California’s law restricting credit card surcharges struck down as unconstitutional; case law emerging

By Thomas G. Wolfe, J.D.

Recently, the U.S. District Court for the Eastern District of California ruled that a California law restricting surcharges on credit cards was unconstitutional. In the March 25, 2015, Italian Colors Restaurant v. Harris case, Chief Judge Morrison C. England determined that the California statutory provision not only placed an impermissible burden on commercial speech in violation of the First Amendment to the U.S. Constitution, but also was unconstitutionally vague.

Similarly, in October 2013, in the case of Expressions Hair Design v. Schneiderman, the U.S. District Court for the Southern District of New York ruled that New York’s credit card “no surcharge” law was unconstitutionally vague and violated the plaintiffs’ right to “free speech” protected by the First Amendment. In each case, various merchants challenged the constitutionality of the “no surcharge” laws in actions brought against the state’s attorney general.

In both the Italian Colors case and the Expressions case, injunctive relief was granted to prevent enforcement of the California and New York laws. While the California law was permanently enjoined, the New York law was subject to a preliminary injunction while the New York federal trial court addresses whether New York’s “no surcharge” law is preempted by the federal Sherman Antitrust Act after further factual development in the case.

In the Italian Colors case interpreting the California statute (Cal. Civ. Code §1748.1(a)), the court depicted the operation of the California statutory provision, stating “a retailer could charge $102 for a product and give a $2 discount, but could not charge $100 and impose a $2 surcharge, despite the situations being mathematically equivalent. Thus, the statute restricts how this $2 price difference is presented to the consumer.”

Likewise, in the Expressions case construing New York’s “no surcharge” statute (N.Y. Gen. Bus. Law Article 29-A, sec. 518), the court related that the law provided that “no seller in any sales transaction may impose a surcharge on a holder who elects to use a credit card in lieu of payment by cash, check, or similar means.” In both the California and New York situations, the pertinent merchant plaintiffs claimed that the applicable state law restricted their protected free-speech rights because the state law required them to only use the “right language” to communicate the difference to purchasers of their products or services; the state law permitted them to refer to a cash “discount” but prevented them from referring to a credit “surcharge.”

As the Italian Colors court pointed out, until fairly recently, “state ‘no surcharge’ statutes were redundant because credit card companies had contractual provisions that prohibited retailers from imposing surcharges. However, in 2013, a nationwide settlement agreement with the credit card companies resulted in the removal of these contractual provisions…Instead, retailers are now required to engage in truthful and prominent disclosure of surcharge information to consumers and cannot recoup more than the cost of the merchant fees [also known as swipe fees] as a surcharge.” In light of the 2013 nationwide settlement with the credit card companies, the plaintiff merchants in the action were “contractually permitted” to impose surcharges, but prohibited to do so by the California law. Consequently, as observed by the court, the merchants initiated the lawsuit, at least in part, to ensure that doing so would not be considered a violation of the California law.

Another interesting highlight was presented in the Italian Colors decision on the merchants’ claim that the California statute was unconstitutionally vague. The merchants successfully maintained that the California law did not “clearly define the line between a permissible ‘surcharge’ and a mathematically equivalent but illegal ‘discount.’” In rejecting the California Attorney General’s argument that many of the merchants’ contentions about the vagueness of the California statute were “hypothetical,” the court emphasized that “[t]hese retailers would like to have a pricing system where a surcharge is imposed for credit card purchases, but do not feel confident that they could do so lawfully. The fact that retailers—even large national retailers with teams of in-house attorneys—do not use a dual-pricing system under the current law due to fear of enforcement is proof that the law is not clear.”

Now that two federal district courts, one in New York and one in California, have discerned constitutional problems with state “no surcharge” laws, will a trend begin to develop for other states as well? Apparently, that remains to be seen. As observed by the Italian Colors court, two other federal district courts, one in Florida and the other in Texas, came to a different conclusion. In examining Florida and Texas laws respectively, those courts upheld state statutes restricting credit card surcharges as a regulation of “economic activity.”

Notably, both the Florida and Texas federal district courts applied a “rational basis” test in upholding the state laws restricting credit card surcharges. In contrast, the New York and California federal district courts that found the state statutes restricting credit card surcharges to be unconstitutional applied an “intermediate scrutiny” test.




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Creditor's interest related back to initial filing

By Lisa M. Goolik, J.D.

An assigned security interest in substantially all of a debtor’s assets held by a creditor serving as an agent for a group of lenders was superior to competing interests claimed by loan participants, despite the fact that the creditor’s interest was assigned after the participants purchased their interests. Applying Delaware law, the U.S. Bankruptcy Court for the Eastern District of New York concluded that the creditor’s interest related back to a financing statement filed by the assignor with the Delaware Secretary of State in 2001.

The facts. The debtor, Oak Rock Financial, LLC, is a failed asset-based lending company which operated out of offices located in Bohemia, New York. In July 2001, the debtor entered into a security agreement (2001 security agreement) with Israel Discount Bank (IDB) and granted IDB a security interest in all of the debtor’s “personal and fixture property of every kind and nature…” The agreement also authorized IDB “at any time and from time to time to file in any Uniform Commercial Code jurisdiction any initial financing statement and amendments” that described the collateral “as all assets of the [Debtor] or words of similar effect.

The same month, a financing statement was filed with the Delaware Secretary of describing the collateral covered by the 2001 financing statement as:

All of Debtor’s now owned and hereafter acquired assets, including without limitation all accounts, goods, inventory, equipment, instruments, documents, chattel paper, deposit accounts, letter of credit rights, commercial tort claims, financial assets, securities, and all other investment property, general intangibles and all supporting obligations and products and proceeds of the foregoing.

In May 2006, the debtor entered into two new agreements (2006 security agreement) to obtain a line of credit extended by an agented group of lenders, including IDB. The debtor granted to Israel Discount Bank of New York, as Administrative Agent (IDB as Agent), for the benefit of the represented lenders, a lien in the debtor’s accounts, bank accounts, chattel paper, documents, general intangibles, payment intangibles and other collateral described in the new security agreement. Two UCC financing statement amendments were filed that amended the name of the secured party of record from “Israel Discount Bank of New York” to “Israel Discount Bank of New York, as Administrative Agent” and assigning the 2001 financing statement from IDB to IDB as Agent. In 2011, a continuation statement was filed to extend the 2001 financing statement.

At some point prior to the 2006 assignment, North Mill Capital, LLC , Medallion Bank, and Medallion Financial Corp (collectively, the True Participants) purchased interests in specific loans of the debtor.

In April 2013, IDB and other lenders filed a petition for involuntary relief under Chapter 7 of the Bankruptcy Code against the debtor. In July 2013, an order was entered the sell the debtor’s interest in loan agreements to satisfy IDB as Agent’s lien. The True Participants objected to IDB as Agent’s lien.

Timing of perfection. Under Revised Article 9, as adopted by Delaware, loan participations are treated as secured transactions. Upon purchasing their interests in specific loans, the True Participants’ interests were automatically perfected under Section 9-309, without the need to file financing statements. Therefore, under applicable law, the True Participants were deemed to have a perfected lien with respect to the subject loans as of the effective date of each loan participation in question. Because IDB as Agent claimed to have a perfected lien on the same collateral, the court was called on to determine whether IDB as Agent had a prior perfected lien, and whether it lapsed at any point in time.

The True Participants claimed that IDB as Agent could not rely on the 2001 UCC financing statement to perfect its lien because:

1. IDB’s loan to the debtor was satisfied in 2006, and as a matter of law, the 2001 UCC financing statement was extinguished;
2. the 2001 UCC financing statement became “seriously misleading” when it was assigned from IDB to IDB as Agent;
3. the lien granted by the debtor to IDB in security agreements executed in 2001 and then in 2004 was never assigned to IDB as Agent, and
4. the debtor and IDB as Agent relied on a different UCC financing statement filed in 2006 to perfect IDB as Agent’s lien on the debtor’s assets, which lapsed in 2011.

Medallion also claimed that because it is a Utah company, IDB as Agent was required to file a financing statement in Utah to perfect its lien within one year after Medallion purchased its loan participations from the debtor.

Relates back. The court concluded that under applicable Delaware UCC law, IDB as Agent’s perfected lien status relates back to the date the original financing statement was filed in July 2001, which did not lapse at any point pre-petition. IDB’s lien attached when the debtor granted a lien to IDB on substantially all of the debtor’s assets in 2001, pursuant to the 2001 security agreement. IDB as Agent’s security interest attached when the debtor granted it a lien in substantially all of the debtor’s assets in 2006, pursuant to the 2006 security agreement. As of 2006, IDB as Agent was listed as a “secured party” on a financing statement that was first filed in 2001, and it was undisputed that the 2001 financing statement never lapsed from 2001 through the petition date.

The 2001 financing statement put the public on notice that a third party may have a security interest in the debtor’s assets, wrote the court. Any third party, including the True Participants bore the burden of inquiry into the debtor’s true state of financial affairs, and so long as the 2001 financing statement remained of record, they were deemed to have assumed the risk of entering into any transaction with the debtor in the face of such financing statement, wrote the court.

Effect of assignment. In addition, the court concluded the assignment of the 2001 financing statement from IDB to IDB as Agent did not render the 2001 UCC financing statement “seriously misleading” because the descriptions of collateral in the 2006 security agreement granting the interests to IDB as Agent sufficiently matched the collateral identified in the 2001 financing statement.

“Any third party searching the public record would discover that the 2001 financing statement was assigned to IDB as Agent, and upon reviewing the operative documents, would discover that the debtor granted to IDB as Agent a security interest in substantially all of its assets in 2006,” wrote the court. 

Filing prior to attachment. The court also held that the fact that IDB as Agent was not granted a security interest in the debtor’s assets until 2006 had no bearing on the date its lien was deemed perfected. Under Section 9-502, a financing statement may be filed prior to the grant of a security interest. Thus, the fact that the 2001 financing statement was originally filed for the benefit of IDB, and was filed approximately five years before the debtor granted a lien to IDB as Agent, did not affect its effectiveness under the Delaware UCC.

Utah provisions. Lastly, IDB as Agent was not required to take any additional steps to maintain its priority position over Medallion. Medallion’s purchase of loan participations from the debtor did not cause it to fit within the definition of a “debtor”—Medallion was a secured creditor with respect to the loans it purchased. Because Medallion was not a “debtor,” IDB as Agent’s lien status was unaffected by its failure to file any documentation with the Utah Secretary of State.

For more analysis and cases like In re Oak Rock Financial, LLC (Case No. 13-72251-reg), subscribe to the Banking and Finance Law Daily.

CFPB targets payday, title loan ‘debt traps’

By Lisa M. Goolik, J.D.

The Consumer Financial Protection Bureau unveiled its plan to target the “debt traps” caused by payday loans, vehicle title loans, deposit advance products, and certain high-cost installment loans and open-end loans. The bureau’s proposals would require lenders to make certain that consumers can repay their loans while also restricting lenders from attempting to collect payment from consumers’ bank accounts in ways that tend to rack up excessive fees. 

“With payday loans, vehicle title loans, and many types of installment loans, the pattern is all too common,” CFPB Director Richard Cordray commented. “A consumer facing difficult financial circumstances is offered quick cash with no questions asked and in return agrees to provide access to a checking account or paycheck or vehicle title in order to get the loan. No attempt is made to determine whether the consumer will be able to afford the ensuing payments,” Cordray said.

Overview. The proposals cover both short-term and longer-term credit products that are often marketed heavily to financially vulnerable consumers. The bureau found that the abbreviated time-frame of short-term loans can make it difficult for consumer to accumulate enough funds to pay off the principal and fees before the due date. For longer-term loans, many consumers struggle to keep up with unaffordable payments, which can result in defaults, costly refinancing, or falling behind on other bills.

For both short-term and longer-term loans, the proposals provide lenders with two options. Lenders would be required to adhere to debt trap prevention requirements or debt trap protection requirements.

Short-term loans. The proposals would cover short-term credit products that require consumers to pay back the loan in full within 45 days, which typically includes many payday loans, deposit advance products, certain open-end lines of credit, and some vehicle title loans. 

Debt trap prevention requirements would require lenders to determine at the outset that the consumer can repay the loan when due— including interest, principal, and fees for add-on products— without defaulting or re-borrowing. For each loan, lenders would have to determine whether the borrower would have enough money left to repay the loan after covering other major financial obligations and living expenses. The proposals also include a 60-day cooling off period between loans, additional requirements for offering a second or third loan within the two-month window, and after three loans in a row, all lenders would be prohibited from making a new short-term loan to the borrower for 60 days.

Debt trap protection requirements for short-term loans would limit the number of loans that a borrower can take out in a row and require lenders to provide affordable repayment options. The proposals also cap short-term loans at $500 and provide that they cannot last longer than 45 days, carry more than one finance charge, or require the consumer’s vehicle as collateral. 

Longer-term loans. The proposals would also apply to high-cost, longer-term credit products of more than 45 days where the lender has access to repayment from the consumer’s deposit account or paycheck, or holds a security interest in the consumer’s vehicle, and the all-in annual percentage rate is more than 36 percent. This includes longer-term vehicle title loans, some high-cost installment loans, and similar open-end products. 

Similar to the short-term loan requirements, the debt trap prevention provisions for long-term loans would require lenders to determine at the outset that the consumer can make each payment on the loan when due—including interest, principal, and fees for any add-on product— without defaulting or re-borrowing. In addition:

• lenders would be required to determine if a consumer is able to repay the loan each time the borrower seeks to refinance or re-borrow; and
• if the borrower has been delinquent on a payment, the lender would be prohibited from refinancing into another loan with similar terms without documentation that the consumer’s financial circumstances had improved enough to be able to repay the loan.

As for debt trap protection requirements for longer-term loans, the bureau is considering two specific approaches. Under each approach, loans would have a minimum duration of 45 days and a maximum duration of six months. Under the first approach, lenders generally could provide the same terms as loans offered under the National Credit Union Administration program for “payday alternative loans.” Additionally:

• the loan principal would have to be between $200 and $1,000, and the balance would decrease over the loan term;
• the lender could not charge an interest rate higher than 28 percent and an application fee higher than $20;
• the borrower could have no other covered loans;
• the lender would be able to provide only two of these loans to a borrower within six months; and
• the borrower is limited to one loan at a time.

Under the second approach, lenders could make a longer-term loan provided that the borrower’s monthly payment is no more than 5 percent of the borrower’s gross monthly income. The bureau would also require that the borrower has no other covered loans and the lender cannot provide more than two of these loans to a borrower in a 12-month period.

Payment collection practices. The bureau is also considering proposals, for both short-term and longer-term loans, that would restrict harmful payment collection practices that lead to insufficient funds and returned payment fees. The proposals would require borrower notification before accessing deposit accounts and limit unsuccessful withdrawal attempts to two consecutive attempts.

Small lender input. The bureau is planning to convene a Small Business Review Panel to gather feedback from small lenders, which is the next step in the rulemaking process. The bureau provided a fact sheet that summarizes the Small Business Review Panel process. In addition, the CFPB issued a list of questions for input on potential rulemaking. While the panel meetings are not public, the bureau said it intends to publish meeting materials on its website.

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Debate continues on raising $50B threshold for enhanced standards

The following post previously appeared in the Banking and Finance Law Daily.

 

By Colleen M. Svelnis, J.D.

 

The Senate Committee on Banking, Housing, and Urban Affairs has continued discussion on the regulation of regional banks and whether to raise the threshold for enhanced prudential standards. Under Section 165 of the Dodd-Frank Act, all banks with assets of $50 billion or more are subject to “enhanced prudential standards,” which can include heightened capital requirements, leverage, liquidity, concentration limits, short-term debt limits, enhanced disclosures, risk management, and resolution planning. The hearing, “Examining the Regulatory Regime for Regional Banks,” was the second on this issue this month.

 

Rigid system. Committee Chair Richard Shelby (R-Ala) noted in his opening statement that “Five years after this threshold was fixed in statute, no legislator or regulator has properly explained where it came from, why it was deemed appropriate at the time, or what analysis supported it. I believe that five years is long enough to know if an arbitrary threshold is appropriate and whether it should be changed.”

 

Shelby expressed concern that the current system is too rigid and that it “imposes unwarranted costs without enhancing safety and soundness. These costs are then passed along to consumers and businesses by restricting credit and other financial services.” According to Shelby, a regulatory regime “should allow for the maximum level of economic growth while also ensuring the safety and soundness of our financial system.”

 

Questions remain. Sherrod Brown (D-Ohio), Ranking Member of the committee, spoke about the need to ensure that prudential regulations for regional banks are crafted appropriately. “We all agree that regional banks are not systemic in the same way that money center banks are. The failure of one regional bank, assuming it is following a traditional model, will not threaten the entire system.”

 

Brown said he hoped the hearing would answer the following questions:

1. Are there specific standards that are inappropriate for regional banks and why? 
2. Do the concerns being raised stem from implementing regulations, which require no legislation to fix, or from the law itself? 
3. Which concerns can be addressed by using the flexibility that the law provides the Federal Reserve Board, with prompting by the Financial Stability Oversight Council to lift the thresholds for some of these standards?  

Regional banks differences. Deron Smithy, Treasurer of the Regions Bank Group, a $120 billion bank based in Birmingham, Ala., said the hearing is addressing issues “of critical importance” to his bank. “Regional banks fund ourselves primarily through core deposits and we loan those deposits back into our communities, where we are important sources of credit to small and medium-sized firms and we compete against banks of all sizes in our markets,” he said. Smithy stressed that regional banks are not complex, saying they “don’t engage in significant trading or international activities, make markets in securities, or have meaningful interconnections with other financial firms,” in describing why regional banks should not be designated systemically important financial institutions (SIFIs). 

 

Smithy talked about the tailoring that currently exists alongside the $50 billion threshold, saying “with an automatic threshold, the tailoring operates only as a one-way ratchet up. Because the threshold for more stringent rules exists as a floor, it separates regional banks from many of their peers and competitors, while occasionally adding new requirements for the most complex firms.”

  

Smithy listed differences between regional banks and the eight U.S. bank holding companies that are global SIFIs.

• Regional banks are more likely to engage in traditional lending.
• Regional banks have a loan-to-deposit ratio of 88 percent and net loans and leases represent 65 percent of assets compared to 61 percent and 25 percent for the global SIFIs.
• Regional banks are less complex. Their broker-dealer assets account for less than 1 percent of total firm assets compared to close to 20 percent for the global SIFIs.  
• Regional banks are U.S. institutions. Less than 1 percent of their deposits and loans are outside the United States, while the corresponding numbers are 28 percent and 18 percent for the global SIFIs.

Increased number of compliance employees. Mike Rounds (R-SD), committee member, responded to news that Smithy’s bank employs more compliance employees than commercial lending employees with the following statement: “When a bank is forced to hire more compliance officers or retain more capital it makes fewer loans, this means that there is less money available for small business owners to start or expand their businesses.”

 

Tailored approach. In his testimony, Oliver Ireland, a financial services lawyer and former Associate General Counsel for the Fed, where he helped establish policies and write rules designed to reduce systemic risk in the financial system and for consumer protection, said that “Section 165 is clearly designed to apply to large, interconnected banking organizations whose failure could threaten the financial stability of the United States.” He stated that other provisions of Dodd-Frank, and other regulatory requirements, including the Volcker Rule and the requirement to use the advanced approaches method in capital calculations, “also provide for varying standards based on thresholds tied to the size of the institution or the size of the activity.” 

 

Ireland said that globally, supervisors are increasingly focused on a broader, more nuanced array of systemic risk measurements rather than just an institution’s size. He gave the example of the Basel Committee on Banking Supervision, which has presented five principal factors for identifying global systemically important banking organizations. These factors include: 

• size (total exposures instead of total consolidated assets);
• interconnectedness;
• substitutability;
• cross-jurisdictional activity; and 
• complexity. 

Ireland said that the BCBS systemic risk factors could be tailored to the U.S. economy, and used to identify banking organizations that pose systemic risks to the United States.

 

Total exposure v. total assets. Simon Johnson, a professor at the MIT Sloan school of Management and co-founder of The Baseline Scenario, also testified for the committee. Johnson said that since 2010, the Fed has not applied one set of standards to all banks with assets over $50 billion, instead, differentiating substantially depending on size, business model, complexity, and opaqueness. He said the differentiation, seems “sensible and reasonably robust.” However, Johnson said the Fed failed to protect consumers in the run-up to the financial crisis, and said these failures were “not due to lack of resources or an unawareness of the changes happening within the financial system.” Johnson said there was a “deliberate strategy of noninterference, along with many instances of actually encouraging various forms of deregulation” and that this resulted in “increased levels of systemic risk.” 

 

According to Johnson, a better measure of potential importance to the financial system as a whole is “total exposure” of a bank holding company, as defined in the Systemic Risk Report form. Johnson said this requires a bank to “report both its on-balance sheet and off-balance sheet activities, including derivatives exposures and credit card commitments, in a comparable way.” The Systemic Risk Reports suggest that at all size levels “it would be sensible to think of bank holding company size more in terms of total exposure (on-balance sheet plus off-balance sheet) as defined in that report, rather than the more narrow measure of total consolidated assets.”

 

Task force recommendations. Mark Olson, Co-Chair, Bipartisan Policy Center Financial Regulatory Reform, testified about his experience as the co-chair of the Bipartisan Policy Center (BPC) Financial Regulatory Reform Initiative’s Regulatory Architecture Task Force. According to Olson, his task force’s recommendations include raising the threshold from $50 billion to $250 billion, “while giving regulators more flexibility to determine whether or not an institution should be subject to more rigorous oversight.” Olson said his task force “found little support for the idea that the current asset threshold, set at $50 billion and not indexed for any future growth, was an ideal solution to the real issues it was meant to address.” 

 

The task force recommendations, according to Olson include the following two elements.

1. Raising the bank SIFI threshold to focus on bank holding companies that are more likely to be systemically important. The task force suggested raising the threshold from $50 billion to $250 billion.
2. Moving from a binary, “solid-line” threshold to a presumptive, “dashed-line” threshold that allows regulators to have more discretion in applying requirements based on other appropriate risk factors.

Olson said the advantages of these recommendations include making the threshold level less arbitrary by making it presumptive. Additionally, he said the threshold would be less likely to capture institutions that pose little systemic risk, and that it would focus scarce regulatory resources where they are most needed.


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Who knows what banks lurk in the shadow?

By J. Preston Carter, J.D., LL.M.

The U.S. financial system is unique in that its evolution has resulted in a shadow banking system of considerable scale and institutional diversity, explained Dennis Lockhart, president and chief executive officer of the Federal Reserve Bank of Atlanta. Shadow banking, which Lockhart defined as “financial services providers and credit intermediaries that operate without a bank charter,” accounts for roughly 40 percent of credit intermediation. Firms that could be classified as shadow banks include money market mutual funds, broker/dealers, nonbank finance companies, business development corporations, hedge funds, pension funds, and peer-to-peer online lending platforms.

However, while the banking system and shadow banking system compete directly for similar business and serve similar functions, nonbanks are much less regulated than banks, and that regulation is largely not prudential in character, warned Lockhart at the Georgia Law Review symposium at the University of Georgia. He explained why he believes market discipline may not be enough and why “Selective supervision and regulation [of shadow banking] is both possible and desirable.”

Market discipline. While the liabilities of the shadow banking system come predominantly from professionally managed money sources, and the spread of firms and activities classified as shadow banks or shadow banking may mitigate the risk of massive concentrations, “shadow banking activity is large, growing, and opaque.”

“A robust regime of monitoring is justified, in my opinion, because of the natural tendency in our economic system for activity to migrate to where it is least regulated,” said Lockhart. “I also do not believe we have to choose between complete exemption from prudential regulation and a wholesale extension of the existing framework of regulation developed for banks.”

Selective supervision. As a result, Lockhart suggests close monitoring with selective supervision by variably monitoring and supervising institutions and activities in the shadow banking system. The concept of differential supervision also is applicable among traditional banks. “The approach recognizes significant distinctions between larger banks and community banks. I expect continuing refinement of supervisory methods along this line,” said Lockhart.

The “true north” of any expansion of the regulatory overlay on shadow banking should be to protect the financial system's ability to support the general economy, Lockhart concluded.

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Senate Banking Committee considers whether $50 billion threshold is one-size-fits-all

By Stephanie K. Mann, J.D.

The Senate Banking Committee held a hearing on March 19, 2015, to examine the impact of the existing regulatory framework on regional banks. Under the Dodd-Frank Act, all banks with assets of $50 billion or more are subject to “enhanced prudential standards,” which can include heightened capital requirements, leverage, liquidity, concentration limits, short-term debt limits, enhanced disclosures, risk management, and resolution planning.

Opening statements. Chairman Richard Shelby (R-Ala) said that regional banks “have been placed in a regulatory framework designed for large institutions because of an arbitrary asset threshold established by the Dodd-Frank Wall Street Reform and Consumer Protection Act.” Shelby expressed concern about the “arbitrary” $50 billion threshold. “I would like to hear from the witnesses today whether the $50 billion threshold is the appropriate and most accurate way to determine systemic risk in our banking sector.”

Ranking Member Sherrod Brown (D-Ohio) also spoke to open the hearing and stressed the importance of ensuring that prudential regulations for regional banks are crafted appropriately. He said that enhanced prudential standards are important not just to respond to the last crisis, but also to prevent the next crisis. “I agree we should not over-regulate, and so did the authors of Dodd-Frank.” Brown stated that the rules were not meant to cover just the “Too Big to Fail” banks, or the “systemically important” ones. He highlighted that the failure of a single large institution can create systemic risk, but so can multiple failures of similar small or mid-sized institutions.

Asset size a “starting point”. Thomas J. Curry, the Comptroller of the Currency, testified at the hearing regarding his agency’s experience with section 165 of the Dodd-Frank Act, and the OCC’s approach to tailoring its regulatory and supervisory expectations. Curry noted that the OCC’s role in section 165 is limited and said its only direct rulemaking authority is with respect to the company-run stress test requirements. But Curry also stated that the provisions of section 165 have a significant effect on national banks and the OCC’s supervisory oversight of those institutions.

Curry said that while “a bank’s asset size is often a starting point in our assessment of appropriate standards, it is rarely, if ever, the sole determinant.” He said the OCC’s supervisory programs are structured to allow adjustments to the supervisory oversight as a bank’s risk profile changes.

Criteria beyond asset size. Martin J. Gruenberg, Chairman of the Federal Deposit Insurance Corporation, testified that the companies that meet the $50 billion threshold for enhanced prudential standards represent a significant portion of the U.S. banking industry. According to Gruenberg, as of Dec. 31, 2014, 37 companies with combined assets of $15.7 trillion reported total assets greater than $50 billion. They owned a total of 72 FDIC-insured subsidiary banks and savings institutions, with combined assets of $11.3 trillion, which is 73 percent of total FDIC-insured institution assets.

The FDIC has developed criteria to identify community banks that included more than a strict asset size threshold according to Gruenberg. These criteria include the following:

• a ratio of loans-to-assets of at least 33 percent;
• a ratio of core deposits-to-assets of at least 50 percent; and
• a maximum of 75 offices operating in no more than two large metropolitan statistical areas and in no more than three states. 

However, Gruenberg said the FDIC does not have a similar set of criteria to identify regional banks. He described regional banks as “institutions that are much larger in asset size than a typical community bank and that tend to focus on more traditional activities and lending products.”

Compliance burden remains. Federal Reserve Board Governor Daniel K. Tarullo testified that the Fed was pursuing a tiered approach to prudential oversight in its supervisory and regulatory practices. Tarullo said the Fed has tailored its supervision of banking organizations by reference to size, business model, and systemic importance. He asked whether there is a threshold that is appropriate for mandatory application of a particular regulatory requirement, taking into account whatever discretion is given to the implementing regulatory agencies.

Tarullo did say that there are some statutory thresholds that might bear reexamination, and specified that:

1. The Dodd-Frank Act provisions related to community banks—even with tailored applications by the regulatory agencies, there still remains a level of compliance necessary at community banks.
2. The 50 billion threshold under section 165—Tarullo cited difficulty in customizing stress testing, which he said can be a challenge for banks that just hit the threshold. Additionally, Tarullo said the supervisory benefits are “relatively modest” for these financial institutions.

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CFPB policy allows consumers to publicly voice complaints

By Katalina M. Bianco, J.D.

The Consumer Financial Protection Bureau has finalized a policy that allows consumers to make public their complaints about consumer financial products and services. Consumers who submit a complaint to the CFPB now have the option of sharing their stories in the CFPB's Consumer Complaint Database.

In July 2014, the bureau proposed to expand the database to include consumers’ narratives of what happened. The CFPB said at the time that the bureau believes that sharing narratives would help spotlight specific trends and spur competition based on consumer satisfaction with the results of their complaints. The bureau also noted that consumer narratives would help other consumers seeking information on financial products and services to make informed decisions. Reviewers could use the narrative to decide for themselves if the problems experienced by other consumers would stop them from purchasing the same product or service.

Industry reacts. The proposal raised industry eyebrows, drawing strong trade group reactions, mainly opposed, to the idea of public sharing of consumer narratives. Arguments against the proposal stemmed from the belief that the narratives would be subjective, not fully verified, and could misrepresent companies and the products and services they offer, ultimately misleading consumers. Some commenters were concerned about consumer privacy, especially in light of the numerous, highly-publicized data breaches that have been ongoing.

Consumer groups, however, came out in favor of public sharing of narratives, believing that narratives would provide consumers with practical information about other consumers' experiences about financial products and services like payday lending, credit cards, mortgages, and the like. The more information for consumers, the better prepared they will be to avoid similar experiences.

Submission procedures. The bureau's final policy outlines procedures for submitting narratives. Under the policy, after a consumer submits a complaint to the CFPB, the consumer will be given a text box to describe what happened and can attach documents to the complaint. The bureau then will forward the complaint to the company for a response, provide the consumer a tracking number, and keep the consumer updated on the complaint’s status.

Safeguards. The policy has some built-in safeguards intended to protect consumers' financial privacy. For example: consumers must opt-in to share their story and can opt-out at any time; personal information will be scrubbed from the narratives; companies will be given the option to select from a set list of structured response options as a public-facing response to address the consumer complaints; and complaints must meet certain criteria to qualify for narrative publication.

Publication of narratives. Consumers can start providing their narratives, but the CFPB said it will not publish any consented-to narrative for at least 90 days after the policy’s publication in the Federal Register so as to provide companies the opportunity to familiarize themselves with the narrative system.



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Trade, consumer groups clash over CFPB mortgage servicing proposal

By Katalina M. Bianco, J.D.

Commenters are weighing in on the Consumer Financial Protection Bureau’s proposal to amend its 2013 mortgage servicing rules. The American Bankers Association and Americans for Financial Reform have submitted comment letters to the bureau and, somewhat predictably, their views on the proposal are polar opposites. The ABA argues that the proposal should be cut back, while the AFR, a coalition of national, state, and local groups advocating financial reform, contends that the proposal does not go far enough to protect consumers.

The CFPB’s proposal would amend Reg. X—Real Estate Settlement Procedures (12 CFR Part 1024) and Reg. Z—Truth in Lending (12 CFR Part 1026) to substantially broaden mortgage borrower protections for consumers who are in financial distress or in danger of losing their homes through foreclosure.

ABA comments. The ABA expressed concern that the proposal would add regulatory requirements to “an already extensive and complex regulatory framework.” The trade group pointed out that the CFPB’s servicing rules already exceed the requirements mandated by the Dodd-Frank Act. The “continued layering of detailed regulatory requirements” will continue to decrease the value of mortgage servicing for banks of all sizes, the ABA argued. “Consumers (particularly those in rural areas) will be hurt, not helped, if rulemakings result in further consolidation in the servicing industry.” The trade group said its members are reevaluating to determine how few loans they can service for servicing to remain a viable business proposition.

AFR letter. The AFR said that there are many areas not included in the proposal that should be covered, such as: requiring servicers to better meet the needs of borrowers with Limited English Proficiency; patching the gaps in the dual tracking rule by allowing applications submitted fewer than 37 days prior to sale to trigger a temporary pause in foreclosures; and requiring servicers to process appeals for all applications submitted within the dual tracking timelines. The coalition also noted that with the upcoming end to the HAMP program, the CFPB should require servicers to provide affordable loan modifications consistent with investor interests. The AFR told the bureau that the coalition believes it is within the CFPB’s authority to issue such a requirement.


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Does CFPB review of credit card markets signal changes in 2016?

By John M. Pachkowski, J.D.

The Consumer Financial Protection Bureau is taking the first steps in reviewing how the credit card market is functioning and the impact of credit card protections on consumers and issuers.

The bureau is required by the Credit Card Accountability, Responsibility, and Disclosure (CARD) Act to undertake a review of the consumer credit market every two years. The last review occurred in October 2013.

To begin its latest review, the CFPB has issued a Request for Information to solicit information from the public about a number of aspects of the consumer credit card market. Comments on the Request for Information must be received by May 18, 2015.

Some of the specific areas that the bureau is requesting information on include:

Changes in agreements & practices. How the terms of credit card agreements and practices of credit card issuers changed from its 2013 review. In particular, the bureau wants to know how card issuers may have changed their pricing, marketing, underwriting, or other practices and whether those changes have benefited or harmed consumers.

UDAP present? Information is also being sought on the extent that unfair or deceptive acts or practices still exist in the credit card market and the effects on consumers.

Collection practices. Debt collection practices within the credit card industry is another area that the CFPB is seeking comments with an emphasis on how often card issuers use third-party collection agencies and how those relationships are managed.

Rewards programs. Finally, the bureau is seeking information on how well consumers understand rewards products and whether the disclosures for these reward products are being made in a clear and transparent manner. Information is also being sought whether improvements to these disclosures may also benefit consumers.

Commenting on the Request for Information, CFPB Director Richard Cordray stated, “With today’s inquiry, the Bureau is seeking to further understand how the credit card market is working in practice and how credit card protections affect consumers and credit card issuers. As we undertake this review, the Bureau wants to ensure it understands the information that consumers, industry, advocates, and other stakeholders believe is most relevant.”

Threat to card issuers. In a note to clients, Jaret Seiberg, an analyst with Guggenheim Securities, stated “The CFPB in late 2015 will issue its second report on the CARD Act, That report is likely to set the blueprint for regulations and enforcement in 2016. This is why we see the report as a threat to card issuers.”

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Utah legislature blazes a trail by passing “White Collar Crime Registry”

By Thomas G. Wolfe, J.D.

Both the Utah House and the Utah Senate recently passed the “White Collar Crime Offender Registry,” and the measure appears to be the first of its type in the United States. Just the name of the legislation brings to mind other types of registries—a sex offender registry, for example. Might that similar function have been sought by the Utah legislature in passing the White Collar Crime Offender Registry? In other words, in addition to seeking to prevent future white-collar crimes and to alert potential victims to be wary of those named on the registry, it seems as though the Utah legislature is communicating, at least in part, that the names of convicted white-collar perpetrators—including corporate executives, attorneys, accountants, and other financial services professionals—should be highlighted in a public register, despite the power, privilege, and/or affluence they might otherwise have possessed in the community?

Moving to Utah’s White Collar Crime Offender Registry itself (Utah H.B. 378), offenses under the Utah Code that are considered “registerable” include: money laundering; mortgage fraud; securities fraud; unlawful dealing of property by a fiduciary; fraudulent insurance; theft by deception; and communications fraud. Notably, the Utah attorney general is authorized to develop, operate, and maintain the Utah White Collar Crime Offender Registry website and to provide the manner and process by which information is disseminated to the public, including the type of information that will be provided. Moreover, the Utah attorney general has rulemaking authority to implement the Registry.

Further, the legislation contains provisions addressing the duration of time offenders must remain on the Registry, and sets forth procedures by which an offender may be removed from the Registry.

The White Collar Crime Offender Registry was chiefly sponsored by Mike K. McKell in the Utah House and was co-sponsored by Curtis S. Bramble of the Utah Senate. Now that the legislation has passed both state chambers, Utah Governor Gary Herbert is expected to sign it soon. A statement  by a spokesperson for Herbert indicates that the Governor supports the Registry.

Assuming the legislation is enacted, some additional queries come to mind. For example, will the Registry be effective as a deterrent to prevent future white-collar crimes? Will other states follow Utah’s lead and produce their own white-collar crime offender registries? Stay tuned.

Body shop's motor vehicle lien fails to make the race

By Lisa M. Goolik, J.D.

In accordance with Ohio law, a body shop’s common law artisan lien in a debtor’s motor vehicle was not superior to a competing creditor’s perfected security interest that was noted on the vehicle’s certificate of title. In Citizens Banking Company v. Ott’s Body Shop, 2015 Ohio 906, the Court of Appeals of Ohio has concluded artisan liens related to motor vehicles are expressly exempt from the application of the rules of priority.

Background. In December 2007, the debtor took his 1970 Pontiac GTO to Ott’s Body Shop to have the vintage motor vehicle repaired and restored. In connection with the restoration, Citizens loaned money to the debtor with the vehicle serving as collateral. Ott’s performed various work upon the vehicle for which it invoiced the debtor for approximately $15,000, of which $11,000 remained unpaid.

In July 2011, Citizens’ interest in the vehicle was formally recorded on the vehicle’s certificate of title, thereby perfecting the security interest in the event of competing order of priority disputes. The debtor ultimately breached his agreement with Citizens, and Citizens obtained a judgment against the debtor for approximately $80,000.

Citizens later filed a complaint for replevin of the subject vehicle, requesting a court order awarding possession of the vehicle to Citizens based upon its security interest perfected in 2011. Ott’s filed an appearance and a competing motion for possession of the subject vehicle.

The trial court held that Citizens’ recorded security interest on the certificate of title was superior to Ott’s common law artisan lien, and Ott’s appealed. Ott’s argued its non-filed common-law artisan lien should be found superior to Citizens’ filed security interest because the final work performed on the vehicle by Ott’s was completed several months prior to the July 27, 2011, filing and perfection of the opposing creditor security interest.

Authentication. According to the Ohio appellate court, Ohio law expressly provides that artisan liens connected to motor vehicles are specifically excluded from application of the Uniform Commercial Code. As such, Ott’s common-law artisan lien did not constitute a recognized competing UCC lien that would entitle the lien to UCC order of priority consideration, said the court. Thus, the timing of the lien’s perfection had no impact on the priority of the liens.

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Deutsche Bank, Santander fail Fed capital review; Bank of America must revise its plan

By Lisa M. Goolik, J.D.

Of the 31 bank holding companies that participated in the Federal Reserve Board’s latest Comprehensive Capital Analysis and Review, only two received a failing grade—Deutsche Bank Trust Corporation and Santander Holdings USA. Bank of America Corporation, which received a conditional non-objection, will need to revise its plan to address capital planning process weaknesses. The Fed commented that the participating BHCs have substantially higher levels of capital than when stress testing began in 2009, and the 29 BHCs whose capital plans did not draw Fed objections, including BofA, will be able to proceed with planned capital distributions, such as dividends and stock purchases.

According to the report, the BHC’s aggregate common equity capital ratio has more than doubled since 2009, rising from 5.5 to 12.5, as common equity capital rose during the period to $1.1 trillion—an increase of more than $641 billion. The participating BHCs projected that their capital will continue to rise for another year.

Santander Holdings. The Fed found “widespread and critical deficiencies” across Santander’s capital planning process. Deficiencies were identified in the following areas: governance, internal controls, risk identification and management, management information systems, and the assumptions and analysis supporting the BHC’s capital planning processes. Santander already is subject to an agreement with the Fed under which it and its subsidiaries are prohibited from any capital distributions without the Fed’s prior approval.

Deutsche Bank. According to the Fed, Deutsche Bank’s plan suffers from “numerous and significant deficiencies” affecting the BHC’s ability to identify, measure, and aggregate risks; its loss and revenue projection processes; and its internal controls. 

Deutsche Bank responded that this was the first time that Deutsche Bank Trust Corporation had participated in the CCAR, and it is "committed to strengthening and enhancing its capital planning process."

Bank of America. The Fed identified deficiencies in the loss and revenue modeling and internal controls aspects of BofA’s capital planning process. Unless the deficiencies are corrected in a revised capital plan to be submitted by Sept. 30, 2015, the Fed may object to the plan and restrict BofA’s capital distributions.

Planned capital distributions. Several of the participating BHCs have already announced plans for stock buy-backs and dividends, including:

• Goldman Sachs plans to increase its quarterly dividend by five cents per share and repurchase some shares, and it also may issue or redeem other capital securities. 
• JPMorgan Chase intends to increase its dividend by four cents per share and buy back $6.4 billion of shares through the end of next June. 
• Morgan Stanley announced a five-cent-per-share dividend increase and a plan to repurchase up to $3.1 billion in common stock over the next five quarters. 
• Bank of America said it will buy back up to $4 billion in common stock while maintaining its current dividend. 

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CFPB report jumpstarts debate on pros/cons of arbitration clauses

By Katalina M. Bianco, J.D.

A report detailing the findings of a Consumer Financial Protection Bureau study of pre-dispute arbitration clauses has become the latest bureau hot topic. Trade groups and consumer groups have weighed in on the subject of arbitration, and predictable lines have been drawn with banking associations thus far backing arbitration and consumer organizations taking the opposite stance.

CFPB report to Congress. The bureau’s report to Congress indicated that arbitration clauses restrict consumers’ relief for disputes with financial service providers by limiting class actions. The bureau found that in the consumer finance markets covered in the study, very few consumers individually seek relief through arbitration or the federal courts, while millions of consumers are eligible for relief each year through class action settlements.

The report uses “a careful analysis of empirical evidence, including consumer contracts and court data, to understand the resolution of consumer finance disputes – both in arbitration and in the courts,” according to the bureau. The study was conducted in a number of consumer markets, including credit cards and checking accounts, which the CFPB said have the largest number of consumers. In addition to determining that millions of consumers are covered by arbitration clauses, the bureau found that:

• larger numbers of consumers are eligible for financial redress through class action settlements than through arbitration or individual lawsuits; 
• arbitration clauses can act as a barrier to class actions. More than 90 percent of the arbitration agreements studied expressly prohibited class arbitrations; 
• there is no evidence that arbitration clauses lead to lower prices for consumers; and 
• three out of four consumers surveyed did not know if they were subject to an arbitration clause. 

Cordray discussion of arbitration. In remarks prepared for a March 11 field hearing on arbitration, CFPB Director Richard Cordray discussed the different views on arbitration held by supporters and opponents. “Arbitration is often described by its supporters as a “better alternative” to the court system—more convenient, more efficient, and a faster, lower-cost way of resolving disputes,” he said. “Opponents argue that arbitration clauses deprive consumers of certain legal protections available in court, may not provide a neutral or fair process, and may in fact serve to quash disputes rather than provide an alternative way to resolve them.”

Consumer groups vs. banking trade groups. Consumer groups responding to the CFPB's findings supported the bureau's conclusion. These groups, which included the Americans for Financial Reform, Center for Responsible Lending, and the Consumer Federation of America, echoed the bureau's results, expressing their belief that forced arbitration limits consumers' rights to relief. The groups disputed the notion that arbitration reduces consumer costs, an argument put forth by various trade groups.

Trade groups, such as the Consumer Bankers Association, Financial Services Roundtable, U.S. Chamber of Commerce Center for Capital Markets Competitiveness, and U.S. Chamber Institute for Legal Reform say that arbitration is indeed beneficial for consumers. Arbitration provides a quick and easy way to resolve disputes, according to the trade organizations, and is beneficial not just for consumers but for lenders.

Next steps. The Dodd-Frank Act requires the bureau to study the use of pre-dispute arbitration clauses in consumer financial markets and gives the CFPB the authority to issue regulations on the use of arbitration clauses in other consumer finance markets if the bureau finds that doing so is in the public interest and for the protection of consumers, and if the rules are consistent with the results of the bureau’s study. Cordray hinted at future action aimed at arbitration clauses, saying that the bureau is pondering what, if any, should be taken to regulate the clauses. Given the responses thus far to the bureau's findings, future CFPB action will be of interest to both industry and consumers.

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Trump Taj Mahal Casino a big loser for repeated BSA violations

By J. Preston Carter, J.D., LL.M.

The Financial Crimes Enforcement Network fined Trump Taj Mahal Casino Resort $10 million for willful and repeated violations of the Bank Secrecy Act. In addition to the civil money penalty, the consent order requires the casino to conduct periodic external audits to examine its anti-money laundering BSA compliance program and provide those audit reports to FinCEN and the casino’s board of directors.

Trump Taj Mahal admitted that it failed to implement and maintain an effective AML program, failed to report suspicious transactions, failed to properly file required currency transaction reports, and failed to keep appropriate records. Many of the violations from 2012 and 2010 were discovered in previous examinations.

“Trump Taj Mahal received many warnings about its deficiencies,” said FinCEN Director Jennifer Shasky Calvery. “Like all casinos in this country, Trump Taj Mahal has a duty to help protect our financial system from being exploited by criminals, terrorists, and other bad actors. Far from meeting these expectations, poor compliance practices, over many years, left the casino and our financial system unacceptably exposed.”

According to the consent order, Trump Taj Mahal has a long history of prior, repeated BSA violations, dating back to 2003. Additionally, in 1998, FinCEN assessed a $477,700 civil money penalty against Trump Taj Mahal for currency transaction reporting violations
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FDIC must pay for breaching failed bank’s contract obligations

By Richard A. Roth, J.D.

A provision of federal law that permits the Federal Deposit Insurance Corporation, acting as a failed bank’s receiver, to transfer the bank’s assets without any prior consent does not immunize the FDIC from damages if it breaches a contract the bank entered into before the failure, the U.S. Court of Appeals for the Ninth Circuit has decided. As a result, the FDIC is liable for damages that resulted from its breach of prior consent and right of first refusal provisions in a loan participation agreement the bank signed (Bank of Manhattan, N.A., v. FDIC).

The uncontroverted facts were that First Heritage Bank bought a 50-percent participation interest in a loan that had been made by Professional Business Bank. The purchase was subject to two conditions: Heritage could not resell the participation without PBB’s consent, and PBB had a right of first refusal if Heritage received any purchase offers.

Heritage failed less than a year later, and the FDIC took over as receiver. The FDIC sold the loan participation without honoring the conditions, in a transaction the agency conceded breached the contract. Subsequently, the loan borrower defaulted; PBB sued the borrower; the FDIC’s buyer sued PBB; and PBB both counterclaimed against the buyer and sued the FDIC for breach of contract.

The FDIC asserted that the Financial Institutions Reform, Recovery, and Enforcement Act provisions on how it could dispose of a failed bank’s assets preempted PBB’s breach of contract claims. Specifically, the authority to “transfer any asset or liability of the institution in default . . . without any approval, assignment, or consent” (12 U.S.C. §1821(d)(2)) immunized it from any claims for doing so, the agency asserted.

State law v. contract law. In analyzing whether FIRREA preempts the contract law claims, the appellate court first examined the effect of an earlier Ninth Circuit decision, Sahni v. American Diversified Partners, 83 F.3d 1054 (1996). The court summarized that opinion as deciding that FIRREA preempted a California statute requiring the prior consent of all general partners before a sale of all of the partnership’s assets. However, since Sahni dealt with statutory limits rather than contractual limits, the precedent was inapposite, the court said.

Prereceivership contracts. The court preferred, instead, to rely on a different precedent, Sharpe v. FDIC, 126 F.3d 1147 (1997). The Ninth Circuit panel in that case decided that 12 U.S.C. §1821(d) governed the FDIC’s authority to transfer assets, but 12 U.S.C. §1821(e) governed the results of those transfers. The latter subsection allows the FDIC to repudiate prereceivership contracts and pay only compensatory damages. According to Sharpe, if the FDIC does not properly repudiate a contract, it is liable for breach of contract damages, the appellate court said.

In other words, when dealing with a receivership asset that is affected by prereceivership contract limits, the FDIC has two options. It can repudiate the contract, transfer the asset, and pay only compensatory damages, or it can breach the contract and become liable for breach of contract damages.

If the FDIC could breach the contract and be immune from damages for the breach, it would have powers greater than the failed bank had, the court said. That was contrary to FIRREA’s receivership provisions, under which the agency succeeded only to the failed bank’s powers. An opinion by the U.S. Court of Appeals for the District of Columbia Circuit, Waterview Management Co. v. FDIC, 105 F.3d 696 (1997), reached the same conclusion, the court added.

Dissenting opinion. A dissent by Circuit Judge Rawlinson argued that there is no difference in principle between preempting a cause of action based on state statutes and one based on state common law. This meant the majority opinion was incorrect in saying that Sahni was inapposite.

Sharpe, on the other hand, was not applicable, the dissenter argued. Sharpe involved persons who had fully performed a contract with a bank that was declared to be insolvent on the same day the bank attempted, and failed, to pay what it owed under the prereceivership contract. That completed performance made a difference, he said.

Effect of decision. As Judge Rawlinson’s dissent points out, the majority opinion has the potential to interfere with the efficient resolution of failed banks by allowing more suits against the FDIC. However, this danger could be avoided if the agency repudiates contracts before taking actions that are inconsistent with those contracts.

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Stress test results show largest banks improving their capital strength

By Stephanie K. Mann, J.D.

The ability of the largest financial institutions to persist through a potential future recession continues to strengthen, says the latest stress tests results released by the Federal Reserve Board. On March 5, 2015, the Fed released the “Dodd-Frank Act Stress Test 2015: Supervisory Stress Test Methodology and Results,” which includes hypothetical scenarios to project loan losses. The 31 firms tested represent more than 80 percent of domestic banking assets.

As Fed Governor Daniel K. Tarullo explained, “supervisory stress tests are designed to ensure that these banks have enough capital that they could continue to lend to American businesses and households even in a severe economic downturn.” The severely adverse scenario projected that loan losses would total $340 billion during the nine quarters tested. This is an improvement over the first year of testing, in 2009, where aggregate tier 1 common capital ratio was 5.5 percent as measured.

Background. Large, complex bank holding companies are required to have sufficient capital to continue lending to support real economic activity while meeting their financial obligations, even under stressful economic conditions. Stress testing is one tool that helps bank supervisors measure whether a BHC has enough capital to support its operations throughout periods of stress. "Higher capital levels at large banks increase the resiliency of our financial system," said Tarullo.

Severely adverse scenario. The most severely adverse scenario shows a deep recession with an unemployment rate of 10 percent, a decline in home prices of 25 percent, a stock market drop of nearly 60 percent, and a rise in market volatility. Projections include:

• loan losses would total $340 billion;
• aggregate tier 1 common capital ratio would fall from an actual 11.9 percent in the third quarter of 2014 to a minimum level of 8.2 percent in the hypothetical stress scenario;
• $340 billion in accrual loan portfolio losses;
• $18 billion in other than temporary impairment (OTTI) and other realized securities losses;
• $103 billion in trading and/or counterparty losses at the eight BHCs with substantial trading, processing, or custodial operations; and
• $29 billion in additional losses from items such as loans booked under the fair-value option.

By comparison, in 2014, projected loan losses were $366 billion and aggregate tier 1 common capital ratio was projected to fall from an actual 11.5 percent in the third quarter of 2013 to the minimum level of 7.6 percent.

Adverse scenario. The adverse scenario features a more moderate recession, but a rapid increase in short- and long-term interest rates. Results showed that aggregate tier 1 common capital ratio of all 31 firms would fall from an actual 11.9 percent in the third quarter of 2014 to the minimum level of 10.8 percent. Results included:

• $235 billion in accrual loan losses;
• $9 billion in OTTI and other realized securities losses;
• $55 billion in losses from the global market shock and the largest counterparty default components; and
• $16 billion in additional losses from items such as loans booked under the fair-value option.

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Cure for the winter blues: Fed reports sunny economic conditions

By Lisa M. Goolik, J.D.

While much of the United States was mired in the relentless cold and snow of a particularly brutal winter, there was one sunny forecast published this week—the Federal Reserve Board’s Beige Book, which reported that economic activity continued to expand across most regions and sectors from early January through mid-February. The winter weather had some impact on economic conditions, most notably on consumer spending, tourism, and construction.

Banking and financial services. According to the Fed, banking conditions were mostly positive across the districts. Overall loan demand increased in all reporting districts, with the exception of Kansas City. Demand for commercial real estate loans was strong in Atlanta, Cleveland, and Philadelphia, while demand increased in New York. Residential lending also was positive across the district, with bankers in Cleveland, Richmond, Chicago, and San Francisco noting an increase in refinancing activity.

In addition, across the districts, credit quality was largely unchanged or improved since the prior reporting period. While most bankers reported no change in their own lending standards, several bankers in the Richmond and St. Louis districts reported relaxed standards, and bankers in the Philadelphia, Richmond, and San Francisco districts noted that competition is lowering lending standards more generally.

Consumer spending. Most districts reported that overall consumer spending increased during the reporting period. The winter weather impacted the types of consumer goods purchased. Notably, the Boston and Cleveland districts reported increased sales of winter-related items, such as winter apparel, rock salt, and snow shovels, while the Minneapolis district noted that some apparel stores had difficulty selling winter clothing due to a relatively mild winter in December and January. 

In addition, automobile sales rose in most districts during the reporting period, which included an increased demand for trucks and SUVs in the Atlanta, Cleveland, Chicago, Kansas City, and San Francisco Districts. The New York, Cleveland, and St. Louis Districts noted higher sales of new vehicles during the reporting period, and the Philadelphia, Kansas City, and Dallas districts were optimistic about future sales.

Surprisingly, consumers braved the cold and travelled to the Eastern Seaboard during the past quarter. The Fed reported that travel and tourism improved in the New York and Philadelphia districts. Ski season tourism also grew at a brisk pace.

Employment. There was more good news on employment, with levels remaining stable or improving in most districts and across a variety of sectors. Several districts reported strong labor demand and challenges filling a variety of skilled positions. Firms in the Philadelphia district reported positive employment trends in a broad range of sectors, with the majority of hires due to economic growth rather than replacement.

In addition, some contacts reported increased wages to attract skilled workers for difficult-to-fill positions. Service sector firms in the New York district noted increasingly widespread reports of wage hikes, and Chicago reported some companies were also willing to raise rates for unskilled workers to reduce turnover. Contacts in Atlanta also reported increasing entry-level wages.

Real estate and construction. While the winter weather also impacted residential real estate conditions, commercial real estate market conditions were stable or improving. The Boston, New York, Philadelphia, and Cleveland districts partially attributed lower construction and low inventory levels to inclement weather conditions. Meanwhile, commercial vacancy rates declined in the Boston, Chicago, St. Louis, and Kansas City districts.

Manufacturing. Manufacturing generally increased since the previous survey, although the rate of growth varied across the districts and sectors. Manufacturers had generally positive outlooks going forward. Firms in Atlanta expect production levels to increase over the next three to six months, and some firms in Chicago expect steady growth in shipments for 2015. Manufacturers in Boston, Cleveland, and Richmond also reported positive outlooks.


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Waters raises objections to ‘abusive’ subpoena process

By Katalina M. Bianco, J.D.

Representative Maxine Waters (D-Calif), Ranking Member of the House Financial Services Committee, is making it clear that she has “serious concerns” about the Republican majority’s “newest effort to undermine” the Consumer Financial Protection Bureau through the GOP’s “unilateral subpoena authority.” Waters expressed her concerns in a letter to House Financial Services Committee Chair Jeb Hensarling (R-Texas).

In her letter, Waters said that she was disturbed by a new process regarding the issuance of subpoenas that affords the CFPB only two weeks to respond to requests for information “before facing the threat of an automatic, unilateral Congressional subpoena. If the Bureau’s responses do not satisfy the arbitrary demands of the majority, a subpoena will be issued.”

Waters’ letter comes as Hensarling amended oversight rules earlier this year, which now vest unilateral subpoena authority with the Committee Chair for the first time in its 150-year history. The Ranking Member noted in the letter that, “in the history of the United States Congress, there have only been three Members to exercise this type of unilateral authority, including Senator Joe McCarthy, who led investigations that are generally considered to be the most partisan, unfair and widely discredited in modern American history.” 

“It is undeniable that substantive oversight is one of the most important functions of Congress. But the coercive use of a Congressional subpoena cannot be justified in the absence of thoughtful deliberation,” Waters wrote. The lawmaker told Hensarling that Republicans have worked to “drain the staff time and resources of the CFPB by bogging it down with a constant barrage of document requests.” Within the past year, the bureau received 30 inquiries from Committee Republicans, including at least 73 separate and extensive document requests, the legislator said. “Moreover, these numbers do not include the hundreds of additional pages of documents requested by the Committee on Oversight and Government Reform, by Committees in the Senate or from individual Members,” Waters wrote.

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Cordray on Congressional hot seat amidst charges of ‘overreaching’

By Katalina M. Bianco, J.D.

The House Financial Services Committee held a full committee hearing with Consumer Financial Protection Bureau Director Richard Cordray on the bureau’s sixth semi-annual report to Congress, but the focus of Committee Chair Jeb Hensarling (R-Texas) was not on the report itself but on what he sees as the failings of the bureau.

In his opening remarks, Hensarling said that Americans are losing their financial independence as well as the protection of the rule of law because of the CFPB’s lack of accountability. He argued that the bureau is unaccountable to the president because the director can only be removed for cause. The bureau, he blasted, is fundamentally unaccountable to Congress because its funding is not subject to appropriations and unaccountable to the courts because the Dodd-Frank Act “requires courts to grant the CFPB deference regarding its interpretation of Federal consumer financial law.”

The chair further stated that the bureau’s QMs (qualified mortgages) stands for “Quitting Mortgages” because community banks find they can no longer offer mortgages to “many of their deserving customers.” He also alluded to the bureau’s stance on overdraft protection, quoting a constituent as saying, “I wish to keep my overdraft protection. I should have the right to choose.” Hensarling’s position is that “true consumer protection empowers consumers and respects their economic freedoms to make important informed choices free from government interference and fiat.”

Cordray testified on the contents of the bureau’s semi-annual report, outlining the CFPB’s efforts to achieve its mission “to stand on the side of consumers and ensure they are treated fairly in the financial marketplace.” He said the bureau is restoring people’s trust in consumer financial markets through fair rules, consistent oversight, appropriate law enforcement, and broad-based consumer engagement

The bureau director highlighted the CFPB’s accomplishments in his testimony and spoke of the bureau’s Office of Consumer Response, which has accepted more than 540,000 consumer complaints. However, the bureau director’s testimony was met with questioning by Representative Scott Tipton (R-Colo) who wanted to know about what the lawmaker termed “millions in unaccountable spending” on management consulting contracts. Cordray responded by pointing out that the bureau had to be built from the ground up over the last several years as it had started “as an agency from nothing.” He offered to meet with Tipton’s staff to provide details on the bureau’s expenditures.
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NY-area bank regulators seek greater efforts on compliance and ethics

By John M. Pachkowski, J.D.

In the past several months, New York-area regulators have taken to the stump calling on financial institutions to take greater steps to ensure that their organizations’ compliance and ethics culture are above board.

Thomas C. Baxter, Executive Vice President and General Counsel of the Federal Reserve Bank of New York, has been one of the more vocal regulators on the subject. In a series of speeches, spanning from July 2014 to February 2015, Baxter has called on banks to: harmonize organizational values with legal compliance; promote a stronger ethical culture; and to adopt tools measure their compliance programs’ effectiveness.

Harmonizing values. Speaking at a July 2014 conference on new compliance landscape, sponsored by the Risk Management Association and Debevoise & Plimpton LLP, Baxter noted, “If organizational values do not support the rules that organizations use to guide the behavior of employees, and worse, if organizational values actually conflict with those rules, the organization is headed for troubled territory.”

He observed that the disproportionate number of economic sanctions cases brought by the U.S. government involving foreign financial institutions was due to the fact that foreign banks viewed economic sanctions differently than U.S. financial institutions. He noted, While U.S institutions generally understood that economic sanctions were narrowly tailored to accomplish a public purpose, the foreign financial institutions “looked at economic sanctions as technical ‘American’ rules that were not seen as consistent with the organization’s larger value system.” Baxter added that the foreign financial institutions “saw the situation as providing financial services to a country; not to a country committing genocide; not to a country building a nuclear weapon; and not to a country fostering an offensive ideology. This failure to correlate the rule with the value is the root of real mischief.”

During his remarks he also expressed his discomfort with a narrow exception the bribery prohibition found in the Foreign Corrupt Practices Act. From Baxter’s perspective, the narrow exception for “facilitating or expediting payments made in furtherance of routine governmental action” allows a certain limited form of governmental corruption. Baxter remarked, “While I understand that the exception is grounded in a practical reality, I feel that zero tolerance for official corruption would have been a better choice.” In his view, when an organizational policy permits “some types of official corruption (and we have come up with candy coated names for this, like facilitation or expediting payments), this diminishes the efficacy of compliance rules that are directed toward stopping official corruption. Again, the best compliance cultures are formed when the rules and the organizational value system are in perfect harmony.”

Stronger ethical culture. In January 2015 remarks at the Bank of England, Baxter highlighted important features of a strong ethical culture in the financial services industry. Although Baxter strongly supports enforcement actions to address bad behavior, he questioned whether the public good would be better served if something more forward looking and complementary were done to deter future bad behavior. He also noted that firms with a service provider business model “tend to have a better culture than those firms that consider their operational model as money maker.” Baxter concluded that changing the time horizon for compensation, so as to dissuade “short termism” will be a significant feature of meaningful cultural reform.

Measuring compliance. Finally, in February 2015 remarks at Fordham Journal of Corporate Counsel & Financial Law Symposium in New York City, Baxter noted the lack of a well-accepted measure of effectiveness of a company’s compliance program. One measure some companies use assess the effectiveness of compliance programs, according to Baxter, is the Program Effectiveness Index (PEI). PEI shows that companies combining their ethics and compliance programs tend to have better PEI scores. This is because ethics programs help to create a culture that is not only conducive to following rules that are embedded in law and regulation, but also conducive to compliance with company mores.
Baxter also addressed the sometime adversarial climate that exists between compliance officers and business leaders that own the risk. He suggested:

• embedding ethics and compliance issues in the disciplines that are more typical of governance issues involving the board of directors, like strategy, business goals, and risk management, all of which touch ethics and compliance; or 
• creating escalation pathways to the board of directors for resolving conflicts between the chief ethics and compliance officer and a senior business leader.

Stronger individual accountability. At the state level, New York Superintendent of Financial Services Benjamin Lawsky said the Department of Financial Services (DFS) is considering making senior executives personally attest to the adequacy and robustness of anti-money laundering (AML) systems. In prepared remarks at Columbia Law School, the Lawsky also stressed the need to hold individuals, not just corporations, accountable for misconduct.

Acknowledging that self-reporting by firms to gauge AML compliance is a “whack-a-mole” approach, Lawsky suggested taking a page from the Sarbanes-Oxley Act and require senior executives to personally attest to their AML systems’ effectiveness.

Another area where more individual accountability is needed is fraud. Many Americans have been “deeply disappointed” by efforts to hold individual, senior executives on Wall Street accountable for misconduct. It’s unsurprising that we continue to see fraud after fraud, said the regulator, because the individuals who engaged in wrongdoing rarely, if ever, face any real consequences.

Even if the misconduct doesn’t rise to the level of criminal fraud, regulators still have options, Lawsky said. In civil enforcement actions, the agency required the CEO of BNP Paribas and the chairman of Ocwen Financial to step down. The agency has also banned multiple senior executives from participating in the operations of regulated institutions.

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Foreclosing banks’ deficiency actions against guarantors not ‘guaranteed’ in NC

By Thomas G. Wolfe

A recent opinion by the North Carolina Court of Appeals shakes things up a bit for banks or lenders that initiate foreclosure proceedings on real property in North Carolina, purchase that property at a foreclosure sale, and then seek to obtain a deficiency judgment against a guarantor of the underlying loan. Of course, this scenario is more likely to occur for creditors where the prospect of actually recovering any deficiency amount against the borrower-mortgagor is bleak, the prospect of at least a partial recovery against a guarantor looks more promising, and/or some other policy consideration is taken into account.

Turning to the court’s Feb. 17, 2015, decision in Branch Banking and Trust Company v. Smith, the North Carolina Court of Appeals was called upon to review the North Carolina law (N.C. Gen. Stat. §45-21.36) making available a statutory defense or offset to certain loan obligors in a deficiency action in which the foreclosing creditor has purchased its collateral—the real property—at a foreclosure sale.

As observed by the court, after a foreclosure sale in North Carolina, the amount of the outstanding debt is deemed to be reduced by the amount of the net proceeds realized from the sale. However, this general rule is displaced by Section 45-21.36 in situations where the foreclosing creditor itself ends up buying the real property as its collateral at the foreclosure sale.

More specifically, Section 45-21.36 provides that where the foreclosing creditor purchases the property and subsequently sues to collect the amount of deficiency, certain obligors may, as a matter of defense, demonstrate that the collateral “was fairly worth the amount of the debt.” In turn, this showing would successfully defeat the deficiency judgment against the obligor. Alternatively, the statute provides that the obligor may, by way of offset, show that the creditor’s winning foreclosure bid was “substantially less than the collateral’s true value.” Consequently, a successful showing along these lines would “offset any deficiency judgment” against the obligor.

What is particularly notable in the Branch Banking and Trust Company case is that the bank sought a deficiency judgment against the guarantors of the bank’s loan for a real estate project. Previously, the borrower-mortgagor, a limited liability company, had been dismissed from the case. Over $1.4 million of outstanding debt was due on the bank’s loan, and the bank purchased the property at the foreclosure sale for $800,000. Consequently, after the net proceeds from the foreclosure sale were applied, there was a remaining deficiency of approximately $700,000. The state trial court granted summary judgment to Branch Banking and Trust against all eight guarantors of the loan for the deficiency.

However, one of the eight guarantors, Mounib Aoun, appealed the amount of the judgment entered against him—approximately $502,310. Essentially, on appeal, Aoun contended that summary judgment in favor of the bank was inappropriate because there was an issue of fact as to whether he was entitled to the defense or offset afforded by Section 45-21.36. Among other things, the court record revealed that there was some evidence tending to show that the bank had ordered an appraisal of the property. The appraisal, apparently dated about five months prior to the foreclosure sale, reportedly indicated that the property at issue was worth over $2.1 million.

In response, Branch Banking and Trust Company argued that Aoun could not invoke the right of defense or offset made available by the North Carolina statute because, as a guarantor, Aoun did not have any “property interest” in the mortgaged property. The only party that had a property interest was the borrower-mortgagor, and it had been dismissed from the case, the bank maintained.

Moreover, the bank argued that even if Aoun conceivably could be considered to have any right to a defense or setoff under Section 45-21.36 as a guarantor, he had waived that right when he signed the guaranty agreement or waived it via the court proceedings. Ultimately, the North Carolina Court of Appeals rejected these arguments by the bank.

In reversing the judgment of the state trial court and remanding the matter, the appellate court determined that Aoun had a right as a guarantor to invoke the North Carolina statute even though the borrower-mortgagor was dismissed from the action. The appellate court determined that the loan guarantor presented sufficient evidence to create a genuine issue of material fact that the real property either was worth more than the amount of the outstanding $1.4 million loan debt, or was worth more than the $800,000 the lending bank paid to purchase the property at the foreclosure sale. The court determined that while Aoun might not be able satisfy the required evidentiary showing, he should be given the opportunity to do so.

Another interesting thing about the decision in the Branch Banking and Trust Company case is that the North Carolina Court of Appeals acknowledged that many of its prior rulings from the modern era “appear to support the position of the Bank that the G.S. 45-21.36 defense/offset is not available to a mere guarantor.” Yet, the court ruled otherwise. Why?

Part of the answer resides in the fact that the appellate court relied heavily on a 1938 decision by the North Carolina Supreme Court, stating, “We are compelled…by our Supreme Court’s holding in Virginia Trust Company v. Dunlop, 214 N.C. 196, 198 S.E. 645 (1938) to conclude that Appellant, though merely a guarantor, is entitled to the G.S. 45-21.36 defense/offset, even where the [borrower-mortgagor] has been dismissed from the action.”

The bank argued that the North Carolina Supreme Court’s 1938 opinion in Dunlop did not make a “clear and unequivocal” ruling about whether the right to a defense or offset under Section 45-21.36 was available to a guarantor. However, that argument did not prevail. The North Carolina appellate court stressed that “though Dunlop contains dicta which might seem equivocal to the modern reader, as it was written in 1938, the holdings are clear…We are bound by this holding until our Supreme Court speaks on this issue and renders a holding contrary to that in Dunlop, notwithstanding holdings by this Court which may appear to conflict with Dunlop.”

As a result, the natural question arises: How would the North Carolina Supreme Court rule today on this issue faced by the state’s appellate court?


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