Chapman Law Review
THE FEDERAL GOVERNMENT IN THE FRINGE ECONOMY
Copyright (c) 2011 Chapman Law Review; Jim Hawkins
When most Americans need to borrow money, they turn to their local bank or credit union. For a substantial minority, around thirty million people, however, banks and credit unions never enter the picture. Instead, people who are unbanked or underbanked turn to payday lenders, pawnshops, rent-to-own stores, or auto-title lenders for loans. These businesses, commonly referred to as fringe banking companies, offer short-term loans to people who have been excluded from mainstream financial services because of poor or nonexistent credit histories or sporadic incomes.
The term “fringe banking” almost conveys the erroneous notion that these lenders are a trivial part of the economy. In fact, quite the opposite is true; payday lenders and check cashers outnumber McDonald’s restaurants and Wal-Mart stores in the United States. Some estimates indicate that one in every ten Americans borrows money from a pawnshop every year. For many Americans, alternative financial services providers represent their only access to financial services.
Despite the important role fringe creditors play in the lives of millions of Americans, the federal agencies that regulate consumer credit have paid little attention to these lenders. Indeed, almost no federal laws are aimed directly at fringe banking. Although many states have implemented measures to protect consumers, the federal government has largely sat on the sidelines–until now.
The Dodd-Frank Wall Street Reform and Consumer Protection Act represents a massive overhaul of the federal government approach to financial markets generally, and a momentous sea change in the relationship between the federal government and fringe banking. One part of this legislation created the Bureau of Consumer Financial Protection (Bureau). Unlike the federal agencies before it, the Bureau presents a remarkable opportunity for the federal government to intervene in the fringe economy. For the first time ever, the federal government has empowered an agency to monitor and supervise fringe creditors, to study fringe credit markets, and to promulgate rules relating to fringe banking transactions.
This Article aims to describe and assess the effects the Bureau will have on fringe credit markets. I make two central claims. First, I argue that the Consumer Financial Protection Act (Act) gives broad, novel powers to the Bureau to regulate fringe credit. Part I describes the scope of the Bureau’s power under the Act, demonstrating how the Act covers the vast majority of fringe credit transactions. Part II surveys the substance of the Act to reveal the surprising emphasis the Act places on the Bureau governing fringe banking transactions. The scope of the Bureau’s authority coupled with its substantive mandate to confront problems in fringe credit markets signal the new power and interest the federal government has taken in the fringe economy.
Second, I argue that most of the justifications that have been offered for the Bureau regulating fringe credit are flawed. To understand why people have contended the Bureau should govern the fringe economy, I surveyed the two most important academic articles arguing in favor of the Bureau, and I conducted an empirical study to measure the frequency of the rationales for the Bureau regulating fringe credit in media, government press releases, and testimony to Congress. Part III presents the results of the study, and it assesses the different rationales for the Bureau intervening in fringe credit markets. Some important rationales, such as the idea that the Bureau is needed to make fringe credit contracts less opaque or to prevent fringe credit from causing borrowers to experience financial distress, fail to comprehend fringe banking transactions and their effects. Other rationales for the Bureau, however, represent solid opportunities for the Bureau to improve the functioning of fringe credit markets and protect consumers. For instance, the Bureau can fill the need for a nimble regulator that can stop innovative ways fringe creditors avoid existing regulation. I conclude by urging the Bureau to seize the opportunity to act and to solve real problems in the fringe economy, not problems that are merely assumed to exist without evidence.
I. The Fringe Economy and the Scope of the Consumer Financial Protection Act
For some time, legislators and commentators debated whether the Act should include pawnbrokers and payday lenders. With the possible exception of rent-to-own contracts, however, it is clear that fringe banking services to consumers are within the scope of the Act. This part outlines which parts of the statute authorize the Bureau to regulate fringe credit.
A. Coverage Generally
The Act empowers the Bureau to “regulate the offering and provision of consumer financial products or services under the federal consumer financial laws.” In determining what consumer financial products or services means, it is important to note that the Bureau only has authority over consumer financial products and services. The Act defines “consumer” as an individual or someone acting on behalf of an individual, although it does not define an individual, and limits consumer financial products or services to those “offered or provided for use by consumers primarily for personal, family, or household purposes.” In light of these definitions, a portion of fringe banking activity will not fall under the Bureau’s authority because these products are used for business purposes, not personal ones. This definition should assuage the fears of those who think that the Bureau’s regulations will prevent small businesses from accessing credit.
The definition for financial products and services reveals the lion’s share of what the Act covers. The Act offers a list of transactions that it defines as financial products or services. Most significantly, the term includes “extending credit and servicing loans, including acquiring, purchasing, selling, brokering, or other extensions of credit.” Credit is given the same expansive definition as debt is in the Fair Debt Collection Practices Act and is given a more expansive definition than in the Truth in Lending Act. Credit means “the right granted by a person to a consumer to defer payment of a debt, incur debt and defer its payment, or purchase property or services and defer payment for such purchase.”
Based on this provision alone, the bulk of fringe banking transactions fall within the scope of the Act. In payday loans, auto-title loans, secured credit cards, and pawn loans, the lender generally directly extends credit to consumers. This definition encompasses the activity of payday and auto-title lenders who act as credit service organizations and merely charge a fee for connecting customers with lenders because it includes firms that broker extensions of credit.
In some cases, the statute even specifies that fringe banking transactions are governed by the Bureau. For instance, check cashing is defined as a financial service. Also, one section empowering the Bureau to obtain reports and conduct examinations of a limited number of non-depository entities specifically gives the Bureau such powers over anyone who “offers or provides to a consumer a payday loan.” Thus, it is clear that the Act is intended to cover payday loans.
There are several groups exempted from the Act’s coverage, but in discussing these exemptions, the Act carefully specifies that fringe transactions are included under the Bureau’s power. The Act exempts tax preparers from the Bureau’s authority, but the Act excludes firms offering refund anticipation loans from this exemption. In a controversial provision, the Act exempts car dealerships, but it still includes companies commonly considered to offer car loans in the fringe economy–car dealerships that directly offer loans to customers and do not assign the loans to third parties.
It is possible that some fringe banking firms will be exempt from the Bureau’s power if the Bureau itself exempts them. The Act gives the Bureau the power to exempt any business from any provision of the Act or rule promulgated by the Bureau. The factors the Bureau must consider in exempting a category of firms include the assets of the category of firms, the volume of transactions in which the firm engages, and “existing provisions of law which are applicable to the consumer financial product or service and the extent to which such provisions provide consumers with adequate protections.” Pawnshops are the most likely possibility because they are declining in number and they are extensively regulated by every state.
Finally, the Act has built into it a mechanism to prevent lenders from circumventing regulation by disguising credit sales as sales of other products or services. Reports indicate some fringe bankers have created such schemes in attempt to avoid state interest rate limits. To prevent this strategic behavior, the Act clarifies that although the Bureau does not have authority to regulate a “merchant, retailer, or seller of any nonfinancial good or service,” this exemption
does not apply to any credit transaction or collection of debt . . . in which the credit extended significantly exceeds the market value of the nonfinancial good or service provided, or the Bureau otherwise finds that the sale of the nonfinancial good or service is done as a subterfuge, so as to evade or circumvent the provisions of this title.
B. Pawnshops as Exchange Facilitators?
One commentator has argued that the Act singles out pawnshops for a study, which would reinforce the belief that pawnshops are covered by the Act. The Act calls for a report on exchange facilitators, and the commentator argues that the report thus refers to pawnshops:
Among other kinds of fringe financial services, pawn shops as a source of temporary credit is suspected to be asset-stripping and predatory. The Bureau must conduct a study on consumers who use exchange facilitators for transactions primarily for personal, family, or household purpose to analyze the effect of these firms on consumer credit.
This is almost certainly not right. The Act’s definition of an “exchange facilitator” is a person who
facilitates, for a fee, an exchange of like kind property by entering into an agreement with a taxpayer by which the exchange facilitator acquires from the taxpayer the contractual rights to sell the taxpayer’s relinquished property and transfers a replacement property to the taxpayer as a qualified intermediary (within the meaning of Treasury Regulations section 1.1031(k)-1(g)(4)) or enters into an agreement with the taxpayer to take title to a property as an exchange accommodation titleholder (within the meaning of Revenue Procedure 2000-37) or enters into an agreement with a taxpayer to act as a qualified trustee or qualified escrow holder (within the meaning of Treasury Regulations section 1.1031(k)-1(g)(3)).
The term exchange facilitator, in both the Act’s definition and common usage within the tax community, references tax transactions where an intermediary facilitates a tax-deferred exchange under section 1031 of the Internal Revenue Code. Thus, while pawnshops are covered in the Act because they extend credit, the Act does not call for a special report on the industry.
The only fringe banking product not clearly covered by the statute is rent-to-own. Commentary has covered a wide spectrum in discussing whether rent-to-own is covered by the Act. Some reports about and analyses of the Act conclude that rent-to-own is covered by the Act. Some consumer advocates have noted it is unclear whether rent-to-own falls within the Act’s control, and some industry sources have similarly expressed concern over whether the Bureau will regulate rent-to-own.
But beyond comments made mostly in passing, there has not been a clear exposition of the Act’s coverage of rent-to-own based on the legislative history, the position taken by supporters of the Act, and the text of the statute. The following surveys the evidence from each of these categories and concludes that although the legislative history and positions taken by supporters do not give a clear indication about whether the law is intended to cover rent-to-own, the text of the statute suggests rent-to-own is not covered by the Act.
First, the legislative history is inconclusive regarding whether rent-to-own falls within the Bureau’s purview. The rent-to-own industry tried to obtain language in the Act which would have explicitly excluded rent-to-own, and this effort failed, potentially signaling that the Act includes rent-to-own. Some Senators balked at the idea of exempting rent-to-own from the Act’s coverage. On the other hand, Charles Schumer attempted to insert language into the Act to ensure the Act covered rent-to-own and failed to get this language passed into law, suggesting the opposite conclusion, that rent-to-own is not covered.
Several pieces of evidence from discussions and testimony about the Act suggest that some Senators thought rent-to-own was covered. For instance, consider this exchange between Senators Dodd and Schumer when discussing the differences between the bill the House and Senate passed:
DODD: Could we try, I’m not going to–as I said I’m not going to offer the amendment now but could we try to deal with the non-bank payday lenders and the non-bank rent to own type people who escape regulation here?
DODD: Well, we’ve raised that with the other side . . .
Testimony from people supporting the Act also assumes rent-to-own is covered. For instance, in support of an amendment to the Act regarding military families, Senator Jack Reed stated:
Rent-to-own loans. This is where you go to a shop and you say I would like to rent a TV for 30 days because you am [sic] deploying in 45 days. Then you don’t deploy so you keep it, and in some cases you end up paying two to three times the retail price of the appliance. At least individual soldiers have to be informed of those practices and know about it. We have to be sure they are getting that information . . . . That is what we want to do–coordinate these activities through a military liaison at a consumer financial protection agency. We want to do that because it is the right thing to do and because if we cannot protect the men and women who are protecting us, then we have to ask seriously whether we are doing our job. I know they are doing their job.
Of course this testimony merely represents a single Senator’s view about the law, and it is not even clear from the statement that Senator Reed believes rent-to-own is covered by the Act, as opposed to Reed believing the Act should cover rent-to-own. In the end, this testimony is like the other evidence of legislative intent–inconclusive.
With the evidence from legislative history being inconclusive, the text of the statute–the starting point for statutory interpretation — is the best guide for determining rent-to-own’s status under the Act. As is the case with many consumer protection laws, how rent-to-own is categorized will determine whether it is covered by the Act.
If rent-to-own is treated as a lease, it will almost certainly fall outside the Bureau’s authority. The Act only governs leases of personal property within the definition of a financial product or service if “the lease is on a non-operating basis . . . [and] the initial term of the lease is at least 90 days . . . .” Rent-to-own contracts are almost universally for less than 90 days, causing them to fall outside the Act. On the other hand, if rent-to-own is considered an extension of credit, it will fall within the basic definition of a financial product or service.
There is a significant debate both in courts and in academic commentary about whether rent-to-own transactions are sales on credit or leases. People who argue it is a lease focus on the fact that the consumer does not have any obligation to complete the contract but can terminate it at any time. Those who claim it is a credit sale emphasize the fact that the transaction is the functional equivalent of credit even if the form is different because the end result is people acquire ownership of a good over time and pay a premium for the good.
The Bureau could govern rent-to-own transactions either if they fall within the Act’s definition of credit or if the Bureau determines rent-to-own is a subterfuge to avoid federal consumer credit laws, like the Truth in Lending Act. The latter power is found in a provision of the definition of financial product or service which states that the Bureau can define rent-to-own as a financial product or service by rule “if the Bureau finds that such financial product or service is entered into or conducted as a subterfuge or with a purpose to evade any Federal consumer financial law.” The fact that some people consider rent-to-own a disguised credit sale might empower the Bureau to regulate it.
One way we could imagine determining whether rent-to-own is credit is by looking to state law. Different states define the transaction differently– most treating it as a lease by statute, and some considering it a credit-sale by judicial decision. Based on differences in state statutes, it is possible the Bureau would only have authority over rent-to-own transactions in states that treat the transaction as a form of credit. This, however, is unlikely because the Bureau or any court interpreting the Act will have to look to the Act’s definition of credit, not any individual state’s definition of credit. The Act sets out a definition of credit. It does not defer to states’ definitions of credit, so courts will have to analyze transactions in light of the Act’s definition regardless of state law. In similar contexts, courts look only to the federal statute’s definition of a term to determine its meaning. For example, in determining whether rent-to-own transactions are credit within the meaning of the Truth in Lending Act, courts do not consider state law but instead just evaluate the definition of credit in the Truth in Lending Act statute.
Looking instead to the Act itself, it seems unlikely rent-to-own is credit. Credit means (1) “the right granted by a person to a consumer to defer payment of a debt, incur debt and defer its payment” or (2) “the right granted by a person to . . . purchase property or services and defer payment for such purchase.” Rent-to-own agreements fall outside both of these parts of the definition. The statute does not define debt, but debt is commonly defined as an obligation to pay money arising out of a transaction. Rent-to-own-agreements do not involve taking on debt because the rental agreements obligate consumers to pay for rental periods at the start of the rental period, not the end, so the consumer generally does not owe money because of the agreement.
Additionally, rent-to-own agreements do not involve deferring payment for a purchase. Like debt, the statute does not define purchase, but in most cases purchase involves a transfer of an interest in property for money. Because payments for renting are due before the rental period begins, rent-to-own does not entail deferring payment for purchasing even the right to possess the goods during the rental period. Also, the consumer must pay in advance to actually acquire ownership of the goods, so purchasing the title of the goods is not deferred. The only way rent-to-own involves a purchase under common definitions of that term is if it is a disguised deferred purchase–i.e., the consumer really purchases title of the goods at the start of the first rental period but defers payment for the title until the end of the rental agreement.
More compelling than the definition of credit, however, is the section of definitions dealing with leases. That section sets out a specific type of lease that is a financial product or service under the Act. Under the principle of expressio unius, the fact it states one type of lease and does not state other types of leases suggests that all leases not covered by the stated definition are not financial products.
More to the point, the section covering leases is plainly aimed at lease contracts that are disguises for credit sales. The only leases covered by the Act are leases that are “the functional equivalent of purchase finance arrangements.” Thus, the statute implies that a deferred purchase that is disguised as a lease should not be considered credit but should instead be covered only if it meets the requirements of the section of leases. The Bureau merely finding that a lease is a disguise for a credit sale should not be enough for the Bureau to govern such a lease or to consider the transaction to be a subterfuge. Instead, deciding that a transaction is the functional equivalent of a credit sale merely meets one of the parts of the definition of what leases are financial products or services.
In the end, it appears that almost all fringe banking products except rent-to-own are within the Bureau’s purview. In surveying the definitions in the Act, this part has taken the first step in establishing the claim that the Act empowers the Bureau to intervene into fringe credit markets because it demonstrates the Bureau has power over fringe banking. The next part looks at the substantive rules of the Act to illustrate the impressive opportunity Congress has given the Bureau to regulate fringe credit.
II. The Consumer Financial Protection Act’s Substantial Power to Regulate Fringe Credit
This part discusses the major components of the Consumer Financial Protection Act that will affect fringe banking and reveals how the federal government will now be directly involved in the fringe economy in a substantial way. Fringe banking permeates the bill. Even beyond the components this section analyzes in depth, which all involve fringe banking, consider the following provisions which demonstrate the sustained attention the Act pays to fringe banking:
• To encourage less reliance on fringe banking services, the Act requires “[e]ach of the Federal banking agencies and the National Credit Union Administration [to] provide guidelines to financial institutions under the jurisdiction of the agency regarding the offering of low-cost remittance transfers and no-cost or low-cost basic consumer accounts, as well as agency services to remittance transfer providers.”
The following goes beyond these few examples to explain the power the substance of the Act gives to the Bureau to affect fringe banking.
A major focus of the Bureau will be research, and the Act instructs the Bureau’s Director to create a research unit. Remarkably, three of the six foci of the research unit directly relate to fringe banking, and the other three are indirectly related to it.
The first area the Act directs the research unit to study is developments in credit markets, “including market areas of alternative consumer financial products or services with high growth rates and areas of risk to consumers.” The phrase “alternative consumer financial products or services” mirrors almost exactly a common name for fringe banking: alternative financial services. While not directly stating that the unit should research fringe banking, this language and the fact fringe banking is a high growth industry that many consider a risk to consumers suggest that this agenda item for the research unit is directed at fringe banking. The other two areas the unit must research involve fringe banking customers in a much clearer way, as one directs the unit to research “access to fair and affordable credit for traditionally underserved communities,” and the other demands research about “experiences of traditionally underserved consumers, including un-banked and under-banked consumers.”
The other three areas of research do not explicitly involve only fringe banking, but they all relate to concerns people have expressed about fringe credit: disclosure and suboptimal consumer decision-making. The research unit must analyze consumers’ understanding of disclosures, awareness of risks and costs of credit, and behavior regarding financial products and services. Each of these three items has been the focus of significant academic debate about fringe banking, and so a study of any one of them is likely to involve fringe credit.
Given the preeminence of fringe banking in the Bureau’s research agenda, it is likely the Bureau will produce a significant number of reports about fringe credit and will fill in some holes in the academic literature about fringe banking. The next section outlines one source of data from which the Bureau will draw: information obtained directly from fringe banking firms through the Bureau’s supervision powers.
B. Monitoring and Supervision
Fringe banking will also be affected in a second innovation found in the Act: the Act empowers the Bureau to monitor and supervise nondepositories. These powers have the potential to dramatically increase the amount of data available about fringe banking firms, but also to impose costs on firms operating in these markets.
First, the Act mandates that the Bureau “monitor for risks to consumers in the offering or provision of consumer financial products or services.” As in other contexts, the fringe economy should play an important role in this monitoring because the Act instructs the Bureau to allocate its resources for monitoring in light of “the extent, if any, to which the risks of a consumer financial product or service may disproportionately affect traditionally underserved consumers . . . .”
This monitoring power has the potential to supply the Bureau with substantial information about the fringe economy because the Bureau can require covered entities to file special or annual reports or to submit answers to questions from the Bureau. This power to obtain information even extends to entities that are not determined to be covered by the Act; the Bureau can require firms to file annual reports so that the Bureau can assess whether they are covered by the Act.
In addition to requiring reports, the Bureau can also require fringe banking firms to register with the federal government. Registration requirements in some cases will be duplicative of the extensive state registration rules, so the Act requires the Bureau to consult with state agencies when promulgating its rules.
Second, in addition to monitoring, the Act empowers the Bureau to supervise some fringe lenders. The Act specifically empowers the Bureau to supervise just three types of lenders: (1) mortgage originators, brokers, and servicers; (2) those offering education loans; and (3) payday lenders. The specific language of the section granting supervisory power over payday lenders is broad enough to include payday lenders operating in a variety of business models because it is not limited to companies that provide payday loans–it includes anyone who even offers them. Thus, the Bureau will supervise payday lenders who operate as Credit Service Organizations that merely connect borrowers with third-party lenders.
In addition to these specific firms to be supervised, the Act sets out two general nets to catch other firms for supervision, both of which have a strong potential to bring in fringe creditors other than just payday lenders. First, the Bureau can supervise anyone who is “a larger participant of a market for other consumer financial products or services . . . .” Several large pawnbrokers, auto-title lenders, and refund anticipation lenders are large publicly held companies and could easily fall into this category. Second, the Bureau can supervise any person who “is engaging, or has engaged, in conduct that poses risks to consumers.” As Part III.C points out, many people believe fringe credit is risky for consumers, so the potential to draw in fringe lenders is substantial. The upshot of these provisions is that payday lenders will certainly be supervised by the Bureau and many other fringe lenders have a strong potential to be supervised.
Being supervised by the Bureau may require firms to produce “reports and conduct examinations on a periodic basis[;]” maintain a certain level of capital or bonds; submit to “background checks for principals, officers, directors, or key personnel[;]” and generate and maintain records so that the Bureau can perform its supervisory function. These requirements could have a variety of effects in fringe markets. For instance, if only payday lenders are supervised, it could put other fringe lenders in a better competitive position because they will be able to avoid the costs payday lenders are paying for compliance. More generally, capital requirements and substantial reporting requirements could favor larger firms and drive mom and pop shops out of business.
It would be easy to underestimate the importance of this information-gathering function. As David Skeel points out:
The power to investigate and require data may be the most important power of all. As a scholar seeking data, Warren was not a welcome presence at the office of the credit card banks. But now banks are required to open their doors and answer questions about their business practices.
This observation is especially true for fringe banking operations that have not been subject to examinations like banks but, for the first time, will have to produce significant amounts of information for the Bureau.
The Bureau’s ability to promulgate rules is the least delimited of its powers, has the least understood power, and has the greatest potential to affect businesses in the fringe economy. The Act empowers the Bureau to make rules supporting two goals: sections 1021(c)(5) and 1022(a) authorize rulemaking to enforce federal consumer protection laws, and section 1031(b) gives the Bureau the right to create rules to identify “unlawful, unfair, deceptive, or abusive acts or practices . . . .” The Bureau’s power to write new rules to enforce existing federal consumer laws might affect fringe lenders, but there is little room for surprise here as the federal consumer laws are already on the books and have been implemented by other agencies writing rules for years. The main effect of this rulemaking power will be that existing laws will be more stringently enforced.
On the other hand, the Act’s instruction to create rules to regulate “unfair, deceptive, or abusive acts” has much more potential to affect fringe lenders. None of these terms are explicitly defined by the Act. The Act does give some indication of when the Bureau can define a practice as unfair and abusive, but it gives no guidance concerning defining acts as deceptive.
The Bureau cannot define a practice as unfair “unless the Bureau has a reasonable basis to conclude that . . . the act or practice causes or is likely to cause substantial injury to consumers which is not reasonably avoidable by consumers; and such substantial injury is not outweighed by countervailing benefits to consumers or to competition.” The Bureau can only define an act as abusive if it:
(1) materially interferes with the ability of a consumer to understand a term or condition of a consumer financial product or service; or
(2) takes unreasonable advantage of —
(A) a lack of understanding on the part of the consumer of the material risks, costs, or conditions of the product or service;
(B) the inability of the consumer to protect the interests of the consumer in selecting or using a consumer financial product or service; or
In addition to this language in the Act, we have some idea of what sort of rules the Bureau will write for unfair and deceptive acts because the Federal Trade Commission (FTC) has had a similar mandate for a considerable time. The FTC Act empowers the FTC to prevent businesses from engaging in unfair or deceptive acts, and the Magnuson-Moss Warranty-Federal Trade Commission Improvement Act gives the FTC rulemaking authority. Thus, the FTC’s enforcement activities against unfair and deceptive conduct may help predict what conduct the Bureau will define as unfair and deceptive.
Like the Consumer Financial Protection Act, the FTC Act does not define unfair or deceptive and only gives guidance about how to formulate rules relating to unfair acts. In the early 1980s, the FTC issued policy statements on both unfairness and deception that are still routinely cited today. The following sections attempt to identify what unfair, deceptive, and abusive mean. Because these terms do not have specific definitions, these sections demonstrate that they give substantial power to the Bureau to regulate fringe credit markets.
i. Unfair Acts or Practices
The FTC’s policy statement on unfairness explains that an act or practice is “likely to cause substantial injury to consumers” only if the injury is a “monetary, economic, or other tangible harm” that is more than “trivial or speculative” and not subjective injuries like “embarrassment, emotional distress, etc.” In determining if consumers can reasonably avoid the injuries, the FTC looks to whether something about the act or practice unjustifiably hinders free market decision-making. Thus, in most cases where the FTC claims an act is unfair, the consumer has been tricked in some way or there will be some sort of market failure. As Jean Braucher summarizes, “The FTC has come to the initially surprising conclusion that unfairness in consumer contracts means gross inefficiency.” Under the statute and its policy statement, the FTC will only take action when the benefits of further regulation outweigh the costs to consumers and competition.
A recent case exemplifies how the FTC approaches unfairness. In F.T.C. v. IFC Credit Corp., a telecommunications company leased telecommunications equipment to consumers. The Equipment Rental Agreements contained a “hell or high water” clause which obligated the consumer to continue making rental payments even if the telecommunication services were terminated, despite the fact the services were the only purpose of the equipment. The FTC alleged that the business’ attempt to collect on the rental agreements “when they are worthless is unfair.” In deciding the issue, the court found that the practice caused a substantial injury to consumers because the cost of renting the worthless equipment was significant and because the practice affected many consumers. Furthermore, it found that the consumers could not reasonably avoid the injury, despite the fact they should have known about the hell or high water clause and had not been deceived under traditional contract law notions. The court explained:
While the consumers knew that their monthly payment was being allocated in prescribed percentages, that fact would have been meaningless to a reasonable consumer and would not have alerted the consumer of what was to come. While the ERA said that the obligation to make monthly payments was unconditional, the consumers could not have reasonably anticipated that, to use Justice Cardozo’s phrase, “the doom of mere sterility was on the [transaction] from the beginning,” and that it was a virtual certainty, not merely a possibility inherent in any comparable transaction, that its contracted for telecommunications services would cease and they would be on the hook to an assignee. Having no reason to anticipate the harm that was certain to befall them, there was no occasion for the consumers even to consider taking steps to avoid it.
Because the practice caused substantial injury that could not be avoided, it was considered unfair.
How might unfairness factor into the rules the Bureau makes concerning fringe banking products? It opens a significant number of practices up to scrutiny. It will not be difficult for the Bureau to establish that some aspects of fringe transactions cause substantial harm because even if the actual dollar amount of each harm is low, fringe banking is a common source of credit, so many consumers will be affected. Also, critics of fringe banking consider several different aspects of fringe transactions to be a result of market failures, meeting the test that consumers cannot reasonably avoid the harm.
The most likely target of rules based on unfairness is payday loan rollovers. Payday lending appears to be a high priority to the Bureau, although it is possible the Bureau will first address credit cards and mortgages. Some payday lenders think the Bureau will address payday lending first because it is low hanging fruit and an easy early win for the Bureau. In any case, given the emphasis on payday lending in the Act itself and news stories about the Act, it is highly likely the Bureau will make rules about it.
Rollovers are a probable place for the Bureau to start. “Rollover” refers to the practice of payday borrowers paying just the interest due on their loans and rolling over the principal for another loan period and thereby incurring another interest fee. Although an amendment to limit rollovers in the Act itself failed, Warren has criticized rollovers both in her academic writing and in her activities as a special advisor to President Obama; some experts have claimed that the Bureau has the power to eliminate rollovers. The Bureau could argue that rollovers are expensive for individual payday lending customers and could use evidence that rollovers are common to establish that many consumers are affected by the practice. Many people claim that consumers do not anticipate rolling over their loans when they take them out, suggesting a market failure, which implies consumers could not reasonably avoid the injury.
What effect would banning rollovers or limiting the number of rollovers have on the industry? It might significantly decrease the number of companies willing to make short term loans. The cost of originated two week loans is high, and rollovers are an important component to payday lenders’ profit models. It is possible that a complete ban on rollovers could cripple the industry.
One industry attorney, Hilary Miller, is tentatively skeptical that the Bureau could take action against payday loans under either the unfairness or deceptive prongs of the Act. Because the FTC already has had the authority to prevent unfair and deceptive acts but has never found payday lending to fall within these categories, Miller argues that the Bureau cannot use these prongs against the industry: “To my mind, this argument entirely disposes of two of the three ‘bad conduct’ badges in the Act . . . . The FTC Act and Title X of Dodd-Frank are manifestly in pari materia, and chaos would result if they were interpreted differently.”
The problem with the argument, however, is that the FTC has never affirmatively found payday lending to be fair or not deceptive. It just has not taken action either way. It is possible to read this as an affirmation of the industry, but it is more likely that the FTC has never acted because it does not have infinite resources. As Jeff Sovern has argued, the FTC lacks the resources to bring even cases it considers worthwhile. Thus, the Bureau could rule that rollovers or some other aspect of a fringe credit transaction are unfair despite the fact the FTC has never pursued a suit against this conduct on the theory that the FTC’s past actions just reflect scarce resources, not a judgment about all consumer credit practices that currently exist in the market. Moreover, because the Bureau was created out of a sense that other agencies were not actually protecting consumers, it is likely the Bureau will take a more aggressive stance than the FTC on many issues. Also, the Bureau will have a much easier time promulgating rules than the FTC. The FTC has a burdensome rulemaking procedure compared to the Bureau’s procedure, which is relatively straightforward. For instance, from 1980 to 2000, the FTC did not create a single rule related to unfair acts or practices. This difference may result in the Bureau having an easier time creating rules for fringe creditors. Finally, the language defining unfairness in the FTC Act is not exactly the same as the language in the Dodd-Frank Act, suggesting the Bureau has a new chance to define unfairness.
ii. Deceptive Acts or Practices
The second prong of rulemaking power for the Bureau–deception–is also in the FTC Act. In general, the FTC produces rules to make it easy to find particular actions deceptive. “A representation or omission is deceptive if the overall net impression created is likely to mislead consumers.” The business’ intent is unimportant, and the act does not actually have to deceive anyone–it is enough that the act is likely to deceive someone, and that the representation is material. Usually, deception cases relate to advertising claims, and the FTC has provided a non-exhaustive list of misleading or deceptive practices:
[F]alse oral or written representations, misleading price claims, sales of hazardous or systematically defective products or services without adequate disclosures, failure to disclose information regarding pyramid sales, use of bait and switch techniques, failure to perform promised services, and failure to meet warranty obligations.
Federal Trade Comm’n v. Pharmtech Research, Inc. provides an example of the FTC’s understanding of the term deceptive. In Pharmtech, the court granted a preliminary injunction preventing a business from continuing to advertise its dietary supplement. The business sold pills made of dehydrated and compressed vegetables and claimed that taking the pills reduced the risk of certain cancers because a study found that “frequent consumption of certain fruits and vegetables is associated with a reduction in the incidence of cancer in human beings, and found that carotene-rich vegetables, such as carrots, and cruciferous vegetables, such as broccoli, cabbage and Brussels sprouts, provide this benefit.” The business’ advertisements were deceptive within the meaning of the FTC Act because “they convey a misleading impression.” They implied that the study found that vegetable pills could reduce the risk of cancer when the study did not explicitly find that; in fact, the study specifically expressed doubts about whether processed vegetables could have the same salutary effects as fresh ones.
The Bureau might use this prong of its rulemaking power to require new disclosures on fringe banking products. For instance, the Bureau might require payday lenders to post information about how often borrowers rollover loans or how much an average loan costs a borrower in total, much like the requirement that credit card companies put information on credit card statements which discloses how long it would take to pay off the debt and how much money borrowers will spend in interest payments if they only make minimum monthly payments.
For the most part, such disclosure requirements will likely have little effect on fringe creditors. As discussed in Part III.A.ii, fringe credit contracts are relatively straightforward. Disclosure regimes are usually supported by mainstream fringe creditors, so such rules would probably not encounter significant opposition. However, some disclosure requirements may have unintended consequences. For instance, some states require rent-to-own stores to disclose APRs on rented goods. This requirement has resulted in rent-to-own firms exiting these states almost completely. Thus, even in promulgating disclosure requirements, the Bureau may exercise its new power in a way to significantly limit the availability of alternative financial services to consumers.
iii. Abusive Acts or Practices
Few federal agencies have powers related to abusive acts or practices, so we have the least guidance when predicting what sorts of rules the Bureau may promulgate pursuant to this power. The examples in current statutes empowering agencies to regulate abusive contracts have either been basically unused or do not parallel the Bureau’s power. For instance, the Federal Reserve has the power to find lending practices related to mortgage financing abusive. The Federal Reserve, however, rarely exercises that power, leaving us with little understanding of the term. Also, the FTC has the power to regulate abusive telemarketing acts or practices, and it has promulgated regulations under this statute, but the regulations do not provide a meaningful parallel to the Bureau’s power. The term “abusive” is not defined in the Telemarketing and Consumer Fraud and Abuse Prevention statute, but the statute and regulations give examples of abusive acts, and courts have deemed some conduct abusive under the statute. Unfortunately, however, very little of the FTC’s power in this area relates to credit, so it is difficult to extrapolate what abusive means from the regulations in this statute.
This lack of current precedent has caused some observers to worry that the Bureau will have vast power to curtail consumer lending products. One recent article in the American Banker, for instance, quotes, among other concerned parties, the president of the Consumer Bankers Association, a partner with Morrison & Foerster LLP, a partner at Covington & Burling LLP, and a partner at Goodwin Procter saying that the power to create rules under the abusive standard is “egregious,” allows the Bureau to pass any rule because the standard is “whatever the bureau director says it is,” and is likely impossible for businesses to comply with because “the term is so broad and the definition is so broad” and the standard is “very subjective.”
The language of the statute, however, suggests that the standard for abusive acts is, for the most part, very similar to the standard for deceptive acts and unfair acts. Several of the bases the Bureau can use to determine an act is abusive relate to a consumer being deceived and misunderstanding a transaction: An act is abusive if it “materially interferes with the ability of a consumer to understand” or unreasonably takes advantage of a consumer’s lack of understanding of the material risks, costs, or conditions of the product or service. Indeed, the requirements that the act “materially” interfere with the consumer’s ability to understand the transaction and that the consumer misunderstand the “material” risks of the product incorporate the court-created requirement that the deceptive act must be material to the transaction.
Similarly, the ability to declare an act abusive if the consumer cannot protect herself from harm contains almost the same language as the definition of an unfair act. The major difference is that this part of the standard for abusive conduct does not require a “substantial injury” to the consumer, potentially opening up new rulemaking for acts that cause insubstantial injury. The standard does, however, require that the transaction unreasonably take advantage of the consumer who cannot protect herself, so the Bureau cannot declare all such acts abusive. Considering the fact the Bureau will not likely concern itself with acts that cause little harm, it is not clear that the ability to declare acts abusive without substantial injury really gives the Bureau any new authority.
The only truly new part of the standard is the Bureau’s ability to declare an act abusive if it “takes unreasonable advantage of . . . the reasonable reliance by the consumer on a covered person to act in the interests of the consumer.” One commentator has suggested that businesses will be able to protect themselves from problems under this part of the standard by disclosing to consumers that they should not rely on the business to protect their interests in the transaction. Such statements have been effective to negate reliance under state consumer protection laws. In Texas, if a consumer signs a contract that states the consumer is purchasing a good or property “as is” and without reliance on the seller’s representations, the consumer cannot claim that she relied on the seller’s representations. The Texas Supreme Court explained in a seminal case that:
[The plaintiff’s] ‘as is’ agreement negates his claim that any action by Prudential caused his injury. His contractual disavowal of reliance upon any representation by Prudential was an important element of their arm’s-length transaction and is binding on Goldman unless set aside. The ‘as is’ agreement negates causation essential to recovery on all theories Goldman asserts . . . .
Thus, it is possible through effective disclosure that businesses will be able to avoid liability under this part of the abusive standard.
The fact that this prong requires the consumer’s reliance be reasonable seems to again incorporate deception into this prong. In most commercial relationships, all parties assume that the other negotiates in such a way as to obtain the maximum benefit for itself under the transaction. Thus, to create a situation in which a consumer reasonably relies on the business to act in the consumer’s interest would seem to require that the business falsely communicate to the consumer that it will act in the consumer’s interest.
Despite my analysis that the abusive power seems largely repetitive of the unfair and deceptive powers, the Bureau may construe the word very differently, as others have urged it to do. As with the unfairness prong, the abusive prong of the Bureau’s rule-making power enables it to potentially intervene into fringe credit markets in substantial, innovative ways.
Fringe banking firms will also likely be affected by enhanced enforcement of existing federal consumer protection laws. As Part III.D explains, current federal consumer law constrains fringe banking transactions. The Act increases the likelihood fringe lenders will pay penalties for violating these laws as well as any rules the Bureau creates because it gives the Bureau significant enforcement powers.
Under the Act, the Bureau can demand material and testimony if it suspects a violation of federal consumer protection law, it can issue cease and desist orders, and it can commence litigation against violators. Although it cannot seek exemplary or punitive damages, it can seek a variety of remedies, including rescission or reformation of contracts, restitution, payment of damages or other monetary relief, civil penalties, and the costs of pursuing the violator. The civil penalties are severe. For violations without recklessness, “a civil penalty may not exceed $5,000 for each day during which such violation or failure to pay continues,” but “for any person that recklessly engages in a violation of a Federal consumer financial law, a civil penalty may not exceed $25,000 for each day during which such violation continues.” If the person knowingly violates the law, “a civil penalty may not exceed $1,000,000 for each day during which such violation continues.”
Perhaps even more threatening to fringe lenders is the increase in information the Bureau will have about businesses violating federal consumer protection law. A primary function of the Bureau is “collecting, investigating, and responding to consumer complaints.” One mechanism the Bureau will have for learning about violations is a consumer hotline for complaints established by the Act. In her work establishing the Bureau, Warren has pledged to use new technologies, such as crowdsourcing, to enhance the amount of information that the Bureau gathers from consumers. After gathering this information, the Bureau will establish procedures to “provide a timely response to consumers . . . to complaints against . . . a covered person . . . .” Both the powers to gather information and to act on that information give the Bureau the power to take definite action to affect fringe lenders who violate federal rules and statutes.
E. The Act’s Relation to State Law
New federal laws and rules governing the fringe economy add to an extensive, diverse array of existing state law. In light of the fact that most fringe banking regulations currently are based in state law, this section analyzes the relationship the Act has to that important body of law and demonstrates that the Bureau will only add regulations to fringe credit markets, not take any away.
i. The Effect of Existing State Laws on Rulemaking
Several provisions in the Act suggest that the Bureau will be less involved in regulating industries that are already covered by extensive state regulation. For instance, in determining how to supervise nondepository firms like fringe bankers, the Bureau will consider “the extent to which such institutions are subject to oversight by State authorities for consumer protection.” Presumably, if transactions are heavily regulated by states, the Bureau will be disinclined to promulgate additional rules.
One problem the Bureau will encounter in following these provisions is the disparate approach states have taken to regulating fringe credit. As just one example, some states outlaw, either explicitly or implicitly, title lending, while others permit it with virtually no restraints. Thus, it is not entirely clear whether title loans are “subject to oversight by State authorities” because it depends entirely on the state. If the Bureau does not create rules on these sorts of transactions, then people in many states are left unprotected; if the Bureau does create rules, the rules may impose duplicative requirements on firms.
The Act attempts to mitigate the effects of duplicative requirements on businesses by requiring the Bureau to coordinate with state regulators. For instance, with the express goal of minimizing regulatory burden, the Bureau must coordinate its supervisory activities with state regulators, “including establishing their respective schedules for examining persons . . . and requirements regarding reports to be submitted by such persons.” Additionally, in setting capital requirements for supervised nondepositories “the Bureau shall consult with State agencies regarding requirements or systems (including coordinated or combined systems for registration), where appropriate.” Finally, the Act mandates that the Bureau coordinate with states when setting up registration requirements for all business it monitors. To the extent this coordination is successful, it will obviously reduce demands on fringe banking firms, but it is again questionable how the Bureau will be able to coordinate with states that have different requirements. While it might be simple to harmonize the federal requirements with a single state, it seems impossible to do so with several states that have different registration requirements, for example.
iii. Powers Given to State Governments
The Act actually confers some powers on state regulators. First, states can prompt the Bureau to consider proposing a rule if a majority of states enact a resolution supporting a rule. Second, in addition to clarifying that states still have the authority to enforce their own consumer protection laws, the Act empowers states to file suits in consultation with the Bureau to enforce Bureau regulations, except against national banks and federal savings associations. These provisions should increase the potential that fringe banking businesses will face enforcement actions of the Bureau’s rules–even beyond the augmentation of general enforcement powers discussed above–because state attorneys general will have a new tool to combat what they perceive to be sharp practices.
The Act specifies that it does not relieve lenders from complying with applicable state laws. The statute asserts that state laws remain in effect “except to the extent that any such provision of law is inconsistent with the provisions of this title.” State laws are not inconsistent with the Act if “the protection that such statute, regulation, order, or interpretation affords to consumers is greater than the protection provided under this title.”
Several federal statutes contain language that is similar to the Act’s language permitting states to offer consumers greater protections. In discussing these statutes, courts have used the requirement that states provide greater consumer protection to be a one-way ratchet to enforce state laws that offer heightened restrictions on businesses’ conduct; only laws that further restrict businesses are said to offer consumers greater protection.
Having a federal law that regulates fringe banking but does not preempt state law is the worst-case scenario for fringe lenders because it involves an expansion of regulatory control over their activities. Many people in the fringe banking industry have pushed for federal laws, but their purpose in doing so is to prevent less favorable state laws from limiting their activities. For example, the rent-to-own industry trade association has supported a federal law on rent-to-own called the Consumer Rental Purchase Agreement Act. This law sets out a variety of rules for rent-to-own and even includes similar language to the Consumer Financial Protection Act regarding state laws that provide greater protection for consumers. But, the bill clarifies that no state law can regulate rent-to-own as a credit sale or require businesses to disclose interest rates. These two rules have historically been of overwhelming importance to rent-to-own companies, so the passage of the bill would be a major victory because it would prevent states from enacting these disfavored regulations. The new Consumer Financial Protection Act as written, however, does not bring this benefit, it only adds restrictions onto fringe lenders’ conduct. As with the other substantive provisions on fringe banking, the sections discussing preemption reveal a profound new power the federal government now has to govern the fringe economy. The next part asks a more basic question: Is this power justified?
III. The Rationales Behind the Bureau Regulating Fringe Banking
As the previous two parts have indicated, it is difficult to predict what the Bureau will do when it begins promulgating rules and enforcing federal consumer protection laws. And, even if we knew exactly what it intended to do, it is impossible to understand all of the effects of the Bureau’s conduct before those effects play out. Thus, the primary way to assess the Bureau’s import before it begins significantly intervening in the fringe economy is to assess the rationales for the Bureau. As David Skeel points out:
We can’t really know in advance whether these costs will materialize, of course. Moreover, the answer will depend on how the Consumer Bureau pursues its regulatory mandate, which will be different at different times in the Bureau’s life. For now, the chief question is simply whether the new consumer champion is justified.
This part takes up that inquiry.
In order to assess the rationales offered for the Bureau regulating fringe credit, it is important to group different rationales into categories. This part categorizes the diverse reasons that popular press, government officials, and academics have proffered to justify the Bureau’s control over fringe banking products. To describe the rationales, I draw primarily on two of Elizabeth Warren’s articles proposing the Bureau. Although these two articles are not the only academic works advocating for the Bureau, they are significant because the President appointed Warren as a special advisor to oversee the creation of the Bureau and these two articles are widely considered the academic work that propelled the Bureau into existence.
To understand how prominent and significant these justifications were in public statements about the Bureau and its relationship to fringe banking, three research assistants and I read virtually every article that mentioned both the Bureau and fringe banking that was found in LexisNexis’ “News, All” source from January 2007, before the Bureau was proposed, to May 21, 2010, the day the President signed the Act into law. This source draws from more than 4650 news outlets across the United States and a variety of countries. The search terms we entered generated 1520 results, and we reviewed 1496 of those results.
We assessed and coded each result to record: (1) the nature of the source (news article, editorial, or government publication); (2) the extent of the coverage (provides no coverage, merely mentions the Bureau and fringe banking, merely explains the law, or offers justifications for the Bureau regulating fringe banking); and (3) the justification, if any, offered for the Bureau governing fringe banking. The coding information was imputed into a custom-designed Microsoft Excel database. Each researcher underwent a training class and received detailed written coding protocols about how to code the results, and we met periodically to ensure we were uniformly carrying out the coding protocol. I reviewed each researcher’s data to lessen the chance of a coding error.
Of the 1496 results we reviewed, 897 were unique articles, and 599 of the results repeated an earlier article verbatim. Of the 897 unique results, 539 were newspaper articles, 121 were newspaper editorials, and 237 were government documents. The government documents consisted of press releases from Congressmen and women and transcripts of hearings.
The majority of the results did not mention any arguments in favor of the Bureau regulating fringe banking. Twenty-one of the results were false positives–they were not actually about the Bureau and fringe banking. Five hundred ninety-eight of the results merely mentioned fringe banking and the Bureau or explained the Act, and thirty-eight of the results presented arguments against the Bureau regulating fringe banking. The remaining 240 results offered arguments for the Bureau regulating fringe lenders, either directly in the case of press releases, testimony at hearings, and editorials, or indirectly by reporting the views of others. For each result that coded a justification, the researcher pasted the text of the article related to the justification in a separate cell of the spreadsheet. Table 1 summarizes the results, which are discussed in more depth below:
In addition to describing the rationales offered for the Bureau’s power over fringe banking, this part evaluates whether these rationales can sensibly be applied to fringe credit products. Some of the justifications are plainly inapplicable to fringe banking transactions, while others accurately point out problems the Bureau could correct in fringe credit markets. One goal of this part is to focus regulators’ attention on the real problems the Bureau could solve in fringe markets and urge the Bureau not to act to “fix” problems that evidence has not demonstrated exist in fringe credit industries.
A central focus of those justifying the Bureau has been the confusing and deceptive consumer credit contracts that borrowers face when borrowing money. Warren has introduced a catchy phrase to sum up the problem, “tricks and traps,” that has been repeated over and over in the media. Our study of news sources regarding the creation of the Bureau found that 19 percent (n=46) of the stories provided deception as a reason the Bureau should regulate fringe credit. Some of the sources noted that payday loan documents are “incomprehensible” and hide terms in fine print, while others simply stated the Bureau will be able to prevent deceptive payday loans. This section discusses the two ways supporters of the Bureau claim credit contracts are deceptive: the terms of the contracts themselves and the credit products’ designs.
i. Tricks and Traps in Contracts
First, consumer credit contracts themselves came under fire from those seeking to establish the Bureau. Warren’s first article proposing the Bureau emphasized how credit contracts have become extremely long and complicated in order to hide unfavorable terms:
Part of the problem is that disclosure has become a way to obfuscate rather than to inform. According to the Wall Street Journal, in the early 1980s, the typical credit card contract was a page long; by the early 2000s, that contract had grown to more than 30 pages of incomprehensible text. The additional terms were not designed to make life easier for the customer. Rather, they were designed in large part to add unexpected–and unreadable–terms that favor the card companies. Mortgage-loan documents, payday-loan papers, car-loan terms, and other lending products are often equally incomprehensible.
Warren even uses a payday lending contract as an example of the sort of “devilishly complex financial undertakings” the Bureau would police. She claims that payday lenders hide “a staggering interest rate” in “the tangle of disclosures,” giving the example of one contract which only listed the interest rate in a page of disclosures and not on the fee page. In a subsequent article, Warren and her co-author, Oren Bar-Gill, point out that payday borrowers frequently know the finance charge for the loan but do not know the interest rate, presumably because it is hidden.
To evaluate whether this rationale is a persuasive basis for the Bureau regulating the fringe economy, I collected contracts from several different fringe banking transactions. Surveying the characteristics of these contracts casts serious doubt on the Bureau regulating fringe credit because of the opaque nature of its contracts.
The first contract I evaluated was a rent-to-own contract used by a regional rent-to-own company headquartered in the Midwest. Its rent-to-own agreement is two pages long, written in ten point font, and contains approximately 2000 words; 576 of those words relate to the mandatory arbitration clause. All of the costs of the transaction are written in a separate box near the top of the first page of the contract. There are several ways to evaluate the complexity of a writing, but under any of these standards, this contract seems basic. Consider the following paragraph which is written in a similar manner as the rest of the contract:
Reinstatement: If you fail to make a rental renewal payment by the renewal date, this Agreement terminates and we are entitled to the immediate return of our property. To reinstate, you must return the property to us as soon as we ask you to. Then, you can reinstate this agreement by making all payments due to us within 21 days of the renewal date if you pay weekly or within 90 days if you pay monthly. If you reinstate, we will provide you the same merchandise, or with substitute merchandise of comparable quality and conditions.
The reader can judge whether this term is comprehensible, but it seems like a significant stretch to call this contract “incomprehensible text.”
Similarly, Rent-A-Center, the nation’s largest rent-to-own company, has a contract that is two pages long, but unlike the first rent-to-own company’s contract, Rent-A-Center has a separate arbitration agreement in addition to these two pages. Like the other rental agreement I discussed, Rent-A-Center’s agreement discloses all costs on the first page of the contract and is written at a similar level of complexity. Rent-A-Center is currently rewriting its rental agreement in New York because of recent changes in the law, and the General Counsel is explicitly attempting to write the contract at a seventh grade reading level.
In addition to rent-to-own contracts, I secured a pawnshop contract from A Plus Pawn Shop, a stand-alone pawnshop located in Houston, Texas. A Plus’ contract is a double sided, half-page document. The font of the text is small, around six point font, and the entire contract contains probably 1000 words. The back page of the contract has two dense paragraphs of text. The following is the entire second paragraph:
If you pay the loan we will return the property to you in the same condition we received it. If we lose your property or if it is damaged while in our possession, we will replace it with identical or similar property or similar property of the same kind and quality or have your property restored to its condition at the time it was deposited with us. All replacements are subject to approval by the Consumer Credit Commission. Any person who possesses this payment ticket may pay us the amount due and we must give that person the pledged goods if we have not been notified in writing that this ticket has been stolen. IF THIS TICKET IS LOST OR STOLEN, YOU MUST NOTIFY US IN WRITING TO PROTECT YOUR PLEDGED GOODS. Fee for lost ticket and statement.
The contract’s front page has very little text, but instead is separated out into numerous boxes that state the amount financed, the finance charge, the APR, and a description of the pawned good, among other things.
The final contracts I obtained were from Speedy Cash, a payday lending company that originated in California and has over ninety locations. Speedy Cash has different payday loan contracts for each state in which it operates to comply with state regulations. The contract from Kansas is five pages long and has 4415 words. The Truth in Lending Act disclosures are on the first page of the contract and in separate boxes, with the APR and finance charges highlighted. The majority of the text is in ten point font, and most of it–2822 words–is an arbitration agreement. One thousand three hundred twenty of the words of the contract are definitions and various terms. In addition to payday lending, Speedy Cash also does auto-title loans. Its auto-title loan documents are similar to its payday loan contracts but they have a single additional paragraph relating to the vehicle as collateral for the loan.
These contracts certainly appear different than the contract Warren refers to in her article in Democracy arguing for the need to regulate payday lending contracts. Without a survey of every payday lender’s contract in America, it is impossible to know the extent of the conduct Warren observed, or that I report here. But, my analysis of these fringe banking contracts reveals that Warren’s observation is not ubiquitous in the payday lending industry or across fringe banking products, suggesting at least a need for more study to make the claim that payday lending contracts are misleading.
More to the point, the contract Warren discusses is already an illegal contract under the Truth in Lending Act (TILA). First, having an APR hidden in the contract violates the TILA provision requiring the APR to be more conspicuous than other disclosed terms. Additionally, an APR disclosure in a place other than the fee page does not follow the tabular format mandated by the TILA. Courts have already found at least one payday lender and one pawnshop to have violated this provision of TILA. In Turner v. E-Z Check Cashing, the payday lender’s APR disclosure was even more conspicuous than the one Warren reports because it was in a block of fee disclosures, but a court in Tennessee found it violated the TILA because “EZ’s disclosure document uses the same typesize, font, and boldness in listing the terms ‘annual percentage rate’ and ‘finance charge’ as it does in listing other terms, data, and information; thus these terms are no more conspicuous than others.” Similarly, in a case involving a contract very similar to the one Warren reports, the court held a pawn ticket violated the TILA because the term “APR” was “contained in the middle of a paragraph in the smallest print on the pawn ticket” and because “this section is similar in appearance to a section entitled ‘Customer Information’ and is less conspicuous than the section setting forth information on the vehicle used for collateral which is outlined in a box.”
Thus, we cannot justify the Bureau because of a need for additional rules for fringe banking contracts because the contracts to which Warren objects are already illegal. It is possible the Bureau’s enforcement powers are needed to enforce the existing laws to a greater extent than other existing agencies have been able to do in hopes of eliminating illegal contracts from the market, but before reaching this conclusion, at least we need more evidence of how widespread confusing terms are used in fringe credit markets.
ii. Tricks and Traps in Product Design
Another basis for the Bureau regulating fringe banking is that fringe banking transactions are designed in a way to deceive borrowers. Bar-Gill and Warren make the argument that people taking out payday loans expect to pay them off in a short period of time, but they actually have to roll the loans over repeatedly. Borrowers are overly optimistic about the likelihood they will be able to pay off the loan, Bar-Gill and Warren contend, so they underestimate the cost of the loan and the risk of nonpayment.
This rationale for regulating payday lending reflects some evidence of how people use payday loans. Studies report a significant number of people rollover their loans, ranging from the modal number of payday loans per year being one or two, an estimate that is likely too low, to customers averaging 12.5 loans a year. Similarly, a study from Tennessee found that “25% [of active title loans in the state] had been renewed one (1) time and 49% were renewed between two and nine times. Fourteen percent (14%) renewed 10 or more times.”
Critical to proving that people are tricked into rolling over their loans at a higher rate than they intended to at the start of the transaction, however, is proof that people did not anticipate rolling over their loans when they took them out. A study from economists Marianne Bertrand and Adair Morse attempts to offer proof that people make mistakes when they take out payday loans, such as rolling over loans at a rate higher than they anticipate. Bertrand and Morse provided four different types of information to different payday lending customers as they were taking out their loans. The information caused borrowers to borrow with reduced frequency than the control group, suggesting that the control group would have acted differently with more or better information about the loan product.
The problem with this study, however, is that it does not offer any conclusions about why borrowers changed their behavior, so it fails to identify any specific cognitive defect that would cause people to rollover at a higher rate than anticipated. Also, Bertrand and Morse do not report whether people anticipated rolling over their loans at a rate lower than their actual rollover activity, so we still do not have a direct answer to the central empirical question: Do borrowers underestimate the likelihood they will rollover their payday loan? Finally, even if we did have evidence payday borrowers acted overly optimistically, this rationale is inapplicable to other forms of fringe credit, like rent-to-own leases, which do not have short-term contracts, and refund anticipation loans, which only involve a single loan based on tax refunds without the possibility of rolling over the principle.
Despite these limitations, the case for intervening in payday lending markets because of mistakes people make about rollovers is slightly more persuasive than the case for deceptive contracts because at least some studies have documented high numbers of rollovers in payday lending markets. But, direct evidence of over optimism in payday lending markets simply does not exist at this point, so it is troubling to think that the Bureau would act on mere speculation about how borrowers use payday loans.
A second basis for the Bureau regulating fringe banking is the high cost involved in these transactions. Twenty-eight percent of the articles and documents we reviewed (n=68) that offered justifications for the Bureau regulating fringe credit cited the cost of fringe credit. Sources said things such as payday loans have “high,” “astronomical” and “outrageous” rates. Refund anticipation loans were claimed to be “high-cost” and involve “super-high-interest,” and sources reported that rent-to-own and payday loans rates are so high they are surprising and that fringe services are usurious. Some sources made the point just by stating the interest rate: “Exhibit A: payday loans and their just-as-evil twin, car title loans . . . . [A] typical borrower will pay $500 in interest on a $300 loan.”
Warren’s work exhibits a general concern that trusting lenders can cause consumers to pay a high price. She points to payday lending specifically as a product with abusive pricing, citing several examples of individuals who paid a lot to service payday loans, and concluding, “In total, the cost to American families of payday lending is estimated to be $4.2 billion a year” and “each year, predatory payday lending practices cost U.S. families $3.4 billion in excess fees and charges.” More significant than just pointing out the high cost of payday loans, however, is Warren’s forecast that the Bureau would allow people to get short-term, small-dollar loans for lower costs. With the Bureau in place, Warren predicted, “An older person who needed a little cash to make it until her Social Security check arrived would have a manageable loan, not one that would escalate into thousands of dollars in fees.”
The claim that fringe financial services are very expensive is undeniably true. While there may be some debate about whether these high costs are justified, no one argues that fringe banking transactions involve low or even moderate cost products. Thus, if policymakers believe price alone is a reason to prevent credit transactions, this rationale represents a strong reason for the federal government to intervene in fringe credit markets.
Yet, despite the relevance of this justification for the Bureau’s activity, it is difficult to see what the Bureau can do to affect the cost of fringe credit. The most significant barrier is the Act’s provision preventing the Bureau from setting a usury limit: “No provision of this title shall be construed as conferring authority on the Bureau to establish a usury limit applicable to an extension of credit offered or made by a covered person to a consumer, unless explicitly authorized by law.” Indeed, some reports suggest this provision was added under pressure from payday lenders.
While the Bureau may be able to limit some fees, such as late fees or fees for products bundled with loans like credit insurance, fringe bankers can easily reprice the loan with a higher interest rate to compensate for any lost revenue. There are many examples of businesses doing repricing, but one recent example from the Credit Card Accountability Responsibility and Disclosure Act of 2009 is illustrative. This act limits upfront fees for secured credit cards, a form of fringe credit lending, but in response at least one card issuer has dramatically increased the interest rate on its secured card to offset losses from lower fees. Thus, without being able to limit both pricing mechanisms, the Bureau may have trouble affecting the cost of fringe credit.
One way the Bureau may reduce the cost of credit to the poor is less direct. The Bureau is required to study mechanisms for encouraging people in the fringe economy to use mainstream financial services. It is possible the Bureau will be able to move some borrowers from fringe credit sources into mainstream credit sources that have lower costs. The FDIC has done a pilot program to encourage banks to supplant payday lenders, and the results are mixed, with payday lenders seeing the experiment as a flop and consumer advocates judging the experiment to be a success. To the extent that the Bureau can lower the cost of credit by matching borrowers with less expensive alternatives, it will add significant value to the welfare of borrowers, but it will be a long time before we know if this feat is possible.
C. Financial Distress
The potential end result of high costs and deception–financial distress–is the third justification offered for the Bureau governing fringe credit. Fifteen percent of sources we found arguing for the Bureau to regulate fringe credit (n=35) asserted that fringe banking causes financial distress. Sources described the effect fringe credit has on the entire economy, on individual borrowers who declare bankruptcy because of fringe credit, and on borrowers who are trapped in debt because of fringe credit. For instance, sources mentioned that payday lending, along with mortgages, “not only cause harm to individual consumers [but] can have a cumulative effect on our economy that is nothing short of devastating.” Testimony to Congress stated that “[o]ne in two consumers who get payday loans default within the first year, and consumers who receive these loans are twice as likely to enter bankruptcy within two years as those who seek and are denied them.” Finally, numerous sources described payday loans as a debt trap.
Warren also states plainly that payday lending causes people to experience financial ruin, noting examples of people hounded by payday lenders until they declare bankruptcy, and explaining that payday loans with individuals can impose costs on third parties:
Credit cards, subprime mortgages, and payday loans can lead to financial distress, bankruptcy, and foreclosure. Economic losses can be imposed on innocent third parties, including neighbors of foreclosed property, and widespread economic instability may affect economic growth and job prospects for millions of families that never took on a risky financial instrument.
Bankruptcy is an unlikely result for a consumer who simply pays a small fee, Bar-Gill and Warren note, but “[t]he problem lies with the substantial subset of consumers who take out multiple advances and pay the $30 fee many times over.” Things will be different under the Bureau, Warren asserts, because “[r]ollovers that can turn a simple loan into a mountain of debt would stop.”
I have argued at length in another article that this rationale for regulating fringe banking is flawed. Two major features of fringe transactions make it highly unlikely that they cause borrowers to become overindebted and experience financial distress. First, most forms of fringe credit are self-liquidating–if the borrower does not make payments on the loan, the lender sells the collateral and does not seek a deficiency from the borrower, so it is literally impossible to become overindebted because the borrower is not personally liable for the debt. Second, all forms of fringe credit involve people borrowing small amounts of principle. Unlike credit cards and mortgages, which can lead to significant amounts of debt, fringe credit transactions all involve very limited debt loads, so the effect of the transactions on the people using them and the economy as a whole is small, especially relative to other credit products. Because of the dubious link between fringe banking and financial distress, the Bureau is on shaky ground regulating fringe credit on this basis.
D. Unregulated Markets
A fourth justification offered for the Bureau regulating fringe credit markets is the claim that these markets are currently unregulated. In the results from our study of rationales for the Bureau governing fringe banking, we repeatedly found claims that fringe banking is currently unregulated. Forty-nine percent (n=118) of the results presenting arguments for the Bureau claimed that fringe banking transactions currently operate under little regulation. Some sources contended that fringe lenders have escaped regulation entirely or that they operate in the Wild West of financial services with little oversight. Other sources noted the inconsistency in state regulations that left some consumers completely unprotected, and others asserted that no federal regulator governed fringe credit before the Bureau.
Warren’s foundational articles take a much more sophisticated position, although at times in making her argument, she seems to suggest that credit markets “follow a caveat emptor model.” She points out that there are some state and federal regulations, but she posits that these regulations of credit products are insufficient because they are not structured to adapt to frequently changing credit markets and they are too diffuse–merely “a loose amalgam of common law, statutory prohibitions, and regulatory-agency oversight . . . structurally incapable of providing effective protection.” These sorts of arguments have been made by others as well, who point out that current federal regulation of credit markets fall to seven different regulators, none of whom have consumers as their central focus. Having divided missions resulted in agencies, like the Federal Reserve, neglecting consumer protection: “It never made sense to simply include consumer protection among the Fed’s other tasks, for instance, since the Fed’s primary concern is maintaining the stability of the banking system, which stands in considerable tension with consumer protection.”
The common claim that fringe banking operates in a regulatory vacuum is easy to dismiss as a faulty reason for the Bureau regulating fringe credit. In every state and under federal law, lending activity is subject to some general regulations, such as the Truth in Lending Act or the state equivalent. Moreover, for many fringe credit transactions, state statutes aimed specifically at that type of transaction govern fringe credit.
Warren’s claim that state and federal regulations are not effective at countering innovative creditor malfeasance is much more applicable to fringe banking markets. Many commentators have noted how adept fringe creditors are at avoiding restrictive regulations. The recent change in the payday lending law in Arizona provides an example. In Arizona, a specific statute enabled payday lenders to operate above the thirty-six percent usury cap in the state for ten years, but in 2010, that statute sunset, effectively making payday lending illegal. In response to the rate cap, some payday lenders are operating as they did before the sunset, but are now essentially offering payday loans disguised as auto-title loans, which remain legal in the state. Before the law even sunset, 200 payday lenders filed for licenses to operate as title lenders, and the Attorney General of Arizona believed that “a lot of people are [getting] ready by telling their customers to shift to auto-title loans, even if they don’t have a car.” Lenders can offer payday-like loans to customers with cars by extending the loan based on the person’s paycheck and taking a second-lien position on the car without ever intending to use the vehicle as collateral. If Arizona really intended to ban payday lending, it appears to have failed. To truly eliminate payday lending, the legislature will have to pass another law altering the title loan statute to prevent the conduct described here.
The Bureau, however, will be able to learn about and act on subterfuge more quickly than a legislative body. Instead of going through the complex steps to pass a law and have it approved by the executive branch, the Bureau will be able to make rules to clarify the consumer protection laws and rules it enforces. If the Arizona situation had happened under the Bureau’s watch, the Bureau could have drafted a rule that prevents lenders from taking a second lien position on the title loan or making a title loan to someone without a vehicle. Although the rulemaking process may take some time, the Bureau would be much more nimble and able to respond to problematic practices. Given the penchant some fringe creditors have shown for evading regulation, the Bureau has an important opportunity to ensure lenders actually comply with federal regulations.
E. Predatory and Abusive Lending
Finally, our study recorded instances where results described fringe banking products as abusive, unfair, or predatory without any further explanation. Most sources, fifty-five percent (n=133), discussing justifications for the Bureau regulating fringe credit appealed to this rationale. The results decried fringe creditors as unscrupulous, rapacious, notorious, unconscionable, like crack, and the worst actors, along with simply abusive and predatory . Warren almost completely avoids merely characterizing fringe banking as predatory without additional details.
It appears that these statements, although common, do not assert separate bases for regulating fringe credit from those already discussed but instead operate as either simply vacuous attacks or summaries of other reasons for regulating fringe credit. Unless the Bureau acts with the least amount of reflection, it is unlikely these blanket assertions will have any influence on its behavior. Because this category is merely a rehash of earlier rationales, I do not discuss it in further detail here.
This Article has argued that the Dodd-Frank Act gives the Bureau the power to intervene in a substantial way in fringe credit markets for the first time. The Consumer Financial Protection Bureau will amass a lot of information about how fringe creditors operate and about market failures in these industries. Moreover, it will have unprecedented power and resources to enforce and promulgate rules restricting fringe banking activities.
The justifications for the Bureau intervening in fringe credit markets are a very mixed lot–some plainly misunderstanding the nature of the markets, and others offering a real opportunity for the Bureau to improve the experience consumers have with these financial services. My fear is that the Bureau will regulate in view of the former instead of the latter. If the Bureau works to restrict fringe credit on the erroneous assumption that fringe credit contracts are deceptive or lead borrowers to financial distress, consumers may lose access to financial services that they desperately need and already understand. Or, in a less extreme scenario, the Bureau could focus its attention on reforming the form of the contracts and miss the opportunity to actively detect and police creditors evading existing laws.
The final part of this Article hopes to urge the Bureau to carefully consider its rationales for regulating fringe credit before undertaking studies, promulgating rules, or engaging in enforcement actions. By ensuring that it acts in response to problems that have been demonstrated with evidence, the Bureau can work to improve credit for those who have been excluded from mainstream financial services without jeopardizing the welfare-enhancing function fringe creditors can have.
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