Payday Lending Provision 2007 Defense Authorization Bill

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1 Payday Lending Provision 2007 Defense Authorization Bill Overview H.R. 5122, the John Warner National Defense Authorization Act for Fiscal Year 2007, includes a provision (Subtitle F, Section 670) originally sponsored by Sen. Jim Talent (R-MO) that would impose a new scheme of rate regulation and disclosure for consumer credit offered to members of the armed services and their dependents. ABA and a wide range of financial institutions (both large and small) have very deep concerns over the regulatory burdens, costs, and impact of this provision on everyday bank operations, and the ability and/or willingness of banks to continue to offer various financial products to servicemembers and such dependents. Current law provides certain protections to the military (i.e., as previously established under the Servicemembers Civil Relief Act (SCRA)) 1. However, this new statutory provision takes a much more expansive approach and will compound the compliance burdens associated with meeting existing consumer protection law requirements (e.g., Truth-In-Lending Act (TILA)) and add to consumer confusion related to such disclosures. Further, by in effect outlawing common pricing structures associated with various traditional consumer loan products and thus potentially undercutting economic pricing models justifying various product offerings, the new law will result in reducing the credit options available to the military and their dependents. Ironically, the provision may also result in an increase in the cost of credit to many low-risk servicemembers and their families who may now become subject to higher rates necessary to offset the potential risk of other products that no longer can be priced appropriately. Importantly, the challenges and risks associated with implementing this provision will be much greater than its authors may have anticipated. Given the extreme difficulty, if not impossibility, in identifying those subject to the provision s protections under the literal terms of the statute, the potential for criminal penalties for certain violations, and the possible voiding of the credit contract for any type of violation, lenders may be forced to apply the standards to a much broader set of consumers perhaps to even all consumers seeking covered loans. Doing so would call into question the viability of many common and popular lending products and contractual terms, and may pave the way for expensive litigation by the trial bar. Providing the Department of Defense (DOD) with exclusive rule writing authority and not bank regulators with knowledge of the potential unintended consequences of such rules merely increases the likelihood that broader consequences will occur. The following are just a few examples of the types of traditional products that are thrown into jeopardy by this provision: (1) cash advances on credit cards; (2) checking account overdraft protection services; (3) direct debit for payment of some loans; (4) new products 1 The SCRA requires creditors to reduce the rate of interest to 6% on obligations of servicemembers, including joint obligations with a servicemember s spouse, that were incurred before the servicemember enters into military service, including fees and charges with respect to the obligations. Servicemembers are required to notify the creditor regarding their eligibility for this protection, and may do so up to 180 days after they have left the service. Interest incurred after the commencement of service but prior to the notice must be forgiven. The new provision is not in the SCRA, and among other things, applies to new credits by protected parties and broadens the subset of dependents eligible for such protections. AMERICAN BANKERS ASSOCIATION

2 developed as lower-cost substitutes for payday lending; and (5) some debt consolidation loans, including the refinancing of prior debt with the same lender at a lower rate. Background The 2006 Defense Authorization bill directed the DOD to examine the impact of predatory lending practices on the military and report back to Congress on its findings, including any legislative and regulatory recommendations that it may have. On August 9, 2006, the DOD issued a 92-page report 2 examining the impact of such practices, concluding that they undercut military readiness. The report outlined a variety of concerns over the prevalence of predatory lending around military communities, the various forms of such lending (e.g., payday, internet lending, car title lending, military installment lending, rent-to-own programs, tax refund anticipation loans, and coercive collection actions), education efforts, and other matters. It recommended that various legislative limits should be imposed on creditors offering such products, including interest rate caps, new disclosures, and prohibitions on certain other practices deemed abusive. The report recognized that such limitations may reduce the availability of credit to servicemembers, but felt such a result was justified given the perceived extent of the problem. The provision enacted in the 2007 Defense Authorization bill echoes various recommendations made in the report, but does so with an extremely broad reach and with terminology that will cause great confusion. This provision was put in the bill on the Senate floor with little debate and no hearings. The provision was then redrafted in conference, without any public debate or discussion. Specific Requirements The provision imposes the following requirements and/or conditions on creditors offering consumer credit to active duty military and their dependents. Here, again, it must be emphasized that lenders have no practical way to identify for certain who is a dependent. With the extreme penalties applied to violations, lenders may have no choice in some instances but to apply these requirements to all covered consumer loans. The provision: Imposes a 36 percent cap, inclusive of all fees, on consumer credit. The term consumer credit is left to the DOD to define, but may include all consumer credit except residential mortgages, purchase money automobile loans, and certain secured personal property loans. The DOD is given broad and unprecedented discretion to set the maximum amount of allowable fees and fee types associated with such consumer credit products; Imposes mandatory disclosures of annual percentage rates, again inclusive of all fees. This APR is different than the APR disclosure required under TILA, and the disclosure would have to be made in addition to those required under TILA. Such disclosures must be made both orally and in writing prior to the extension of credit; Imposes a variety of other limitations on the terms of such loans, including limits on: refinancing by the same creditor, recourse waivers, arbitration clauses, onerous legal notice provisions in the case of disputes, prepayment penalties, and the use of a check and other bank account access mechanisms (e.g., ACH transactions); 2 The report can be found at AMERICAN BANKERS ASSOCIATION 2

3 Establishes monetary and criminal penalties for knowing violations; Voids agreements prohibited under this provision; Preempts state and federal laws, rules, or regulations inconsistent with this provision, but does not preempt those that provide protections in addition to the protections of this new provision; and, Provides the DOD with sole rule writing authority, in consultation with the FTC, the four bank regulators, NCUA, and Treasury. The DOD does retain some authority to narrow the scope of the provision, such as by way of more narrowly defining what creditors and consumer credit[s] are subject to the bill s limitations. The provision generally becomes effective on October 1, 2007, or at an earlier date determined by DOD. DOD can issue interim rules under the provision. Analysis The requirements of this provision essentially mirror long-term recommendations made by various consumer groups with respect to payday lending generally, though technically applicable only to servicemembers and their dependents. However, in application, the provision is not limited to what has been traditionally considered payday lending, nor does it apply only to payday lenders. It applies to all lenders and to a broad range of consumer loans. This will present very severe practical implementation problems. For example, Unidentifiable Protected Class. Because of the application of this provision to both active duty military and their dependents (which includes not just children but individuals for whom the servicemember provided one-half of that individual s support in the prior six months), financial institutions will face enormous, likely insurmountable, problems accurately identifying individuals eligible for the provision s protections, as well as monitoring for their continued eligibility. o While the SCRA requires servicemembers to notify financial institutions regarding their eligibility for that Act s protections, no such notification requirement is included in the new statutory requirements. It would appear that every consumer would have to be asked if they were seeking a loan product covered by the new law. o Moreover, even if a self-certification requirement is required under DOD rules, it will be a near impossibility to verify the accuracy of the servicemember s or dependent s claim, absent a DOD-provided exhaustive list of eligible parties. It must also be considered that, once individuals become aware of the limits on costs and other protections afforded under this provision, there will be a significant incentive for ineligible individuals to claim such protections. o Given the extremely severe penalties involved for a violation, it may be that creditors will have no choice but to apply the rules very broadly, beyond those who are actually intended to be covered. Note that it would be a crime to extend credit that AMERICAN BANKERS ASSOCIATION 3

4 does not meet the tests to even one dependent. As such, this provision may, as a practical matter, be an entirely new set of regulations for a broad range of consumer credit. Confusing and Multiple Disclosures. By providing a definition of annual percentage rate that differs from TILA requirements, the provision mandates that military and dependents actually receive two different APR disclosures, and likewise requires that disclosures of such rates and other TILA disclosures be provided both orally and in writing before credit (including internet transactions) can be extended. While imposing onerous and unnecessary burdens on financial institutions, this requirement will clearly confuse consumers. Indeed, the creditor would have no way to know in advance whether someone initially shopping for a loan and comparing terms was covered by the law or not, and therefore it would seem the new disclosures would have to be made available to all, whether they apply or not. It also would likely cut out certain Internet lending because of the required oral disclosures. Applies to Traditional Bank Products. By including all fees as part of the interest rate calculation subject to the 36 percent cap, the provision would apply to a variety of other traditional banking products clearly not envisioned by congressional sponsors. A credit card cash advance feature that contains a cash advance fee, for example, when coupled with a low balance may easily surpass the 36 percent APR limit when calculated on an annual basis. Overdraft protection products, valued by a broad range of consumers in the marketplace, can easily fall subject to the provision s limitations, as even modest monthly fees could result in triggering the provision s APR limits when calculated annually. Limits Credit Options to the Military. Applying interest rate caps, including all fees, to these and other types of regulated bank products, when coupled with the potential imposition of monetary and criminal penalties for knowing violations, will cause regulated lenders to reduce or eliminate the credit options available to the military. Various banks and credit unions, for example, have created low-dollar, short-term, credit products with low fees for the military unfortunately such products likely violate this new law. 3 This would be troubling, as it conflicts with existing efforts by financial institutions and regulators to increase financial options available to those who may otherwise seek to use more troubling payday products. 4 The ability of DOD to cap the amount and types of fees associated with any particular product merely exacerbates concerns. 3 For example, certain credit unions in four states, in an effort to offer a low-cost alternative to payday lending, offer loans up to $500 for up to 90 days, with an APR of 18% and a $25 application fee. A $100 loan made under such a program that is held for 90 days would have an APR under the new law in excess of 100% and thus violate the new law s 36% cap on APRs. A number of banks offer similar products. It would likely be uneconomic to offer such unsecured and potentially risky loans at fees and rates that would comply under the new law, leaving serviecmembers with fewer credit options. 4 The DOD report recognized that products and services provided by a number of banks on military installations have been positive alternatives to payday lenders, though no explicit recognition of that fact was made as part of the legislative language. It is clear that absent rulemaking limiting the impact of the new law on such products and services, military banks may be unable to offer such products and services. AMERICAN BANKERS ASSOCIATION 4

5 Higher Costs to Military Borrowers. Lower rates offered to military borrowers or their dependents (and possibly other consumers) for choosing preauthorized payment options have also been placed in jeopardy by this provision. For example, lenders appear to be prohibited from using preauthorized electronic debit payment mechanisms as a means of payment for outstanding indebtedness. Such a payment mechanism better protects lenders from credit risk and thus allows them to reduce rates to borrowers authorizing such payments. Reduced rates currently available on student loans, for example, may no longer be possible. Limits Access to Lower Cost Alternatives. The provision prohibits a creditor from refinancing consumer loans (other than mortgage, auto, and secured personal loans) if the creditor made the original loan. While this limitation was presumably added to prevent the rollover of abusive payday loans, it also has the effect of eliminating the ability of the lender to offer popular workout loans that both assist the borrower in managing his/her outstanding indebtedness and actually reduce the rate of interest applicable to the debt. Credit and Litigation Risks. Lenders may also be unable to fully gauge the level of credit risk associated with their military consumer portfolios. Given the difficulty identifying members of the protected class under the provision, the potential voidability of the contract due to violations (and thus the possibility that they will be unable to collect on existing debt), the possibility that various common practices will now be illegal (e.g., arbitration clauses, products with non-interest rate fee structures that trigger this new usury ceiling), and the exposure to increased litigation risk as a result, lenders may be faced with no other choice but to restrict the types of credit products available to servicemembers and many others. These are but a few of the clear problems arising from this provision. There are likely to be other significant issues raised as institutions have a chance to consider the impact of this new law on their operations, including the potential compliance challenges presented by the application of state laws authorized by way of the new law s preemption provisions. Uncertainty due to broad scope, conflicts with current law and established practice, new and conflicting terminology, and certainty of major litigation and class action suits will cause creditors to consider affected products as more risky and, therefore, increase the cost of credit. AMERICAN BANKERS ASSOCIATION 5