On August 31, in Consumer Financial Protection Bureau v. CashCall, Inc., the U.S. District Court for the Central District of California ruled that CashCall was the “true lender” on loans issued by Western Sky Financial, a type of tribal lender, because the entire monetary burden and risk of the loan program was placed on CashCall such that CashCall, and not Western Sky, had the predominant economic interest in the loans that were made. The court relied on the fact that, although Western Sky was the stated lender on the loans, CashCall funded a reserve account to fund two days’ worth of agreed-upon loans and purchased all of the loans originated by Western Sky after a three-day holding period, but prior to any consumer payments being made on the loans. In addition, CashCall agreed to indemnify Western Sky for any liability that it might incur in connection with the loans. The loan products in question included a $2,600 loan with an APR of 134 percent and a $700 loan with an APR of 318 percent.

The court reached four significant conclusions in its summary judgment: (1) CashCall, and not Western Sky, was the “true lender”; (2) the laws of the borrowers’ home states applied to the loan agreements, despite the tribal choice-of-law provision in the loan agreements; (3) the Western Sky loan agreements are void or uncollectable under the laws of 16 states; and (4) CashCall violated the Consumer Financial Protection Act of 2010 (CFPA), and, more specifically, the act of servicing and collecting on those loans, where payments were not due and owing, was deceptive.

True Lender

The court’s decision was based on the “totality of the circumstances” test to determine which party to the transaction had the “predominant economic interest” in the transaction. The Central District of California is the first federal court to use the “predominant economic interest” test for determining “true lender” status, which had previously only been used in state court cases. The court made little effort to distinguish this decision from the prevailing view of other district courts and circuit courts that have weighed in on the proper standard to apply in true lender cases and made only a passing mention in a footnote that other standards may even exist.

The court stated that, under the “totality of the circumstances” test, the key and most determinative factor was whether Western Sky placed its own money at risk during the transaction or whether the monetary burden and risk of the loan program was borne by CashCall. Based on an examination of the facts, the court concluded that CashCall, not Western Sky, was the true lender for several reasons. First, CashCall, and not Western Sky, placed its money at risk. Second, CashCall assumed all economic risks and benefits of the loans immediately upon assignment. Third, CashCall bore the risks of default as well as the regulatory risk. Fourth, CashCall agreed to fully indemnify Western Sky Financial for all costs of litigation, civil assessments or penalties. Accordingly, the court concluded that the entire monetary burden and risk of the loan program was placed on CashCall because it had the predominant economic interest in the loans and was therefore the “true lender” and real party of interest under the “totality of the circumstances” test.

Choice of Law

The court relied on section 187(2) of the Restatement (Second) of Conflict of Laws, which lays out two tests as to whether the law of the state chosen by the parties to govern their contractual rights and duties will be applied. First, the court examined whether the chosen state had a substantial relationship to the parties or the transaction and, if not, whether there was another reasonable basis for the parties’ choice. Once the true lender was identified to be someone other than Western Sky Financial, the court concluded that the Cheyenne River Sioux Tribe (CRST) had no substantial relationship to the parties or the transaction and there was no other reasonable basis for the parties’ choice of CRST law. Under the second test, the court concluded that the application of CRST law would be contrary to a fundamental policy of the 16 states with usury laws that have a materially greater interest than the CRST in the determination of the particular issue. Therefore, absent an effective choice-of-law provision, the subject states’ laws apply.

Void or Uncollectable Loans

The court concluded that the Western Sky loan agreements are void or uncollectable under the laws of 16 states. A violation of those usury laws either renders the loan agreement void or relieves the borrowers of the obligation to pay the usurious charges. Additionally, most of the states require a consumer lenders license before being able to make loans to consumers in those states. A lack of license also renders the loan contract void and/or relieves the borrowers of the obligation to pay certain charges.

Unfair, Deceptive or Abusive Acts

The court concluded that CashCall violated the CFPA by servicing and collecting on loans where payments were not due and owing. The court found that servicing and collecting on those loans constituted conduct that was deceptive. The court found that, because CashCall was servicing and collecting on those loans, it created the “net impression” that the loans were enforceable and that borrowers were obligated to repay the loans in accordance with the terms of their loan agreements. That collection coupled with the “net impression,” according to the court, was deceptive.

We expect that CashCall will appeal this decision to the Ninth Circuit at the appropriate time. Regardless of whether the case is appealed, this ruling should serve as a warning bell to those involved in bank collaborations that the true lender issue remains unsettled.

Pepper Points

• The CashCall model has been consistently viewed as one that provides a roadmap for those wishing to avoid its fate. Western Sky is not an “arm of the tribe,” as most tribal lenders are structured, but is only a tribal entity owned by a tribal member — a fact mentioned by the court in its decision.

• Many marketplace lenders and other third-party bank partners have already revised their business models and contracts with their lending partners to ensure that banks have continued “skin in the game,” have real economic risk, and remain involved in the economic risks of the loan to deal with the Madden decision, and these changes will no doubt help as well in the true lender arena.

• This ruling could also have secondary effects on holders of loans that are not valid under state law at the time of origination because, under the ruling, seeking to collect on those loans may be considered an unfair, deceptive or abusive act or practice. This regulatory risk, in addition the underlying credit asset risk, needs to be a factor that investors take into account when purchasing loans or interest in loans.

We believe that, while this case is critical of the “sham” relationship between CashCall and the lender, it is an extremely fact-specific outcome and provides a good outline of issues to consider and structures to avoid in designing bank collaboration models in the future.