Financial Services Law

Holder Vows To Continue Operation Choke Point; House Considers Bill To Stop It

Depending on whom you ask, Operation Choke Point has a promising future ahead of it – or will soon be history.

The controversial initiative by the Department of Justice (DOJ) is intended to limit certain lenders and merchants from access to consumers by cutting off their relationships with entities like check cashers and nonbank financial service providers.

But the agency’s efforts have faced criticism from both industry and lawmakers, who have expressed concern that the operation may be having a negative impact on lawful companies as well.

In response, Attorney General Eric Holder posted a video address to the agency’s website in which he vowed to continue to investigate financial institutions “that knowingly facilitate consumer scams, or that willfully look the other way in processing fraudulent transactions.”

“While we will not target businesses operating within the bounds of the law, and we have no interest in pursuing or discouraging lawful conduct, our Consumer Protection Branch in the Civil Division is leading a range of investigations into banks that illegally enable businesses to siphon billions of dollars from consumers’ bank accounts in exchange for significant fees,” Holder said.

He also referenced the operation’s successful efforts such as the agency’s action against Four Oaks Bank in North Carolina, where the bank agreed to pay $1.2 million to settle allegations of facilitating fraudulent transactions.

“In the months ahead, we expect to resolve other investigations involving financial institutions that chose to process transactions even though they knew the transactions were fraudulent, or willfully ignored clear evidence of fraud,” Holder added.

Critics reacted to the video with proposed legislation that would effectively halt the DOJ’s operation.

Pursuant to H.R. 4986, the “End Operation Choke Point Act of 2014,” proposed by Rep. Blaine Luetkemeyer (R-Mo.), banking regulators could not “prohibit or otherwise restrict or discourage” financial institutions from dealing with a licensed merchant, including one registered as a “money transmitting business” or that has a “reasoned legal opinion that demonstrates the legality” of its business dealings. A state-licensed attorney could provide the “reasoned legal opinion.”

“It’s time to stop these backdoor attempts by government bureaucrats to blackmail and threaten businesses simply because they morally object to entire sectors of our economy,” Rep. Luetkemeyer said in a press release about the bill.

Backed by the American Bankers Association (ABA), the law would also place limits on the DOJ’s subpoena power over banks under the Financial Institutions Reform, Recovery, and Enforcement Act. “This bill goes a long way toward restoring the proper relationship between banks, their customers, regulators and law enforcement,” executive vice president of the ABA James Ballentine said in a press release about the bill.

To view AG Holder’s video address, click here.

To read H.R. 4986, click here.

Why it matters: What does the future hold for Operation Choke Point? Controversy, at the very least, as AG Holder continues to press forward with investigations of financial institutions as lawmakers push back with legislation.

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U.S. Bank Wins Coverage Under Delaware Law For $55 Million Overdraft-Related Settlement

Three class actions were filed against U.S. Bank in 2009 with identical allegations. The plaintiffs claimed that instead of applying transactions in chronological order, the bank posted transactions from the highest amount to the lowest amount, creating the most overdrafts and maximizing the overdraft fees assessed on customers.

Four years later the bank settled the suits for a total of $55 million. U.S. Bank then sought coverage for the settlement and defense costs from two insurers: Indian Harbor Insurance Company and ACE American Insurance Company. Both insurers denied coverage.

First, the insurers took the position that the settlement was not a covered loss under the insurance policies because coverage was barred in “[m]atters which are uninsurable under the law pursuant to which this Policy is construed,” such as, they claimed, restitution. As a fallback position, the insurers contended that an exclusion for Extension of Credit by the bank applied and precluded coverage.

U.S. Bank sued for breach of contract and sought a declaratory judgment that defense and indemnification were owed by Indian Harbor and ACE. The insurers moved for judgment on the pleadings, but the court sided with the policyholder.

Significantly, applying Delaware law, the court noted that no authority in the state has held that restitution is uninsurable as a matter of law. Thus, while both parties speculated as to how courts in the state might rule, the court limited its analysis to the disputed exclusion finding that it only precluded coverage for restitution resulting from a final adjudication, thereby including by implication restitution stemming from a settlement.

The court reasoned that the policies “exclude from coverage money to which U.S. Bank ‘is not legally entitled’ only ‘as determined by a final adjudication in the underlying action.’ The provision shows not merely that the parties contemplated the possibility of coverage for restitution, but that they agreed coverage would exist unless the restitution was imposed by a final adjudication.” “When an underlying action alleging ill-gotten gains settles before trial, there is no final adjudication in that action. So here, where the class actions alleging ill-gotten gains were settled before trial, there is no final adjudication and the settlement is not excluded from coverage.”

“The insurers’ reliance on the uninsurable provision to assert that the settlement is not a covered loss under the policies is misplaced,” the court held. “Delaware law does not prohibit insurance for restitution and the parties agreed that restitution is insurable when, as here, the underlying allegations of ill-gotten gains were not finally adjudicated.”

The judge was likewise unmoved by the insurers’ efforts to apply an exclusion for losses paid as a result of an “extension of credit.” As for the Extension of Credit provision, the court found the insurers’ interpretation “overbroad and untenable” because “taken to its extent, the provision would bar coverage of any professional liability claim relating to U.S. Bank’s lending operations. The parties could not have intended to exclude from coverage such a large swath of potential claims.”

To read the opinion in U.S. Bank v. Indian Harbor Insurance Co., click here.

Why it matters: In a victory worth tens of millions of dollars, a Minnesota federal court ruled that U.S. Bank is entitled to coverage for three class actions challenging overdraft fee practices. Plaintiffs in the underlying litigation claimed that the bank reordered transactions from highest to lowest instead of chronologically, leading to quicker overdrafts and more fees. U.S. Bank settled the suits for $55 million and then sought coverage from its insurers. The insurers balked, arguing that the settlement constituted uninsurable restitution. The federal court disagreed, concluding that restitution was not barred as a matter of law and so the policy exclusion that precluded coverage for restitution arising from a final adjudication did not apply to a settlement. It is significant that the court held Delaware did not preclude coverage of restitution or “ill-gotten gains claims” as a matter of state law.

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Supreme Court Adopts Broad Interpretation Of Bank Fraud

Choosing to adopt a broad view of what constitutes bank fraud under the federal bank fraud statutes, the U.S. Supreme Court held that to constitute a violation of the statute, no proof of intent to defraud the particular financial institution is required.

Instead, in a unanimous opinion authored by Justice Elena Kagan, the Court held that the statute requires only that a defendant intended to obtain bank property “by means of” a false statement.

The case involved defendant Kevin Loughrin, who stole checks from mailboxes while pretending to be a Mormon missionary going door to door in a Salt Lake City neighborhood. He then presented altered or forged checks at a Target store to make a purchase. After making each purchase, Loughrin then would return the items for cash. Loughrin attempted the scam six times; three of the checks were submitted for payment. Each of the six checks was drawn on an account at a federally insured bank. Once the authorities caught up with him, Loughrin was charged with six counts of committing bank fraud under 18 U.S.C. §1344. The statute provides:

“Whoever knowing executes, or attempts to execute, a scheme or artifice–

  • (1) to defraud a financial institution; or
  • (2) to obtain any of the moneys, funds, credits, assets, securities, or other property owned by, or under the custody or control of, a financial institution, by means of false or fraudulent pretenses, representations, or promises; shall be fined not more than $1,000,000 or imprisoned not more than 30 years, or both.”

At trial, Loughrin requested a jury instruction that in order to be found guilty, he needed to be shown to have acted with “intent to defraud a financial institution.” He argued that he only intended to deceive Target, not the banks, and therefore could not be found guilty. The court rejected the instruction and Loughrin was convicted on all six counts. The Tenth U.S. Circuit Court of Appeals affirmed.

Loughrin filed a writ of certiorari to the U.S. Supreme Court, noting a split of authority in the federal appellate courts. While the 6th Circuit agreed with the 10th Circuit, the 1st, 2nd, and 3rd Circuits have all held that the statute requires proof of intent to defraud a financial institution.

Affirming the 10th Circuit and Loughrin’s conviction, the Supreme Court said the statute only requires a showing that a defendant intended to obtain bank property – not that he or she also specifically intended to deceive a bank.

“[N]othing in the clause additionally demands that a defendant have a specific intent to deceive a bank,” Justice Kagan wrote for multiple occurrences. “And indeed, imposing that requirement would prevent §1344(2) from applying to a host of cases falling within its clear terms.”

Loughrin’s interpretation would create an untenable reading of the provision, the Court added, because §1344(1) includes a requirement that a defendant intend to “defraud a financial institution.” Reading §1344(2) to repeat that requirement after the word “or” would disregard what “or” customarily means, Justice Kagan explained. When Congress includes particular language in one section and omits it in another – let alone the very next provision – the Court must presume the legislature intended a difference in meaning. “And here…overriding that presumption would render §1344’s second clause superfluous,” the Court said.

Loughrin also argued that adopting a broad interpretation of the statute would leave the law applicable to every fraud and constitute a sweeping expansion of federal criminal law in violation of the principles of federalism. Not so fast, Justice Kagan cautioned. The statute itself contains a textual limitation that will prevent the federal prosecution of garden variety fraudulent schemes, she said, because it requires that a criminal must acquire, or attempt to acquire, bank property “by means of” the misrepresentation.

Looking at the facts of Loughrin’s case, she wrote that he satisfied the “by means of” requirement because his false statement was the mechanism naturally inducing the bank to part with money in its control. Alternatively, in a case where a swindler sold a knockoff Louis Vuitton handbag, for example, the bank’s involvement in the case is wholly fortuitous, the Court said, because the check to pay for the bag is perfectly valid and not a false or fraudulent means of obtaining the bank’s money.

To read the Court’s decision in Loughrin v. United States, click here.

Why it matters: While the Court gave credence to Loughrin’s argument that the government’s interpretation of the statute seemingly expanded the scope of the statute to cover even petty fraud, the justices determined that a textual limit within the law would keep federal prosecutions in check. Congress amended the bank fraud statute in 1984 in part to incorporate situations where a bank is not the intended target of fraud, the Court noted. “Congress passed the bank fraud statute to disapprove prior judicial rulings and thereby expand federal criminal law’s scope – and indeed, partly to cover cases like Loughrin’s,” Justice Kagan wrote. Accordingly, this opinion marks the recognition of a broad expansion of the statute to cover conduct that on first blush might not appear to constitute “bank fraud.”

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OCC Report Lists Key Risks For Review In Upcoming Examinations

Highlighting the operational, strategic, and compliance risks confronting financial institutions, the Office of the Comptroller of the Currency (OCC) published its “Semiannual Risk Perspective” report in late June based on 2013 year-end data. Banks examined by the FDIC or Federal Reserve should also consider the report a weather vane for their next examinations.

While the agency began its report on a positive note, describing the improved financial performance of federally chartered institutions in 2013 and a new record level of net income, it identified significant challenges and concerns in the current lending and operating environment. Competition for limited lending opportunities is resulting in loosening credit policies and underwriting standards and a search for revenue in new, often less familiar and higher risk products and services or outsourcing expense control solutions, sometimes without sufficient due diligence. The report also noted the cost and challenge to banks as “the volume and velocity of change in technology systems and business processes continue to increase.”

Cyberthreats and risks related to the Bank Secrecy Act and anti-money laundering compliance (BSA/AML) rank among on the agency’s list of key risk areas. Both the volume and sophistication of electronic banking fraud have increased, the OCC said, making it hard for banks to keep pace. Methods of money laundering continue to develop and change, requiring financial institutions to stay on their toes. “BSA programs at some banks have failed to evolve or incorporate appropriate controls into new products and services,” according to the report, suggesting that additional resources be devoted to the issue.

While most cyber attacks currently aim to disrupt business, the report expressed concern that attackers could change their approach and aim for “destruction and corruption.” Complicating the issue is the growth in “the number, nature, and complexity” of foreign and domestic third-party relationships, which leads to increased interconnectedness of systems and, in turn, greater cyber vulnerability.

Banks also face significant strategic risks, the OCC said, in looking for sustainable ways to generate target rates of return in the wake of the continued slow pace of the recovery from the financial crisis. Many banks are reevaluating their business models by expanding into new products while others are trying to cut costs and lower overhead. Smaller banks continue to lag behind larger banks in returns on equity and increasingly face competitive pressure from nonbank firms seeking to expand into traditional banking activities, the report acknowledged.

The OCC cautioned that examiners have begun to detect an “erosion in underwriting standards” due to the increased competition, citing the indirect auto lending market as problematic. Auto loans – typically obtained through a dealership – were a source of growth for banks, the report noted, but competition has led to tweaks in lending terms. “The results have yet to show large-scale deterioration at the portfolio level, but signs of increasing risk are evident,” the OCC said.

To read the OCC’s Semiannual Risk Perspective, click here.

Why it matters: Boards of Directors and senior bank management should not be surprised if their governance and risk management are questioned in upcoming examinations for shortcomings in credit underwriting or new strategic efforts as well as lapses in controls and compliance—particularly in BSA/AML or cyberfraud protection. The OCC emphasized the need for risk management by “balancing resource constraints, retention of key talent, and overall capability to monitor the breadth of change.” For cyberthreats and vulnerabilities, the agency referred financial institutions to statements from the Federal Financial Institutions Examination Council earlier this year cautioning banks about data security threats, adding that the “threats require heightened awareness and appropriate resources to identify and mitigate the evolving risks.”

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New York AG, Capital One Agree On Credit Screening Changes

New York Attorney General Eric T. Schneiderman recently announced an agreement with Capital One Financial Corporation that will require the bank to adopt new policies regarding the screening of consumers seeking to open checking or savings accounts.

The deal resulted from an investigation launched in mid-2013 by Schneiderman’s office into screenings used by major banks performed by credit bureaus like ChexSystems, the company used by Capital One. When a consumer applies for a bank account, ChexSystems conducts a review of the individual’s banking history. If ChexSystems declares that an applicant presents a credit or fraud risk, a bank will typically deny the application, the AG said.

According to Schneiderman, the screenings may have an adverse impact on lower-income applicants or those who might have fallen victim to identity theft, reducing their access to the banking system and “forcing them to resort to fringe banking services that are more costly than mainstream checking and savings accounts.” An estimated 3 million New Yorkers are considered unbanked or underbanked, he added.

In the first agreement arising from the investigation, Capital One agreed to implement nationwide policy changes by the end of 2014 that Schneiderman said “will allow many thousands more New Yorkers and consumers nationwide to open bank accounts by the end of this year.” While the bank will continue to screen customers for past fraud, it promised not to allow the system to predict whether a customer presents a credit risk.

Capital One also made a $50,000 donation to the state’s Office of Financial Empowerment, an agency that provides counseling for applicants rejected by banks on the basis of a credit bureau report.

To read the AG’s office press release about the agreement, click here.

Why it matters: The agreement between Schneiderman and Capital One is the first to result from the investigation and the AG suggested that additional banks could be in the crosshairs. “Equal access is the least we can do to ensure that all New Yorkers have access to widely used services such as our nation’s banking system,” he said in a statement. “I commend Capital One for stepping up and working with us to help eliminate an unnecessary barrier to opening a checking or savings account. I would hope other banks will step up and join us to do the same.”

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Bitcoin In The News: International Reports, California Makes It Legal

Virtual and digital currencies continue to be the focus of policy makers around the globe.

In addition to new reports from international bodies addressing both the benefits and risks of the currencies, California enacted a new law removing barriers to recognizing Bitcoin and other digital currency as “lawful money” in the state.

Three international reports recently addressed Bitcoin. First up: The Organisation for Economic Cooperation and Development (OECD) published “The Bitcoin Question: Currency Versus Trust-less Transfer Technology.”

The working paper acknowledged that cryptocurrencies present “genuine policy issues” including consumer protection and money laundering, but focused on the underlying technology, which the OECD believes could ultimately shift the basis of trust in financial transactions and eliminate the need for trusted third parties.

“The general aim of policy should be to encourage technologies that improve competition in the payments system, and to ensure that the use of crypto-currencies remove anonymity where money transmission is concerned (to avoid the darker aspects of Bitcoin use) and to meet minimum requirements for consumer protection,” the OECD concluded.

Just a few days later, the Financial Action Task Force (FATF) published a report suggesting a conceptual framework for understanding and addressing the anti-money laundering and combating the financing of terrorism (AML/CFT) risks associated with virtual currencies.

The FATF report, “Virtual Currencies – Key Definitions and Potential AML/CFT Risks,” agreed with the OECD that digital currency “has the potential to improve payment efficiency and reduce transaction costs for payments and fund transfers,” as well as improve access to financial inclusion for the underbanked and unbanked.

But the report also outlined a number of potential risks based on the various features of the virtual currency from greater anonymity to a global reach heightening AML/CFT risks. Decentralized systems are “particularly vulnerable,” the FATF noted, lacking a central oversight body or AML software to monitor and identify suspicious transaction patterns, and thwarting law enforcement without a central location or entity for investigative or asset seizure purposes.

The third body weighing in on virtual currency: the European Banking Authority (EBA), which published an opinion advocating for “a substantial body of regulation.”

After identifying more than 70 risks across several categories, the EBA said a regulatory regime was required, including the segregation of client accounts, the establishment of capital requirements, and the creation of “scheme governing authorities” accountable for the integrity of a particular virtual currency scheme.

As no regulation currently exists, the EBA advised as an “immediate response” that EU authorities discourage regulated financial services entities from buying, holding, or selling Bitcoin or other virtual currency until regulation is in place. Importantly, the opinion encouraged the continued innovation and development of virtual currency outside of the financial sector, which could still allow financial institutions to maintain relationships with businesses engaged in the field of virtual currency.

In the United States, digital and virtual currencies (as well as coupons and reward points) became legal money in California with the repeal of Section 107 of the Corporations Code, which previously characterized alternative forms of value as not having the status of lawful money. In recognition of changing times and changing payment systems, state legislators passed AB 129 and Governor Jerry Brown signed the updated law.

Although regulators have not taken action against the use of digital currencies in the state, the bill’s sponsor, Rep. Roger Dickinson, was concerned the old law could inhibit the growth of virtual currency in California. “In an era of evolving payment methods, from Amazon Coins to Starbucks Stars, it is impractical to ignore the growing use of cash alternatives,” Rep. Dickinson said in a statement about the bill’s passage.

To read the OECD paper, click here.

To read the FATF paper, click here.

To read the EBA’s opinion piece, click here.

To read AB 129, click here.

Why it matters: Virtual currencies are increasingly being taken seriously by regulators around the globe, who are recognizing the benefits offered by the technology despite the risks. While the OECD took a bullish stance on the disruptive benefits of the technology, the FATF fleshed out terms and concepts related to virtual currency and focused on AML/CFT issues. The EBA opinion followed a much more cautious approach, recommending that financial institutions take a hands-off approach until regulation is in place – yet leaving the door open for some interaction between financial institutions and businesses associated with virtual currency. In the meantime, California has removed a potential barrier to use of virtual currencies in that state.

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