Opportunity Financial, LLC v. Clothilde Hewlett: A Case to Watch
California has some of the strictest consumer financing laws in the country, so what happens when a company seeks to avoid multiple state regulations by entering into an agreement with a state-chartered bank in a state with less regulations?
BY STEVEN N. KURTZ, ESQ., LEVINSON ARSHONSKY & KURTZ, LLP
Government regulations have increased in the factoring and asset-based lending industry, primarily because of actions by some highly aggressive and unscrupulous lenders. For example, California has had a regulatory and licensing system in place to regulate non-bank lenders for years. In this environment, a valid California Finance Lenders License operated as a safe harbor from California’s strict usury laws. California has also enacted commercial financing disclosures which will go into effect soon. In addition to California, New York and Utah have enacted laws impacting non-bank lenders which specifically include those that purchase accounts. Other states should be following this path as well. Against this backdrop, the case of Opportunity Financial, LLC (Opfi) v. Clothilde Hewlett, although a consumer financing dispute, should impact all non-bank lenders, including factors and asset-based lenders.
Clothilde Hewlett, the defendant in the Opfi case, is the commissioner of the California Department of Financial Protection and Innovation (DFPI), the California agency that regulates non-bank lenders. Opfi sued Hewlett as a government official after the DFPI accused Opfi of intentionally violating California’s consumer protection laws, among other infractions. Now let’s dive into in how we got here.
An Out-of-State Arrangement
California has very strict consumer financing laws, which, in addition to requiring a California Finance Lenders License, caps the interest rate on loans up to $10,000 at 36%, requires certain disclosures and imposes a duty upon lenders to have systems in place to determine if a consumer borrower can repay a loan.
To avoid California’s strict consumer financing laws and regulations, Opfi, a consumer financial technology platform that makes consumer loans to Californian borrowers of $10,000 and under and charges an average interest rate of 150%, devised a plan and entered into an arrangement with Finwise, a small, state-charted bank based in Utah. State-chartered banks are uniformly exempt from state laws and regulations which affect non-bank lenders because a state-charted bank answers to federal and state bank regulators. In addition, a state-chartered bank can charge the highest interest rate allowed in the state in which it is charted. Utah does not have a cap on interest rates, so Finwise has no interest rate limit and, as a Utah state-charted bank, can export its products to a borrower in a different state with a lower interest rate cap. Once a state-chartered bank like Finwise makes a loan, it can be sold and assigned to a third party and that third party can hold the loan with the same protections as the originating Utah bank because the loan was “valid when made.”
Opfi sought to take advantage of the protections afforded to Finwise as a Utah state-charted bank through an arrangement that worked as follows: Opfi supplied the entire fintech lending platform and did all of the marketing and then handled everything upfront involving getting the borrower, signing up the loan, making the credit decisions, documenting the loan under its loan documents and handling customer service. However, Finwise used its own money to fund the consumer loans (which averaged 150% interest), with the lending documents in its name. At the same time, Opfi’s servicing agreement with Finwise had Opfi doing everything and anything relating to all loans and setting up a cash collateral account for Finwise’s benefit secured by cash and letters of credit. If there was insufficient collateral, Finwise would not have had to make the loan, a problem which did not happen. Days after a loan, Opfi bought into a participation agreement with Finwise in which Opfi would hold 98% of the risk while the loan remained in the name of Finwise as the “lead” with Opfi as the participant. Opfi also paid Finwise a “program fee” that insured that Finwise always turned a profit. The loans averaged 150% interest and 38% of the loans defaulted. Apparently, the margins were such that everyone made money despite the high default rate.
The Ensuing Fallout
The DFPI was not happy about this arrangement and the problem also caught the attention of a California state senator, who sponsored certain consumer protection legislation and specifically stated that Opfi was a reason why new California laws were passed. Thereafter, the DFPI turned its attention to Opfi, accusing it of intentionally violating California’s consumer protection laws, demanding that it immediately stop what it was doing, stating that the loans were unconscionable and did not need to be repaid and that Opfi had to return at least $150 million in wrongful gains back to the California consumers and pay a substantial fine to the DFPI. The DFPI also accused Opfi of “renting a bank” and that Opfi was the “true lender” on all of its deals with Finwise.
Opfi had a different view of the world than the DFPI and decided to file suit first against the DFPI, knowing that it would soon be in litigation. Opfi claimed the loans were “valid when made” and that California’s consumer protection laws as it relates to the Opfi-Finwise deal were preempted by federal law and sought to enjoin the DFPI from taking enforcement action. The DFPI filed its claim in response to Opfi’s first filed suit, and the case is pending in the Los Angeles County Superior Court. The stakes are high. It’s California’s regulatory system vs. Opfi’s business model and it’s likely a battle for survival.
The concepts of “valid when made,” “true lender” and “rent a bank” are terms and business practices which affect all non-bank lenders, including factors and asset-based lenders. The “valid when made” rule allows a party to acquire a loan from the loan originator that was valid when made because the loan was initially fully compliant with certain applicable laws. In this case, Opfi claimed since the loans were valid when made by Finwise, the Utah state-charted bank, Opfi could acquire an interest in the loans and be protected by applicable federal law. The “true lender” rule is brought in response to someone who claims that its loan was valid when made. In this case, the DFPI claims that it can look past the transaction, review the entirety of the situation and determine from the facts and conduct that the “true lender” is Opfi. The “true lender” rule is being litigated across the country by state and federal government agencies against non-bank lenders. The “rent a bank” concept is similar to the “true lender” rule, which, when successful, sets aside the state-chartered bank protections because the “true lender” is “renting the bank” to avoid state and federal laws applicable to non-bank lenders.
Impacts of the Opfi Case
The concepts from the Opfi case, although against a consumer lender, will significantly impact the factoring and asset-based lending industries as they seek to navigate through increased regulatory scrutiny. Bad actors and hyper aggressive conduct will invoke the wrath of regulators, in blue and red states alike. As regulators look at bad actors and conduct they consider unlawful, they will feel emboldened to look at different situations. For the factoring and asset-based lending industry, the DFPI has mostly limited its enforcement activities to the “low hanging fruit problem,” which happens when someone seeks a license after doing business for years in California, discloses it has transacted business in California (or the DFPI figures it out) and then the DFPI looks into past California activity. The DFPI, after an applicant’s self-disclosure, then demands the applicant return to all of its borrowers the difference between what was charged and 10% (the highest interest rate in California). The DFPI also imposes penalties against the license applicant, who merely wanted to become compliant with California’s financial laws.
The “low hanging fruit problem” can result in headaches and, in some situations, nightmares for someone who simply wanted to be compliant. But now the DFPI may expend its enforcement against factors and asset-based lenders beyond the “low hanging fruit problem.” When state regulators see bad conduct in one place, they tend to look for similar problems in other places. Also, keep in mind this is not only a California problem. I have confirmed with California state regulators that the DFPI is in touch with other states and discussing their issues. Indeed, it seems like New York is following some of California’s systems that have been in place for years, and other states will do the same.
The Opfi case also will likely impact participations. A traditional participation is entered into between one or more parties in order to spread the risk of a particular deal or set of deals. A traditional participation will involve one financing provider as the “lead” and one or more as the “participant.” Typically, the lead takes the active role in the deal and manages the transaction, with the participant purchasing a piece of a deal or sets of deals. There are often discussions between the parties to the participation agreement as to standards of care and how much of a voice one has in certain decisions.
A true participation should be outside the scope of regulatory review because it involves how the lead lender/factor raises money for its capital structure. The ways for a factor or asset-based lender to raise capital in a private business-to-business contract should not be subject to regular scrutiny (unless the factor or asset-based lender is a borrower based in California). The regulator can look at the loans or factoring transactions, but provided the regulated lender’s balance sheet is in order, the factor/lender’s source of money should not be scrutinized. I have had conversations with the prior head of the DFPI’s licensing group about this issue, and so far, participations have not been subject to regulatory review. However, this might change given the fact that Opfi did everything in its deal that the lender holding a loan would do. Looking into participations could be pretty easy for a regulator to do, as it can be added in as a line item in the annual reports which regulated lenders have to submit. This level of review would not likely otherwise happen but for bad actors.
The Opfi case will likely impact servicing agreements as well. Servicing agreements are typically involved in every case when the “true lender” rule is at issue. When all financing decisions and deal administration is left to the servicer, like in the Opfi case, regulators may start asking around in different deals. Servicing agreements are a necessary and vital complement to the factoring and asset-based lending industry. In theory, servicing agreements offer competitive advantages to someone entering a market with a solid back office. For those who enter into servicing deals, it is important to make sure significant and “shot caller” type decisions are left to the actual factor/lender. It is also a good idea for the actual servicer to hold any applicable state licenses or otherwise be exempt from state laws regulating non-bank lenders. Servicing arrangements are addressed in the DFPI forms and may be subject to more scrutiny because of the Opfi case. Again, other states seem to be following California’s lead.
Scrying the Bones for Future Guidance
Bad actors and bad facts result in bad law. The Opfi case is worth watching to see how it plays out and to be aware of what regulators may do in the future. With that in mind, there is a decent chance this case may never make it to the end. The Opfi deal structure likely skirts other state usury laws and may likely attract federal attention. Also, there is a good chance class action suits will be filed. There is also a chance Opfi will not be able to withstand all of these legal challenges and may end up in bankruptcy. An Opfi bankruptcy would likely be a liquidating case leading to the selling of the good assets, which is probably the fintech platform, and leaving in place lots of litigation against all kinds of people the various bankruptcy groups deem responsible for this problem, such as directors, officers, lawyers and financial advisors. No matter how the Opfi case turns out, when folks take hyper-aggressive steps to avoid multiple laws, regulators may find problems with their newly acquired knowledge. We’ll keep you posted.