Financial Services Law

NY's DFS Reaches $3M Deal Involving Payday Lending Debts

Continuing its efforts against payday lenders, New York's Department of Financial Services (DFS) announced a consent decree with National Credit Adjustors (NCA) and Webcollex totaling $3 million.

What happened

The two debt buying companies, based in Kansas and Virginia, respectively, improperly purchased and collected on illegal payday loans over several years, the regulator said. Both companies operated with a business model to collect debts on behalf of other creditors—or purchase debts at a discount of the face value—and then collect on the full amount allegedly owed by the consumer.

Under New York law, the annual interest rate on loans is capped at 16 percent for civil usury and 25 percent for criminal usury. Many of the debts purchased by the companies had interest rates high above these rate limits, DFS said, particularly payday loans.

According to an investigation by the state regulator, NCA attempted to collect on 7,325 payday loan debts of New York consumers and between 2007 and 2014 managed to collect payments on 4,792 of those debts. In addition, NCA engaged in unlawful debt collection practices by repeatedly calling consumers at home and at work, threatening to call consumers' employers, and calling the family members of consumers in order to apply pressure to pay, DFS alleged.

Webcollex engaged in similar conduct on a smaller scale, the regulator said, attempting to collect on "hundreds" of payday loan debts of New Yorkers and collecting payments from 52 consumers.

To settle the charges of violating the federal Fair Debt Collection Practices Act, New York Debt Collection Procedures Law, and Section 601(2) of New York General Business Law, NCA agreed to discharge more than $2.26 million worth of payday loan debts of New York residents for loans taken out between 2007 and 2014 and provide more than $724,000 in refunds to more than 3,000 people. The company will also pay a penalty of $200,000 to the DFS.

For injunctive relief, the company promised to contact credit reporting bureaus and request that any negative information provided by NCA related to payday loan accounts for New Yorkers be removed and move to vacate any judgments obtained on payday loan accounts in the state, as well as release any pending garnishments, levies, liens, restraining notices, or attachments relating to any judgments on payday loan accounts for New York consumers.

Webcollex will discharge more than $52,000 from debt collected between 2012 and 2014 and pay more than $66,000 in refunds to 52 New Yorkers and a $25,000 penalty.

To read the consent order in In the Matter of: National Credit Adjustors, click here.

To read the consent order in In the Matter of: Webcollex, click here.

Why it matters

The settlement is the first time the DFS has provided consumer restitution in an action involving payday loans, the regulator said, sending a "clear message that New York State will not tolerate those who attempt to profit from illegal payday loan activity." Noting that payday lending is illegal in the state, Acting Superintendent of the DFS Maria Vullo said that debt collectors like NCA and Webcollex "who collect or attempt to collect outstanding payments from New Yorkers in violation of New York State and federal Fair Debt Collection Practices law will be held accountable." The DFS reinforced its anti-payday lending position by advising consumers to "steer clear" of such loans, with suggestions on steps to take to stop recurring bank account debits to a payday lender and encouraging consumers to file complaints with the agency about such loans. The settlement is a reminder that the Consumer Financial Protection Bureau is not the only agency focused on payday lending, and state regulators are active as well.

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CFPB Report Crashes Into Auto Title Loans

Analogizing to payday loans, a new report from the Consumer Financial Protection Bureau (CFPB) said research revealed that auto title loans reflect high rates of reborrowing that can lead to long-term "debt traps" where a borrower cannot repay the initial loan by the due date and must reborrow or risk losing their vehicle.

What happened

The Bureau defined auto title loans (also known as vehicle title loans) as "high-cost, small-dollar loans borrowers use to cover an emergency or other cash-flow shortage between paychecks or other income." Borrowers use their vehicles as collateral for the loans, with the lender holding the title in exchange for the loan amount. The typical loan amount is about $700 with an annual percentage rate of 300 percent, the CFPB said.

For the auto title loans in the report, a borrower agreed to pay the full amount owed in a lump sum plus interest and fees by a certain day. Only 20 states permit this type of loan, the Bureau said, with five other states allowing auto title loans that are repayable in installments. The CFPB examined about 3.5 million anonymized, single-payment auto title loan records from nonbank lenders from 2010 to 2013, analyzing loan use patterns such as reborrowing and rates of default.

The agency was not happy with what it found, noting similarities between auto title loans and payday loans such as high rates of consumer reborrowing and high costs in fees and interest, with "collateral damage" to a consumer's life and finances.

One in five borrowers who take out a single-payment auto title loan have their car or truck seized by their lender for failing to repay the debt, according to the report, while more than four in five of the loans are renewed the day they are due because borrowers cannot afford to repay them with a single payment. Just 12 percent of the loans studied by the Bureau were "one and done," where borrowers paid back their loan fees and interest with a single payment without reborrowing.

More than half of the auto title loans became what the CFPB characterized as "long-term debt burdens," where borrowers took out four or more consecutive loans. "This repeated reborrowing quickly adds additional fees and interest to the original amount owed," the Bureau wrote. "What starts out as a short-term emergency loan turns into an unaffordable, long-term debt load for an already struggling consumer."

The CFPB's research also showed that greater than two-thirds of auto title loan business comes from borrowers who take out seven or more consecutive loans, with less than 20 percent of a lender's overall business composed of loans paid in full in a single payment without reborrowing.

To read the "Single-Payment Vehicle Lending" report, click here.

Why it matters

"Our study delivers clear evidence of the dangers auto title loans pose for consumers," Bureau Director Richard Cordray said in a statement about the report. "Instead of repaying their loan with a single payment when it is due, most borrowers wind up mired in debt for most of the year. The collateral damage can be especially severe for borrowers who have their car or truck seized, costing them ready access to their job or the doctor's office." In the fourth report in the CFPB's series of studies on small-dollar loans, the agency said the findings from the auto title loan research would help shape proposals to regulate the market, such as requiring lenders to take steps to determine whether borrowers can repay their loan and still meet other financial obligations. Critics have challenged the data used in the Bureau's report as well as the assumption that borrowers are unable to repay loans, ignoring the possibility that a consumer may choose to default on the loan for various reasons, such as the condition of the vehicle. But the CFPB remains concerned with auto title loans, which are within the scope of the CFPB's recently published proposed rules on small-dollar lending.

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State Banking Regulators Issue Annual Report

What were state banking regulators focused on last year? A new report from the Conference of State Bank Supervisors (CSBS) reveals that state regulators "increased coordination and collaboration between state regulators and other stakeholders, fostered and developed research and analytical tools, developed innovative solutions for a rapidly changing financial services industry, and provided education and training for examiners and supervisors."

What happened

The report touts the CSBS's 2015 accomplishments. Composed of banking regulators from all 50 states, as well as the District of Columbia, Guam, Puerto Rico, and the U.S. Virgin Islands, members of the CSBS supervise almost 4,850 state-chartered financial institutions along with other nonbank financial services providers.

Over the course of 2015, CSBS advocated for legislation supporting community banks that was approved by Congress. For example, the group pushed for the increase from $500 million to $1 billion as the threshold for well-capitalized banks eligible for an 18-month exam cycle. A provision requiring at least one Federal Reserve Governor to have demonstrated primary community bank experience, and a measure that allowed community banks to more easily qualify for rural or underserved designations pursuant to the Ability to Pay rule of the Consumer Financial Protection Bureau (CFPB).

The group focused on improving supervisory processes for both bank and non-depository institutions as well as education and training. To that end, CSBS collaborated with the Federal Financial Institutions Examination Council (FFIEC) for a line-item review of the Call Report to find opportunities to reduce the reporting burden for community banks and conducted case studies to evaluate the impact of community banks on the local economy.

Efforts on the non-depository supervision front included the establishment of a new committee to encourage policy discussions with other non-depository regulators and a Model Framework for State Regulation of Certain Virtual Currency Activities.

The Multi-State Mortgage Committee continued its work on mortgage exams while the Multi-State Money Service Businesses Examination Task Force executed 68 joint exams with the CFPB and Financial Crimes Enforcement Network (FinCEN) of money service businesses licensed in more than 40 states.

Working on a "major issue facing the financial services industry," CSBS launched a new initiative in 2015. The Executive Leadership of Cybersecurity is meant to drive home the message to banks that cybersecurity is "more than a 'back office' issue, but an executive issue that requires CEO and Board level attention," the organization said.

To read the CSBS 2015 Annual Report, click here.

Why it matters

"As the financial services industry continues its rapid progress and change, CSBS and state regulators remain committed to being at the forefront of supervision," CSBS Chairman and Commissioner of Banks at the Massachusetts Division of Banks Chairman David J. Cotney said in a press release about the report. "I look forward to CSBS continuing its work in the coming years. We've made significant progress in 2015, and there is still much more to do in 2016 and beyond."

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Bank of America Wins Reversal of FIRREA $1.27B Penalty

A breach of contract is insufficient to also support a claim for fraud, the Second Circuit Court of Appeals has ruled, reversing a $1.2 billion verdict against Countrywide Home Loans in the process.

What happened

The U.S. Court of Appeals for the Second Circuit handed Bank of America a victory on May 23, reversing a $1.27 billion penalty imposed on the bank. A jury in the case below imposed that penalty for alleged mortgage fraud arising out of events that took place at Countrywide Financial before it was acquired by the bank. In reversing, the Second Circuit concludes that breach of contract cannot support fraud without a demonstrable intent to defraud at the time of contract formation.

Filed in early 2012, the suit alleged mail and wire fraud based on violations of the federal Financial Institutions Reform, Recovery and Enforcement Act of 1989 (FIRREA). In 2007, Countrywide sold loans to Fannie Mae and Freddie Mac through Countrywide's so-called "High-Speed Swim Lane" (HSSL) loan program, which allegedly expedited the processing of mortgages but with inadequate risk checks. Pursuant to its contracts with Fannie Mae, Countrywide as the seller of mortgages represented that, "as of the date [of] transfer," the mortgages sold would be an "Acceptable Investment." Likewise, Countrywide similarly represented to Freddie Mac that "all Mortgages sold to Freddie Mac have the characteristics of an investment quality mortgage." These loans, the government claimed, were then sold to Fannie Mae and Freddie Mac, where many then defaulted. Even though HSSL was short-lived, and all of the alleged wrongdoing took place before Bank of America acquired Countrywide, a jury concluded that the bank itself committed fraud.

In reversing the ruling, the Second Circuit answered a core question at issue in many fraud suits, i.e., when may a breach of contract claim also support a claim for fraud? In asserting claims for mail and wire fraud, the government (originally through a qui tam relator, or "whistleblower") argued that Countrywide knew that its sales of poor-quality mortgages to government-sponsored entities (GSEs) were not of the quality promised in their contracts with Fannie and Freddie. The Second Circuit concluded that this is, at most, intentional breach of contract, and not fraud.

The government argued that Countrywide sold loans under these purchase agreements, intending to defraud Fannie and Freddie because it thereafter sold loans to these entities knowing the loans were not investment quality. To support this argument, the government offered evidence of quality problems in the loans approved through the HSSL program. To demonstrate the requisite intent, the government presented evidence that the Key Individuals were informed of the poor quality of HSSL loans by Countrywide employees and internal quality control reports and nonetheless sold them to the GSEs. The government presented no evidence that any of the Key Individuals were involved in the negotiation or execution of these contracts, nor did it present evidence that any of them communicated with either GSE regarding the loans sold; in fact, Defendants elicited testimony from GSE witnesses to the contrary.

The provision of FIRREA under which Defendants were found liable provides for civil penalties against "[w]hoever" violates or conspires to violate, inter alia, the federal mail or wire fraud statutes, see 18 U.S.C. §§ 1341, 1343, in a manner "affecting a federally insured financial institution." 12 U.S.C. § 1833a(a), (c)(2). While this is the first appellate case to consider whether FIRREA even applies to self-affecting conduct, the Second Circuit never reaches this issue. Instead, the court decided the issue on a much simpler point: a defendant cannot commit fraud in a breach of contract case unless the plaintiff proves an intent to defraud at the time of contract formation.

Bank of America argued, as it did below, that the conduct alleged and proven by the government is, at most, a series of intentional breaches of contract. The common law, it argued, does not recognize such conduct as fraud, and as a result, the federal statutes do not either. Because the only representations involved in this case are contained within contracts—to demonstrate fraud, rather than simple breach of contract, under the common law and federal statutes, the government had to prove (and it did not) that Countrywide never intended to perform those contracts at the time of contract execution. By contrast, the government argued that any contractual relationship between the defendant and an alleged fraud victim is "irrelevant," citing as examples decisions in which this court and others recognized a fraud claim where the parties were engaged in a contractual relationship.

The federal mail and wire fraud statutes, in relevant part, impose criminal penalties on "[w]hoever, having devised or intending to devise any scheme or artifice to defraud, or for obtaining money or property by means of false or fraudulent pretenses, representations, or promises[,]" uses the mail, 18 U.S.C. § 1341, or wires, id. § 1343, for such purposes. Thus, the essential elements of these federal fraud crimes are " '(1) a scheme to defraud, (2) money or property as the object of the scheme, and (3) use of the mails or wires to further the scheme.' " The court then noted that statutes employing common-law terms are presumed, "unless the statute otherwise dictates, . . . to incorporate the established meaning of these terms." Nationwide Mut. Ins. Co. v. Darden, 503 U.S. 318, 322 (1992). These statutes require proof—as at common law—that the misrepresentations were material, notwithstanding the fact that a solely "natural reading of the full text" would omit such an element.

The first element—a scheme to defraud—is noticeably absent in a breach of contract case unless that scheme existed at the time the contract was made. As the court put it, "a contractual relationship between the parties does not wholly remove a party's conduct from the scope of fraud. What fraud in these instances turns on, however, is when the representations were made and the intent of the promisor at that time. As explained below, where allegedly fraudulent misrepresentations are promises made in a contract, a party claiming fraud must prove fraudulent intent at the time of contract execution; evidence of a subsequent, willful breach cannot sustain the claim." … "It is emphatically the case—and has been for more than a century—that a representation is fraudulent only if made with the contemporaneous intent to defraud—i.e., the statement was knowingly or recklessly false and made with the intent to induce harmful reliance." In short, because the government failed to prove an intent to defraud at contract formation, there was no violation of the mail and wire fraud statutes.

To read the opinion in United States ex rel. Edward O'Donnell v. Countrywide Home Loans, Inc., click here.

Why it matters

Until this case, there was little or no useful case law to battle plaintiffs who allege fraud arising out of mere intentional breach of contract. This case provides defendants with the necessary ammunition to attack fraud allegations where there is zero evidence that the defendant intended at the time of contracting to defraud the other contracting party.

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Justice Department Sides With Financial Industry on Madden Case

Marketplace loan investors may want to "gather ye discounted Madden loans while ye may," as the Robert Herrick poem reads (taking some fintech license, of course).

In the strongest rebuke yet of the U.S. Court of Appeals for the Second Circuit's opinion in Madden v. Midland Funding, LLC, the Solicitor General of the United States (SG) has filed its requested brief with the United States Supreme Court (Court). The Court is currently considering whether to accept the case for review. The SG, which is a unit of the Department of Justice, represents the interests of the United States before the Court. The brief includes input from counsel at the Office of Comptroller of the Currency.

Quick refresher—New York resident Saliha Madden was issued a credit card by Bank of America and later FIA Card Services, each a national bank. Madden defaulted on her approximately $5,300 balance, and FIA wrote off the debt as uncollectible and sold the debt to Midland Funding. Midland sought payment from Madden and continued to charge the 27 percent interest rate that she was previously charged. Madden brought suit alleging that charging such a rate was unlawful, as it exceeded New York's civil usury cap of 16 percent, or 25 percent if Midland was licensed by the New York Department of Financial Services. In the original card agreement, both parties stipulated to Delaware law governing the agreement. Under Delaware law, the 27 percent interest rate is allowed. The question before the Court was whether the Second Circuit was correct in claiming that the preemption granted national banks over state law under the National Banking Act (NBA) applied to purchasers of loans originated but no longer held by banks. The case threatens the cardinal rule of usury that a loan contract that is valid when made can never be invalidated by any subsequent transaction (quoting the 1833 case of Nichols v. Fearson). For more information on the case, see http://www.lendacademy.com/madden-2015-has-nothing-to-do-with-football/. The Second Circuit did turn the case back to the District Court for determination of (i) whether the Delaware choice of law should be honored (and therefore, according to the SG, Midland wins) and (ii) if not, whether New York law would nonetheless honor the "valid when made" doctrine (which the SG asserts it does, and therefore Midland still wins).

In its brief, the SG notes that the powers of a national bank granted by the NBA (specifically Sections 85 and 24 (Seventh)) specifically allow for loans to be originated and sold without modification:

"The court of appeals' decision is incorrect. Properly understood, a national bank's Section 85 authority to charge interest up to the maximum permitted by its home State encompasses the power to convey to an assignee the right to enforce the interest-rate term of the agreement. That understanding is reinforced by 12 U.S.C. 24 (Seventh), which identifies the power to sell loans as an additional power of national banks. The court of appeals appeared to conclude that, so long as application of New York usury law to petitioners' collection activities would not entirely prevent national banks from selling consumer debt, state law is not preempted. That analysis reflects a misunderstanding of Section 85 and of this Court's precedents."

This is surprisingly definitive language siding with Midland and almost reflects incredulity by the SG directed toward the well-respected Second Circuit in a very public forum. It is clear, the SG concludes, that Midland, a nonbank collection company, may charge the same rate of interest that was charged by FIA. The SG determines that the Second Circuit erred in three respects:

  1. The Second Circuit failed to recognize that a national bank's power to charge certain rates carries with it the power to assign to others the right to charge the same rates (per Section 85 of the NBA);
  2. The Second Circuit provided "misconceived" analysis that by limiting the activities of Midland, they were not limiting the activities of the national bank. The SG notes that imposition of this rule unduly restricts the bank from being able to sell loans; and
  3. The Second Circuit too narrowly draws the line of conflict preemption between the NBA and state law. "When a federal law explicitly grants a national bank an authorization, permission or power and does not explicitly state that the exercise of that power is subject to state law, state law is preempted to the extent that it restricts that power." (SG citing the 1996 Barnett Bank of Marion County v. Nelson case.)

Okay, so the SG recommends that the Court hear the case and fix the error, right?

No. The SG's recommendation is that the Court turn down the case so that it may properly be played out in the district court, which is the federal trial court that first heard the case. The SG is mindful of the Court's extremely demanding docket and limited capacity to decide every case. Therefore, because the SG believes that Midland will win on either the Delaware choice of law argument or the New York state law recognizing "valid when made," the SG recommends the Court deny the petition for hearing the case. The problem with this result is that it leaves the "erroneous" Second Circuit opinion on NBA preemption, which has now been discredited. But that is not really Midland's problem.

The SG also cites a few other reasons why this case is a poor forum for the Court to weigh in on preemption:

  • There is no split among the circuits; the Second Circuit did not properly apply its own precedents (an argument Midland's attorneys made in their brief).
  • The parties were deficient in making the preemption argument and addressing whether the application of state usury law would interfere with the national bank's exercise of powers; in other words, the lawyers for both sides did not present the correct analysis and the Second Circuit limited its ruling to the arguments presented.
  • Midland will likely win anyway under Delaware choice of law or the application of New York law itself.
  • No analysis has been made of how many states do not incorporate "valid when made," and therefore the decision of the Court might be inapplicable in the presumed majority of states that recognize valid when made.

Got it? So where does that leave marketplace lenders?

This case represents the strongest proclamation yet against the Second Circuit's Madden opinion. Regular readers of Manatt client alerts and our Financial Services biweekly newsletter will recall that there are several other points of distinction between a typical consumer marketplace lending model and the facts in Madden:

  • First, marketplace lenders (MPLs) do not operate under the NBA, but rather the Federal Deposit Insurance Act and the full faith and credit/parity principle. Technically, although the facts seem similar to an MPL bank partner structure, only the NBA is being challenged here, which none of the MPLs currently use.
  • Second, MPLs utilize the underwriting principles of a funding bank and work in very close collaboration with the funding bank. The funding bank is involved in the origination process and does not "sell and go away," as is the case in the debt collections context. Funding banks use their own capital to originate loans, not the funds from the platform.
  • Third, many MPLs are tightening the relationships with their banks in part to counter the argument that a bank is not involved in the process post-origination. This may take the form of appointing banks to service the debt (with possible subservicing to professional servicing firms) or holding loans on bank balance sheets with a sale of the economic interests of each loan to the platform and onto investors.

What are some other key takeaways for MPLs?

As for Madden, the Court is likely to accept the recommendation of the SG and pass on hearing the case. The district court will now determine the choice of law and, if necessary, the state law issues.

It remains to be seen whether a plaintiff will attempt to create a case out of the distinction that MPLs have in that they operate through state law and therefore the NBA would not be applicable. In April, we saw the filing of the Bethune v. LendingClub and WebBank case in which a plaintiff is asserting violations of the "true lender" doctrine—that WebBank is not in effect acting as the true lender in a LendingClub loan and is a "sham" bank. This argument is different from Madden in that instead of litigating the transferability of banked loans to a nonbank, the plaintiffs are asserting that there was never any bank to begin with. We believe this argument faces several challenges, given the reality of the relationship that WebBank and other funding banks have to loans that are originated by MPLs. This case will also test the mandatory arbitration clauses written into most loan agreements and currently under fire by CFPB proposed rulemaking.

It will be interesting to see whether loans from the Second Circuit that exceed state usury caps (so-called Madden loans) will make a comeback on the origination and investment side. In a recent joint study by Columbia and Fordham Universities, a decline in available credit was observed in Madden jurisdictions because of the uncertainty of being able to sell the loans and of investors being able to enforce them through their term. One of the Department of the Treasury's observations under its recent white paper was the lack of available credit to higher-risk consumers. It is possible that the ultimate resolution of Madden in the district court results in the increase in available credit to the underserved consumer borrowing base to whom a loan at the state usury caps would not be economically feasible.

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