By: Catherine M. Brennan and Hurshell Brown
In August, the California Supreme Court issued its decision in De La Torre v. CashCall, Inc., which answered “yes” to the question “Can the interest rate on consumer loans of $2,500 or more render the loans unconscionable under section 22302 of the Financial Code?”
The fear generated from this decision stems from the fact that the California Financing Law (“CFL”) expressly provides that for loans with a bona fide principal amount of $2,500 or more, the rate of finance charges must be accurate and must not exceed that disclosed in the consumer loan contract or note. Cal. Fin. Code § 22332. The CFL also provides that if a court, as a matter of law, finds the contract or any clause of the contract to have been unconscionable at the time it was made, the court may refuse to enforce the contract, or it may enforce the remainder of the contract without the unconscionable clause, or it may so limit the application of any unconscionable clause as to avoid any unconscionable result. The CFL does this by specifically incorporating into its provisions another California law that bans unconscionable contracts. Cal. Fin. Code § 22302; Cal Civ. Code § 1670.5(a).
The plaintiffs in the litigation obtained CashCall loans of $2,600 with an annual percentage rate of 96% to 135%. They then sued CashCall claiming solely that the loans they obtained were unconscionable. They did not claim that CashCall’s advertising was deceptive. They do not claim that CashCall failed to disclose accurately the terms of the loan as required by federal law. The sole claim in the lawsuit was that the loans were unlawful because they were unconscionable.
The litigation proceeded in federal court until it reached the Ninth Circuit. The Ninth Circuit posed the question of whether a loan that was originated under a statute that allowed the parties to contract for any rate of interest could nevertheless be unconscionable. This question has never been answered by the highest court in California, so certification of this question by the federal appellate court to the state high court made sense.
And so, “yes” as the answer has raised many questions for lenders and investors in the subprime lending space. And although the fear is real, the reality is that not much has changed.
A careful reading of the decision makes very clear that it is highly doubtful that the interest rate – standing alone – would be enough to justify a finding of unconscionability. As the court notes, “(u)nconscionability is a flexible doctrine. It is meant to ensure that in circumstances indicating an absence of meaningful choice, contracts do not specify terms that are ‘overly harsh,’ ‘unduly oppressive,’ or ‘so one-sided as to shock the conscience.’” The court goes on to say that “at least one thing about the doctrine is clear: it requires more than just looking at one particular term in a contract, comparing it to a fixed benchmark, and declaring the term unconscionable.”
In California, for a contract to be unconscionable, the proponent must show both procedural unconscionability, which can come through surprise, and substantive unconscionability, which is demonstrated through showing one-sided results. Both facts must be present for a court to declare a contract unconscionable. Importantly, context matters; “(e)ven when a party complains of a single contract clause, the court usually must still examine the bargaining process for any procedural unfairness.” Additionally, when the price is alleged to be substantively unconscionable, it is not enough for a court to consider only whether the price exceeds cost or fair market value. The court also must examine the justification for the price. “If, for example, the interest rate is high because the borrowers of the loan are credit-impaired or default-prone, then this is a justification that tends to push away from a finding of substantive unconscionability.”
The heart of the De La Torre decisions follows (internal citations removed):
“These factors underscore why finding unconscionable a contract setting an interest rate is categorically different from imposing an unvarying cap on the interest rate. To declare an interest rate unconscionable means only that — under the circumstances of the case, taking into account the bargaining process and prevailing market conditions — a particular rate was “overly harsh,” “unduly oppressive,” or “so one-sided as to shock the conscience. … An unconscionability determination does not generally depend on a single factor, and tends to be “highly dependent on context.” … This is a far cry from how a rate cap operates. If an interest rate exceeds a cap, then it will always exceed the cap, as will all rates above it, regardless of the circumstances under which those rates came about. A rate cap is uniform and rigid; unconscionability, on the other hand, is context-specific and malleable. A reasonable Legislature can lift an interest rate cap without also intending that unconscionability will never apply to an uncapped rate. Indeed, a reasonable Legislature can lift an interest rate cap, but — intending to protect consumers — specify that terms of consumer loans are still policed by the flexible standard of unconscionability.”
So, although the court answered “yes” to the question presented – “Can the interest rate on consumer loans of $2,500 or more render the loans unconscionable under section 22302 of the Financial Code?,” the court did not conclude that the interest rate, standing alone, is enough to render such loans unconscionable. The court did not establish a bright line rule, nor did it say that interest rate on its own would make a loan unconscionable.
How does De La Torre impact non-CFL lenders? The CFL specifically does not apply to banks, although banks are also exempt from the restrictions on interest rates that are found in the California Constitution. This is important because under federal law, state-chartered banks and national banks are permitted to export the interest rate permitted to them by their home state, but such exportation authority must include the provisions of state law relating to that class of loans that are material to the determination of the permitted interest. For example, a national bank may lawfully charge the highest rate permitted to be charged by a state-licensed small loan company, without being so licensed, but subject to state law limitations on the size of loans made by small loan companies. However, as noted above and as incorporated into the CFL, California has a stand-alone unconscionability statute that does apply to California banks, whether they are chartered by California or the federal government. This is not a new proposition; the California Supreme Court, the same court that decided the De la Torre case, concluded as such in 1985 in Perdue v. Crocker National Bank. In that case – which determined that NSF fees imposed by a national bank chartered in California could be subjected to an unconscionability analysis on price, even where California law did not limit the fee charged – the court noted that although it is unlikely that a court would find a price set by a freely competitive market to be unconscionable, “the market set by an oligopoly should not be immune from scrutiny.” The court concluded that Crocker National Bank structured a totally one-sided transaction, and that “(t)he absence of equality of bargaining power, open negotiation, full disclosure, and a contract which fairly sets out the rights and duties of each party demonstrates that the transaction lacks those checks and balances which would inhibit the charging of unconscionable fees.” The court made this determination by examining the context of the transaction, not just the price – a path forward like that suggested by the De La Torre court.
With all this in mind, what should a lender do? Lenders should continue doing what they always should do – follow the law and treat consumers fairly. To that end, we recommend specific actions lenders should take, including:
- Maintaining strict compliance with all state and federal laws applicable to the loans;
- Ensuring extreme transparency of disclosures during the loan process and in the loan agreements;
- Implementing well-conceived underwriting standards based on analytics, relevant third-party credit bureau information, historical loan performance and other statistically-significant, non-discriminatory factors;
- Adoption of a voluntary right to rescind a loan transaction without penalty within the first few days after the loan is made;
- Varying interest rates depending on the borrowers’ underwriting scores;
- Managing and monitoring default rates;
- Conducting market studies to document the terms for financial products in the marketplace that are available to your typical borrower; and
- Performing a formal market analysis to consider the “context” of a lender’s California operations, considering cost of capital and operating costs, historical default rates, other variable for California operations, and the rates offered by competitors.
And if you are hit with an unconscionability lawsuit despite your best efforts? It is unlikely that such lawsuit would decimate a lender or an investor’s portfolio. As an initial matter, the unconscionability determination is highly fact-specific. This alone makes such disputes unlikely to be amendable to class action treatment. Secondarily, the statute that permits the unconscionability lawsuit has limited remedies. Importantly, private individuals who sue cannot obtain damages or attorney’s fees. As the De La Torre court notes, “(t)he relative paucity of remedies under the UCL should serve to limit pure attorney-driven lawsuits (since no attorney fees may be recovered) as well as blackmail settlements (since no money recovery beyond restitution is possible).” With such financial disincentives, and with adherence to both the letter and spirit of the law to ensure fair treatment of consumers, the De La Torre case should not significantly hamper the operations of California lenders. Nevertheless, this decision is a good reminder that all lenders should review their lending policies and loan agreements for possible deficiencies and to ensure their lending practices are within market standards.
Catherine Brennan is a partner in Hudson Cook LLP’s Maryland office. Cathy primarily assists investors in the consumer financial services and alternative business funding sectors. She engages in credit due diligence on behalf of investors in Fintech firms, bank partnership platforms, small business lenders, merchant cash advance companies, consumer finance companies, title loan companies and payday lenders. Contact Cathy at cbrennan@hudco.com.
Hurshell Brown is a partner in Hudson Cook, LLP’s Texas office. Hurshell has extensive experience in providing regulatory guidance for both storefront and online lending operations, including experience in online loan originations, online commerce, electronic payments and collections. He also assists clients with state and federal supervisory exams with regulators, including the CFPB, and he works with clients to develop and maintain effective compliance management systems. Contact Hurshell at hbrown@hudco.com.
This article is provided for informational purposes and is not intended nor should it be taken as legal advice. The views and opinions expressed in this article are those of the authors in [his][her] individual capacity and do not reflect the official policy or position of their partners, entities, or clients they represent.
