Payday Proposal: What is Abusive?

The Dodd-Frank Act prohibits “abusive” acts and practices in the offering or provision of consumer financial products and services. That prohibition was new in federal law in 2010, and it engendered significant uncertainty about what would mark an act or practice as abusive. The Act identified four different types of potentially abusive conduct, each with elements set forth in the statute. But for each type, the statutory elements used some open-ended terms, like “unreasonable,” which the Consumer Financial Protection Bureau was left to elaborate. In particular, three of the four descriptions of abusive conduct in the Dodd-Frank Act involve “tak[ing] unreasonable advantage of” some characteristic that exposes consumers to potential harm (such as a lack of understanding of material risks). What qualifies as taking unreasonable advantage?

Bureau enforcement actions have shed at best a dim light on how the Bureau understands and applies these concepts, in part because there has been little occasion for actual briefing on abusiveness claims in the Bureau’s enforcement complaints. In the proposed rule on payday lending, the Bureau explained an abusiveness theory in a rulemaking for the first time. Nobody should realistically expect the Bureau to lay out a definition or a bright-line rule, and indeed this proposed rule did not. But how much leeway courts give the Bureau to determine what is “unreasonable advantage” will probably depend on the clarity and rigor of its reasoning when it makes those determinations.

As background, the payday proposal addresses two types of loans that the rule would define: covered short-term loans and covered longer-term loans. Subject to certain exceptions, a loan on which repayment is due within 45 days would be a covered short-term loan. A loan of longer than 45 days would be a covered longer-term loan if it has an interest rate over 36% and the lender either takes a vehicle title as collateral or “obtains a leveraged payment mechanism,” such as a right to make automated withdrawals from a bank account. For either type of covered loan, the proposed rule would determine that it is an unfair and an abusive practice to make a loan without reasonably determining that the borrower will have the ability to repay the loan. The rule would specify various ways a lender should make an ability-to-repay determination, and it would provide a number of exceptions. The exceptions are important and complicated, and the proposed rule would have a number of other features. But as indicated above, this post focuses on the proposed determination that lending without reasonable underwriting is an abusive practice. IIn addition, I’ll discuss only short-term loans, for the sake of brevity and because that will be enough to illustrate the point.

The Bureau would find that lending without underwriting “takes unreasonable advantage” of borrowers’ lack of understanding of material risks. The Bureau says payday borrowers don’t understand the risk that a first short-term loan will grow into a multi-loan sequence with much higher borrowing costs (and risks of default). Second, the Bureau would find that making covered loans without underwriting takes unreasonable advantage of borrowers’ inability to protect their interests. The proposal suggests that payday borrowers are unable to protect themselves from the risks just mentioned, because they borrow at times when they need cash immediately and don’t have the time, resources, or opportunity to find other sources.

The Bureau acknowledges that a lender can take some amount of advantage of a borrower. As the statute says, conduct is abusive only if it takes “unreasonable” advantage. In principle, a business could take advantage of consumers’ misunderstanding of risks, or inability to protect their interests, without being abusive, so long as the advantage doesn’t cross the line to being unreasonable. What leads the Bureau to think the accused practice is unreasonable here is a combination of “[s]everal interrelated considerations.” The Bureau observes that lending without regard to the borrower’s ability to repay is different from how lenders operate traditionally and in (says the Bureau) “virtually every other credit market.” Meanwhile, the proposal states, short-term lenders’ business model depends on consumers’ being unable to repay their loans, because customer acquisition costs are high enough that single short-term loans, paid in full, would not be profitable. “Also relevant” is the fact that payday borrowers generally have “moderate incomes, little or no savings,” and poor access to other credit. Finally, the proposal says that lenders do things that “further exacerbate the risks and costs” for consumers, such as using marketing techniques to push consumers to treat the loans as short-term credit, facilitating rollover into new loans, and not encouraging borrowers to pay down principal gradually as they reborrow.

The proposal doesn’t explain why these four considerations make the accused practice abusive. However, only the fourth seems potentially robust as a contribution to a decision that the practice takes unreasonable advantage. Strikingly, that is the one most tenuously related to the definition that the Bureau has actually proposed for an abusive practice.

The first two observations, about lenders’ business model, must stand or fall together. Failure to assess a borrower’s ability to repay, on its own, might be different from many other credit markets. (But perhaps not all. Microfinance famously relies on alternative models of loan decisionmaking.) Novelty and difference might be suspicious, but it would seem like a dangerous use of the law to make them indicators of unreasonableness. Moreover, in general it is hard to see how not assessing borrowers’ ability to repay would enable a lender to take any advantage of borrowers’ vulnerability to the risk of not repaying. As the proposal notes, a borrower’s failure to repay is, in most credit markets, bad for the lender. The critical difference here is that, according to the proposal, lenders don’t assess ability to repay because they would actually rather borrowers don’t repay immediately, but rather reborrow and support the business model.

This situation is to be assessed against the statutory criterion: that the practices “takes unreasonable advantage of” consumers’ inability to protect themselves. Consider the latter. There is evidently a population of consumers who need credit in urgent circumstances and who, for various reasons, have little choice about where to get it. Providing that credit will involve some cost. Charging the borrowers that cost, plus profit, might well amount to taking advantage of their inability to protect themselves. Still, as the Bureau acknowledges, only taking unreasonable advantage is abusive. Perhaps charging too much would be unreasonable. But the proposal does not go that way. Rather, it argues that the structure itself—imposing a hefty finance charge over a series of short-term loans and therefore not wanting the borrower to pay the first loan back in full—is an unreasonable way to collect the money. Why that should be so is not obvious, and the proposal does not say.

The Bureau’s third consideration is that payday borrowers tend to be particularly vulnerable. That vulnerability is certainly relevant to the question whether they are unable to protect their interests. And therefore it might be something a lender would try to take advantage of. But unless the Bureau means to suggest that for some vulnerabilities, any advantage a business might take would be unreasonable, the fact that many payday borrowers have an inability to protect their interests does not weigh in either direction on whether a particular business model is unreasonable.

That leaves us with the fourth consideration, the observation that payday lenders do marketing to push consumers to focus on the short-term—and thus underestimate the full costs and risks of the loans. That consideration does sound more like unreasonableness, and it is consistent with claims of abusiveness the Bureau has made in a few enforcement actions. Roughly speaking, the idea would be that payday lenders have partly caused or contributed to consumers’ vulnerability—the lack of understanding of the risks, and the inability to protect themselves—by using marketing techniques that obscure the risks and encourage consumers to underestimate them. Perhaps it might be acceptable to take advantage of preexisting consumer misapprehensions; but, in this line of thought, a practice becomes abusive when it profits from consumer misunderstanding that the lender has enhanced in service of its business.

To my eyes, that looks like a potentially quite viable theory of an abusive practice. However, it would not be the practice that the Bureau’s proposal identifies! Under the proposed rule, every covered short-term loan made without reasonably assessing the borrower’s ability to repay the loan would be abusive—regardless whether the lender had done anything to foster consumer misunderstanding. Conversely, a lender might obfuscate the costs of its loans by every means possible, which is the sort of conduct that led to the Bureau’s fourth consideration. Such a lender might achieve great success in inducing borrowers to take high-cost loans. But as long as it had assessed their ability to repay, it would not be liable for the abusive practice this proposal discusses.

All this might seem theoretical, because if the Bureau issues a rule that looks like the proposal, it will still have the unfairness determination, and the rule might look almost exactly the same even if a court struck the abusiveness finding. It is actually quite important. As a practical matter, a defendant facing potential liability will care a great deal whether lending without underwriting is only unfair, or is unfair and abusive. In the second situation, the same course of conduct might lead to multiple sets of civil penalties.

More significantly, though, the proposal’s discussion of “unreasonable advantage” is important for what it reveals about the Bureau’s approach to abusiveness. I suggest that the agency is still so awed by its new abusiveness authority that it is reluctant to use it as a real policymaking tool. Since the enactment of the Dodd-Frank Act, the power to find conduct abusive—even if it was not unfair or deceptive—has been a sword of possibly broad sweep that the Bureau could wield in its regulatory mission. As the discussion above indicates, the payday proposal contains material that might have supported a specific, precise finding about a relatively narrowly defined abusive practice. But adopting that finding, especially alongside the sweeping unfairness determination, might have brought “abusive” down to earth. Instead, the Bureau proposed to make an equally sweeping abusiveness determination, at the cost of providing a fairly vague and thinly explained rationale for the finding.

Courts may accept this, or they may develop a narrower understanding of “unreasonable advantage” on their own. The Bureau has taken a gamble on the scope of the prohibition on abusive practices.

Payday Lending: Will the Proposal Alone Be Fatal?

Like many people, I am still digesting the Bureau’s proposed rule on payday lending.  It’s been three months, I know; but it’s a complicated proposal with a lot of moving parts.

One feature has become clear, though, and that is the simplicity with which the proposed rule would identify an unfair practice. For all that the rule would set up various off-ramps, exceptions, and safe harbors, it would begin with this statement: It is an unfair practice for a lender to make a loan, if it is among certain types, without reasonably determining that the borrower will have the ability to repay the loan. That simple statement on its own could be quite dangerous for the industry, even if the Bureau makes much more generous exceptions in the final rule, or even if it doesn’t finalize the rule.

The Bureau has been studying short-term, small-dollar loans for at least a few years. Its primary concern appears to be that—as the Bureau describes it—lenders market their loans as short-term debt, while fully expecting and indeed relying on borrowers not to be able to repay in the short run, so that they refinance repeatedly and end up paying astronomical amounts of interest. To prevent that behavior, the Bureau proposes to determine that it is an unfair (and an abusive) practice to make a covered loan without making a reasonable determination of ability to repay. (The proposal would cover two defined sets of loans, which it calls “covered short-term loans” and “covered longer-term loans.” For purposes of this discussion, we can set aside the scope of those definitions, and the differences between them.) The proposal would specify in further detail how to conduct an acceptable underwriting process, and it would also set up alternative lending models that a company could pursue instead of doing traditional underwriting. For example, a lender could make short-term loans without underwriting if (among other conditions) the loans were designed to prevent borrowers from refinancing more than two times, and the lender made certain disclosures.

Perhaps the underwriting model the Bureau sets forth would be workable for some small-dollar lenders, and perhaps the alternative models would work for others. (Or perhaps not, as the comment record for the rulemaking suggests.) But because of the way the proposal is structured, those features may not matter much as a practical matter. Given the authority that the Bureau claims in the proposal to prescribe a broad range of measures so long as they “have a reasonable relation” to an unfair practice, the Bureau had some latitude about what to identify as the unfair practice and how to connect its other provisions to that determination. What the Bureau has proposed is the broadest possible description of the unfair practice: lending “without reasonably determining that the consumer will have the ability to repay the loan.” Much of what the Bureau could have framed as ancillary regulations “reasonably related” to an unfairness determination is presented, in the proposal, as exceptions from what would otherwise be an absolute prohibition.

Why does this matter? The Bureau is not the only locus of enforcement regarding unfair practices. States can enforce the Consumer Financial Protection Act, including its prohibition on unfair practices. Of course the Bureau could make clear that a lender using its alternative models is exempt from the statutory prohibition on unfair practices, as well as the regulatory requirements of the Bureau’s putative rule. But states, and in many states consumers, can also enforce state laws prohibiting unfair practices. In many states, the unfair practices law is essentially identical to the one governing the Bureau; many others borrow from federal law, in that an act that is wrongful under federal law can be an unfair practice under state law.

So let us suppose the Bureau issues a rule like what it has proposed. A lender opts to use the alternative lending models the Bureau makes available. Doing so would protect the lender from liability under the Consumer Financial Protection Act. But a consumer plaintiff—or a class of consumer plaintiffs—could still sue under state law, charging that the failure to do reasonable underwriting is an unfair practice. Such a plaintiff would point out that the Bureau has determined it is unfair to issue a covered loan without making a reasonable determination of ability to repay. That the Bureau offers the alternative lending models as an exemption from the federal prohibition on unfair practices, the plaintiff would continue, does not immunize the lender’s misconduct under state law.

The problems do not stop there. Suppose a different lender performed underwriting compliant with the rule’s specifications on how to make ability-to-repay assessments. That lender might like to think compliance would protect it from unfair-practices liability. But the Bureau’s proposal doesn’t include those underwriting specifications in the definition of the unfair practice. It identifies the unlawful practice as not “reasonably determining that the consumer will have the ability to repay.” What is “reasonable,” and what is “ability to repay”? The proposed rule would elaborate on those concepts only for use in the Bureau’s ancillary regulations related to the unfair practice. In a lawsuit under state law based on the premise that not reasonably determining ability to repay is an unfair practice, the parties would have to litigate what kind of determination is reasonable, and what counts as ability to repay.

Perhaps most difficult of all, a state-law plaintiff would not have to wait for the Bureau’s final rule. So far as one can tell from the proposed rule, the criteria for determining by rule that a practice is unfair are exactly the same as those for finding it unfair in any other proceeding. If the Bureau finds the identified practice unfair, it has always been unfair (or at least since section 1031 of the Dodd-Frank Act took effect)–and it is unfair already. A plaintiff could sue a small-dollar lender for that unfair practice now, both for ongoing business and for past lending stretching as far back as the applicable statute of limitations will allow. The plaintiff would of course need to prove that doing small-dollar lending without reasonable underwriting is an unfair practice. While the Bureau’s proposed rule would not be as powerful an aid as a final rule conclusively determining the point for purposes of the Dodd-Frank Act, it is still a great help. A court or a jury might place substantial weight on the assessment in the Bureau’s proposal, preliminary though it is.

Note also that the alternative lending models will not even be protection from the federal violation unless and until the Bureau issues a final rule granting those exemptions. Until that time, lenders could even be vulnerable to aggressive state-based enforcement of the federal prohibition on unfair practices.

These issues might ultimately be hypothetical, if the rule as proposed would destroy the small-dollar lending industry anyway. However, the Bureau seems to think small-dollar lending will continue, albeit in different forms and with lower volume. The current proposal, because it doesn’t take careful account of state law, may make that outcome less likely.