California Passes First-in-Nation Disclosure Requirements for Small Business Loans

Financial Services Law

At literally the 11th hour on August 31, the California legislature passed Senate Bill 1235 (SB 1235). Governor Brown has until September 30 to sign this legislation. Although not certain, we believe it is more likely than not that he will do so. (SB 1235 has not been signed as of this writing.)

As we noted in July, SB 1235, if signed into law, will impose first-in-the-nation disclosure requirements in connection with certain business-purpose loans similar to those imposed under federal and some state laws in connection with consumer-purpose loans, such as the federal Truth in Lending Act (TILA).

Although added to the California Financial Code immediately following the California Financing Law (CFL), the scope of SB 1235 is much broader, covering “commercial financing.” That term includes commercial loans and commercial open-end credit plans as defined in the CFL, but extends further to include factoring and merchant cash advances (MCAs), among other commercial financing. Also, the definition of “provider” in SB 1235 reaches bank sponsorship arrangements where the commercial financing is extended by a bank but arranged through “an online lending platform” administered by a nonbank. (Banks and other depository institutions that are providers are exempted from coverage, so this provision will pick up only platforms.)

SB 1235 will not apply to an offer of commercial financing of more than $500,000, and so effectively, SB 1235 is aimed at such financing extended to small and midsized businesses (SMBs).

Disclosures required by SB 1235 include the total amount of funds provided; the total dollar cost of the financing; the term or estimated term; the method, frequency and amount of payments; a description of prepayment policies; and “the total cost of the financing expressed as an annualized rate.” (This last disclosure is scheduled to sunset by 2024, but could be extended or made permanent.) Although some of these disclosure items are relatively straightforward, others are less than clear, and their application to financing such as factoring and MCAs is very uncertain or even unworkable. (SB 1235 allows a factor to provide an alternative disclosure by way of an “example of a transaction,” but even an example will present similar problems.)

Also, SB 1235 essentially creates a disclosure scheme similar to TILA, but TILA is a much lengthier law than SB 1235, and TILA is fleshed out by Regulation Z and Official Interpretations, as well as other agency guidance and case law. As a result of negotiations during the legislative process, a specific calculation of the APR-type disclosure was removed, and the legislation delegates to the California Department of Business Oversight (DBO) the extremely challenging task of developing regulations clarifying the bare provisions of SB 1235.

Whether a violation of SB 1235 may be enforced only by the DBO (it provides that it can be if the provider is licensed under the CFL) or could provide a basis for a private right of action is another matter left uncertain by the legislation.

Why it matters

If the bill is signed into law, compliance with SB 1235 will be very challenging for SMB lenders, and SMB lenders including those operating under bank sponsorship arrangements will need to closely monitor the regulatory process at the DBO. Also, legislation first adopted in California often leads to similar legislation being passed in other states, and some states including New York have previously expressed concerns with SMB lending.