RegFi Episode 34: Bank Partnerships and the Implications of DIDMCA Opt-Outs
31 min listen
Not all of our listeners will be familiar with the Depository Institutions Deregulation and Monetary Control Act of 1980, but pending litigation on state DIDMCA opt outs could upend the bank partnership models employed by many fintechs. RegFi co-hosts Jerry Buckley and Sasha Leonhardt welcome welcome Orrick partner James McGuire for an overview of DIDMCA’s interest rate exportation rules for state-chartered financial institutions and the lawsuit filed by industry groups in response to Colorado’s recent opt-out legislation. The conversation explores the critical balance between state regulations and national lending practices, including the potential implications to traditional banking, fintech innovation and consumer access to credit.
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Jerry Buckley: Hello, this is Jerry Buckley, and I'm here with my co-host, Sasha Leonhardt. We are joined today by our Orrick partner, James McGuire. James is resident in the firm's San Francisco office, and he represents banks and other financial services companies in bet-the-company, complex civil litigation. We've asked James to join us today to discuss a subject that some of our listeners will be hearing about for the first time, DIDMCA opt outs.
Now, before you pull out your ear pods, I think you will be intrigued by the significant impact that DIDMCA opt outs could have on American banks, and in particular, on the fintech sector. DIDMCA is Washington speak for, “Depository Institutions Deregulation and Monetary Control Act of 1980.” For our purposes today, we will focus on one feature of the legislation contained in sections 521 to 23 of the Act, that allow state-chartered banks and credit unions insured by FDIC or NCUA to contract for an interest rate permitted by the state where the institution is located and to export that interest rate to other states where they are lending.
However, states are permitted under the provisions of this act to opt out of this rate exportation arrangement. What makes this such a timely issue is that there is, after about 40 years of acceptance of rate exportation as a way of doing business, now there are a number of states that are trying to, or actually have, and are considering opting out. But whether or how they can do that, as they say, is complicated.
So, we've asked James to walk us through this issue that has significant implications for the dual banking system and for many fintech companies.
James let's start with the basics. Could you share with our listeners the policy reasons that led Congress to enact the interest rate export provisions of DIDMCA in the high interest rate environment of 1980? And putting aside the opt-out language for the moment, could you then walk us through how those provisions work by way of loan origination example?James McGuire: Sure, Jerry, and thanks for having me on your podcast. So, I'll admit this was a little before my time, but it's something I've worked with for a really long time. And so, as you mentioned, in 1980 and really from the 70s, the country was experiencing an incredibly high interest rate environment.
I think, and I took a look at this, that in January of 1980, the Fed funds rate was 14%. And I think today where we believe we're in a high interest rate environment, it's somewhere around 5.5%. And that by the end of 1980, the Fed funds rate had gone up to 20%. So, the country was confronted with a really significant interest rate environment.
And that, in turn, was creating, obviously, a number of problems. And DIDMCA did a number of things that we're not going to talk about today, but these interest rate exportation rules were designed, I think, to combat or to address a couple of issues or a couple of problems. One was that the cost of funds in that interest rate environment, coupled with low interest rate caps, were creating real problems for state-chartered banks.
So, by way of example, if your cost of funds was 14% and your state limited you to lending at 6%, it doesn't take a mathematician to realize that you're not going to be making very many loans in that environment. And that led to a really significant restriction of credit in states where they had that collision of issues. And then the second piece, the second policy thing that Congress was looking at was the competitive disadvantage that state-chartered banks were at vis-a-vis national banks, federally chartered banks, who had the ability to export interest rates, which we're going to talk about in a little bit, under Section 85 of the National Bank Act.
That statute, Section 85, permitted national banks to lend at either 1% over the federal discount rate or the rate permitted by their home states. And in a decision in 1978, a couple of years before DIDMCA the Supreme Court had held in a case called Marquette that in addition to the rates that the statute permitted, that national banks could export those rates to states around the country.
So, this was really the foundation for national credit card programs at the time. You would have Citi Bank, for example, lending out of South Dakota and able to employ the uniform Section 85 rate around the country.
So long answer to your question, Jerry, I think Congress was trying to address two things, which was the credit shortage created by the collision of the high interest rate environment and state usury caps and the competitive disadvantage vis-a-vis national banks. And the solution they came up with was what you described, which was to basically put state-chartered banks on equal footing with national banks in Section 521 through 523 by allowing them to essentially export the rate of their home state or to use the higher of that rate or 1% over the Fed funds rate.
You asked about an example. I'll just give the simplest one, which is kind of near and dear to my heart, because this is when I first encountered this, which was a state-chartered bank, for example, in Virginia, would suddenly be able to run a national program. And what it would not have to do would be to figure out the permissible interest rate in the 50 states in which it wanted to lend. It could export a uniform rate. And so it really was a model that enabled that business.Jerry: Well, that's really great, and you've really set the table very well. Sasha, why don't we bring you in on this? Sasha Leonhardt: James, thank you for joining us today, and I'm glad you mentioned your example of getting to bypass the headache of dealing with 50-state law, because as someone who maintains a 50-state practice, has done more than my fair share of 50-state surveys, I appreciate the tedium and cost that comes with those.
Turning to the opt-out language in DIDMCA, which is what's in the news now, could you explain how that works operationally? And could you touch on some of the early attempts to opt out after the statute passed, as well as how the opt-out provision was interpreted by federal regulators when the first opt-out efforts were initiated in some states?James: Yeah, I'm happy to. And as you alluded to, this is frankly why we are having this conversation today. And I know we're going to circle back to this in a minute. So, Section 525 of DIDMCA, not the exportation provisions, but Section 525 permitted states to opt out of the DIDMCA regime.
And what it said was, in language that has created a lot of controversy today, is that sections 521 through 523, the exportation provisions, will not apply to loans made in any state if a state adopts a law which states explicitly and by its terms that such state does not want the amendments to apply in that state. And so, you know, the mechanics of it were a state could pass a law that said, “that we do not want sections 521 through 523 to apply to loans made in our state.”
So shortly after DIDMCA passed, seven states and Puerto Rico, in fact, opted out. And one of those states, which was Colorado, which is interesting because we'll talk about that again in a few minutes. And then within a couple of years, six of those states had opted back in.
So today, as we sit here, Puerto Rico and Iowa are opted out of DIDMCA and Colorado is opted out of DIDMCA, but its statute doesn't go into effect until July 1 if it ultimately goes into effect. So, the real question about the opt out is not really can a state opt out or the real question is what does it mean to opt out? And this sort of falls into two camps, which are by opting out a state, and again, the state can opt out of loans made in the state.
So, this also devolves into the question of what does it mean for a loan to be made in a state? It's effectively the same question as what is the impact of the opt out? And that has been the source of some controversy. So, on the one hand, the argument is the state cannot, when a state opts out it, what it simply does is it, is it handicaps its own banks within that state from participating in the DIDMCA regime and they cannot, they cannot exceed the state usury caps either inside or outside of the state.
The contrary view is that it effectively allows the state, by opting out, to regulate the activities of banks in the 49 other states and that they are unable to import their rates, or export into, Colorado, you know, for example. And so, you know, regulators were asked about this early on in the 80s and the 90s. And, you know, they discussed the question of, well, how do you decide whether a loan is made in a given state? And they looked at the way that question had traditionally been assessed, including some language in the Marquette case, which really was focused more on where the bank was located, but those two questions are going to somewhat overlap as we go through this.
And in 1988 the FDIC issued a decision, or it was actually a general counsel opinion, that said that loans are made where the charges are assessed, payments were remitted, crediting decisions were made and credit card — this was in the context of a credit card program — and credit cards were issued and they also focused on choice of law and essentially said, you know, the final conclusion of where a loan is made is a factual one that's based on the terms of the contract and all the facts present.
And the facts present were those things that I just listed, where the crediting decision was made, where the payments were made, where the funds were dispersed from. And it gave lenders some certainty because if you normally apply those factors, you can normally conclude where a loan is made, which in turn allows you to define what the scope of the opt out means.
And again, in 1988, the FDIC issued what's known as General Counsel Opinion 11, which suggested that a loan is made where what had sort of has evolved into the non-ministerial function test, where the three non-ministerial functions are performed. And those are the decision to extend credit, the communication of that decision, and the dispersal of loan proceeds.
And so that was a fairly uniform position of the regulators. There are OCC statements that are similar to that, and again, it gave industry what it normally needs, which is certainty about how its products are going to be interpreted going forward.Jerry: Well, that's a great summary. And now that you've given us that context and a bit of history, let's bring this down to the present. The opt-out issue, as I said, was quiescent for a number of years and now, all of a sudden, it's come alive in Colorado and under consideration in other jurisdictions. Can you share with us who's pushing for an opt out and who's pushing against it? James: Sure. So, the current drive towards opt out, and Jerry, you're right, and I think I mentioned this earlier, Colorado has enacted a statute opting out of DIDMCA, or I guess re-opting out since this is their second go-around. And there's legislation that is actively being considered or has been introduced in D.C., Minnesota, Nevada, Rhode Island, and it's actively being considered in others.
It will come as no surprise that on one side of this issue are consumer advocates who believe that industry has exploited the DIDMCA exportation regime to permit what, you know, what they would call predatory lending around the country. And on the other side of this, there's generally industry, which believes that it offers useful products that consumers want and that are compliant with federal law, including DIDMCA, the state law whose exportation rules are being used, and then a host of other federal laws. So that's kind of the array of forces in the debate.
In terms of the really current state of play, Colorado enacted its opt-out provision in June of 2023, and it was set to go into effect on July 1 of this year, 2024. And it's known as Section 3. Section 3 provides that Colorado has opted out of Section 525 of DIDMCA and, in language that is important to the discussion, it says that they do not want DIDMCA to apply to consumer credit transactions in this state. What the statute has made, what Colorado has made clear is that, and I should back up by saying, as I said before: there's no real debate about Colorado's ability to opt out. The debate is around what the opt out means.
And Colorado has sort of thrown down the gauntlet on this and said that when we opt out, what we mean is that nobody can engage in a transaction with a Colorado resident that exceeds the Colorado usury gap. So, if you're out of state, if you're in state, if you enter into a loan transaction with a Colorado resident, you're not permitted to exceed Colorado's interest rate limitations.
On March 25 of this year, a consortium of business trade groups — the National Association of Industrial Bankers, the American Financial Services Association, and the American Fintech Council — filed suit against Colorado, in federal district court in Colorado, seeking injunctive and declaratory relief that Section 3, as I've just described it, is invalid under federal law. They filed a motion for a preliminary injunction, hoping to get the law enjoined before it goes into effect on July 1. And that motion has been fully briefed by the plaintiffs, those trade groups, by Colorado, the Colorado officials charged with enforcing the statute. And there have been a variety of amici who have also appeared. And it is set for hearing on May 16 in front of the federal district court. So, there will be a lot of eyes on that.
The main arguments that are being advanced in the case by the plaintiff trade groups are that, again, not that Colorado can't opt out, but that this particular opt out has exceeded the scope of Section 525 by seeking to limit the ability of banks outside of Colorado to export their rates into Colorado by legislating that any loan made with a Colorado consumer is made in Colorado. Their position is that the question of where a loan is made must be determined by reference to a uniform federal standard. Given that this is a federal statute, it wouldn't make sense for states to be able to legislatively decree whether a loan was made in that state. And noting that we have a variety of authorities that I've already described about where loans are made, that essentially, as the FDIC and the OCC and others have opined, that loans tend to be made where the non-ministerial functions that I won't go over again occur.
The responsive argument by Colorado is essentially the converse of that, which is that where a loan is made by necessity has to include the assessment of the physical location of the borrower. But again, the position would be that is a peculiar argument to the state and that the state doesn't get to decide where the loan is made and that has to be a uniform standard. So those arguments are not terribly surprising. The big surprise came in the litigation when the FDIC weighed in on the side of the state in an amicus brief and took the position that, in fact, the equation of where a bank is located and where a loan is made, that it's a false equivalency. And to be clear, I don't think that the plaintiffs were really saying that they were the same.
I think they explicitly said that they were overlapping inquiries and that, in fact, given what the non-ministerial functions are, where a bank is located often ends up being where a loan is made just by virtue of the application of those well-established factors. But they took the position that a loan is made in a state if either the borrower or the lender enters into the transaction in that state. So, in the FDIC's view, if a Utah bank lends to a consumer in Utah, that loan is made in both the states of Utah and Colorado, which is interesting for-Jerry: I think you meant if a Utah bank lends in Colorado, it is both in Utah and Colorado. James: That is definitely what I meant. And I'm sorry. Jerry: No, no, no. No problem. James: And so it really, you know, it creates a couple of issues. One is it really, and although the FDIC goes to great lengths to say that it's not the case, it seems really inconsistent with the position that they have taken historically on this issue. And, you know, there's a lot of flux in administrative law right now. There's a case pending up in front of the Supreme Court in terms of deference owed to positions of agencies.
But, you know, historically, a changing position taken for the first time even as an amicus in litigation, is often not given a lot of deference. But it's very interesting in the sense that it's inconsistent with their prior take. And they do cite those opinion letters that I've described, but they don't make any effort to discuss the portions where they really described how you would determine where a loan was made.
And I think the second interesting point to me is the idea that the loan could be made in two different places is unique. And I think it leads to a lot of outlier hypotheticals, in my view, in a mobile society, because you often don't know where the borrower might be when they're engaging or entering into a loan transaction.
And again, those are going to be outlier transactions. And I suppose the obligation, if their position prevails, will be to ask the borrower where the borrower is physically sitting when they click agree. But it's a really interesting position to have taken. So that's where we are on the litigation. As I said, a number of other amici have weighed in. I saw the PBA, I think, filed an amicus brief this morning, which I didn't have a chance to look at before the podcast. And I know that some, and I believe some consumer organizations have weighed in as well.Jerry: Could you just — any idea of how long, given the pendency next month or the month after an effective date, how long do you think the court would be — you're a litigator — how long do you think the court will take to rule on this? James: So, I think that the court will rule well in advance of the July 1 deadline. And it just suddenly dawned on me that the hearing is today. That it is in fact May 16 today. Jerry: Yes. Right. James: I think they're there six weeks in advance of the law going into effect, which is a pretty significant amount of time. And I think that the court can rule on the preliminary injunction, which doesn't necessarily require it to do a full merits analysis. It does require it to delve into the merits some. But I think they're there in ample time if the court acts quickly.
And I think the court will. Most of the federal courts really try to get on these things quickly where they perceive there to be an actual timing concern. And as I'm sure many of our listeners will know, there's been a, you know, that issue in another context has been something that people have been focused a lot on in Texas over the last couple of months with the credit card late-fee rule.Sasha: No, James, we're following that closely on the card side and appreciate the description of the litigation in Colorado. I wanted to change the text slightly here. In speaking with clients, we're hearing concerns that DIDMCA opt outs and the accompanying uncertainty from litigation and the FDIC's shifting position will have a serious impact in particular on fintech lenders.
These lenders often operate in a bank partnership model, and rely upon their bank partners to export interest rates to all 50 states. Could you touch on how this works and what this means in particular for the fintech universe?James: Yeah. So, you know, and we talked about this a little bit, you know, at the beginning. I mean, and, you know, I'm a litigator by trade, and I know Sasha and others, you guys work more on the front end of these things. But, you know, fintechs partner with insured depository institutions for a number of reasons.
But, you know, I think large among them are the ability to offer uniform services on a nationwide basis and partnering with those institutions allows them to, you know, avoid the 50, the so-called 50-state hodgepodge of laws, at least in at least in some contexts, you know, usury, money transmission, you know, sometimes, you know, the regulatory licensing requirements. And I think it allows, you know, and you would know this better than I would, but it allows sort of the parties to those transactions to focus on what they do best, right?
The fintechs are able to, you know, to bring their expertise to bear on, you know, marketing and servicing and technology and allows the big partner to expand their business. And the trade-off is that the fintech often becomes, you know, subject to significantly more law and oversight than it otherwise would be had it not entered into the transaction.
But, you know, if the Colorado position or the FDIC position prevails, what I think one could expect, you know, so the first step, of course, would be to see what happens, like how many other states would opt out is, you know, and, you know, there are some, but I think there are also a number that have not. And that's, you know, there's also the question of whether those things can be achieved legislatively in a given state.
But at the end of the day, if there was a trend in that direction, then obviously the fintechs need to begin to adjust their business in a way that either accounts for having to deal with some lack of uniformity in the product, which could be by continuing to do business in those states and complying with those states’ specific laws, it could be pulling out of those states altogether and the consequences that arise from that.
There could be partnering with other banks like national banks with some irony in terms of the, you know, the policies of DIDMCA, you know, one of the policies that I talked about earlier. But, you know, we'll have to wait and see. And I think the national bank partnership model, you know, that is an option, a theoretical option. But I don't know, you know, whether that would be sufficient to take up the slack that would exist if a number of states opted out of DIDMCA, if it would be able to take up the slack where the state-chartered banks could no longer operate.Sasha: And as I hear you talk about this, it occurs to me that this must be a particularly difficult issue for the Conference of State Bank Supervisors, since some states favor rate exportations and others like Colorado are moving in the opposite direction. To revisit your comment about uniform law, it seems that a balkanized approach with multiple state usury ceilings would set back the state banking system and could wind up denying borrowers living in certain states access to fintech loans.
What happens when a borrower goes on the internet, which knows and respects no state boundaries, finds a loan that meets their needs, but then learns that the loan product is not available in their state due to interest rate limitations?James: Right. So, my take is that that consumer is going to be disappointed. They're not going to be able to get the product that they are looking for, that they went on the internet to look for in their state. As you indicated, they're — the outcome of this, and I think the designed outcome is that, in other words, it's a feature, not a bug, is that a number of products, which by their nature tend to carry higher interest rates, some short-term loans, I think, you know, BNPL products, you know, even credit cards are simply not going to be available because they're not — they don't make economic sense in some instances with the lower rates.
And then that same issue is going to apply to populations of consumers. And again, I think it's — for the advocates of this — it's a feature, not a bug — is that there is going to be swaths of the population that will be essentially priced out. They'll be deemed too risky to lend to at the rates that the state would permit.
And, I litigate in this space a lot, and part of the concern is, you know, what is that going to mean for those consumers? As I said, they’re going to be disappointed. But like a lot of other things, the demand is probably not going to go away. And those consumers are still going to need funds for a variety of things. Some of it may dry up. But I think there's a real policy question about where, you know, what happens to those consumers who still need those funds. Where are they going to go for them? And, you know, I think there are many, you know, sort of less palatable options that one would find out there in the wilderness that might, you know, be where they turn.
And I think this is, you know, because there's that sort of narrow fight that I just described, you know, there's the other, you know, I think kind of interesting policy outcome is the, you know, that essentially these states, and it is particularly ironic as we move into this higher interest rate environment that, you know, the other policy outcome, of course, is that, and this is less consumer focused, but kind of along the lines as I just described, it ends up restricting credit in a given state that has opted out.
The costs of funds are going up, and if you can only lend at a certain, artificially-lowered or non-market rate, there are going to be significant instances in which you're going to choose not to make those loans.
And then, as we just described in terms of the market response options, it clearly is going to lead to more of a disadvantage for state-chartered banks, vis-a-vis national banks and a competitive disadvantage. That is, what they're doing is creating business opportunities that national banks will be able to take advantage of that state-chartered banks will not. And there will be fewer players in that market, which normally is not a good thing in terms of consumer choice.Jerry: There is a bit of irony in that FDIC is the primary federal regulator for state-chartered banks, has generally encouraged the state-chartered banking system, and works with the Conference of State Bank Supervisors, supervising those institutions for the individual banking regulators. So they've made an interesting decision here, which has policy implications for the banks that they regulate. It'll be interesting to see how this all works out going forward from a policy point of view.
James, our time has run out, unfortunately, but you have done a great job in teeing up this issue for our listeners, and a lot of thank you for joining us today.James: Yeah, it's my pleasure, Jerry. And I think, you know, keep a lookout. The hearing in Colorado was today. We would expect to get some reports from the hearing fairly soon. And, you know, keep a lookout because I'm sure we will be putting out some client alerts in terms of continuing developments in that litigation. Sasha: Thank you, James. We certainly will keep an eye out for that. I promise you. James: Thanks so much, guys.