On July 26, 2019, the California Department of Business Oversight (DBO) issued a draft regulation and draft disclosures to implement the state's first-of-its-kind commercial financing disclosure law enacted last year. With this draft regulation, the DBO wades into uncharted waters in implementing the first law requiring disclosures of key terms in connection with certain commercial financings by non-banks.
As discussed in our previous Client Alert, in September 2018, California enacted SB 1235 (the Act), which requires consumer-style disclosures for commercial financing. The goal of the Act is to provide recipients more information about the actual costs and terms of financing agreements, as well as help them comparison shop for financing. The Act provides a general framework for the disclosures, but directs the DBO to promulgate implementing regulations with the details. The Act's disclosure requirements will not become effective until the DBO has issued final implementing regulations.
On December 4, 2018, the DBO requested public comment on the substance and form of the disclosures (the "initial Request for Comment"). Almost three dozen organizations, including non-bank lenders, submitted comments in response. The DBO then issued its draft regulation (the Draft Regulation).
Perhaps in recognition of the challenges in implementing the Act, the DBO has not yet initiated a formal rulemaking process with the Office of Administrative Law. Instead, the DBO issued the Draft Regulation and a second request for public comment. This request gave stakeholders a chance to provide the DBO with early feedback on the proposed disclosures.
KEY ISSUES UNDER THE DRAFT REGULATION
Scope — Providers of Commercial Financing Offers
The Draft Regulation would provide certain clarifications and narrowing provisions to the scope of the Act.
First, the Draft Regulation would narrow the scope slightly by excluding a non-bank entity that provides technology and support services to banks, as long as the non-bank entity does not obtain an interest in the commercial financing extended by the bank.1
Second, the Draft Regulation would clarify that the "depository institution" exemption from the Act would not extend to a depository institution's non-depository subsidiaries or affiliates.2
Third, the Draft Regulation appears to attempt to limit coverage to California-based recipients of covered financing offers by providing that the Act applies only to persons as defined in the Act "if they are domiciled, headquartered, or otherwise identify their principal place of business in California and are the entity seeking the commercial financing (i.e., not a third-party broker)."3
Scope — Thresholds for Determining Whether Commercial Financing Offer Exceeds $500,000
The Act requires a provider to give disclosures for commercial financing offers of $500,000 or less.4 The Draft Regulation would clarify how to determine whether the financing offer meets this requirement. For an open-end credit plan, for example, the transaction would be exempt if the approved credit limit exceeds $500,000.5 Similarly, for asset-based lending, the provider would use the approved credit limit if the parties have a written agreement that describes the general terms and conditions that will govern the transaction, the maximum advance limit exceeds $500,000, and the parties agree in writing before they execute their agreement that an amount exceeding $500,000 is reasonably expected to be unpaid and outstanding at some point during their agreement.6
For factoring, the provider would use the maximum advance limit to determine coverage if the parties have a written agreement that describes the general terms and conditions that will govern the transaction, the maximum advance limit exceeds $500,000, and the parties agree in writing before they execute their agreement that at some point an amount exceeding $500,000 is reasonably expected to be advanced for legally enforceable claims that have not yet been paid.7
Types of Commercial Financing Covered
The DBO's initial Request for Comment sought input on the types of commercial financing transactions that would be subject to the Act in addition to fixed-rate, fixed-payment financing. The DBO listed several examples, including merchant cash advances, open-end credit plans, and recourse and non-recourse factoring. The Draft Regulation proposes to cover the following types of transactions: 1) closed-end credit transactions;8 2) open-end credit plans; 3) accounts receivable purchase transactions, including factoring; 4) lease financing; and 5) general asset-based lending. In addition, the Draft Regulation clarifies how to disclose covered transactions that involve sales-based financing (e.g., merchant cash advances).
These categories are all subsets of "commercial financing" as defined under the Act, so the creation of these categories would not impact the scope of the Act. Instead, these categories would determine which disclosure requirements would apply to a given type of financing.
Proposed Disclosure Format and Content Requirements
The Draft Regulation would require disclosures to be presented in a table, with rows labeled Amount of Funds Provided, Annual Percentage Rate, Finance Charge, Payment Amount/Frequency, Term, and Prepayment.9 For some products, the rows are labeled as estimates. Other specific statements are also required.10 The formatting requirements are designed to help a recipient compare offers; however, given the significant differences between the covered products, meaningful comparisons could be challenging. In addition, it is not clear whether use of the draft disclosure forms provided with the Draft Regulation would be required, or whether they would be optional safe harbors for providers making disclosures required under the Act.
Computation of Annual Percentage Rates and Finance Charges
Interested parties were waiting to see whether and how the DBO would adapt the consumer-style disclosures in the Truth in Lending Act (TILA) to commercial financing. The DBO addressed this issue directly in its initial Request for Comment, noting that the Act required it to select the appropriate method to express the annualized rate disclosure. The DBO mentioned as possible options the Annual Percentage Rate (APR) calculated according to TILA, the Annualized Cost of Capital, or some other measure.
For purposes of the Draft Regulation, the DBO decided to stick with the APR, with adjustments made for covered transactions that are not credit, such as leases and accounts receivable purchase transactions, and for transactions that do not include fixed terms and repayment schedules.11 The Draft Regulation also would include all of the finance charges used in Regulation Z to calculate an APR.12 However, the Draft Regulation does not incorporate all the provisions in Regulation Z that pertain to these two important measures of credit costs. We highlight below some of the differences between the Draft Regulation and Regulation Z.
General Observations About the DBO's Approach to the Finance Charge and APR
The Draft Regulation would require covered lenders to include all charges in the finance charge that would be included under Regulation Z for consumer credit.13 Thus, lenders could look to Regulation Z to determine what charges must be included in the finance charge. It is not clear, however, whether providers could rely on Regulation Z's differing treatment for charges depending on whether the credit is open- or closed-end. For example, while Regulation Z generally includes origination fees and similar up-front charges in the finance charge, fees for participation in open-end credit plans are excluded from the finance charge.14 In addition, the Draft Regulation does not explicitly authorize reliance on the Consumer Financial Protection Bureau's Official Staff Commentary to Regulation Z, which contains a significant amount of information relating to the determination of the finance charge for purposes of that regulation.
Moreover, the Draft Regulation would not provide a tolerance for accuracy of the finance charge. In contrast, Regulation Z provides that for closed-end credit, in a transaction with an amount financed of more than $1,000, a disclosed finance charge that is under- or overstated by no more than $10.00 is deemed accurate.15 It may be that the DBO believes a finance charge tolerance is unnecessary given the relatively simple fee structure of commercial lending as compared to consumer credit, some of which involves third-party fees as well as creditor fees.
The Draft Regulation would require providers to use Regulation Z's actuarial method in Appendix J, and would adopt Regulation Z's general tolerance for APR accuracy. Thus, a disclosed APR that is either over- or understated by no more than 1/8 of a percentage point from the correct APR would be deemed accurate.16 However, the Draft Regulation would not adopt Regulation Z's more generous tolerance of 1/4 of a percentage point for irregular transactions. Regulation Z defines an irregular transaction as including one or more of the following features: multiple advances, irregular payment periods, or irregular payment amounts (other than an irregular first period or an irregular first or final payment).17 Given the nature of some commercial financing products, where repayment amounts can vary based on sales, it could be meaningful to include Regulation Z's larger tolerance for irregular transactions.
In addition, the Draft Regulation would not include Regulation Z's guidance permitting creditors to ignore, for purposes of calculating the disclosures, irregular first payment periods and odd days' interest.18 Regulation Z also instructs a creditor disclosing a closed-end loan with a demand feature to assume a one-year maturity period.19 If made applicable to the final DBO regulation, this additional guidance from Regulation Z could be helpful.
Estimated Term Disclosures and Annualized Rates
The Act authorizes providers to disclose "the term or estimated term," but does not explain when estimates may suffice or estimated terms should be calculated.20 Similarly, the Act requires the DBO to determine when a provider may disclose an estimated annualized rate and how that rate should be calculated.21 And some products do not provide for a set disbursement of funds or require the borrower to make payments at pre-determined periods. Not surprisingly, then, the DBO asked for input on these issues in its initial Request for Comment. We highlight a few provisions in the Draft Regulation regarding these issues below.
Proposed Methods for Estimates
Factoring — Estimated term to maturity. For a factoring transaction disclosed as a single transaction, the Draft Regulation would require the provider to estimate the term as the time that would elapse between the date of the original advance and the date the legally enforceable claim becomes due and payable.22 If an example is disclosed, the provider would estimate the term using the maximum receivable term.23
Factoring — Estimated amount of funds advanced. Where the agreement would allow the recipient to take advances up to a maximum aggregate purchase price for claims that have not yet been paid, the provider would assume that the recipient has drawn half the maximum aggregate purchase price for purposes of disclosing an example transaction.24 If there is no maximum aggregate purchase price, the Draft Regulation would require the provider to make disclosures based on a $10,000 advance.25
Accounts receivable and asset-based lending — Sales-based financing. For accounts receivable and asset-based lending transactions that are sales-based, the Draft Regulation would permit the provider to choose between two methods for estimating key elements of the disclosures, including the estimated periodic payments, charges, monthly costs, bona fide true-up amounts, term, and APR.
- Under the historical method, the provider would calculate the disclosures based on the recipient's historical average sales volume or income for a particular payment channel or mechanism over a specific time period.26 The provider would be required to choose a time period of at least one month and no more than 12 months, and would be required to use that same time period to calculate average sales volumes for each recipient to which it provides disclosures.
- Under the underwriting method, the provider would calculate the disclosures using an "internal estimated sales" projection for the particular payment channel or mechanism, using the best information reasonably available to the provider.27 Every 12 months, the provider would be required to audit its commercial financings that have paid off as agreed over the previous 12 months, calculate a "retrospective APR" for each transaction audited, and compare it to the disclosed APR. If the difference between retrospective APRs and disclosed APRs over a 12-month period exceeds certain tolerances in the Draft Regulation, the provider would not be permitted to use the underwriting method for the next 24 months.28
Timing of Disclosures and Requirement for New Disclosures After Consummation
The Act requires a provider to give disclosures "at the time of extending a specific commercial financing offer."29 The Draft Regulation provides further details, stating disclosures must be given "when the terms of a final loan offer are made." 30 This indicates that disclosures would not be required during negotiations, but would be required before a transaction is consummated. In addition, the Draft Regulation would require disclosures before a recipient agrees to a change in the terms of an existing covered transaction that would change the finance charge or APR as previously disclosed.31 This could result in delays if the parties wish to modify their existing credit agreement.
The Draft Regulation would not exempt such changes due to modifications or loan workouts, one of several situations in which Regulation Z generally does not require new disclosures.32 The Draft Regulation also would appear to require new disclosures even where changes to the disclosed APR or finance charge are de minimis/within tolerance, and even when changes result in a reduction of the disclosed APR or finance charge.
Adaptability to Modern Methods of Doing Business
The Act requires the recipient to sign the disclosure before consummating the commercial financing transaction.33 The Draft Regulation recognizes the online nature of many lending businesses and expressly permits a recipient to sign the disclosure electronically, but only if the transaction is being consummated via the internet.34
The Draft Regulation would require the disclosures to be presented as a separate document from any other contract or disclosure.35 This requirement could create additional burdens without any clear benefit.
As indicated above, the Act requires the disclosure to be given at the time of extending a specific commercial financing offer, which the Draft Regulation would define to mean (with respect to new financing offers) the time when the terms of a final loan offer are made to a recipient and any subsequent time when the contract is amended or supplemented and the changes would result in a change to the finance charge or APR previously disclosed. For heavily negotiated financing arrangements, there could be difficulties with determining what constitutes "the terms of a final loan offer." Similarly, providers would need to be attentive to whether routine amendments to commercial financing agreements would trigger redisclosure requirements.
WHAT HAPPENS NEXT?
Now that the comment period on the Draft Regulation has closed, we expect the DBO to consider the comments received and issue revised proposed regulations. If the revisions are extensive, the DBO may choose to seek further comment outside the formal rulemaking process. Otherwise, the DBO may start the formal rulemaking process, which is discussed in our previous Client Alert. We note that the Senate Banking and Financial Institutions Committee Chair recommended that the DBO engage in testing of proposed disclosures for commercial financing. If the DBO were to undertake a testing program, that could extend the issuance of final regulations and the mandatory compliance date.
The Act is the first state law to require TILA-style disclosures for commercial financing transactions. Stakeholders should consider engaging with the DBO as the agency its undertakes preliminary rulemaking efforts and throughout the rulemaking process. This is particularly important, given that the Act could serve as a template if other states choose to follow California's lead in mandating commercial financing disclosures.
1 Draft Regulation § 2057(a)(18).
2 Draft Regulation § 2057(a)(9).
3 Note, though, that the term "person" also is included in the definition of "provider," which is inconsistent with the reference in the Draft Regulation to "the entity seeking the commercial financing." Draft Regulation § 2057(a)(17); Cal Fin. Code § 22800(m).
4 Cal. Fin. Code § 22800(m), (n) and § 22802(a).
5 Draft Regulation § 2071.
8 The Act does not define closed-end financing. The Draft Regulation would define a closed-end transaction as one in which "credit is extended only once over a specific period and is repaid in regular predetermined payments of a specified amount over a fixed period of time." Draft Regulation § 2057(a)(8). This definition would exclude a credit transaction in which multiple advances are made up to a specified amount and where the borrower does not have the right to re-borrow amounts previously repaid.
9 E.g., Draft Regulation §§ 2060–2067.
10 See, e.g., Draft Regulation § 2060.
11 Draft Regulation § 3001
12 Draft Regulation §§ 3001(f), 3010.
14 12 C.F.R. § 1026.4(b)(3), (c)(4).
15 12 C.F.R. § 1026.18(d)(2).
16 Draft Regulation § 3001(c).
17 12 C.F.R. § 1026.22(a)(3).
18 12 C.F.R. § 1026.22(b)(1).
19 12 C.F.R. § 1026.18(i).
20 E.g., Cal. Fin. Code § 22802(b)(3).
21 Cal. Fin. Code § 22804(b)(2).
22 Draft Regulation § 2090.
24 Draft Regulation § 3022.
26 Draft Regulation § 2091.
27 Draft Regulation § 2092.
28 Draft Regulation § 2092(d)–(f).
29 Cal. Fin. Code § 22802(a).
30 Draft Regulation § 2057(a)(4)(i) (emphasis added).
31 Draft Regulation § 2057(a)(4)(ii).
32 See 12 C.F.R. § 1026.20(a), which applies to closed-end credit transactions. For open-end credit, significant changes to certain account terms require written notice to the borrower, and in some cases, the notice must be provided 45 days in advance of a change. 12 C.F.R. § 1026.9(c).
33 Cal. Fin. Code § 22802(a).
34 Draft Regulation § 2070(b).
35 Draft Regulation § 2060(f).
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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