June 2008 Legal Briefs

June 1, 2008

Consumer Loan Dollar Amounts Adjust on July 1
Paying 3% Interest on County Deposits
Accepting Checks with Missing Endorsements
Accepting Checks for Collection

1. Consumer Loan Dollar Amounts Adjust on July 1

As of July 1 each year, the Consumer Credit Administrator adjusts for inflation certain dollar amounts found in various sections of Oklahoma’s Uniform Consumer Credit Code (U3C).

A new set of increased U3C dollar amounts (in a chart at the end of this article) takes effect on July 1, 2008. (Most amounts have increased by approximately 4.8%, compared to amounts established on July 1, 2007.)

a. Increased Late Fees. The fee that banks ask about most often is the maximum late fee for consumer loans and dealer paper. Since July 1, 2007 the maximum permitted late fee has been the greater of $21.00 or 5% of the past-due payment. This formula will change on July 1, 2008 to the greater of $22.00 or 5% of the past-due payment.

Before a bank can charge any late fee, the consumer must agree to it in writing. When a loan is originated, deferred or renewed, the signing of documents is an opportunity to get the borrower to consent in writing to the new $22.00 portion of the late-fee formula. However, if a loan is already outstanding and is not being modified or renewed, a bank has no good way to increase the amount of late fee that the consumer has previously agreed to pay.

Some banks’ loan documents have specifically pegged the “dollar amount” portion of their late fee formula at $21.00 (or lower amounts in earlier years)—and so for existing loans there may be no way to raise the late fee at July 1. Other banks have used an adjustable formula in the late-fee provision of their loans, allowing for the greater of 5% of the late payment or the maximum dollar amount established by rule of the Consumer Credit Administrator from time to time. (Banks using a formula that specifically allows for this type of inflation adjustment can now re-set their existing loans to charge the new, higher late fee as of July 1.)

b. “508B” and “508A” Loans. Some banks make small consumer loans based on a special finance-charge method that combines an initial “acquisition charge” with monthly “installment account handling charges,” and does not have a stated maximum annual interest rate. The requirements for such loans are outlined in Section 3-508B of the U3C.

The maximum permitted principal amount for one of the small loans just mentioned has been $1,260.00, but is adjusting to $1,320.00 at July 1.

The specific fees chargeable on one of these “508B” loans depend on where the loan falls within certain dollar brackets. Both the dollar brackets and the fees chargeable within each bracket are adjustable for inflation, and the revised amounts as of July 1 are set out in more detail in the chart at the end of this article.

Lenders making “508B” loans should be careful to switch promptly to the new dollar amount brackets, and the new permissible fees within each bracket, as of July 1. Because of peculiarities in how the bracket amounts are adjusted, using a chart with the old rates after June 30 (without shifting to a revised chart) might result in excess charges for certain small loans. (See the attached chart.)

The chart that banks use to determine the “maximum rate of interest” allowable on small loans calculated by the other available finance charge method (under Section 3-508A) will also change somewhat because of adjustments for inflation at July 1. The maximum consumer-loan dollar amount on which a blended interest rate higher than 21% can be charged by the 3-508A method will increase from $4,200 to $4,400.

At www.americanbanksystems.com/compliance/3508A.pdf there is an online chart showing the maximum interest rate chargeable on “508A” loans of various dollar amounts as of July 1, 2007, as well as a calculator for “508B” loans. A new chart and calculator, using the amounts taking effect on July 1, 2008, should be available there soon.

c. Dealer Paper “No Deficiency” Amount. Based on Section 5-103(2) of the U3C, if dealer paper is consumer-purpose and is secured by goods having an original cash price less than a certain dollar amount, and those goods are later repossessed or surrendered, the creditor cannot obtain a deficiency judgment if the collateral sells for less than the balance outstanding. This dollar amount was previously $4,200, and increases to $4,400 on July 1.

2. Paying 3% Interest on County Deposits

Several bankers have asked recently whether there’s a law requiring county treasurers to obtain a minimum of 3% interest on county deposits. Yes, it’s true. This law is found in Title 19, Oklahoma Statutes, Section 682, and has been around for a long time.

A provision like this doesn’t get much attention as long as interest rates are higher; but the recent sharp decline in rates is causing county treasurers to point out the requirement to bankers. Particularly for NOW accounts (used by public entities for checking accounts), a 3% rate is very high in relation to a bank’s deposit pricing for ordinary customers.

Here’s what the provision states: “All monies . . . received by the county treasurer . . . shall be deposited in interest-bearing accounts in financial institutions designated and qualified as county depositories as now provided by law and shall draw interest, subject to deduction of financial institution charges for maintaining, processing and collateralizing the account, at a rate of not less than three percent (3%) per annum on average daily balances, which interest shall be paid monthly . . .”

In the current interest-rate environment, this statute could put county treasurers in a bind: Legally, they must deposit county funds at a financial institution that will pay the minimum required rate—but in some cases there may be no local institution willing to pay that rate.

This problem is slightly easier to deal with (as explained below) if banks and county treasurers all recognize that the statute allows a “net” interest rate somewhat lower than 3%. An account must pay a “gross” interest rate of at least 3%, but certain allowable fees (described below) can be deducted from the calculated amount of interest, resulting in a “net” interest payment (an amount actually paid) that is less than 3%.

Because of unique limitations imposed by the statute governing county deposits, a bank should consider using a different approach to “pricing” county deposits (a different combination of rates and fees), in contrast to how other accounts at the bank are priced. There is nothing wrong with using a different pricing structure, because the statute requires a minimum interest rate and gives specific allowed offsets or deductions.

I will discuss several allowable pricing components that a bank may want to consider in pricing county deposits:

1. Maintenance Charges. For competitive reasons, it’s becoming less common to have monthly service charges on any type of checking account with large balances. But the statute clearly allows a monthly service charge on a county treasurer’s transaction accounts (a fee larger than what a bank charges on personal accounts with less activity). When such a fee will be applied to a county treasurer’s accounts, this and other special provisions should be carefully disclosed in writing. One approach is to put these special provisions in an amendment to the bank’s otherwise-standard account agreement.

Because of expense-paying procedures imposed by law on county government, it’s simpler to deduct or “net” the monthly service charge (and other permissible fees, discussed below) against the amount of interest that otherwise would be owed monthly–instead of listing such fees as separate expense items on a monthly account statement. (The county receives “net interest income,” with no “expense” itemization. This appears to fit the statute’s provisions.)

Someone might argue that county deposits are similar to, and should not involve higher fees than, deposits of business corporations, LLCs and partnerships. But there’s a difference: By law a bank cannot pay interest on regular transaction accounts of business corporations, LLCs or partnerships. Banks often sweeten the arrangement for these business entities by waiving all or most of the processing costs—particularly for larger deposit balances. Compared to this, a county’s NOW-account deposits (required to earn at least 3% interest, before deductions) represent a very different situation. With market interest rates now so low, there’s no economic logic in waiving either maintenance or processing costs on a county’s deposits.

2. Per-Item Processing Charges. The statute also specifically allows “processing” charges on county deposits. (At least in the past, “per-item” fees were charged on higher-volume business checking accounts—a certain fee for each check written or item deposited.) Because a 3% interest rate on county deposits is already high, a “per-item” charge on various accounts maintained by the county treasurer may be appropriate—especially for higher-volume accounts that receive deposits of tax payments, filing fees, and court costs. Like monthly service charges, “per-item” charges probably should be deducted or “netted” from the amount of interest paid monthly, not separately itemized on the county’s account statement.

3. Collateralization Charges. A bank incurs various expenses in pledging securities to secure the uninsured portion of public deposits. If a bank can identify out-of-pocket costs of collateralizing the county’s deposits, the statute allows these charges to be deducted from the amount paid as interest.

4. Determination of “Average Daily Balances.” Banks are required to pay interest on “average daily balances” of county deposits; but the statute doesn’t mention “funds availability.” Surely a bank cannot be expected to pay interest on uncollected funds. Logically, the phrase “average daily balances” must actually mean “average collected balances.”

As long as a bank stays within the limits prescribed in Regulation CC, it can establish its own definition of “collected funds.” (Differences in “funds availability” are most obvious when comparing one bank to another; but there can also be differences between different categories of customers, or different types of accounts, within the same bank. Reg CC does not require all customers to be given the same “funds availability”—although that approach may be simpler. Instead, the regulation requires the bank to advise each customer of the availability schedule applicable to that customer.)

Some banks (particularly in metro areas) are providing availability for ordinary “local” checks after one business day, or (for some customers) even on a “same-day” basis—although the bank may be unable to collect those checks as quickly as it is providing availability. Reg CC only requires banks to make funds available for ordinary “local” checks on the second business day after they are deposited. Similarly, Reg CC only requires a bank to make funds available for ordinary “nonlocal” checks by the fifth business day after deposit.

I believe a bank is permitted (with a written agreement and a conforming “funds availability policy” disclosure) to extend the availability schedule for county deposits to match the maximum time periods allowed in Reg CC (two business days for ordinary “local” checks, and five business days for ordinary “nonlocal” checks).

You may ask, “Why should a bank consider this?” The advantage is in somewhat reducing the county’s “collected balances” and the “average daily balances” on which the bank must pay 3% interest. Anything that shaves off part of the interest that is required to be paid may be helpful.

Also you might ask, “Why would a county treasurer agree to this?” The answer partly depends on what other local banks are willing to do. If no local bank really wants to pay 3% interest (particularly on NOW account balances), the county treasurer may have difficulty finding a deposit arrangement that meets the statute’s requirements. An arrangement that technically complies with the statute, while including various “deductions” and provisions (above) that reduce the “net” interest payment to the county, may be the best “pricing option” available to the county treasurer. It gets the compliance issue off the treasurer’s back, and it fits the bank’s situation better—although it’s still more expensive than the bank would prefer to pay.

5. Minimizing Deposits That Require Pledging.

The FDIC insures public funds up to $100,000 for demand deposits, and up to an additional $100,000 for time and savings deposits. However, a NOW account is technically a savings deposit, not a demand deposit. Because of the statute discussed earlier, a county treasurer cannot place county funds in a non-interest-bearing checking account. Therefore, the first category of deposit insurance is completely unavailable to counties. Consequently, in Oklahoma a county treasurer’s funds can be insured to a maximum of $100,000–all falling within the second category.

Any public deposits above the FDIC insurance limits must be collateralized by pledging eligible securities (such as U.S. Treasury obligations, or state and municipal bonds). It’s always relevant to consider what “spread” a bank can earn by investing public-funds deposits. For this purpose it’s useful to view non-insured deposits (those in excess of $100,000) as if they are invested to “fund” the bonds pledged against those same deposits.

In general, banks can earn a significantly higher rate of interest by making loans–compared to the amount of interest banks can earn on bonds. Banks can afford to pay a somewhat higher interest rate for deposits that can be invested in loans, in contrast to deposits that must be invested in bonds for pledging against those same deposits. From this perspective, the deposits on which a bank can least afford to pay 3% interest would be public funds in excess of the insurance limit, on which the bank must pledge bonds as collateral.

Following this logic, the first $100,000 of a county’s deposits on which a bank is required to pay 3% interest will be most “affordable” for the bank, because those deposits can be used for any purpose; and any deposits in excess of $100,000 on which the bank must pay 3% interest are more “expensive” to hold, because (directly or indirectly) these uninsured deposits are invested to “carry” municipal bonds.

While the current low interest rates continue, banks may find it useful to hold down a county treasurer’s deposits to a level closer to $100,000. (This may be impossible from a practical standpoint, although it would be highly desirable financially.) It would also help if all of the local banks are willing to do their “fair share,” by each taking at least $100,000 of county deposits. (Each bank can invest the first $100,000 more profitably than any higher amounts, as explained above.)

It could also be more profitable for a bank to receive $100,000 of deposits each, from the treasurers of three surrounding counties ($300,000 total), than to take an additional $300,000 of deposits from the treasurer of the county where the bank operates. (Again, the FDIC-insured portion of public funds can be invested more profitably than the uninsured portion of public funds, which require pledging.)

A provision in Title 19, Oklahoma Statutes, Section 121, instructs the county treasurer to deposit county funds daily “in one (1) or more banks located in the county and designated by the board of county commissioners as county depositories.” However, Section 122 of Title 19 states that “nothing in this act shall be construed to prohibit the county treasurer from depositing funds of the county in banks outside of the county when such bank shall give security [for the uninsured portion of deposits] in the amount and in the manner hereinbefore provided.” County commissioners must pre-approve depositories, but the commissioners can apparently pre-authorize the county treasurer to use a large number of financial institutions, both in and outside of the county.

For so long as it remains difficult to find banks willing to pay 3% interest on county deposits, a county treasurer may want to spread county deposits around in $100,000 amounts to as many separate banks as are willing to accept the money—not only other banks in the county, but even banks is surrounding counties. (Obviously, spreading county deposits around in $100,000 increments is much more feasible for C.D. money, and much less workable for accounts that have frequent deposits—so this approach will not be a complete solution.)

Particularly at times of the year when lots of tax collections are coming in, the county treasurer’s primary local bank may want to have arrangements in place whereby the bank can help the county treasurer to wire out funds regularly into short-term C.D.’s at other banks, to attempt to minimize the amount of uninsured county deposits on which the local bank must pay 3% interest and also must pledge securities.

3. Accepting Checks with Missing Endorsements

Current law relating to missing indorsements on checks has been the same since 1992, when Oklahoma adopted Revised U.C.C. Section 4-205. Some banks are unfamiliar with this provision, or do not fully understand it.

Depositary banks are complaining that checks continue to be improperly returned to them by paying banks, marked "indorsement missing." Paying banks are also asking what they should do with checks that (1) don’t have the payee’s indorsement, and also (2) don’t have any indorsement supplied by the depositary bank, such as "deposited to the account of the within named payee" or "prior endorsements guaranteed" or the abbreviated form, "P.E.G." All such indorsements by the depositary bank are now unnecessary under the provisions of Revised Section 4-205, in effect since 1992.

Subpart (1) of Section 4-205 states that if a customer delivers an item to a depositary bank for collection, "The depositary bank becomes a holder of the item at the time it receives the item for collection if the customer at the time of delivery was a holder of the item, whether or not the customer indorses the item, and, if the bank satisfies the other requirements of Section 3-302 [of the U.C.C.], it is a holder in due course."

Based on this first subpart, a depositary bank with no knowledge of other problems takes good title to a check, and any subsequent holder takes good title to the check, even without the payee’s indorsement, provided that (1) the depositary bank is acting as the payee’s agent for collection, and (2) the payee is actually paid or credited for the check by the depositary bank. If these assumptions are both true, then neither the paying bank, nor the drawer of the check, nor the payee can raise any claim that the check has not been properly negotiated and paid.

Subpart (2) of Section 4-205 states, "The depositary bank warrants to collecting banks, the payor bank or other payor, and the drawer that the amount of the item was paid to the customer or deposited to the customer’s account." This automatic warranty is given by a depositary bank each time it transfers a check. The warranty protects the paying bank, whether there is an actual indorsement by the payee or no indorsement at all.

Therefore, based on subpart (a)(1) of Section 4-207 (transfer warranties) and subpart (2) of Section 4-205, the depositary bank automatically warrants (1) that the depositary bank is entitled to enforce the check, and (2) that the payee has been paid by the depositary bank. The paying bank can safely assume that these facts are true because the paying bank has a statutory right to collect from the depositary bank for “breach of warranty” if these facts are not true. (An indorsement is not needed because the paying bank’s legal rights against the depositary bank are just as strong without the indorsement.)

One purpose behind Revised UCC Section 4-205 (adopted in Oklahoma in 1992) is to facilitate lock-box situations. Banks often set up a lock-box arrangement with utility companies as a matter of convenience, or with other companies in order to control incoming receipts that represent accounts receivable pledged on a loan.

With a lock-box arrangement, the bank opens the envelopes that are received in the lock-box and credits the checks (payable to the company) directly to the company’s bank account without any need to use an indorsement stamp. The official U.C.C. Comment to Section 4-205 states, "No function would be served by requiring a depositary bank to run these [lock-box] items through a machine that would supply the customer’s indorsement except to afford the drawer and the subsequent banks evidence that the proceeds of the item reached the customer’s account. . . Paragraph (2) [of Section 4-205] satisfies the need for a receipt of funds by the depositary bank by imposing on that bank a warranty that it paid the item to the customer’s account."

So what’s wrong if a paying bank wants to send a check back to the depositary bank anyway, marked "indorsement missing"? In these circumstances the paying bank appears to be wrongfully dishonoring its customer’s check. Section 3-501(b)(3) of the U.C.C. states, "Without dishonoring the instrument, the party to whom presentment is made may (i) return the instrument for lack of a necessary indorsement . . ." But, as discussed above, Revised Section 4-205 does not require the depositary bank to obtain an indorsement from the payee at all—on the basis that the depositary bank gives the automatic warranty even when there is no indorsement. Returning a check in order to obtain a missing indorsement (if the UCC says the indorsement is unnecessary) is improper.

But I need to add a note of caution: In recent years three states still had not adopted the revised version of Section 4-205–South Carolina, New York, and Massachusetts. However, Massachusetts recently adopted the changes, and South Carolina has just adopted them this spring (effective July 1, 2008). A paying bank should continue to be alert to the fact that depositary banks located in New York (and also depositary banks in South Carolina, until July 1) are not giving any automatic warranty that they have paid the payee in cash or that they have deposited the check to the payee’s account. Therefore, for depositary banks in New York (and in South Carolina, until July 1) it is still proper to return checks marked "indorsement missing."

4. Accepting Checks for Collection

When a paying bank returns a check marked “insufficient funds” or “funds not available,” the depositary bank sometimes sends the check back to the paying bank as a collection item. A paying bank that accepts the item for collection takes on certain duties, as explained below:

1. Is a paying bank required to accept an item “for collection” that was previously returned unpaid to the depositary bank? A paying bank can always decline to hold the previously dishonored item “for collection,” sending it back with a letter explaining that the paying bank does not agree to hold it on this basis. (However, if the item would actually pay from collected funds on the date that the paying bank receives it, it should be paid.)

2. Why do paying banks accept items “for collection,” if not required? It’s a courtesy between banks—although it’s optional. Depositary banks send items “for collection” to assist their customers. (Sending an item for collection creates a longer “window of time” during which the item might be paid—compared to simply re-presenting the item, which will result in payment only if funds are available at the second presentment.) Paying banks accept items “for collection” because they want to maintain good relations with the depositary bank, and/or because they want that other bank to extend the same courtesy.

3. Should banks agree on how long an item will be held “for collection”? Certainly. The depositary bank can request that the paying bank return the “for collection” item if it cannot be paid within 10 days, 15 days, etc. If the depositary bank gives no time limit, the paying bank probably should tell the depositary bank (by letter or phone) that it will only hold the item “for collection” for some specific period of time.

There are good reasons on both sides for limiting the time period. The depositary bank needs a reasonably quick indication from the paying bank as to whether the item can be paid. With a timely negative response (“Here it is back; the time period you stated has expired (or) we don’t think we can pay it by holding it longer”) the depositary bank can return the item to the payee, who is alerted to take alternative action to protect his position. Further, it is unreasonably burdensome for the paying bank to continue checking daily (for a long time) to see whether the item will pay. The paying bank earns no fees for holding an item “for collection,” and does not want to carry out this labor-intensive task for too long.

4. What duties and potential liability does the paying bank have? Once a paying bank accepts a request to hold an item “for collection,” that bank automatically undertakes certain duties as agent for the depositary bank. Among these duties are the following: (a) to attempt in good faith to pay the item, (b) to check daily whether the item will pay, (c) to pay the item ahead of other items presented to the bank (when it becomes possible), and (d) to discontinue holding the item “for collection” (and return it) after a reasonable time, or as soon as it becomes clear that the item cannot be paid.

Paying banks have been sued successfully (1) because the paying bank received adequate funds to pay the item, but failed to pay it; (2) because the item was held too long (or longer than requested), causing the payee to lose some other opportunity to collect the funds owed; or (3) because the paying bank by its delay created reliance that there was some chance of paying the item, when under the facts it should have been clear that the item couldn’t be paid.

5. What situations should result in return of a “for collection” item? If a paying bank accepts a check “for collection” and continues to hold it, that implies that there is some reasonable chance of the item paying in the future. When some event happens that will cause the check not to pay at any time in the near future (or ever), the paying bank should immediately return the item to the depositary bank. (The paying bank should not hold a check “for collection” after doing so becomes pointless.)

The following situations should cause a check held “for collection” to be returned: (1) The account on which the item is drawn is closed—by the customer or the bank. (2) The bank receives a DHS levy on the account (requiring all deposits to the account for the next 60 days to be frozen and turned over to the DHS). (3) Recent inactivity on the account and a low balance suggest that the customer is unlikely to make further deposits from which the check held “for collection” can be paid.

6. Should the paying bank tell its customer that it is holding one of his checks “for collection”? Generally, no.When a bank accepts a request to hold an item for collection, it undertakes a duty to the depositary bank to use “good faith” in trying to pay the item. (The customer, on the other hand, has written the check and needs no notice that it remains outstanding.) If informing the customer will cause the customer not to make further deposits, the bank’s “tip-off” to the customer may be contrary to the paying bank’s duty as agent for the depositary bank. On the other hand, if the paying bank legitimately believes that its customer will be more likely to satisfy the check if he is aware that the bank is holding it, it could be reasonable and consistent with the bank’s duty to notify the customer.

7. Is a paying bank required to pay a check held “for collection” in any order? When an item is held for collection, the paying bank should attempt each day to pay it before paying other items that are being presented on the same day. To accomplish this, as soon as adequate funds become available a bank should “force pay” the collection item. (This avoids the possibility that other items presented on the same day will accidentally be paid first, because of whatever standard check payment order the bank’s processor is using.) It’s a problem if sufficient funds are in the account, some other checks are paid first, and as a result the check held “for collection” still does not pay. This situation probably violates the paying bank’s duty as agent for the depositary bank.

8. Should a bank place a freeze on deposits received, until there are sufficient funds in the account to pay the check held “for collection”? No. Freezing funds is not authorized. Although there may be some funds in the account, if there is never a day when the account has sufficient available funds to pay the collection item, the bank can (and should) continue to pay other checks that are being presented each day.

Changes in Oklahoma UCCC Dollar Amounts Effective July 1, 2008

The designated sections and the corresponding dollar amounts to become effective on July 1, 2008, are as follows:

Designated Sections	July 1, 2007	July 1, 2008
2-201(2)(a)(i)	$1,260	$1,320
2-201(2)(a)(ii)	$1,260-4,200	$1,320-4,400
2-201(2)(a)(iii)	4,200	$4,400
2-203(1)(a)	$21.00	$22.00
2-407(1)	$4,200	$4,400
2-407(1)	$840	$880
2-413	$4,200	$4,400
3-203(1)(b)	$21.00	$22.00
3-203(5)	$21.00	$22.00
3-203.1	$21.00	$22.00
3-508A(2)(a)(i)	$1,260	$1,320
3-508A(2)(a)(ii)	$1,260-4,200	$1,320-4,400
3-508A(2)(a)(iii)	$4,200	$4,400
3-508B(1)	$1,260	$1,320
3-508B(1)(a)	$125.96	$131.96
3-508B(1)(a)	$4.20-21.00	$4.40-22.00
3-508B(1)(b)	$125.96-147.00	$131.96-154.00
3-508B(1)(b)	$12.60	$13.20
3-508B(1)(c)	$147.00-294.00	$154.00-308.00
3-508B(1)(c)	$14.70	$15.40
3-508B(1)(d)	$294.00-420.00	$308.00-440.00
3-508B(1)(d)	$16.80	$17.60
3-508B(1)(e)	$420.00-630.00	$440.00-660.00
3-508B(1)(e)	$18.90	$19.80
3-508B(1)(f)	$630.00-1260.00	$660.00-1320.00
3-508B(1)(f)	$21.00	$22.00
3-510(1)	$4,200	$4,400
3-511(1)	$4,200	$4,400
3-511(1)(a)	$1,260	$1,320
3-511(1)(b)	$1,260	$1,320
3-514	$4,200	$4,400
5-103(2)	$4,200	$4,400
5-103(3)	$4,200	$4,400
5-103(7)	$4,200	$4,400

A word of caution for Lenders operating under Section 3-508B:

After 6-30-2008, certain loan amounts made under the 7-1-2007 dollar amounts could result in an excess charge if Lender continues to use those dollar amounts listed under 7-1-2007 and does not use the dollar amounts shown for 7-1-2008. For example: A loan of $125.97 through $131.96, $147.01 through $154.00, $294.01 through $308.00, $420.01 through $440.00, and $630.01 through $660.00 would be an excess charge.