in Polk County, Texas, known as “Cedar Point,” for $1.1 million. Included in the sale was 100% of the stock in a utility company that served Cedar Point, and 199 performing promissory notes. Sounds like the remnants of the S&L fallout of the early ‘90s.
Sexton couldn’t find financing to close the deal, so he met up with Zer-Ilan, a Californian who owned a company which sold security services and equipment. Zer-Ilan, removed from Texas real estate and our peculiar and very stringent state usury laws, agreed to a sale-leaseback arrangement. For an investment of $1.4 million, Zer-Ilan stood to gain between $525,000 and $900,000 in profit within just a few months.
Fortunately for Zer-Ilan, he had retained a Texas lawyer who said “that thar deal that looks too good to be true, and well, it is.” It charged too much interest to be legal. This is known as “illegal usury.” Usury is a charge for compensation for the use, forebearance, or detention of money. It makes no difference what the parties call it, or disguise it as, if it’s compensation for the use, forebearance or detention of money, it’s usury and subject to Texas’ strict and punitive usury laws.
So when Zer-Ilan’s lawyer pointed out that he was about to sign an illegal deal, they all went back to the drawing board, and came up with a totally new 4 part deal:
1. Sexton signed a $1,075,000 promissory note, at 18% per annum interest, payable to Zer-Ilan. Sexton pledged the title to Cedar Point as security.
2. Sexton signed another $200,000 note, at 18% per annum interest, payable to Zer-Ilan. Sexton pledged the stock in the utility company that serviced Cedar Point as collateral.
3. Zer-Ilan purchased the 199 performing notes for $100,000.
4. Ideal Systems, Zer-Ilan’s company, and CPDC, Sexton’s company, entered into a “Consulting Agreement” by which CPDC agreed to pay Ideal $750,000 for a security system and the provision of related security services at Cedar Point for two years.
This plan got a little further than the first plan–documents actually got drafted and signed. But the ink was barely dry when the dreaded usury issue was again raised by the lawyers involved. So the boys retroactively reduced the 18% interest figure to 10%, and released Sexton’s claims against Zer-Ilan for illegal usury. A sweet deal just got a little bit sour.
The ink on that deal didn’t get a chance to dry either before more trouble developed. In early September 1994, CPDC failed to make its first payment due under the notes and consulting agreement. You know things are bad when the not even the first payment is made. This was becoming a very strong blend of lemonade for Zer-Ilan.
Zer-Ilan didn’t budge. When CPDC failed to make its second payment, Zer-Ilan accelerated the loan and posted the property for foreclosure. Extended workout negotiations took the parties through April of 1995, when Zer-Ilan’s new attorney sent Sexton a letter renouncing any intention to charge usurious interest under the notes, and waiving Ideal’s right to compensation under the consulting services agreement. As Zer-Ilan attempted to foreclose in May, CPDC filed for bankruptcy.
In bankruptcy various parties got to fighting about the whole Zer-Ilan deal. This fight ended with a judgment against Zer-Ilan to pay nearly $1.8 million in damages, and over $380,000 in attorneys fees and court costs. This, after loaning and being prevented from collecting some $1.275 million. How in the world could something like this happen? By now, this lemonade was too strong to even swallow.
Basically, the bankruptcy court looked at the transactions and applied what I call the “Whole Deal Principle.” This principle says that a court considers and interprets all documents that constitute the same transaction as a whole, and it is presumed that documents executed at the same time are part of the same transaction. They are considered and interpreted in light of the circumstances at the time they were signed.
For example in this transaction, the two notes do not constitute the entire transaction. There is the sale of the performing notes, and there is the consulting agreement. They combine with the two notes to make the Whole Deal. If these two documents are usurious and are not contradicted by the notes, then the whole deal, including the notes, is usurious. As you can see, under this Whole Deal Principle, usury in any one part infects the whole.
This is not an uncommon or unusual scenario. Very often, purchasers or investors want to receive a very high rate of return for their investment in a risky deal. And so it falls to the lawyers to figure out how to legally accomplish this. One way to do it is to set the amount of the note in relation to the value of the fixed assets (here, the land), and then have side deals for other payments, such as consulting services, as long as services are actually provided. Or the investor can get a sweetheart deal on purchasing other assets.
The bankruptcy court must have seen the Whole Deal this way. Zer-Ilan figured that this deal with Sexton was very risky, and he wanted to be compensated for the risk. Turns out he was right, as Sexton didn’t even make the first payment under either note or the consulting agreement. Since the lawyers told him he couldn’t receive more than 18% per annum interest (at first-later reduced to 10%), on the notes, he needed to realize some additional return somehow. He did this by buying notes for less than their real value, which gave him $62,100 in additional “interest”, and by forcing Sexton’s company to agree to pay $750,00 to Ideal for phantom security services.
And so the dominoes fell. The jury found the real value of the services provided under the consulting agreement to be $40,000, not $750,000 as per its terms. The court also concluded that the real value of the performing notes sold by Sexton to Zer-Ilan were worth $161,200, not the $100,000 they were sold for. The $61,200 and $710,000 was really just more compensation for the use of money. When you added those figures to the interest in the 2 notes, the Whole Deal became usurious.
Since this result was so horribly sour for Zer-Ilan, he appealed to the district court, which voted with Zer-Ilan. Then the parties aligned against Zer-Ilan appealed the district court loss to the Fifth Circuit federal court. And bucking the strong trend of the Fifth Circuit refusing to consider bankruptcy -related cases, the court accepted it. Would it add some much needed sugar to this concoction being force fed Zer-Ilan? There were no usury issues on the 2 promissory notes themselves. And so the whole case came down to the (1) consulting agreement and (2) the sale of notes.
The Court of Appeals made short work of the consulting agreement. First, it was between two companies, whereas the notes were between two individuals. Second, the rule of law is this: fees which are an additional charge supported by a distinctly separate and additional consideration, other than the simple lending of money, are not interest and thus do not violate the usury laws. Although illusory consulting payments may constitute interest (as in payments for services never rendered), and although the corporate veil may be pierced under the right circumstances, neither of those applied here. In fact, the Court of Appeals astutely remarked “Ideal’s failure to perform services pursuant to the contract is irrelevant here, because CPDC never made a single payment on it.”
The Court made even shorter work out of the promissory note issue, basically saying the bankruptcy court made an error in accepting CPDC’s expert evidence concerning the alleged value of the 199 notes.
And so, finally, after a very exhaustive and extensive fight in bankruptcy court, district court, and the Fifth Circuit Court of Appeals, Zer-Ilan won. Here’s what he won–the right to file claims in the bankruptcy case in yet a further attempt to collect something on all this debt. And he probably won title to Cedar Point. One wonders how much of this was throwing good money after bad–keep in mind one side’s attorneys fees were $380,000 and that was just for the bankruptcy court portion of the fight.
So what’s the moral of this story? Make sure, when you structure your deals, you consider the Whole Deal looking at it as a whole, ignoring the form and looking at the substance. That perspective has to make sense and be defendable from usury and other perspectives. The wise will seek appropriate professional advice in structuring these complex multi-faceted transactions. Zer-Ilan’s lawyers eventually won the day, although he got burned a bit just because he decided to play with fire.
In re: CPDC, Inc.; Zer-Ilan v. Frankford, et al., Case No. 02-20197, United States Court of Appeals for the Fifth Circuit, July 1, 2003, revised July 23, 2003.