On Thursday, March 28, California Governor Gavin Newsom announced that Manuel “Manny” Alvarez, 38, has been appointed Commissioner of the California Department of Business Oversight (DBO). Alvarez is currently general counsel, chief compliance officer and corporate secretary at Affirm Inc., the point-of-sale lending platform founded by PayPal’s Max Levchin in 2012. Alvarez’s appointment requires California State Senate confirmation. See the Governor’s press release here.
The Supreme Court and the Third Circuit decided three cases in the last week relating to the interpretation and enforceability of arbitration agreements. We discuss them below.
Third Circuit Compels Arbitration of an E-Signed Enrollment Agreement
The Third Circuit compelled arbitration of an agreement signed electronically by a student taking online courses. In Dicent v. Kaplan University, Maria Dicent, who represented herself in the case, filed a complaint against Kaplan University for various causes of action. Kaplan moved to compel arbitration on the basis that Dicent electronically signed a packet containing both an enrollment agreement and an arbitration agreement. Dicent claimed that she was not aware of the arbitration agreement and that Kaplan “tricked” her by including it within the enrollment packet.
According to the lower court, Kaplan supported its motion to compel with an affidavit explaining its e-signature verification process. To enroll in courses, students must log into an enrollment portal website. After clicking the “Electronically Sign” button, students enter personal identifying information on a verification page. An e-signature verification company compares the information with that in a confidential database. Upon positive verification of the student’s identity, the student and Kaplan receive a confirmation that the e-signature was successful. Kaplan’s records showed that Dicent’s enrollment packet, including the arbitration agreement, was accepted.
The Third Circuit explained that the first step in deciding whether to compel arbitration is to ask whether the parties have a valid agreement to arbitrate. In this case, the issue was whether Dicent assented to the agreement. Assent, the court explained, turns on ordinary state-law contract principles. The court observed that Pennsylvania, which the parties agreed governed the contract, recognizes e-signatures as a valid means to register legal assent.
The court held that there was no genuine issue of material fact as to whether Dicent assented to the arbitration agreement. Kaplan had presented evidence of her e-signature and Dicent conceded that she e-signed the enrollment packet. It concluded that the “most reasonable inference we can draw from the evidence presented is that Dicent simply did not read or review the Enrollment Packet PDF closely before she e-signed it, which will not save her from her obligation to arbitrate.”
A link to the opinion is here.
Justices Reject Judicially-Created Exception Limiting Enforcement of Arbitrability
In Schein, Inc. v. Archer & White Sales, Inc., Justice Kavanaugh, writing for a unanimous Court, rejected the judicially-created “wholly groundless” exception to arbitrability.
Archer & White filed a complaint against Henry Schein, Inc. for various causes of action. Schein moved to compel arbitration on the basis that the parties’ contract required arbitration of “[a]ny dispute arising under or related to this Agreement.” Archer & White opposed the motion, arguing that it was “wholly groundless.” It pointed to the arbitration clause’s exception for “actions seeking injunctive relief” and argued that Schein sought injunctive relief in addition to damages.
The Court considered this question: does a court or an arbitrator decide whether a dispute falls within an exception to the parties’ arbitration clause? The arbitrator decides, the Court held; a court has no power to decide the arbitrability issue if the parties’ contract delegates that issue to an arbitrator. The Court concluded that the “wholly groundless” exception, adopted by some lower courts, was inconsistent with the Federal Arbitration Act’s text, which contains no such exception. It also contravened earlier cases, the Court said, that held courts cannot screen from arbitration cases that appear frivolous on the merits and that arbitrators may decide “gateway” questions of arbitrability.
A link to the opinion is here.
Justices Uphold Statutory Exemption for Independent Contractor
In New Prime Inc. v. Oliveira, a unanimous opinion penned by Justice Gorsuch, the Supreme Court affirmed the First Circuit’s judgment that it lacked authority under the Federal Arbitration Act to enforce an arbitration agreement between an interstate trucking company and one of its drivers. The driver, purportedly an independent contractor, had argued that an exception to the Act for “contracts of employment” for transportation workers removed his agreement from the Act’s coverage.
The Supreme Court first considered whether a court or an arbitrator should decide whether the statutory exception applies. The court should decide, it held. The Court reasoned that the provisions of the Act empowering courts to stay litigation and compel obligation apply only if the Act applies, which requires an initial determination of whether the contract falls within the Act’s “contracts of employment” exception.
The Court then turned to the term “contracts of employment.” Looking to its meaning in 1925, the year the Act was adopted, the Court concluded the term “meant nothing more than an agreement to perform work.” Dictionaries of that era, the Court said, did not distinguish between employees and independent contractors.
Although New Prime did not distinguish Schein, discussed above and decided only a week earlier, the key difference appears to be that Schein involved interpreting a contract whereas New Prime involved interpreting the statute, the source of the court’s authority to compel arbitration in the first place.
A link to the opinion is here.
With the SEC prioritizing protection of retail investors, investment advisers are facing increased scrutiny for misappropriation offenses. Adviser representatives are becoming more creative, making it harder for investment advisers to detect misappropriation. It may be easy for investment advisers to rely on software and automated-alerts to safeguard client assets, but the days of solely relying on software or even traditional confirmation letters are gone.
On Sept. 25, 2018, the Security and Exchange Commission (SEC) charged a former adviser representative for misappropriating more than $1.6 million from primarily elderly clients over the span of 14 years. This comes after the SEC announced on Aug.15, 2018 that an investment adviser agreed to pay $4.5 million to settle charges that it failed to safeguard retail investors’ assets from theft after four adviser representatives misappropriated, in aggregate, $1 million. This Alert discusses the significance of the Order and what investment advisers can do to avoid similar offenses.
Under Section 206(4) of the Investment Advisers Act of 1940 (the Act), investment advisers are required to exercise the duty of undivided loyalty and utmost care to their clients. Specifically, Rule 206(4)-2, commonly referred to as the “custody rule,” requires investment advisers who have custody of its clients’ funds or securities to adopt and implement policies and procedures reasonably designed to prevent violations by the investment adviser and its supervised persons.
In the Order, the SEC’s primary concern with the investment adviser’s supervisory systems was whether the system effectively detected misappropriation and the breadth of its detection. According to the SEC, the investment adviser had a hybrid supervisory system with manual and automated reviews which combined a geographical field-based supervisory model and a centralized supervisory model. However, because of the volume of transactions processed daily, a technical error, and limitations in the supervisory system, the investment adviser was unable to detect misappropriation that the SEC believed it was capable of discovering. For example, one adviser transferred funds from his client’s account to an account he effectively controlled for his personal business. The investment adviser’s supervisory system did not account for “controlled accounts” because the investment adviser’s system used a “hot list” of addresses, which, at the time, did not include the adviser representative’s business addresses. Further, the investment adviser’s system was limited only to flagging “exact addresses” so variations as subtle as using avenue instead of ave. would not have identified fraudulent transfers from a client’s account.
Moreover, the SEC highlighted the importance of investment advisers ensuring that its heightened supervision unit adequately monitors recidivist adviser representatives. An adviser representative under heightened supervision for prior unauthorized trading was one of the five representatives that misappropriated $1 million between 2011 to 2014. With the lowest offender misappropriating $21,000 in funds, the SEC sent a clear message; it will not tolerate misappropriation of any retail investors’ funds, no matter how small. Despite reimbursing clients for the misappropriated funds, the investment adviser was still penalized.
This Order comes weeks after another investment adviser faced a multi-million dollar fine for failing to reasonably design policies and procedures to prevent its adviser representatives from misappropriating client funds. One adviser representative’s misappropriation of $7 million led the SEC to uncover that the investment adviser’s policies and procedures, while appearing robust, failed to detect or prevent the adviser representatives from misusing or misappropriating client funds through use of internal electronic forms. The investment adviser allowed for its clients to place verbal requests by phone or in-person for outgoing wire transfers and journals of up to $100,000 per day per account. Based on the adviser representative’s attestation on an electronic form and providing certain details, the requests were completed. However, the investment adviser failed to account for fabricated request made by the adviser representatives. The SEC suggested the investment adviser could have routinely called clients to verify the authenticity of the transfer request or require oral requests be followed-up with a letter of authorization from the client or any writing with the client’s signature.
Investment advisers should reevaluate their supervisory policies and procedures to ensure their systems are performing as intended. Accordingly, investment advisers should:
- Ensure if they are handling large volumes of transactions daily, their systems are capable of processing and reviewing the mass number of transactions;
- Increase personal client-contact, not merely sending a letter, but rather client callbacks, at random and based on risk, to verify fund transfers are approved; and
- Increase anti-fraud expenditures to guarantee that automated-fraud software systems can account for third-party transfers for “controlled accounts” of persons associated with the advisers.
Investment advisers should consider retaining a compliance consultant to access the reasonableness of their policies. As the recent SEC Orders illustrate, the cost of noncompliance is greater than the cost for failing to comply.
The CFPB is proposing revisions to its 2016 no-action letter (“NAL”) policy and is planning to establish “BCFP Product Sandbox,” a regulatory sandbox that would encourage financial institutions to explore innovative products. The revamped policy would address the shortcomings in the 2016 version and streamline the application submission and review process, thus providing banks with increased incentives to seek NALs. Specifically, the revised policy proposes the following key changes:
- Including language in NALs that the CFPB would not make supervisory findings or bring a supervisory or enforcement action under its UDAAP authority or other authority within its jurisdiction, so long as the NAL recipient acts in good faith and substantially complies with the conditions of the letter;
- Decreasing the number of required items of information from 15 to seven;
- Inviting applications from trade associations, service providers, and other third-parties;
- Including language on coordination between the CFPB and other regulators to provide alternate means of obtaining a NAL;
- Removing any temporal limitations on NALs;
- Removing the requirement to share data with the CFPB; and
- Broadening the categories of information to be considered in reviewing NALs.
The “sandbox” concept would presumably allow an innovator to market a new product in a limited way without fear of penalization. To that end, “sandbox” would offer relief similar to a NAL. Additionally, participants would receive “approval relief” that protects actions or omissions made in conformity with approvals pursuant to TILA, ECOA, and EFTA, or “exemptive relief” that creates an exemption from statutory or regulatory provisions such as ECOA, HOEPA, and FDIA. The CFPB expects that relief pursuant to the sandbox concept will be limited in time—in most cases, to two years. The sandbox proposal differs from the new NAL policy in the following important ways: (1) sandbox applicants would describe the data regarding the impact of the proposed product or service and share that data with CFPB if the application is granted; (2) participants would share information about how their product or service would affect complaint patterns and default rates; (3) participants would commit to compensate consumers for material economic harm caused by the product or service; and (4) the CFPB would publish information about application denials on its website.
Comments on the proposal are due 60 days after it is published in the Federal Register.
We expect the U.S. Senate to confirm, as soon as this afternoon, President Trump’s nominee to lead the CFPB as its Director, Kathy Kraninger. A positive, though razor-thin and highly contested, outcome for Kraninger appears inevitable based on the Senate’s vote just a few days ago, strictly along party lines, to invoke “cloture” on the nomination by a margin of 50-49 (with one Republican absent), thereby prohibiting a Democratic filibuster on the confirmation. If Kraninger is not confirmed today to be the next CFPB Director, we expect confirmation to occur at least by December 21, when the current Senate session will end.
Kraninger has served in the Trump administration at the Office of Management and Budget under Mick Mulvaney, who of course has also occupied the position of Acting Director at the CFPB for the past year. She has been promoted by supporters as a highly competent government manager, but has had very little experience in consumer financial services. The extent to which she will deviate from how Mulvaney has directed the Bureau is yet to be determined but will be closely watched.
Once confirmed by the Senate, Kraninger’s term as Director would be for 5 years if she serves out the full term. This could create conflict down the line, in the event that President Trump is not re-elected. In that case, unless Kraninger resigns voluntarily (as presidential appointees at some other independent agencies have done on occasion when a new President is elected), the new President would only be able to remove her “for cause.”
While numerous litigants have challenged the constitutionality of this “for cause” limitation on the President’s authority to remove the Director, no final appellate decision has endorsed that view to date. (See our prior post, here.) However, briefing recently closed on the issue in a case now before the U.S. Court of Appeals for the Fifth Circuit, so a new decision may be near.
A recent FDIC request for information (RFI) suggests the FDIC is interested in enabling banks to offer small, short-term loans to consumers. Over the coming weeks the FDIC will be taking comments on the matter. After analyzing the comments received, the FDIC may issue guidance or regulations encouraging banks to offer these products.
FDIC data suggests that 13% of U.S. households have unmet demand for small loans from banks, representing 14.8 million potential financial consumers. This correlates with a 2017 Fed survey showing that 40% of U.S. adults would not be able to pay a $400 bill without borrowing, selling, or going broke. The FDIC wants this demand met by insured, stable, and well-regulated banks.
The FDIC’s RFI follows efforts by the Office of the Comptroller of the Currency to similarly encourage small-dollar lending by banks. The Comptroller believes that banks’ increased small-lending supply will decrease consumers’ costs and promote their long-term financial goals. The FDIC likely believes the same.
Specific comment areas the FDIC is concerned with include:
- The small-dollar products currently offered and how much demand is unmet?
- The potential for banks to work with third-parties
- Risk factors
- Regulatory or other legal factors discouraging these loans
- Using technology to improve services
Interested parties may submit comments until January 22, 2019.
Movements by the FDIC and other federal regulators suggest that the Trump administration is pushing heavily towards making widespread small-dollar lending at banks commonplace. While the increased competition will hurt payday lenders, it should benefit consumers. Importantly, due to the complex nature of the industry, FDIC-insured lenders should consult counsel concerning any new regulations.
This Post is a “Part II” to our recent blog post describing the CFPB’s current plans to consider new rules that may narrow lenders’ exposure to “disparate-impact” liability under the Equal Credit Opportunity Act (“ECOA”), as well as other federal developments along the same lines, particularly with respect to auto lending. Today, we report on important countervailing developments at the state level, which indicate a more aggressive fair lending enforcement posture. Particularly because state laws can impose disparate-impact liability without regard to how the CFPB or the U.S. Supreme Court may interpret federal law, vigilance as to these developments is warranted.
Any review of state-level developments must account for important changes from the elections results this month at the state level. Democrats, who historically have taken a more activist position on fair lending, flipped the attorney general’s office from Republicans in four states (Colorado, Michigan, Nevada and Wisconsin), which will mean that for the first time in the recent past a Democrat will be the top prosecutor in a majority of U.S. states. Given how often state AG enforcement matters require coalitions of cooperating AGs to pool resources, these developments can make state enforcement actions more likely.
Many of these “blue state” AGs had already expressed their “grave concerns” about indications that the CFPB may be retreating from prior positions on disparate-impact liability, particularly in the auto lending space. In a letter to Acting CFPB Director Mulvaney, those AGs also stated their intent to fill any gap created by changes at the Bureau, so as to “ensure nondiscriminatory lending to the residents of our states,” including by enforcing their own states’ prohibitions on disparate-impact discrimination. Just before sending that letter, the AGs made those same points in a letter to the U.S. Department of Housing and Urban Development (HUD) urging that HUD not tinker with its disparate-impact rule under the Fair Housing Act. Both letters emphasize that regardless of disparate-impact developments at the federal level, states still have their own disparate-impact liability laws under which they can bring, and have brought, enforcement actions.
The states also have taken more concrete steps in response to federal developments. For example, the New York State Department of Financial Services recently issued new guidance on New York’s Fair Lending Law, with a press release that explicitly linked it to statements by the CFPB. The agency reiterated that under New York law, lenders still face liability on a disparate-impact basis, including specifically “for any discrimination that may result from markup and compensation policies with third parties such as car dealers.”
Importantly, however, when it comes to imposing data collection requirements to facilitate fair lending enforcement, state power is not unlimited. In particular, there are now serious concerns that a recent change to Connecticut law on that subject is preempted by ECOA. The amendment purports to require auto lenders, in all instances, to collect information on loan applicants’ race, gender and ethnicity. Under prior law, lenders had only been required to record that information “if known.” The change appears generally inconsistent with, and in this case would therefore be preempted by, ECOA’s implementing Regulation, Regulation B. Regulation B, subject to various narrow exceptions, generally prohibits lenders from asking an applicant to identify his or her race, sex, and ethnicity (as well as certain other protected characteristics, like religion). 12 C.F.R. § 1002.5(b). Because of the preemption concerns, the Connecticut Banking Department recently published a memorandum stating that it would be taking a “no-action” position, and therefore not enforcing, the new law until further notice. The agency also indicated that it has submitted a formal request to the CFPB for an Official Interpretation as to whether the new law is preempted by Regulation B.
On November 13, 2018, the Supreme Court agreed to review the Fourth Circuit’s decision in Carlton & Harris Chiropractic, Inc. v. PDR Network, LLC, 883 F.3d 459, 462 (4th Cir. 2018), addressing whether the Hobbs Act requires district courts to accept the Federal Communication Commission’s interpretation of the Telephone Consumer Protection Act. The case could affect the judiciary’s power to interpret agency rules.
A split Fourth Circuit panel held that the Hobbs Act, 28 U.S.C. § 2341 et seq. – also known as the Administrative Orders Review Act – requires district courts to defer to FCC rules interpreting the TCPA. District courts lack authority, the majority held, to apply Chevron’s two-step analysis in deciding whether to adopt such rules.
Carlton & Harris, a West Virginia chiropractic office, filed a class action against PDR Network, the publisher of a physician’s reference book. Carlton & Harris alleged that PDR violated the TCPA by sending a fax inviting it to reserve a free e-book on PDR’s website. PDR moved to dismiss the complaint on the grounds that offering a free e-book was not an “unsolicited advertisement” under the TCPA, 47 U.S.C. § 227(b)(1)(C), because the book was not for sale. Carlton & Harris responded that a 2006 FCC Rule interpreted the term “unsolicited advertisement” broadly enough to include promoting goods at no cost.
The district court sided with PDR, holding that the TCPA’s definition of the term was unambiguous under Chevron’s step one and did not include free promotions. It declined to follow the FCC’s rule.
A divided Fourth Circuit panel reversed, holding that the Hobbs Act, which gives federal appellate courts exclusive jurisdiction “to determine the validity of” FCC rules interpreting the TCPA, precluded the district court from reaching Chevron’s step one. The Hobbs Act bound the district court to apply the FCC’s rule without ever comparing it to the statute. The dissent countered that the Hobbs Act did not strip the district court of its judicial review power because it never held the rule invalid. The district court, in the dissent’s view, simply gave no deference to the rule because the statute’s plain language controlled the outcome of the case. The dissent warned against equating a decision that a statute is unambiguous with a decision that an agency’s rule is invalid.
PDR argued in its certiorari petition that the federal circuits are split on whether a district court must automatically defer to the FCC’s interpretation of the TCPA. PDR took the position that the Hobbs Act bars only facial challenges to an agency’s orders before a district court, not challenges to how an order applies to a particular set of facts.
In light of Veterans Day, there are some recent notable developments regarding the Military Lending Act (MLA) worth discussing. Enacted in 2006, the MLA caps the annual interest rate for an extension of consumer credit to a servicemember and/or their dependents at thirty six percent, among other protections. The MLA initially applied to a narrow range of payday, auto title, and tax refund anticipation loans, but was expanded in 2015 to include credit cards, installment loans and overdraft lines of credit.
The Consumer Financial Protection Bureau (CFPB) recently announced it plans to end supervisory examinations for alleged violations of the MLA. Supervisory examinations are one of the agency’s key tools to ensure that supervised entities comply with federal consumer financial laws and allow the agency to proactively uncover abuses and patterns of illegal practices by companies suspected of wrongdoing.
According to the CFPB’s Acting Director Mick Mulvaney, neither the Dodd-Frank Act nor the MLA contain explicit provisions for it to conduct supervisory examinations related to alleged violations of the MLA. Under the Obama Administration, the agency conducted dozens of investigations into payday and other lenders pursuant to the MLA without any significant legal opposition or challenges.
According to Mulvaney, the CFPB plans to ask Congress to provide it with express authorization to conduct active monitoring of lenders’ MLA compliance. With the Democrats achieving a majority in the House, Congress may very well introduce legislative changes in January 2019. However, until these changes are enacted, the CFPB plans to halt its use of supervisory examinations to investigate alleged MLA violations.
In response to this announcement, a coalition of thirty-three, bi-partisan state attorneys general sent a letter the CFPB, asking it to reverse course. The coalition argued that MLA permits the CFPB to conduct supervisory examinations and implored the agency to continue strong enforcement of the MLA. Consumer groups and groups representing servicemembers and their families also strongly oppose the CFPB’s change in position.
For financial institutions, the CFPB’s change in supervisory policy will mean reduced oversight through routine supervisory examinations based solely on the MLA. While the CFPB will continue to pursue cases against creditors for violations of the thirty-six percent interest rate cap and other MLA prohibitions, it will rely solely on complaints from servicemembers, rather than its own examinations to uncover violations.
A year ago, the CFPB reported that it had handled over 91,000 complaints from servicemembers, veterans, and their families since 2011. Its 50-state snapshot showed servicemembers are less likely to submit complaints than non-servicemembers about mortgages and credit reporting.
In its recently published Fall 2018 Rulemaking Agenda, the Bureau of Consumer Financial Protection announced that it is considering future rulemaking activity regarding the requirements of the Equal Credit Opportunity Act (“ECOA”) – specifically, “concerning the disparate impact doctrine in light of recent Supreme Court case law and the Congressional disapproval of a prior Bureau bulletin concerning indirect auto lender compliance with ECOA and its implementing regulations.”
In May, President Trump signed a joint resolution passed by Congress disapproving the Bureau’s March 21, 2013 Bulletin titled “Indirect Auto Lending and Compliance with the Equal Credit Opportunity Act.” The Bulletin’s purpose was to “provide guidance for indirect auto lenders within the Bureau’s jurisdiction on ways to limit fair lending risk under the ECOA.” The Bulletin had been controversial from the start, suggesting that indirect auto lenders — who purchase and service loans made by auto dealers that fit criteria agreed to between the dealer and lender — consider imposing controls on dealer markup and eliminate the dealer’s discretion to markup buy rates.
Acting Bureau Director Mick Mulvaney praised the congressional resolution, continuing the Bureau’s move away from the fair lending enforcement priorities of the Bureau’s first Director, Richard Cordray (who, as an aside, was just defeated this past Election Day as the Democratic nominee for Governor of Ohio). Mulvaney thanked President Trump and Congress “for reaffirming that the Bureau lacks the power to act outside of federal statutes.” Mulvaney also referred to the Bulletin as an “instance of Bureau overreach,” and asserted that the initiative “seemed like a solution in search of a problem.” He indicated then that Bureau rulemaking on disparate impact would reflect another theme of his approach: a move toward formal rulemaking in lieu of bulletin issuance or “regulation by enforcement.”
Although the Bureau’s Rulemaking Agenda does not address the details of the contemplated rulemaking activity around ECOA, the Agenda’s reference to “recent Supreme Court case law” suggests that any rulemaking may be designed to address unanswered questions following the Supreme Court’s 2015 decision in Tex. Dep’t of Housing & Community Aff. v. Inclusive Communities Project, Inc., 135 S. Ct. 2507 (2015), in which the Court upheld the concept of disparate impact liability under the other principal federal lending discrimination law, the Fair Housing Act, but also emphasized that disparate impact litigants must prove causation – in other words, proof of a statistical disparity among racial groups alone is not sufficient. Inclusive Communities also imposed other restrictions on disparate impact liability.
Potential Bureau rulemaking might focus on application of the Court’s holdings to ECOA. Such a rule would be more durable than the Bureau’s earlier fair lending bulletin, remaining in effect unless altered by later rulemaking (and thus surviving any future leadership change at the Bureau). A rule would also be binding on other federal agencies and the courts, and thus could provide much-desired clarity for lenders.