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.

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2 thoughts on “Payday Lending: Will the Proposal Alone Be Fatal?

  1. Interesting observations! I agree with you that the Bureau’s disclaimer of any effect on state UDAP law wouldn’t really help a lender. Whether a practice is a state UDAP is up to state law, subject to federal preemption which is really the only say the Bureau has on the matter. In light of the savings clause in section 1041, the Bureau would have to make a fairly involved determination if a declaration that the payday rule doesn’t affect state UDAP law would actually have preemptive effect. Far from attempting that determination, the proposed rule includes language like this from proposed Comment 11(a)-1: “Section 1041.11(a) provides a conditional exemption from certain provisions of section 1041 only; nothing in 1041.11 provides lenders with an exemption from . . . State laws.”

    I take your point about the difference between legislative and adjudicative facts, and I should probably clarify my observations. The key here, I think, is how this could play out as a practical matter.

    Suppose a state’s law mirrors federal law on unfair practices. That is to say, a practice is unfair if it is likely to cause substantial injury to consumers, the injury is not reasonably avoidable, and the injury is not outweighed by benefits to consumers or competition. (This is a slight simplification of Dodd-Frank Act section 1031 or FTC Act section 5, but no need for the details here.) If a lender in that state does something that would fall within what the Bureau proposes to determine is an unfair practice, a plaintiff would still have to prove the practice was unfair according to those elements. The plaintiff would probably need expert economic evidence, etc. Still, the Bureau’s proposal simplifies the plaintiff’s task immensely. It provides a factual record that can be the basis of a plaintiff’s submission, and that makes the task of developing the evidence much easier. That record, we know, was enough that the Bureau felt justified in proposing to find the conduct in question unfair. So it seems unlikely that any trial court, presented with at least that body of information (in which the various studies would appear as informing the expert opinion, rather than as evidence themselves), would grant a defendant summary judgment. And then a defendant faces trial–and if that’s in front of a jury, that jury may very well hear that the Bureau has proposed to find the alleged conduct to be unfair. That seems like a difficult situation for a defendant.

    If and when the Bureau finalizes its unfairness finding, the situation will only get harder.

    Now suppose a state’s law directly borrows from federal law, in that a wrongful act that is unfair under federal law is unfair under state law. While the proposal is still pending, a plaintiff still has to go through the proof process described above. But if the Bureau finalizes its determination, that legislative determination will take a range of issues off the table of adjudications–for the Bureau, which is part of the point of a section 1031 rule making, and also for litigants under a state law like this. (A la Vermont Yankee, in which the NRC made legislative-type determinations on certain issues that had been part of adjudications.) A plaintiff will only need to prove that a lender engaged in the conduct that that Bureau defines as the unfair practice. Given the state’s law, the plaintiff will not have to prove substantial injury and the rest; the Bureau’s determination will suffice.

    None of which is to say that proving a lender made loans without reasonably assessing borrowers’ ability to repay is an easy task. And the Bureau’s apparent decision not to define “reasonable” in its unfairness finding will complicate matters. Still, if a plaintiff can show that a lender engaged in the practice, the Bureau’s rule will make it a lot easier for the plaintiff to litigate whether the practice is unfair.

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  2. CES

    These do seem like interesting issues. I believe the proposed rule disclaims any effect on state UDAP law, but that may not respond to your points in detail.

    One possible response might be a distinction between “adjudicative” and “legislative” facts.

    In an adjudication, the court (or agency) would assess the facts of the individual case based on a preponderance-of-the-evidence standard (or substantial evidence if an agency) and would reach a conclusion that the defendant committed unfairness or abusiveness.

    In informal rulemaking, the agency assesses legislative facts that are generalizations about millions of transactions and reaches conclusions that cannot be arbitrary or capricious. A conclusion like “It is an abusive and unfair practice for a lender to make a covered longer-term loan without reasonably determining that the consumer will have the ability to repay the loan” is based on legislative facts. It may not be a claim that every loan could be individually proven to be abusive and unfair.

    Arguably, an adjudicator of a state unfairness statute should not automatically apply the agency’s conclusion to individual cases that are not governed by the final rule. A conclusion based on legislative facts can inform the adjudicator’s analysis. But in cases where it lacks the force of law, it can’t wholly substitute for an analysis of adjudicative facts.

    An exception is states that treat violations of federal regulations as per se unfair, meaning that they give federal regulations the force of law. But I don’t think that these states would treat violations of a federal regulation as per se unfair before the effective date of the federal regulation.

    In any event, some very interesting ideas.

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