New Developments under the Holder Rule Increase Risk to Creditors

Stroock & Stroock & Lavan LLP

In our February 16, 2021, Client Alert (“Holders Beware”), we noted recent California caselaw expanding consumer plaintiffs’ rights to seek attorneys’ fees and court costs from creditors pursuant to the Federal Trade Commission’s “Holder Rule,” 16 C.F.R. § 433.2.  Since then, the California Supreme Court has agreed to consider the fee and cost issue.  Additionally, the FTC recently issued new guidance rejecting transaction-size exemptions from the Holder Rule.  Both developments may increase creditors’ liability risk associated with financing consumer purchases.

The “Holder Rule” requires creditors that finance the purchase of consumer goods, by taking an assignment of the purchase contract, to include within the contract a clause preserving the right of the debtor-purchaser, in the event the goods are defective, to sue the creditor-assignee (or a subsequent assignee).  The contract also must provide that the debtor can defend against the assignee’s collection claim on the grounds that the goods are defective.  Thus, the FTC’s Holder Rule reverses the common-law rule that a holder in due course, who receives an assignment of the contract in good faith and for value, is not liable for the acts and omissions of the original seller.  To protect assignees against excessive liability, however, the Holder Rule limits the debtor’s affirmative recovery against the assignee to the total amount the debtor paid under the contract. Additionally, since 1976, the FTC interpreted the Holder Rule to apply only to financing transactions less than the “large transaction” exemption from certain provisions of the Truth in Lending Act (“TILA”), as set forth in 15 U.S.C. § 1603 (originally $25,000, and later increased to $50,000, with further increases tied to the rate of consumer price inflation).  Both of these protections are now in jeopardy.

Longstanding California appellate jurisprudence held that the cap on the creditor’s total liability included potential claims for attorneys’ fees and costs.  See Spikener v. Ally Financial, Inc., 50 Cal. App. 5th 151 (Cal. Ct. App. 1st Dist. 2020); Lafferty v. Wells Fargo Bank, 213 Cal. App. 4th 545, 563 (Cal. Ct. App. 3d Dist. 2013).  This protection was extremely important to finance companies, as often the attorneys’ fees associated with a disputed claim could greatly exceed the original purchase price under the contract.  However, the California Legislature purported to abrogate this protection, to wholly exclude attorneys’ fees and costs from the liability cap.  See Cal. Civ. Code § 1459.5.  Earlier this year, the California Court of Appeal’s Second District also held that the Holder Rule cap does not preclude the debtor from recovering attorneys’ fees and costs, and that the cap only limits the debtor’s damages recovery.  Pulliam v. HNL Auto. Inc., 60 Cal. App. 5th 396 (Cal. Ct. App. 2d Dist. 2021).  Finance companies theoretically face no limit on their fee and cost exposure under Pulliam and the California legislation.

On April 28, 2021, the California Supreme Court granted review in Pulliam.  Case No. S267576.  Significantly, the California Supreme Court invited lower courts to follow Pulliam, rather than the earlier pro-creditor authorities, while the case is pending.  The Court’s April 28 order granting review expressly denied a request for depublication of the Court of Appeal’s opinion and stated that the pro-consumer opinion “may be cited, not only for its persuasive value, but also for the limited purpose of establishing the existence of a conflict in authority that would in turn allow trial courts to exercise discretion … to choose between sides of any such conflict.”  See also CAL. SUP. CT., ADMIN. ORDER 2021-04-21 (Apr. 21, 2021) (recent rule change allowing lower courts greater latitude to rely on opinions for which California Supreme Court review is pending).  This appears to be a clear signal to California courts to apply the Holder Rule in a more pro-consumer fashion across the board.

Also significant is the FTC’s April 12, 2021, announcement through a “Staff Note” that the “large transaction” exemption will no longer apply to the Holder Rule.  This change upends forty-five years of established understanding by finance companies that the rule would not apply to transactions larger than the exempt amount, and thus threatens to greatly increase liability for such companies under both new contracts and existing contracts.  According to the Staff Note, the exemption was never validly adopted by the Commission itself, and that because the Holder Rule was not originally promulgated pursuant to TILA (even though it makes use of certain terms defined in TILA), the restrictions set forth in TILA do not apply.  Moreover, according to the Staff Note, the original intent of the Commission in 1975, when it first announced the Holder Rule, was for no transaction limit whatsoever to apply.  Accordingly, the staff now concludes that it was mistaken in 1976 to create any exemption based on transaction size.

It remains to be seen, however, whether (for existing contracts, and perhaps also for new ones) courts will give creditors the benefit of the former exemption for large transactions because of how long the 1976 staff guidance had been in place.  A core principle of administrative law is that agencies should not change established interpretations in a manner “that creates unfair surprise to regulated parties” and that threatens “the upending of reliance.”  Kisor v. Wilkie, 139 S. Ct. 2400, 2418 (2019) (internal quotation and citation omitted).

Taken together, these developments suggest increasing legal risk for finance companies and are yet more examples of a more generally pro-consumer regulatory climate.  All participants in the consumer finance space should be mindful of these additional risks as well as active enforcement efforts by federal and state regulators, and litigation pursued by private attorneys representing consumers and debtors.

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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