September 2016 Legal Briefs

• MLA Guidance is Here!
• ODFI Warranty Risk under NACHA Rules

MLA Guidance is Here!

By Andy Zavoina

On August 26, the Department of Defense published at 81 FR 58840  an interpretive rule (I’ll refer to it as guidance but it is similar to an official staff commentary in that it carries the same weight as the regulation) in response to questions many banks had on the new Military Lending Act (MLA) regulation which goes into effect on October 3, 2016. We are a month away as this is written and based on the questions and comments from bankers, you’re all in a high state of change management. But the guidance hasn’t answered all the questions and it may actually create some new ones.

This 24-page document is written in a Q&A format. Here is a quick review to explore what some of these may mean to you but you are encouraged — no, required — to review the full document. These are explanations of the requirements I wrote in detail about in August 2015. The current MLA rule was much ado about nothing because it covered so few loan types. That’s not the case under the new rule, which covers loans subject to Reg Z with just three exceptions. “Covered loans” are those offered to servicemembers or their dependents primarily for personal, family or household purposes that are subject to a finance charge or payable by written agreement in more than four installments. The rule’s reach was broadened intentionally and now includes both open- and closed-end credit.

Your loans to a covered borrower (a current servicemember or a dependent) which are subject to Reg Z are covered, except for residential mortgages or purchase money loans where the personal property purchased is your collateral. If you want to make a car purchase loan and provide any additional funds, you will want to read question #2. Some bankers feel the wording of that answer may alter their loan products significantly. The purchase-money exceptions apply to vehicles and personal property. Credit card restrictions are delayed, but the rule will apply to overdraft lines of credit now. Overdraft coverage is the first topic addressed in the guidance.

1. What types of overdraft products are covered?

Overdrafts do not meet the definition of “consumer credit” as there is a processing fee, not interest, and they are not repaid under a written agreement of more than four installments. Typically, your overdrafts are not a covered loan but some products may fit the definition under the MLA rule and Reg Z. The guidance reminds banks to verify whether products offered will meet the exemption or not.

2. When credit is extended to purchase personal property, and simultaneously the loan includes more than the purchase price, will that meet the MLA exemption?

The answer provided is “No.” Section 232.3(f)(1) defines consumer credit and (f)(2) defines the exemptions for the purchase price of personal property when used as collateral. If additional loan proceeds are offered there could be “shell loans” where cheap property is technically sold and the servicemember walks away with thousands in cash as a way for unscrupulous lenders to skirt these new requirements. These “hybrid” loans will not meet the exception rules.

The guidance tells us that a hybrid purchase money loan with a cash advance is not expressly intended to finance the purchase of personal property, because the loan provides additional financing that is unrelated to the purchase. To qualify for the purchase money exception a loan must finance only the acquisition of the personal property. Any credit transaction that provides purchase-money secured financing of personal property along with additional “cash-out” financing is not eligible for the exception.

Many people read the section on exemptions to personal property and vehicles and group them together. The exemptions for personal property and vehicles are actually listed separately in the rule and there may be good reason for this. There has been much discussion from bankers as to whether answer #2 would allow the purchase and financing of a vehicle if there are fees financed, or negative equity in a trade-in. The question of what is “related to the purchase” and would fit the exemption and what is not, is not clear. Some bankers immediately questioned loan products they offer and the feasibility that they may be off limits after October 3. It should be noted question 2’s answer cites § 232.3(f)(2)(iii), which is expressly for personal property. The exception for vehicles is under § 232.3(f)(2)(ii). This begs the question of whether the same interpretation would apply to a vehicle as applies to personal property. The intent would be the same, but a difference was obviously drawn in the MLA because it separates those exemptions. While a vehicle may be viewed as “personal property,” for the MLA personal property and a vehicle are two different items and should be addressed separately. Financing a vehicle and simultaneously consolidating other debt with it would appear to be problematic and the same as a cash out disbursement. Perhaps by separating these two the DoD intended to allow more latitude in what is “related to a purchase” because vehicle loans are more complex than loan for personal property, or perhaps the question pertaining to vehicle loans was just not asked. Either way, I recommend caution and restraint when financing a vehicle and including any funding of items not truly justifiable as being related to the purchase.

3. Question 3 addresses open-end credit under § 232.4(b) and the ability to waive fees at the end of a billing cycle to bring the MAPR to 36% or less.

The answer was that nothing prohibits the bank from either using a low rate and fee combination that will not exceed a 36% MAPR, or from reducing fees at the end of a billing cycle to bring the MAPR to within tolerance. Systems using the latter approach should be thoroughly tested and periodically reviewed but this may be a way to comply with the MLA and not forgive any more income than necessary.

4. Is a minimum interest charge that a bank may charge a covered borrower as a part of a credit card account under an open-end (not home-secured)  consumer credit plan and that is generally disclosed in the account-opening table under § 1026.6(b)(2)(iii) eligible as a bona fide fee excludable from the calculation of the MAPR?

Especially as it relates to government taxes and filing fees such as title charges, many bankers asked if these are finance charges. Section 232.4(c)(1) defines what is added to the calculation of the MAPR, but the guidance more clearly states that when it is not included in the MLA rule, and Reg Z excludes it, such as title fees, it is excluded from the MAPR. For reference, Reg Z, at § 1026.4(a)(1)(i) excludes taxes, license fees and registration costs that would be owed in a cash transaction as well as a loan.

5. For open-end credit, what constitutes a situation where the MAPR cannot be calculated because there is “no balance” in the billing cycle under § 232.4(c)(2)(ii)(B)?

The rule states that if there is no balance, there should be no finance charges or fees other than those specifically allowed such as a participation fee that complies with the limitations described in § 232.4(c)(2)(ii)(B). This limits the fee to up to $100 for non-credit card products and a reasonable bona-fide participation fee for credit cards. These fees are excluded from the MAPR calculation. Late fees also fit this excluded category of fees.

The answer goes on to explain that if there was no balance there would be no effective APR and the MAPR closely follows Reg Z in this formula calculation. “If there is no balance to which the charge is applicable, an effective APR cannot be determined. Similarly, § 232.4(c)(2)(ii)(B) relates to when finance charge imposed during the billing cycle is or includes a minimum, fixed or other charge not due to the application of a periodic rate, other than a charge with respect to a specific transaction charge, and there is no balance to which the charge is applicable.”

6. Is a minimum interest charge that a bank may charge a covered borrower as part of a credit card account under an open-end (not home-secured) consumer credit plan and that is generally disclosed in the account-opening table under § 1026.6(b)(2)(iii) eligible as a bona fide fee excludable from the calculation of the MAPR?

If your bank offers this product, bona fide minimum interest charges other than a periodic rate, are not charges required to be included in the MAPR and are excludable. These should be included in the product’s account opening table under § 1026.6(b)(2)(iii). These charges are not based on a periodic rate.

7.. Under § 232.4(d)(3)(ii), may creditors rely on commercially compiled sources of information in conducting calculations necessary for the conditional reasonable bona fide credit card fee safe harbor?

The answer is Yes. “The Final Rule intends to provide a firm, yet flexible, adaptable standard allowing credit card issuers to exclude bona fide and reasonable credit cards from the calculation of the MAPR.” Commercially available databases are acceptable so long as they comply with the conditions in the MLA rule which states, “Under this provision, a creditor may compare the amount of the bona fide fee to “an average amount for a substantially similar fee charged by 5 or more creditors each of whose U.S. credit cards in force is at least $3 billion in an outstanding balance (or at least $3 billion in loans on U.S. credit card accounts initially extended by the creditor) at any time during the 3-year period preceding the time such average is computed.”

Under § 232.4(d), is it permissible to consider benefits provided by credit card rewards programs in determining whether the amount of a fee is (a) less than or equal to an average amount of a fee for a substantially similar product or service for purposes of comparison under the safe harbor and (b) reasonable overall?

Yes, is the DoD response. Under the guidance § 232.4(d)(3)(iv) states, “whether a participation fee is reasonable may be determined in reference to whether a credit card offers additional services or other benefits.” The guidance also says, “Under the Department’s flexibly applied conditional exclusion, creditors may use any reasonable approach in identifying whether a fee is substantially similar for purposes of comparison and reasonable overall. Thus, the Department’s policy, in this regard, permits a creditor to consider … the benefits provided by a rewards program in determining whether a fee is reasonable overall.”

8. Under § 232.5(b), is an assignee permitted to avail itself of a covered borrower identification safe harbor if the assignee has maintained the original creditor’s record of a covered borrower check?

The DoD has clarified that so long as the covered borrower verification was done timely and correctly, an assignee will enjoy the same safe harbor as the original creditor. If your bank is involved in these transactions, due diligence indicates you verify the verifications were completed according to the MLA at § 232.5(b)(2).

9. Does the historic lookback provision of § 232.5(b)(2)(B) prevent creditors from adopting a risk management plan that includes periodically screening credit portfolios to discover changes to covered borrower status?

The DoD clarified that when it said “At any time after a consumer has entered into a transaction or established an account involving an extension of credit, a creditor (including an assignee) may not, directly or indirectly, obtain any information from any database maintained by the Department to ascertain whether a consumer had been a covered borrower as of the date of that transaction or as of the date that account was established,” what it meant was a bank can periodically verify the borrower’s status to determine if the MLA protections continue for them. The explanation in the response was essentially that to gain the safe harbor, use one of the two methods described prior to consummation, namely directly through the DMDC MLA database or from a national credit reporting agency which gets the data from that database. A bank can use another method to verify who is a covered borrower, but it will not enjoy a safe harbor if it is wrong. This is a risk issue some banks may want to address.

Perhaps the best explanation I hear from banks for continued review is not for any future loan requests, but to determine whether open-end statements would still be applicable to the MLA rules. Once a covered borrower loses that status, protections under the MLA rule end. And just like the Servicemembers Civil Relief Act, the borrower has no obligation to inform creditors of a change of military status. A bank can employ a batch checking process directly with the DMDC database at no cost whereas credit bureaus will impose a fee for this ongoing monitoring.

As to future use of a covered borrower verification, § 232.5(b)(3)(i)-(ii) indicate that when a covered borrower verification is completed 30 days prior to initiating a transaction or applying to establish an account, that determination is valid for safe harbor protections.

10. Does the particular internet address referenced in § 232.5(b)(2) limit the availability of a safe harbor for a covered borrower check conducted through alternative methods of accessing the MLA database provided by the Department?

The DoD response indicates that the URL used to verify a borrower’s status could change from that specified in § 232.5(b)(2) and the change would offer the same protections. The bank needs to ensure that any change is verified and the true source data is the DoD.

11, How may a creditor orally provide the payment obligation disclosure required under § 232.6(a)(3) (A clear description of the payment obligation of the covered borrower…) to meet the requirements of § 232.6(d)(2) (The creditor also shall orally provide the information required…)?

I’ve seen many answers to this question that dance around the ambiguity of the question itself. The guidance tells us lenders have latitude and that the disclosure need not be unique to a specific loan. “The requirement of a clear, oral payment obligation disclosure has sufficient breadth that creditors may choose a variety of acceptable oral disclosure compliance strategies. Thus, under the Department’s approach, a generic oral description of the payment obligation may be provided, even though the disclosure is the same for borrowers with a variety of consumer credit transactions or accounts.”

Orally, the lender must provide 1) the MAPR statement, 2) a “general description of how the payment obligation is calculated or a description of what the borrower’s payment obligation would be based on an estimate of the amount the borrower may borrow,” and 3) a reference to the written disclosure. These are § 232.6 requirements. While my solution below isn’t “pretty,” I believe it works. It is for a simple interest loan and may be used as a starting point if your bank wants to offer oral disclosures that are generic. These could be face-to-face when the exact terms are not yet known, or a recording on an extension number reached via your toll-free number.

I propose bankers put on their thinking caps and determine how to best accomplish making oral disclosures in a compliant and meaningful way. I believe my starter script will meet the requirements of the rule, but check with bank counsel. I’m only describing closed-end credit here because open-end may require some specific product knowledge about what is offered.
This disclosure itself requires math skills on the part of the borrower to apply to their loan request but I believe it follows the intent and is not unlike some Reg Z allowances where payments are described such as in a cost per thousand dollars borrowed. I suggest to meet all three requirements, you can use a disclosure such as:

“Federal law provides important protections to members of the Armed Forces and their dependents relating to extensions of consumer credit. In general, the cost of consumer credit to a member of the Armed Forces and his or her dependent may not exceed an annual percentage rate of 36 percent. This rate must include, as applicable to the credit transaction or account: The costs associated with credit insurance premiums; fees for ancillary products sold in connection with the credit transaction; any application fee charged (other than certain application fees for specified credit transactions or accounts); and any participation fee charged (other than certain participation fees for a credit card account).

“For each $1,000 you borrow for 1 year at an APR of 8%, your monthly payment will be $86.99. For each $1,000 borrowed for 2 years at an APR of 8%, your monthly payment will be $45.23. If you borrow $2,000, double those payment amounts. Your loan may vary based on the exact terms and days in the months during your loan. Your exact terms will be disclosed to you before you become obligated on your loan.”

This script should be adjusted to use an APR that you are likely to charge. You could increase the number of payment examples to include more than one APR, but It takes me 1 minute and 15 seconds to recite what’s written above.

If you remove the numeric example from the script, it is shorter, just as confusing, but has less meaning for those who will call and listen, like your regulators. At the end of the day, I believe it meets the requirements and is not long.

12. If a creditor chooses to provide the information that is required to be provided orally by providing a toll-free telephone number, consistent with § 232.6(d)(2)(ii)(B), when must the information be available to the borrower?

The guidance explains that if your bank uses a toll-free number to provide oral disclosures, the number must be provided on a form your bank uses to direct the consumer to use to apply for the transaction or account, or on the written disclosure pertaining to the MAPR and payment obligations required under § 232.6(a)(1) and (3). These must be made prior to consummation.

13. In circumstances where Reg Z allows a creditor to provide disclosures after the borrower has become obligated on a transaction (as in the case of purchase orders or requests for credit made by mail, telephone, or fax), does the MLA provide for similarly delayed disclosure?

This is an exception to what you just read in Q13. The guidance states “the disclosures required in Section 232.6(a) [which includes all the MLA disclosures, including those unrelated to Regulation Z] may be provided at the time prescribed in Regulation Z.” For this purpose, the MLA follows Reg Z so in the case of purchase orders or requests for credit made by mail, telephone, or fax under (§ 1026.17(g)), the MLA’s general timing requirement does not override the more specific disclosure timing provisions in Reg Z.

14, Under § 232.8, within a single credit agreement may creditors permissibly use a “savings clause” that excludes covered borrowers from prohibited notice, waiver, arbitration, or other terms that would otherwise be applicable to non-covered borrowers?

Your forms vendors were unhappy to read this as it means you may use one form if these clauses are already in your forms, but there should be some notice that they do not apply in the case of a covered loan under the MLA.

15. Does the limitation in § 232.8(e) on a creditor using a check or other method of access to a deposit, savings, or other financial account maintained by the covered borrower prohibit the borrower from repaying a credit transaction by check or electronic fund transfer?

The MLA rule states, “…it unlawful for any creditor to extend consumer credit to a covered borrower with respect to… (e) The creditor uses a check or other method of access to a deposit, savings, or other financial account maintained by the covered borrower…” and further (e) addressed the ability to require funds transfers and direct deposits (already prohibited by Reg E), and the taking of a security interest in funds deposited after the extension of credit which questioned deposit secured loans and setoff.

This section of the MLA rule was really intended to thwart payday lenders but the law of unintended consequences had many questioning whether a bank would be able to establish a funds transfer agreement for regular payments. The guidance is helpful here in that it does allow funds transfers and says in no case does this prevent a borrower from paying by check or authorizing access to a deposit account, even on a recurring basis, to repay a loan. Reg E and other laws and regulations still apply so a bank cannot require recurring funds transfers as a method of loan repayment. What the rule does prevent are remotely created checks and post-dated checks from being used based on the account information or procured at or around the time the loan was made. Again, this is directed at payday lenders, but it could include a workout situation if a lender wanted postdated checks from a borrower when the loan was refinanced.

16. Does the limitation in § 232.8(e) on a creditor using a check or other method of access to a deposit, savings, or other financial account maintained by the covered borrower prohibit the borrower from granting a security interest to a creditor in the covered borrower’s checking, savings or other financial account?

When read literally (especially in the context of questions 16-18) the MLA rule seemed to prevent making a deposit secured loan. Again this was the rule of unintended consequences aimed at payday lenders, but apparently restricting one of the lowest cost loans a borrower might have when a certificate of deposit is pledged as collateral.

Fortunately, the DoD response is “No.” The prohibition in § 232.8(e) does not prohibit covered borrowers from granting a security interest to a creditor in the covered borrower’s checking, savings, or other financial account, provided that it is not otherwise prohibited by applicable law and the creditor complies with the MLA regulation including the limitation on the MAPR to 36 percent.”

17. Does the limitation in § 232.8(e) on a creditor using a check or other method of access to a deposit, savings, or other financial account maintained by the covered borrower prohibit a creditor from exercising a statutory right to take a security interest in funds deposited within a covered borrower’s account?

This directly applies to the right to setoff, because many interpreted the MLA rule to prohibit setoff. What the MLA rule says is that a bank can exercise its statutory right to setoff to use its security interest in deposited funds for repayment. Your loan and deposit documents should include a contractual right to setoff and there is a common law right to setoff. There is USC 1757(11) which seems to grant a credit union the statutory right to setoff, but I found no similar statutory right for a bank at the Federal level. Fortunately, Pauli Loeffler pointed me to Oklahoma’s Title 42 O.S. Sec. 32: “A banker has a general lien, dependent on possession, upon all property in his hands belonging to a customer, for the balance due to him from such customer in the course of the business.” If you are doing business in other states, you may need to verify those states provide the bank with a statutory provision, and are not relying on common or contract law.

18. Under § 232.3(f)(2)(ii) and 232.8(f) what methods of transportation are included within the definition of a “vehicle”?

The guidance helps us understand how “vehicle” is defined for the MLA rule when a vehicle is used as loan collateral. It means any self-propelled vehicle primarily used for personal, family, or household purposes for on-road transportation. The term does not include motor homes, recreational vehicles (RVs), golf carts, or motor scooters.

ODFI Warranty Risk under NACHA Rules

By John S. Burnett

Under NACHA rules, a Receiving Depositary Financial Institution (RDFI) has about 60 days to return most unauthorized consumer ACH entries, even if they affect business accounts (e.g., check conversion entries). But both RDFIs and Originating Depositary Financial Institutions (ODFIs) should be aware that breach of warranty claims can be made against an ODFI for a lot longer than 60 days.

Let’s start with the NACHA rules. There are two subsections that are pertinent to the question of the ODFI’s responsibility for unauthorized debit. The first, subsection 2.4.1.1, prescribes the ODFI’s warranty to each RDFI and ACH Operator that “The Entry has been properly authorized by the Originator and the Receiver in accordance with these Rules [the NACHA Rules].”

The second is subsection 2.4.5.1, which provides that “An ODFI shall indemnify every RDFI and ACH Operator from and against any and all claims, demands, losses, liabilities, and expenses, including attorneys’ fees and costs, that result directly or indirectly from (a) the breach of any warranty made to such party by the ODFI under these Rules…..”

The 60-day extended return item “window” restricts the time within which the RDFI can use the ACH network to return an unauthorized entry (or one based on an ineligible source document such as an ARC entry for a check over $25,000 or for any check with an auxiliary on-us field in the MICR line — a business format check). But it does not limit the RDFI’s ability to make a claim for breach of the ODFI’s warranty that the item was properly authorized. That, and other, warranties imposed by the NACHA Rules, are enforceable under state contract law in the place where the transactions originated (the state in which the ODFI is located).

The warranty survives long after the return entry window has closed. The duration of the warranty varies from state to state, typically for a period of from two to five years (you’ll need to research state laws to see how long a particular ODFI’s warranty endures).
How does the RDFI pursue a breach of warranty? Much the same as a bank would pursue a breach of the warranties of presentment and transfer under the UCC in an attempt to collect on a check with a forged indorsement or a check that’s been altered.

The claim is made directly, without entry, in the hope that the ODFI will agree that it’s liable and pay up. If the “direct approach” doesn’t work, the RDFI can pursue the “legal route,” starting with engaging an attorney and, if the cost-benefit analysis works, through the courts. For smaller warranty claims, RDFIs often don’t bother because the costs of pursuing the claim, monetary and others, are too high, even if the ODFI ends up losing and having to pay the RDFI’s costs.

An ODFI makes a strategic error if it bases its risk analysis of prospective Originators on a 60-day return window for unauthorized entries. Knowing that the longer state statute of limitations will apply to breach of warranty claims makes it imperative to know as much as possible about an Originator’s business ethics and practices. An RDFI should understand its option to make a breach of warranty claim before giving up on recovering funds for an unauthorized item.