Pentagon Formally Proposes Limits On "Predatory Lending" To Soldiers

On April 11, the U.S. Department of Defense ("DOD") published proposed regulations prohibiting certain lending practices directed at members of the Armed Forces and their dependents. The Secretary of Defense must promulgate a final regulation prior to October 1, 2007, and, therefore, is seeking comment regarding the regulation by or before June 11.

The regulations¹ were issued as mandated by Section 670 of the John Warner National Defense Authorization Act for Fiscal Year 2007 (the "Defense Authorization Act"),² which adds a new Section 987 to Title 10 of the United States Code ("Section 987") directing the Secretary of Defense to establish regulations to implement Section 670. The Secretary must promulgate a final regulation prior to Section 670 going into effect on October 1.³

Specifically, Section 987(h)(2) requires the Secretary of Defense to issue regulations on the following matters:

1. Disclosures required of any creditor that extends consumer credit to a covered member or dependent of such a member;
2. The method for calculating the applicable annual percentage rate of interest on such obligations;
3. A maximum allowable amount of all fees, and the types of fees associated with any such extension of credit, to be expressed and disclosed to the borrower as a total amount and as a percentage of the principal amount of the obligation, at the time at which the transaction is entered into;
4. Definitions of "creditor" and "consumer credit;" and
5. Such other criteria or limitations as the Secretary of Defense determines appropriate, consistent with the provisions of Section 987.

Simply stated, the regulation would apply to "consumer credit" extended by a "creditor" to a "covered borrower." Creditor is defined as any person or entity engaged in the business of extending consumer credit to a covered member (defined below) of the Armed Forces and dependents, excluding governmental entities. The phrase "engaged in the business" likely refers to a person who regularly extends consumer credit and not to a person who infrequently extends consumer credit. Pursuant to the DOD’s authority to specify additional criteria, a person would be a creditor only if the person is also a "creditor" for purposes of the Truth in Lending Act.

The term consumer credit is defined as the range of credit products comprised of payday loans, vehicle title loans, and refund anticipation loans, and specifically excludes residential mortgages and loans procured in the course of purchasing a car or other personal property, when that loan is offered for the express purpose of financing the purchase and is secured by the car or personal property procured. Section 232.8(a) of the proposed regulation implements Section 987(e)(1), which prohibits a creditor from extending consumer credit to a covered borrower in order to roll over, renew, or refinance consumer credit that was previously extended by the same creditor to the same covered borrower. The proposed regulation includes a limited exception to this prohibition, however, to permit workout loans and other refinancings that may benefit the borrower. This definition of consumer credit (payday loans, vehicle title loans, and refund anticipation loans) is predicated on what the DOD identified as the three most problematic credit products in its August 2006 Report to Congress on the Impact of Predatory Lending Practices on Members of the Armed Forces and Their Dependents.

With respect to exclusion of residential mortgages, the proposed regulation clarifies that the exclusion applies to any credit transaction secured by an interest in the borrower’s dwelling.⁴ Thus, home purchase transactions, refinancings, home equity loans and reverse mortgages would be excluded. Home equity lines of credit are also excluded. In addition, the property need not be the consumer's primary dwelling to qualify for the exclusion. A "dwelling" is defined as a residential structure containing one-to-four units, whether or not the structure is attached to real property. This also includes an individual condominium unit, cooperative unit, mobile home, and manufactured home. One question raised by this definition is whether a condominium or cooperative with more than four units also constitutes a dwelling.

The term covered borrower is defined as active members of the Armed Forces (including activated members of the National Guard and Reserve forces) and their dependents.⁵ All such members, according to the regulation, should be able to identify themselves with either issued military identification cards and, in the case National Guard and Reserve force members, copies of the military orders calling the covered member to military service and any orders further extending military service. "Dependents" include the member’s spouse, the member’s children and any other individual for whom the member provides more than one-half of the individual’s support for 180 days immediately preceding an extension of consumer credit.

Maximum Interest Rate

The DOD notice states that payday lenders typically offer short-term loans (usually between $100 and $500) that customers are expected to repay when they receive their next paychecks. These payday loans, otherwise known as deferred presentment loans, are allowed in 39 states as a separate credit product from other forms of credit regulated by federal or state statute. States authorizing these types of loans require payday lenders to obtain a license to operate within the state. States have defined these products and services, primarily through the basic process used to secure a payday loan, either through holding a check or by obtaining access to a bank account through electronic means. These basic processes have been included as part of the definition of payday loans. The proposed regulation provides that "[t]his provision does not apply to any right of a depository institution under statute or common law to offset indebtedness against funds on deposit in the event of the covered borrower's delinquency or default." This exemption only applies if the depository institution has a right of offset under state or other applicable law.⁶

Section 987(b) imposes an annual interest rate cap of 36% which would limit these alleged predatory fees to $1.38 for every $100 loaned.⁷ At that rate, payday lenders have already stated that they will cease offering payday loans to military personnel.⁸ This response is consistent with opponents of the proposed regulation who claim that the limits will only hurt competition and decrease short-term loan options for military service members. The New York Federal Reserve Bank issued a report in January 2007 stating that increased regulation of payday loan providers (and loan products in general) may result in higher rates and less convenience for consumers, due to the negative impact such regulation would likely have on market entry by providers.⁹

Identifying Covered Borrowers

The proposed regulation mandates a safe harbor allowing lenders to require an applicant to sign a statement declaring whether or not he or she is a covered borrower, to prevent inadvertently violating the statute.¹⁰

However, if the loan applicant signs a declaration that denies being a covered borrower, but the creditor obtains documentation as part of the credit transaction reflecting that the applicant is a covered borrower, the applicant's declaration would not create a safe harbor for the creditor.¹¹ This is intended to prevent creditors from using the declaration to allow covered borrowers to waive their right to the protections provided by the regulation.

Creditors may request service members or dependents to provide a copy of their military identification card, which would clearly identify them as covered borrowers.¹²

Although a consumer might become a covered borrower after obtaining consumer credit, the regulations state that it would be unnecessarily burdensome to impose a duty on creditors to make a new determination in each transaction given that a change in the borrower's status will infrequently occur with short-term transactions. Accordingly, the proposed rule would not apply when the same creditor extends consumer credit to a covered borrower to refinance or renew an extension of credit that was not covered by these proposed regulations.¹³

This proposed Section 232.5(a) safe harbor states that Part 232 will not apply to a consumer credit transaction within the safe harbor. This would seem to include the limitations set out in proposed Section 232.8(a), which, in accordance with Section 987(e), makes it unlawful to extend credit to a covered borrower if the terms require the covered borrower to submit to arbitration or if they impose onerous legal notice provisions. The Secretary’s authority to override Section 987(e) and (f) and the voiding effect of Section 987(g) is not clear.

Mandatory Disclosures

The proposed regulations provide for disclosures that must be provided to covered borrowers before they become obligated on a consumer credit transaction, which includes the new disclosures established under Section 987 but also includes disclosures that creditors are already required to provide pursuant to the Federal Reserve Board's Regulation Z, which implements the Truth in Lending Act (TILA). Regulation Z contains certain requirements pertaining to the format of the TILA disclosures for closed-end credit transactions, including a requirement that they "shall be grouped together, shall be segregated from everything else, and shall not contain any information not directly related" to the disclosures required under Regulation Z. The Department intends that the disclosures required under this proposal be provided consistent with the format requirements of Regulation Z. All required disclosures must be provided orally as well as in writing.¹⁴ However, in credit transactions entered into by mail or on the Internet, a creditor complies with this requirement if the creditor provides covered borrowers with a toll-free telephone number on or with the written disclosures and provides oral disclosures when the covered borrower contacts the creditor for this purpose.

Exemptions

The regulations further provide an exemption to creditors, with respect to consumer credit, to use an electronic fund transfer to repay a consumer credit, require direct deposit of the consumer's salary as a condition of eligibility for consumer credit, or take a security interest in funds deposited after the extension of credit in an account established in connection with the consumer credit transactions that are below the 36% maximum interest rate.¹⁵ However, as noted earlier, the creditor cannot require the covered borrower to establish an allotment to repay the obligation. An "allotment" is a system assisting military personnel with making loan payments using deductions from their pay. Once the Defense Authorization Act goes into effect, creditors cannot require allotments from active military lenders. Perhaps that explains the use of the term "consumer’s salary" in the conditions of proposed Section 232.8(a)(5)(ii). However, proposed Section 232.8(a)(5)(i) permits the creditor to require an electronic fund transfer, presumably a preauthorized debt transfer.

Prepayment Penalties

The regulations prohibit creditors from charging a prepayment penalty to covered borrowers, based on existing state and federal laws, as applicable.

Void Contract

Any credit agreement, promissory note, or other contract with a covered borrower which fails to comply with the statute as implemented by these regulations or which contains one or more provisions prohibited under the statute as implemented by these regulations is void from the inception of the contract. Thus, the creditor cannot contract to require payment of principal or interest.

Preemption

Section 987, as implemented by this regulation, will preempt any state or federal law, rule or regulation, including any state usury law, to the extent such law, rule or regulation is inconsistent.¹⁶ However, similar to other consumer protection statutes, any law, rule or regulation is not preempted to the extent that it provides protection to a covered borrower beyond those protections provided by the statute and regulations. In addition, the regulations provide that states may not authorize creditors to charge covered borrowers percentage rates for consumer credit higher than the legal limit for residents of the state, or permit the violation or waiver of any state consumer lending protection that is for the benefit of residents of the state on the basis of the covered borrower’s nonresident or military status, regardless of the covered borrower’s domicile, provided that the protection would otherwise apply to the covered borrower.¹⁷

Arbitration

As noted previously, the regulation also makes it unlawful for any creditor to extend consumer credit to a covered borrower if the creditor requires the covered borrower to submit to arbitration or imposes other onerous legal notice provisions, or if the creditor demands unreasonable notice from the covered borrower as a condition for legal action.¹⁸ "Onerous legal nature," as a standard, is vague for a criminal provision.

Enforcement

Finally, with regard to enforcement, the proposed regulations incorporate the incomplete penalties and enforcement provisions contained in the statute. The enforcement provisions state, among other things, that any credit agreement subject to the regulation that fails to comply with the statute and regulation is void from inception. It further provides that a creditor or assignee who knowingly violates the regulation shall be subject to certain criminal penalties.

The statute, however, does not provide explicitly for enforcement of these rules beyond these provisions. While the federal bank, thrift and credit union regulatory agencies have authority to enforce these rules with respect to the organizations that they supervise, this authority does not extend to other creditors, such as nonbank lenders, that would also be covered creditors and that may be most likely to provide the types of consumer credit restricted by these regulations. The Justice Department, of course, can enforce the criminal provisions of the statute.

While the proposed regulation exempts many of the major lending products offered by banks and financial service companies, it warrants attention by the financial services community since several military-affiliated groups, including the National Military Family Association, want the coverage of the regulation expanded. The regulation is another small step in the continuing trend of the criminalization of finance. In the case of this statute and regulation, it is the creditor and not the employees of the creditor who are subject to criminal penalty.¹⁹ It remains to be seen what this does to the supply of short-term credit to service members and their dependents.

Pillsbury Winthrop Shaw Pittman LLP will continue to monitor the proposed legislation and provide further updates as events warrant.

Appendix

1. Should the final regulation exclude regulated banks, credit unions and savings associations and their subsidiaries from coverage by the regulation generally, or in limited circumstances such as when: (1) the depository institutions are subject to supervision and regulation by a federal regulatory agency; (2) the institution extends covered ‘‘consumer credit’’; (3) the extension of consumer credit by the institution is subject to supervisory guidance by the federal bank regulatory agency that addresses consumer protection, disclosure, and safety and soundness criteria applicable to such lending; and (4) the federal bank regulatory agency agrees to act on matters referred to it by the DOD concerning complaints that such lending to a covered member may be inconsistent with the supervisory guidance, applicable law, or is having an adverse effect on military readiness?

2. Does the duration limit (91 days or less) and monetary limit (cannot exceed $2,000) on the amount of the loan included in the definition of "payday lending" create any unintended consequences for other credit products?

3. Do the limits established for vehicle title loans for the duration of the loan (180 days or less) included as part of the definition cause any unintended consequences for other credit products?

4. What regulatory approaches would encourage creditors to offer affordable, small-dollar, short-term loans to covered borrowers?

5. Are there other fees that should be expressly excluded from an annual percentage limit?

6. To what extent are creditors involved in the tax-filing aspects of a refund anticipation loan?

7. Does the proposed rule for providing certain disclosures orally adequately addresses the compliance difficulties associated with the statutory requirements for oral disclosures, or is another approach more appropriate?

8. The DOD seeks comment on alternative approaches as to whether there is potential confusion created in mandating the disclosure of two annual percentage rates (the maximum annual percentage rate required by these regulations and the annual percentage rate required by the Truth in Lending Act).

9. The DOD seeks comment on whether it can or should adopt the proposed approach whereby a creditor is prohibited from extending consumer credit to a covered borrower in order to roll over, renew, or refinance consumer credit that was previously extended by the same creditor to the same covered borrower, and the limited exception to this prohibition permitting workout loans and other refinancings that may benefit the borrower.

10. Assuming the final rule permits a creditor to roll over, renew or refinance credit that it previously extended to the same covered borrower in limited circumstances, should the DOD adopt a rule clarifying that refinancings or renewals of a covered loan require new disclosures under Section 232.6 only when the transaction would also be considered a new transaction that requires Truth in Lending Act disclosures?

11. The DOD seeks comment on the proposal that creditors do not need to make a new determination in each transaction given that a change in a borrower’s status will infrequently occur with short-term transactions, allowing creditors to rely on their original determination regarding whether a consumer is a covered borrower. In addition, should the disclosures in Section 232.6 only be required for transactions also deemed to be transactions requiring new disclosures under the Truth in Lending Act?

12. The DOD requests examples of legal notice provisions that should be considered onerous.

13. Comment is requested on the provision making it unlawful for any creditor to extend consumer credit to a covered borrower if the creditor demands unreasonable notice from the covered borrower as a condition for legal action.

14. With respect to consumer credit, should creditors be allowed to use electronic fund transfer for repayments, require direct deposit of the consumer’s salary as a condition of eligibility for consumer credit, or take a security interest in funds deposited after the extension of credit in an account established in connection with the consumer credit transactions that are below the 36% maximum annual percentage rate?

15. Should the regulation prohibit creditors from charging a prepayment penalty?

16. Should the proposed regulation mandate that any credit agreement subject to these regulations which fails to comply with this regulation is void from inception, and that any creditor or assignee who knowingly violates the regulation shall be subject to certain criminal penalties? Comment is sought on how to ensure uniform implementation of, and compliance with, the statute by creditors not subject to oversight by the federal bank, thrift, and credit union regulatory agencies.

17. Comment is solicited on the proposed timing for the publication of final rules. In particular, the Department requests comment on the ability of covered creditors to comply with the proposed rules by October 1 in light of the specific credit products that would be covered by the regulations.

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