Legal Briefs
Income Share Agreements – Operating Under Current Regulations and Preparing for the Future
February 28, 2020The Income Share Agreement (“ISA”) market is rapidly developing with more providers offering ISA programs to students and outside money moving into the space. However, the legal environment remains uncertain, and providers entering the ISA market must prepare themselves both to operate in the current environment and for potential changes.
Background – What is an Income Share Agreement?
ISA providers have set a modest goal: disrupt the $1.6 trillion-dollar student loan market that has wreaked havoc on a generation’s finances by aligning the interests of students and providers. In an ISA transaction, the student does not owe a specific amount of money and no interest is charged on a balance. Instead, the student agrees to pay a proportion of their future income above a specified threshold for a certain number of years. The provider of an ISA has an interest in the student consistently earning a high income for the duration of the contract—because the ISA provider generally does not get paid if the student fails to earn sufficient income.
Evolving Legal Environment
The current legal environment has not yet adapted to ISAs entering the market for funding education and associated expenses. No federal statute directly addresses ISAs and only one state—Illinois—has passed legislation contemplating ISAs. Even that legislation (the Student Loan Investment Act) merely permits a state investment fund to enter into ISAs and does not impact the private ISA market.
California and Washington have both considered legislation related to ISAs, but neither passed anything into law. Indiana’s legislature exempted certain “State educational institutions” from its Uniform Consumer Credit Code, including leading ISA provider Purdue University. However, Indiana did not expressly address ISAs under the UCCC.
No federal or state courts have published cases analyzing the treatment of ISAs under state or federal credit laws. But federal regulators appear to be aware of this issue. In a December 2019 discussion paper on ISAs released by the Federal Reserve Bank of Philadelphia, the authors acknowledged the uncertainty created by the lack of authoritative statements from courts and regulators, but did not weigh in on the legal issues.
Careful Consideration Required
When considering compliance with state and federal laws in this uncertain environment, participants must first assess which laws may apply. For state laws, if an educational institution is entering an ISA with a student, the institution must consider licensing, disclosures, and other restrictions applicable under state installment sales acts. Third-party providers must consider the application of lender licenses and associated disclosures and restrictions.
In either case, providers must consider the application of the Truth in Lending Act (“TILA”), the Equal Credit Opportunity Act (“ECOA”), the Credit Practices Rule, state laws governing the assignment of wages, and generally applicable state and federal laws, such as laws governing unfair and deceptive acts and practices and certain anti-discrimination laws.
Careful analysis of each statute, implementing regulation, and associated commentary provides some initial guidance. For example, TILA’s Regulation Z commentary excludes an “investment plan” where the party extending capital to the consumer risks the loss of capital advanced from the definition of “credit” under the Truth in Lending Act. 12 CFR 1026.2(14) cmt. 1(viii). However, participants must carefully consider with their counsel whether the Regulation Z exclusion is intended to only apply to traditional equity investments because they are not debt, or if it more broadly excludes investments that do not create an absolute obligation to pay.
Additionally, the definition of “credit” under ECOA in Regulation B not only lacks a similar comment, but also includes a comment stating that Regulation B “covers a wider range of credit transactions than Regulation Z.” 12 CFR 1002.2(j) cmt. 1. Although the Regulation B comment arguably only refers to ECOA’s coverage of commercial credit and credit regardless of the number of installments or inclusion of a finance charge, this is one example of how providers must carefully consider each potentially applicable law.
Merely assuming that laws applicable to credit do not apply to an ostensibly non-credit product without conducting an appropriate analysis creates serious regulatory risks.
Potential Federal Changes
In 2017, Senators Rubio and Young introduced the Student Success Act, and in 2019, Senators Warner and Coons joined them with a more robust ISA Student Protection Act of 2019 (the “Act”). The Act proposes a number of important steps. First, it proposes substantive consumer protection rules on ISAs and defines a “qualified ISA” to include only ISAs meeting those substantive requirements. Second, the Act would expressly preempt state laws affecting the validity of a qualified ISA, in addition to state usury, ability to pay, and licensing laws for qualified ISAs. Third, the Act would clarify the treatment of ISAs under federal credit, security, and tax laws, and empower the CFPB to promulgate certain guidance and regulations.
However, that Act has not become law and it is unclear if, or how, lawmakers will address the issue in the future. For example, in response to reports that the U.S. Department of Education was exploring offering ISAs, Senator Warren questioned whether ISAs were “in the best interest of students,” stating they could be “predatory and dangerous.”
Conclusion
The market for ISAs continues to grow, and it’s easy to see why. Given the growing student lending crisis, the presence of an alternative has significant potential. However, due to the current regulatory uncertainty, market participants must carefully weigh the legal risks.
Caleb Rosenberg is an associate in the Maryland office of Hudson Cook, LLP. Caleb can be reached at 410-782-2323 or by email at crosenberg@hudco.com.
New York Appellate Court Overturns QFC, LLC v Iron Centurian, LLC
February 7, 2020The Appellate Division, 2nd Department of The Supreme Court of New York, overturned QFC, LLC v Iron Centurian, LLC and Mohamed Sadiqui last month, granting victory to a merchant cash advance company. The case can be summed up as follows:
A Confession of Judgment (COJ) was filed by plaintiff against defendants for breach of contract. Defendants argued by way of motion that the COJ should be vacated and agreement voided because the underlying transaction was really a criminally usurious loan. The trial court concurred and ruled in favor of defendants, vacating the COJ and voiding the “illegal” merchant cash advance transaction.
Plaintiffs appealed.
On January 29, 2020, the Appellate Division unanimously sided with the plaintiffs and overturned the lower court’s decision. Similar to two other rulings issued the same day (Volunteer Pharmacy, Micromanos), the Court said that a COJ cannot be vacated in the manner in which defendants sought it.
Lender Ranking Website Accused By FTC Of Misleading Rankings
February 6, 2020
LendEDU, a Hoboken-based company that lists and ranks loan providers, came under fire this week after the FTC filed a complaint detailing how LendEDU charged businesses for higher positions in its rankings of lenders and promoted fake testimonials. Providing ratings for student loan refinancing, personal loans, and mortgage lenders, it is the first of these loan types that is in the spotlight.
While LendEDU initially denied that it received any compensation for its lists, saying, “ratings are comparatively objective and not influenced by compensation in anyway” and that “research, news, ratings, and assessments are scrutinized using strict editorial integrity,” this assertion was disproved by the FTC’s investigation.
Emails were discovered which featured CEO Nathaniel Matherson and Vice President of Products Alexander Coleman discussing with a business the pricing per click to hold the #1 spot on the best student loan refinancing company list, as well as what sort of traffic could be expected at this ranking. Accompanying this was a contract between LendEDU and a student loan refinancing company, revealing that in return for compensation the company would drop “[n]o lower than position three” in the rankings. It was also found that if businesses who were already in the rankings refused to pay for the clicks they received, they would drop down in the list.
The testimonials that featured prominently on LendEDU’s homepage, which noted alleged consumers’ names, colleges, and years of graduation, were found to be wholly false, with the people portrayed in them being nonexistent.
And the reviews of LendEDU that were found on Trustpilot and subsequently posted to the company’s own website, were also shown to be fake. Of the 126 reviews, 123 were found to be 5-stars; and only 11 were proven to be from customers (this was confirmed as the emails matched those used by customers), the other 115 were deigned to be written by friends, family members, and associates of LendEDU members, as well as by LendEDU employee’s themselves under false names.
All this is coming after LendEDU landed in hot water following a controversy in 2018 that saw Matherson admit to working with others to create a fictitious expert on student loans, named Drew Cloud, who would give interviews and comments to publications, creating a pro-student loan refinancing discourse. According to Matherson, Cloud “was created as a way to connect with our readers (ex. people struggling to repay student debt) and give us the technical ability to post content to the WordPress website.” Cloud was even given a pixelated face and backstory that extended into high school, imbuing him with a passion for journalism even in his teenage years. Neither Matherson’s comments on Cloud nor his fictional biography do anything to explain how or why his creators decided to give him a name that is quite clearly fake.
LendEDU promptly agreed to settle the charges and pay $350,000 while not admitting or denying the allegations. The public has 30 days to comment on the settlement prior to it becoming final.
Appellate Court Affirms Decision in Merchant Funding Services, LLC v Micromanos Corporation etc.
February 1, 2020On January 29th, 2020 the Appellate Division, 2nd Department, of the Supreme Court of New York, upheld the original decision issued in Merchant Funding Services, LLC v Micromanos, etc. et al.. The case concerns a Confession of Judgment (COJ) filed following Micromanos’ default on a merchant cash advance contract. The defendants sought to vacate the COJ on the basis that the underlying agreement was allegedly a criminally usurious loan but the original judge ruled in favor of the plaintiffs.
The case was so notable that deBanked published a summary of the decision three years ago. Of particular interest is that the defendants not only lost but were accused by the judge of attempting to mislead the Court. Despite that, the defendants appealed.
The defendants have now lost again. The underlying case law they had relied on to support their arguments, Volunteer Pharmacy, was overturned the same day this decision was issued, leaving little room to wonder why the Appellate Division ruled accordingly.
One Of The Most Devastating Court Decisions Against Merchant Cash Advances Has Been Overturned
January 29, 2020
Merchant Cash Advances have sat on comfortable legal footing in New York ever since an appellate court ruled in favor of Pearl Beta Funding, LLC against Champion Auto Sales, LLC in 2018, but even so, it hasn’t stopped lawyers from trying to invalidate merchant cash advance (MCA) contracts on behalf of aggrieved customers.
That’s because an MCA provided by New York-based Merchant Funding Services LLC to a business known as Volunteer Pharmacy in 2016 was ruled by New York Supreme Court Judge David F Everett to be so “criminally usurious on its face” that the normal process required to vacate a Confession of Judgment could simply be bypassed without even having to evaluate the merits of each side’s arguments and the matter automatically won in favor of Volunteer Pharmacy. The judge’s written decision, which voided the MCA contract ab initio, was replete with a scathing opinion of MFS’s business model.
The decision quietly stunned the merchant cash advance industry. MFS understandably appealed.
Dozens of lawsuits against MCA companies in the ensuing years went on to cite Judge Everett’s decision in Volunteer Pharmacy with limited success. And while the industry sat around to find out what would happen in that case, Pearl Beta Funding, a rival to Merchant Funding Services, won an appeal of its own, the landmark usury case in March 2018 that seemingly solidified once and for all the commonly held understanding that such MCA agreements were not usurious.
Despite this, the uncertainty of Volunteer Pharmacy still lingered in the background, that is until now.
On January 29th, 2020 the Appellate Division, 2nd Department, of the Supreme Court of New York, overturned Judge Everett’s decision and ruled in favor of Merchant Funding Services. The panel of judges said they need not even weigh a lot of Everett’s contentions because he was wrong on the underlying procedural issue, that a judgment by confession could be vacated in such an instance without having to go through the normal legal process.
The ruling ultimately provides clarity on the process that determines how a judgment by confession can be vacated. One major impact is that lawyers seeking to invalidate merchant cash advance agreements will no longer have Volunteer Pharmacy as a crutch to rely on.
Former 1 Global Capital CFO Alan Heide Sentenced to 5 Years in Prison
January 17, 2020Alan Heide, the former CFO of defunct Hallandale Beach-based 1 Global Capital, was sentenced to 5 years in prison earlier this week for his role in the company’s securities fraud. He is one of three individuals that have pled guilty so far and the first to be sentenced.
The other individuals, attorney Jan Douglas Atlas and former 1 Global COO Steven Allen Schwartz are awaiting their sentencing.
Additional individuals are still expected to be charged.
SEC, US Attorney Charge Steven A. Schwartz in 1 Global Capital Case
January 6, 2020
New criminal and civil charges have been filed against an individual in the 1 Global Capital case. This time it’s Steven A. Schwartz, who served as 1 Global’s Director and Chief Operating Officer.
The SEC alleges that Schwartz aided and abetted former CEO Carl Ruderman in carrying out a securities fraud.
The US Attorney for the Southern District of Florida separately alleged that Schwartz engaged in a conspiracy to commit wire fraud and securities fraud.
Schwartz is the third person to be charged criminally in connection with 1 Global Capital’s scheme. Alan Heide and Jan Atlas already pled guilty to their roles in the fraud.
The SEC said of its case against Schwartz:
The complaint further alleges that Schwartz became trustee of a Ruderman family trust in June 2014, and that shortly afterwards, Ruderman had Schwartz execute an agreement conveying ownership of 1 Global to the trust. As alleged, until 1 Global declared bankruptcy in July 2018, Schwartz allowed Ruderman to use the trust to misappropriate several million dollars in investor funds to pay for Ruderman’s luxury lifestyle.
Jonathan Braun Has Checked In To Prison
January 2, 2020
Jon Braun, who Bloomberg Businessweek profiled in a 2018 story series, checked into FCI Otisville on Thursday. He was sentenced to 10 years in prison on May 28th for drug related offenses he committed a decade ago. He was originally scheduled to surrender on August 25th but he successfully delayed the date until today, January 2nd.
I have not attempted to contact Mr. Braun since the day of his sentencing. But purely by chance I shared an elevator with him in the Brooklyn Federal Courthouse on May 28th just mere minutes after he had been handed ten years. Given the opportunity, I asked him how he felt about what just happened.
“I hope it goes by quick,” he replied stoically.
