Articles by Patrick Siegfried
Court Refuses to Apply Federal Preemption to Loan Servicer Despite Bank’s Continued Interest in LoanJanuary 20, 2016
In November 2014, the Pennsylvania Office of Attorney General (“OAG”) filed a complaint against a number of companies that did business with a group of payday lenders. The payday lenders were a Delaware bank and three tribal entities. The defendants provided marketing services and operational support to the lenders and in some instances purchased portions of the loans. In its complaint, the OAG alleged that the defendants, and not the bank or tribes, were the de facto lenders and that their partnership with the bank and tribes were constructed to circumvent Pennsylvania usury laws.
In their motions to dismiss, the defendants argued that, in regards to the loans issued by the Delaware bank, federal law preempted the OAG’s state usury claims. They explained that the Depository Institution Deregulation and Monetary Control Act (“DIDA”) allows state-charted federally insured banks to charge the same interest rate in any state as they are legally permitted to charge in the state in which they are located. The DIDA mirrors the language of section 85 of the NBA.
The defendants argued that because the Delaware bank was a state-charted federally insured bank, the DIDA preempted the causes of action in the OAG’s complaint as they pertained to the defendants’ partnership with the bank. As additional support for their preemption argument, the defendants highlighted the fact that the bank not only originated the loans but also retained them wholly, or at least in part.
Despite the bank’s origination and retention of the loans, the District court rejected the defendants’ arguments. It held that federal preemption only applied to the bank. In support of its holding, the court cited to the Third Circuit’s decision in In re Community Bank of Northern Virginia, 418 F.3d 277, 295 (3d Cir. 2005). In that case, the Circuit court held that state law claims against a non-bank were not preempted by the DIDA or the NBA.
The District court refused to apply federal preemption to the defendants even though the bank retained ownership of all or part of the loans. The court noted that the complaint alleged that the defendants, and not the bank, were the real parties in interest and therefore reasoned that preemption should not apply.
Pennsylvania v. Think Fin., Inc., 2016 U.S. Dist. LEXIS 4649 (D. Pa. 2016)
In a previous post, Creditor Fails to Navigate Usury Law “Minefield”, Ordered to Refund $1.3 Million to Debtor, I discussed a recent bankruptcy case in California. In the case, a lender had filed a claim in the borrower-debtor’s bankruptcy case. The debtor objected to the claim and brought a usury claim against the lender for allegedly usurious interest that it claimed it had paid.
After a two day trial on the debtor’s objection to the lender’s bankruptcy claim, the court found in favor of the debtor and ordered the lender to refund the usurious interest it had charged the debtor. The court also ordered post-trial briefing on a number of issues, including:
Are the debtors barred by the two year statue of limitations on usury actions from recovering usurious interest paid prior to the 2 years before the date of the bankruptcy petition?
In its post-trial brief, the lender argued that the California statute of limitations provides that a borrower that commences an usury action against a lender may only recover the amount of usurious interest paid to the lender in the preceding two years prior to filing the complaint. Therefore, the lender argued, the amount that the debtor could recover should be limited to those payments that the debtor had made within the two years preceding the filing of the bankruptcy petition. The court disagreed.
The court first noted that California usury claims generally must be filed within two years of the payment at issue. However, if the lender brings an action on the debt, the borrower may cross complain for recovery of all usurious interest paid, regardless of the two year statute of limitations. The court found that this was also true where a lender files a claim for usurious interest in a bankruptcy proceeding. As support the court cited a recent ninth circuit which explained:
The filing of a proof of claim is analogous to filing a complaint in the bankruptcy case… And a claim objection by the debtor is analogous to an answer… In re Cruisephone, Inc., 278 B.R. 325, 330 (Bankr. E.D.N.Y. 2002) (“In the bankruptcy context, a proof of claim filed by a creditor is conceptually analogous to a civil complaint, an objection to the claim is akin to an answer or defense and an adversary proceeding initiated against the creditor that filed the proof of claim is like a counterclaim.”).
Based on the Ninth’s Circuit holding, the court found that the lender had “‘brought an action’ by filing its proof of claim and actively and aggressively pursuing its remedies in the course of the bankruptcy case, and the usury defenses and claims of the Debtors are in the nature of counterclaims, thus rendering the two-year statute of limitations inapplicable here.” As a result, the debtor was permitted to recover all of the usurious interest that the court had awarded it at trial.
In re Arce Riverside, LLC, 2015 Bankr. LEXIS 4380 (Bankr. D. Cal. 2015)
California Finance Lenders Push Legislative Agenda in Response to Growth of Alternative Small Business Finance IndustryDecember 8, 2015
On October 10, 2015, California Governor Jerry Brown signed into law SB 197, a bill that allows licensed California finance lenders to pay commissions to unlicensed persons that refer prospective commercial loan borrowers to licensees that offer certain types of lower cost loans. The bill was co-sponsored by Opportunity Fund and the California Association for Micro Enterprise Opportunity. The stated purpose of the bill was to “remove a competitive disadvantage that applies to C[alifornia Finance Lender Law (“CFLL”)] licensees making commercial loans.” As the bill’s legislative background explains,
Existing CFLL regulations prohibit CFLL licensees from paying any compensation to any person or company that is unlicensed, in exchange for the referral of business. This places CFLL licensees who make commercial loans at a competitive disadvantage relative to their direct competitors, who are not required to hold CFLL licenses and are thus not subject to this restriction. Two types of direct competitors that are not required to hold CFLL licenses include merchant advance companies (not required to be licensed under the CFLL, because they are advancing, rather than lending money) and companies that partner with banks (not required to be licensed under the CFLL, because the loans are made under the banks’ charters).
Prior to the passage of SB 197, a CFLL licensee was prohibited from paying a commission to an unlicensed person that referred a potential commercial loan borrower to the licensee. The California Code of Regulation states that “no finance company shall pay any compensation to an unlicensed person or company for soliciting or accepting applications for loans…” 10 CCR § 1451.
The new legislation overrides the regulatory restriction and permits licensees to pay compensation to unlicensed persons if certain conditions are met. A CFLL licensee may pay a commission to an unlicensed person if:
- The loan made to the borrower does not charge an annual interest rate in excess of 36%.
- The lender conducts an underwriting and obtains sufficient documentation to ensure that the borrower has the ability to repay the loan.
- The lender maintains records of all compensation paid to unlicensed persons for at least 4 years.
- The lender submits annual reports to the California Commissioner of Business Oversight.
While the bill permits an unlicensed person to refer potential borrowers to commercial lenders in exchange for compensation, it limits the activities in which the unlicensed person can engage. Under the new legislation, unlicensed persons that refer borrowers for compensation may not:
- Participate in any loan negotiation.
- Counsel a borrower about a loan.
- Prepare any loan documents, including credit applications.
- Contact the lender on the borrower’s behalf, other than to refer the borrower.
- Gather documentation of the borrower or obtain the borrower’s signature.
- Participate in the development of any sales or marketing materials.
To be clear, the purpose of SB 197 was not to prohibit licensees from paying compensation to unlicensed persons in exchange for borrower referrals (licensees have been prohibited from paying commissions to unlicensed persons since the CFLL was enacted). Instead, the bill allows certain lenders that charge annual rates under 36% to do something that they were previously prohibited from doing, i.e. pay commissions to unlicensed persons for commercial loan referrals.
On Friday, the CFPB issued its semiannual update to its rulemaking agenda. The agenda lists the Bureau’s major current and long-term initiatives. Long listed as a long-term item, the Small Business Data Collection rule required by section 1071 of Dodd-Frank is listed on the update as a current initiative.
The move is unsurprising given the number of lawmakers that have publicly called for implementation of the rule. CFPB director Richard Cordray also recently mentioned that the Bureau would begin its initial work on the rule early next year.
In the update, the Bureau states that it plans to build off of its recent revision to the home mortgage data reporting regulations as it develops the new Small Business Data Collection rule. The first stage of the CFPB’s work will focus on outreach and research. This will be followed by the development of proposed rules concerning the type of data to be collected as well the procedures, information safeguards, and privacy protections that will be required of the small business lenders that will report information to the Bureau.
On November 6, the Federal Deposit Insurance Corporation (FDIC) issued Financial Institution Letter FIL-49-2015, titled “Advisory on Effective Risk Management Practices for Purchased Loans and Purchased Loan Participations.” Though billed as an update to an advisory letter issued in 2012, the new guidance requires all FDIC-supervised banks and savings associations to implement a number of new procedures before purchasing loans or loan participations that are originated by third-party nonbank entities. These restrictions would include the purchase of or participation in small business loans originated by marketplace lenders. In fact, the letter cautions supervised entities from relying on marketplace platforms that the FDIC believes do not provide sufficient information to potential investors:
[A]n increasing number of financial institutions are purchasing loans from nonbank third parties and are relying on third-party arrangements to facilitate the purchase of loans, including unsecured loans or loans underwritten using proprietary models that limit the purchasing institution’s ability to assess underwriting quality, credit quality, and adequacy of loan pricing. In some situations, it is evident that financial institutions have not thoroughly analyzed the potential risks arising from third-party arrangements.
The three pages of new guidance require a variety of procedures be implemented, including:
1. The new guidance significantly expands the policies a bank must establish before purchasing, such as:
- Establishing detailed procedures for purchased loans and participations
- Defining loan types that are acceptable for purchase
- Requiring board of directors approval of arrangements with third-parties to purchase loans and participations
Additionally, financial institutions are required to establish ongoing risk management processes for purchases made through third-party relationships.
2. The new guidance requires enhanced independent analysis of purchased loans and participations. A purchasing institution must ensure that it has “the requisite knowledge and expertise specific to the type of loans or participations purchased and that it obtains all appropriate information from the seller to make an independent determination.” The loans and participations must also be determined to be consistent with the bank’s appetite for risk. The letter states that this analysis must be done in-house and may not be contracted out to a third-party.
3. A supervised bank must also perform due diligence on the validity of a third party’s credit models if the bank relies on the model for credit decisions. A bank is permitted to subcontract this due diligence to third-parties but is still required to review the model validation to ensure it is sufficient.
The new guidance will undoubtedly increase the costs FDIC insured banks incur to purchase loans and loan participations originated by small business marketplace lenders. What effect these costs will have on current and future bank involvement in marketplace lending remains to be seen.
In the past two weeks, four ranking members of Congress have sent letters to the Treasury Department, SBA, SEC and CFPB requesting information about alternative small business lending. On November 3, Senators Jeff Merkley (D-OR), Sherrod Brown (D-OH) and Jeanne Shaheen (D-NH) sent a letter to the Treasury Department and the SBA requesting information about the impact of marketplace lending on small businesses. The Senators serve, respectively, as the ranking member of the Senate Subcommittee on Financial Institutions and Consumer Protection, the ranking member of the Senate Banking Committee, and the ranking member of the Senate Small Business Committee.
In their letter, the Senators cited concerns of some observers about the regulatory framework governing the space:
Observers have questioned what the appropriate role of federal regulators should be in supervising non-bank companies providing small business capital. Government agencies such as the federal financial regulators, Small Business Administration (SBA), or the Federal Trade Commission may have a role to play, as well as state regulators. However, it is possible that ‘the current online marketplace for small business loans falls between the cracks for Federal regulators.’ As we saw during the crisis, financial markets that fall between the cracks may result in predatory lending, consumer abuse, or systemic issues.
And last Thursday, Nydia Velazquez (D-NY), ranking member on the House Committee on Small Business, sent a letter to the SEC and CFPB inquiring about small business lending marketplaces. Rep. Velazquez cited a 2011 GAO report discussing early developments in P2P lending. Rep. Velazquez noted that in the report the GAO had proposed two approaches for federal regulation of online lending: one SEC-centered and the other CFPB-centered. Rep. Velazquez requested the agencies to provide her with more information concerning their regulation of online lending marketplaces for small business borrowers.
The lawmakers also posed a number of specific questions to the agencies, such as:
- What are the most significant risks in the market?
- What authority exists for federal agencies to supervise and examine companies offering online small business loans?
- What impact is the market having on community banks?
- How do online business lenders fit in the broader financial regulatory framework?
- What disclosures are required in small business lending?
- What resources have your agencies devoted to the regulation of the online lending marketplaces?
- Do you believe that your agencies possess the necessary legal authorities to protect small business borrowers and retail investors as it relates to the online lending marketplace?
And most interesting:
8. What statutory changes, additional legal authorities, and resources are necessary to support your agencies’ role in the regulation of online lending as it relates to small business loans and extensions of credit?
The recent congressional interest is likely a result of the RFI issued by the Treasury Department regarding marketplace lending. It seems Capitol Hill is also interested in learning more about the topic and, specifically, how alternative small business finance products are currently being regulated.
Treasury Official Discusses Responses to RFI, Offers Mixed Review of Alternative Small Business LendingNovember 3, 2015
Antonio Weiss, Counselor to the Secretary of the US Treasury, recently spoke at the Information Management Network Conference on Marketplace Lenders. In his prepared remarks, Mr. Weiss discussed the comments Treasury had received in response to its Request for Information about marketplace lenders. Mr. Weiss highlighted a number of themes about alternative small business finance that he believed had emerged from the responses.
First, Mr. Weiss stated that alternative small business lenders have the potential to increase lending to a historically underserved market.
Structural challenges in the small business lending market often make it difficult for business owners to obtain affordable credit. While larger businesses typically rely on banks for 30 percent of their financing, small businesses receive fully 90 percent of financing from banks. However, small business lending has high fixed costs for banks– it costs about the same to underwrite a $5 million dollar loan as a $200,000 loan. And we know that many small business owners are unable to access the credit they need to grow their businesses. Marketplace lending has the potential to unlock access to the capital markets for these borrowers.
Second, he stated that many responses to the RFI had cautioned that the new underwriting models used by market entrants were still untested. Mr. Weiss stated that many commenters had “noted that new underwriting models have yet to be tested through a full credit cycle” and therefore it was too soon to tell if these alternatives were better than traditional models at predicting future performance.
Third, Mr. Weiss noted that many commenters had argued that protections provided to consumers should be extended to small business borrowers. “[M]any commenters highlighted the need to establish a level playing field. All borrowers—businesses as well as consumers—should have the same protections. Small businesses are run by people. Those people receive protection as individual consumers, but when they are called ‘small businesses’ they get no protection,” he stated.
Mr. Weiss also highlighted calls for increased disclosure requirements. “…[C]ommenters almost universally agreed on the need for, and benefits of, greater transparency. To my mind, this means clear, simple terms that borrowers and investors can understand. For small businesses, transparency requires standardized all-in pricing metrics, so that a business understands a loan’s true cost and can make like-to-like comparisons across different loan products,” he stated.
In closing, Mr. Weiss noted that while Treasury will continue to monitor developments in the marketplace it is not a regulator in the space. Instead, Mr. Weiss stated that Treasury would work to inform those state and federal agencies that do have regulatory authority about developments in the market so that they could take any necessary actions.
Some interesting legislation was introduced last Tuesday by Senator Marco Rubio. The bill entitled “Investing in Student Success Act of 2015” would allow individuals to enter into Income Share Agreements that bear some of the characteristics of merchant cash advances. The bill defines an Income Share Agreement as,
[A]n agreement between an individual and any other person under which the individual commits to pay a specified percentage of the individual’s future income…in exchange for payments to or on behalf of such individual for postsecondary education, workforce development, or other purposes.
The bill goes on to state other aspects of a Income Share Agreement: “the agreement is not a debt instrument, and…the amount the individual will be required to pay under the agreement…may be more or less than the amount provided to the individual; and…will vary in proportion to the individual’s future income…” That last part differs from merchant cash advances in that there is no cap on the total amount an individual could be required to pay pursuant to an Income Share Agreement.
There are, however, a number of restrictions contained in the bill. The total percentage of income a person may be required to pay under an agreement—the split—may not exceed 15%. If a person’s income dips below $15,000 in any year, that person would not be required to pay any portion of their income. Also, the agreement may not exceed a term of 30 years, though the agreement may be extended for a term equal to the number of years the person was not required to pay because their income did not exceed $15,000.
Many states have enacted bans on income assignment agreements that would seem to prohibit the type of agreement proposed by the legislation. To address these laws, the bill contains a preemption provision: “Any income share agreement that complies with the requirements of [the bill] shall be a valid, binding, and enforceable contract notwithstanding any State law limiting or otherwise regulating assignments of future wages or other income.”
Additionally, because there is potential that a funder could receive an amount from an individual in a time period that would translate to a rate that exceeds state usury laws (as some merchant cash advances do, depending on the business’ performance) the bill also provides for preemption of state usury laws: “Income share agreements shall not be subject to State usury laws.”
So will Student Cash Advances be the next big thing in educational finance? Maybe, maybe not. For now, the bill has been referred to the Senate Finance Committee for further review.
You can read the full text of the bill here.