California DBO Challenging Transactions as Disguised Loans

Manatt, Phelps & Phillips, LLP

Manatt, Phelps & Phillips, LLP

Potentially redefining the nature of a “loan,” the California Department of Business Oversight (DBO) is pursuing multiple enforcement efforts against certain financing vehicles that have long been recognized as exempt from lending laws. While the purpose of these efforts seems to be to enable greater regulation of transactions the DBO considers potentially harmful to borrowers, they are creating substantial uncertainty for many finance companies and may impair credit availability in California.

Retail Installment Sales Contracts

The most public of these campaigns concerns retail installment sales contracts (RISCs), a widely used form of purchase financing also known as credit sales. RISCs are already regulated by the Unruh Act, Cal. Civ. Code § 1801, et seq. On December 30, 2019, the DBO issued a press release announcing actions taken against two companies that contended their products are RISCs rather than loans. DBO denied a lending license to one of the companies on the ground that it had been offering disguised loans (not RISCs) before obtaining a license; and it denied the other company’s request for a determination that its product is a RISC or forbearance rather than a loan. A few weeks later, DBO issued a second press release announcing a consent order with the first company in which the company agreed to return to its California customers all fees they paid for the financing in exchange for continued consideration (not granting) of its license application. The DBO said in the second press release that it “continues to investigate other companies in the point-of-sale lending industry.”

There most certainly are grounds on which to distinguish the products offered by these companies from RISCs offered by others. For example, the first company allegedly entered into agreements directly with consumers rather than purchasing contracts between merchants and consumers, which is an important aspect of the RISC structure. However, DBO’s legal positions are alarming because they rely on an aggressive interpretation of California case law to recharacterize the transactions as loans. Whether intended by DBO or not, the same interpretation could be applied to products well-established as RISCs, making them “loans” and subjecting their purchasers to potentially substantial liability.

Among other things, DBO took the position that RISCs are likely to be loans if the finance company supplies the contract form, has a pre-existing relationship with merchants, markets the availability of the financing or conducts its own underwriting, all of which are common practice in this space. DBO also signaled its expansive view of what constitutes “evasion” of lending regulations, such as by suggesting that having four or fewer installments in a credit sale is an improper attempt to avoid making disclosures under the federal Truth in Lending Act.

Merchant Cash Advances

Another product under DBO scrutiny is the merchant cash advance (MCA), wherein a merchant sells to the finance company part of its future sales revenue. Although DBO has not taken any public actions in this space to date, it has signaled concern about the relative lack of regulation of small-business finance and its intent to police the space. We understand that among other things, the agency is focused on companies that collect purchased receivables through fixed daily ACH debits and do not regularly adjust the daily remittance amount or reconcile accounts based on the merchant’s actual revenue. Other concerns include the use of confessions of judgment and collections practices that are inconsistent with the nature of the product.

Why it matters

DBO is taking a tough stance on products structured as purchase financing rather than as loans. Some believe that the agency, rather than seeking new legislation or regulations to achieve its public policy goals, is seeking to regulate through enforcement actions, as was done in the first years of the Consumer Financial Protection Bureau. Combined with the Governor’s recent proposal to expand the size and mission of the agency, these developments suggest that the regulatory environment in California will continue to change and possibly make it more difficult to do business.

In order to mitigate these risks, companies offering RISCs, MCAs or other nonloan financing should revisit their agreements and regulatory compliance as soon as possible.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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