State Legislatures Continue to Adopt True Lender Legislation
State legislatures in Maine and New Mexico enacted state consumer credit laws designed to regulate FinTech companies that operate through partnerships with traditional depository institutions. In general, these laws are structured to exempt depository institutions, but regulate the non-bank entities with whom they partner, by treating the non-banks as if they are the lenders in credit transactions, which leads to the moniker “true lender” in describing the legislation. As discussed in prior surveys, FinTech businesses often operate through partnerships with traditional depository institutions, which makes regulation focusing on such partnerships and limiting the interest rates of consumer credit products facilitated through them particularly impactful for FinTech companies.
Maine True Lender Legislation
The Maine legislature adopted requirements in 2021 regulating non-bank financial services providers in a manner similar to creditors. The Maine legislation treats non-lenders as if they are the lender if they hold the predominant economic interest in the loans, conduct pre-origination activity, and hold a right or requirement of first refusal to purchase the loan or a receivable to the loan, or if the totality of the circumstances indicate they are the true lender. In addition, the Maine legislation treats parties other than the traditional creditor to be a “lender” for purposes of the entirety of Article 2 of the Maine Consumer Credit Code, not just for purposes of the civil interest rate limitation. Article 2 includes finance charge restrictions, the requirements relating to licensure as a supervised lender, restrictions on taking real estate security, payment interval and loan term restrictions, and some servicing requirements, including servicing related fees. This creates a statutory true lender test imposing the consumer credit regulations applicable to non-depository lenders, but not to depository institutions, upon companies potentially subject to its requirements. In addition, the Maine civil usury limit for closed-end installment loans above $2,000 is 18 percent per annum, significantly below the 36 percent Military Annual Percentage Rate cap imposed by the Illinois law that the Maine law was modeled on.
New Mexico True Lender Legislation
The New Mexico legislature adopted similar requirements, effective on January 1, 2023, and paired them with a reduction of the applicable civil usury limit to 36 percent per annum, calculated in a manner similar to that prescribed by the Military Lending Act. However, the legislation’s impact is more limited, as it applies to a “Small Loan” of $5,000 or less, with that amount increasing to $10,000 or less on January 1, 2023.
Valid-When-Made Rules Survive Challenges
As detailed previously in the previous survey, a small number of state attorneys general filed suit seeking to overturn the OCC’s and FDIC’s Valid-When-Made final rules on the basis that the OCC and FDIC violated the Administrative Procedures Act and exceeded their respective authority. These rules established that purchasers of loans originated by national banks regulated by the OCC and FDIC-insured state-chartered banks may lawfully collect the interest contracted for within those loans. The federal district court issued orders dismissing both actions, ruling on cross-motions for summary judgment in each case that neither agency exceeded its authority. The court concluded that, under a Chevron deference analysis, the agencies’ decisions were not unreasonable in the context of the facts on record, it was not unreasonable to promulgate the rules given acknowledged market uncertainty, and noted in the case of the FDIC that the agency’s rule did not remove the ability of state legislatures to opt out of the law permitting interest rate exportation authority. The plaintiff attorneys general did not appeal the orders, ending longstanding legal uncertainty on the matter.
The CFPB Reverses Course on Handling Adverse Action Notice Requirements for Machine Learning Underwriting Models
Artificial intelligence (“AI”) relies on detailed datasets to power algorithmic decision-making models. Machine learning (“ML”) is a subset of AI that uses algorithms and large amounts of data to automatically learn insights and recognize patterns, improving decision-making ability. In its 2020 Innovation Spotlight blog post, the CFPB acknowledged the potential benefits of underwriting based on AI and ML:
AI has the potential to expand credit access by enabling lenders to evaluate the creditworthiness of some of the millions of consumers who are unscorable using traditional underwriting techniques.
The CFPB noted that, although uncertainty may exist regarding how to provide compliant adverse action notices, “if the reasons driving an AI decision are based on complex interrelationships,” Regulation B nevertheless offers flexibility. A creditor need not describe how or why a disclosed factor adversely affected an application, or, for credit scoring systems, how the factor related to creditworthiness. Additionally, creditors have latitude to provide adverse action reasons that reflect alternative data sources and more complex models.
CFPB Circular 2022-03, entitled Adverse Action Notification Requirements in Connection with Credit Decisions Based on Complex Algorithms, took a less accommodating tone, explaining that the statement of reasons for adverse action taken on credit applications must be specific, must not merely be the closest identifiable factor listed on sample forms provide by Regulation B, and, with respect to credit scoring systems, may not exclude a factor that was a principal reason for adverse action. A creditor's lack of understanding of its own methods, the CFPB said, is not a cognizable defense against liability: “The ECOA [Equal Credit Opportunity Act] and Regulation B do not permit creditors to use complex algorithms when doing so means they cannot provide the specific and accurate reasons for adverse actions.”
With the publication of Circular 2022-03, the CFPB also placed a warning label on its 2020 Innovation Spotlight post, stating that it conveys an “incomplete description of the adverse action notice requirements of ECOA and Regulation B, which apply equally to all credit decisions, regardless of the technology used to make them.” The warning label also refers readers to CFPB Circular 2022-03, suggesting that it completes the “incomplete” Innovation Spotlight post.
The CFPB’s latest communication appears to respond to the potential for AI to have a negative impact on consumers, using the substantive content requirements of the adverse action notice either to explain or stop the use of ML practices in underwriting. Although the Innovation Spotlight post discussed certain elements of flexibility within the adverse action requirements, by issuing Circular 2022-03, the CFPB clarified that its expectations for industry practices are not similarly flexible. The CFPB’s circulars are general statements of policy issued to promote consistency across enforcement agencies and provide transparency regarding its approach. And the CFPB’s stated policy, applicable to users of traditional or AI/ML underwriting techniques, requires creditors to provide applicants against whom adverse action is taken with an accurate statement of reasons that are specific and indicate the principal reasons for the adverse action.
The CFPB Rescinds No-Action Letter and Sandbox Policies
The CFPB proposed a Trial Disclosure Program in 2013 and its first policy on No-Action Letters (“NAL”) in 2014, which resulted in non-binding staff-level no-action recommendations after it was finalized. In 2018, the CFPB proposed revisions to increase the utilization of the NAL and to establish a “Product Sandbox.” The CFPB finalized the NAL and Sandbox policies in 2019.
The Sandbox provided for the issuance of approvals that the CFPB noted would offer “a regulated entity that confronts regulatory uncertainty the binding assurance that specific aspects of a product or service are compliant with specified legal provisions” that would therefore result in immunity with respect to those aspects. No-Action Letters were similar, providing “an entity with the Bureau's discretionary determination not to exercise supervisory or enforcement activity against specific aspects of a product or service.”
In May 2022, the CFPB announced that it would replace its Office of Innovation with the Office of Competition and Innovation. The Office of Innovation’s primary focus was to process applications for No-Action Letters and Sandboxes, which the CFPB said were “ineffective.” However, the CFPB did not explicitly state that it was ending the Sandbox and NAL policies. However, in September 2022, the CFPB determined that the NAL and Sandbox policies did “not advance their stated objective of facilitating consumer-beneficial innovation” and that they “failed to meet appropriate standards for transparency and stakeholder participation.” Consequently, to “preserve resources and reduce inefficiency and burden,” the CFPB did not renew the policies' Paperwork Reduction Act of 1995 authorizations, resulting in the rescission of the NAL and Sandbox policies effective September 30, 2022. The CFPB will continue to accept and process requests under the Trial Disclosure Policy, but the CFPB’s rescission of the NAL and Sandbox policies indicates an intent to require compliance with applicable federal law and that companies will have to address regulatory uncertainty without its assistance.