In June and July 2020, the Federal Deposit Insurance Corporation (FDIC) and Office of the Comptroller of the Currency (OCC) issued a rule and proposed rule that could significantly impact cross-state banking partnerships.
Numerous states employ usury limits to prohibit or limit high-cost, short-term loans. However, national banks are exempt from state usury limits. Historically, this structure encouraged nonbank lenders in states with usury limits to offer loans that were originated by national banks and thus were not subject to the usury limits otherwise applicable in the lender’s state. From the 1990s to mid-2000s, state and federal regulators stamped down on this practice. Regulators argued that usury limits applied to loans originated by national banks when state nonbanks were the ‘true lenders’ of or had the ‘predominant economic interest’ in those loans. Numerous courts upheld these arguments and regulators exerted pressure on the partnerships between national banks and state nonbanks.
Recently, the FDIC and OCC issued one rule and one proposed rule reversing this regulatory trend:
- Valid When Made Rule. On June 2, 2020 and July 22, 2020, the OCC and FDIC endorsed the ‘valid when made’ doctrine. The doctrine allows a nonbank lender to charge the same interest rate that the originating national bank charged prior to transferring the loan to the nonbank. The interest rate is valid even if it exceeds the nonbank lender’s state usury limit.
- True Lender Proposed Rule. On July 20, 2020, the OCC published a Notice of Proposed Rulemaking defining a national bank or federal savings association as the ‘true lender’ of a loan if, as of the date of origination, the bank (1) is named as the lender in the loan agreement, or (2) funds the loan. This definition applies regardless of what portion of the loan the bank and nonbank each fund, and a bank would remain the true lender even after transferring the loan to a nonbank. The FDIC is set to address the doctrine in future rulemaking, but its endorsement of the ‘valid when made’ doctrine alongside the OCC points to a harmony between the agencies.
State regulators have previously sued third-party nonbank lenders for evading usury laws by buying debt from national banks. If finalized, the Valid When Made and True Lender rules, would permit these lenders to lend above their state’s usury limit as long as they buy the debt from a national bank that was named on the loan or funded the loan as of the date of origination. However, third-party lenders need to be careful about relying on the True Lender rule even if it is finalized. Consumer groups and state regulators have condemned the OCC’s rulemakings, and the attorneys general for New York, California, and Illinois already filed a challenge to the ‘valid when made’ rule in July 2020. Although the OCC’s definition of true lender would likely be subject to deference in the courts, the rule would still be vulnerable to an attack on the grounds that it unconstitutionally infringes on a state’s long-held right to enforce usury limits.
While the True Lender rule could contract the number of loans for which a nonbank is the true lender, the flip side is also true: the rule could expand the number of loans for which a national bank is deemed the true lender. Rather than simply receiving a fee for originating and selling a loan to third-party lenders, national banks would have to ensure that they are complying will all applicable prudential and consumer laws. Such laws require banks to, among other things, undertake risk-assessments, consider a borrower’s ability to repay, provide consumers with adequate disclosures, and refrain from unfair, deceptive, or abusive acts or practices. These laws will apply no matter how quickly a bank transfers a loan after originating it. Although the rule is designed to facilitate liquidity by providing definitional clarity in bank-nonbank partnerships, the OCC has highlighted that it will continue to supervise such partnerships to ensure they do not “take unfair advantage of borrowers” or “have a detrimental impact on communities.” In particular, the OCC has essentially warned that the leeway afforded to nonbank lenders will not prevent it from evaluating banks’ compliance with consumer and prudential regulations under a framework it established in previous administrations. Under that framework, the OCC will assess national banks according to the following factors:
- Whether the bank appropriately manages the risks associated with its third-party relationships, including through policies and procedures that ensure adherence to the bank’s risk appetite and tolerances and by ongoing monitoring of the third party’s activities;
- Whether the underwriting criteria for loans are consistent with criteria the bank would use for loans made without a third party, and whether they are consistent with existing safety and soundness standards;
- Whether the bank’s overall returns are reasonably related to its risks and costs, such as whether the risks on short-term loans are not substantial in relation to or do not exceed the principal amount;
- Whether disclosures sufficiently draw the borrower’s attention to key terms and enable them to determine whether the loan meets their particular circumstances and needs; for example, the OCC would consider whether a borrower would understand the terms of the loan (including its costs, risks , and benefits) if they are not financially sophisticated or are vulnerable to abusive practices;
- Whether the loan’s terms and structures and whether the bank’s lending practices are appropriate; including whether (i) there are characteristics that make it difficult for a borrower to reduce or repay its indebtedness (e.g., repeated capitalization of interest; extended negative amortization; or a single payment or balloon payment), and (ii) borrowers are forced into costly rollovers, renewals, or refinancing transactions that are likely to result in debt traps or ongoing cycles of debt?
Given the OCC’s warning, if they have not done so already, banks should implement policies and procedures that ensure compliance with applicable laws and account for the above factors as listed in the OCC’s proposed rule.
Finally, as many will already be aware, the direction of federal regulators may change drastically based on the outcome of the November elections. As such, national and nonbank lenders should be aware that the True Lender proposed rule may never be finalized and bank-nonbank partnerships may be more closely scrutinized by the federal government. In any case, these lends should be cautious about relying upon recent and potential rule changes until they are finalized and upheld in the courts, and until lenders develop policies ensuring compliance with all applicable federal laws.
The OCC invites comments that will inform its consideration of the administrative burdens and the benefits of its proposal, as well as the effective date of the final rule. As ever, the Banking & Financial Services team at Michael Best has experts who can advise lenders on regulatory issues and assist them in responding to proposed rulemakings.