Cheat Sheet: Online Lenders' Legal Minefield

Not all online lenders are the same. That's perhaps the simplest way to summarize the head-spinning array of businesses that are currently making consumer loans over the Internet.

There are firms that are clearly operating within the boundaries of the law, and there are also companies of disputed legality. The latter group, which banks are now under pressure to cut ties with, includes lenders that are licensed in one state but making loans in many others. It also includes companies based overseas. And it includes lenders owned by an American Indian tribe, or even by a member of a tribe, often with an assist from a non-tribal payday lender.

As these envelope-pushing business models have become the target of increased regulatory scrutiny, the debate over so-called online lending has been muddied by confusing terminology and a lack of clear legal standards regarding what is allowable and what is not.

The agencies that are currently focusing on Internet lenders include the Federal Deposit Insurance Corp., the Department of Justice, the Consumer Financial Protection Bureau and regulators from New York, Maryland, Oregon, Washington and numerous other states. State regulators, in particular, are concerned that many companies are using the web's ubiquity to get around state-by-state interest-rate ceilings.

Revenue from online consumer loans more than tripled from $1.4 billion in 2006 to $4.3 billion last year, according to data from the investment bank Stephens Inc.

Often the companies that make these loans are described as "online payday lenders," but that term is not entirely accurate. Some of them offer loans that aren't tied to the borrower's pay cycle; instead they make installment loans with terms lasting several months.

The term "online lenders" also gets invoked frequently, but that broader descriptor can be misleading, too — after all, there are a slew of companies making small-business loans over the Internet, and they belong in an entirely different category than any of the online consumer lenders do.

Even within the realm of what might be called "online consumer lenders" — the area where federal and state authorities have been focusing their attention — companies have attempted at least five different models for obtaining licenses to operate in states with sometimes conflicting consumer lending laws.

"Every one of our members, regardless of model, believes that it is complying with state law, or has a sound legal basis to conclude that the state law does not apply," said Lisa McGreevy, the president and chief executive of the Online Lenders Alliance, an industry trade group.

The complexity of conducting online business where a lender's state may have different laws than a borrower's state is compounded by the uncertainty over which jurisdiction governs transactions in cyberspace.

"How these online transactions will ultimately be regulated still remains, to some extent, and an open question," said Jeremy Rosenblum, a partner at Ballard Spahr LLP.

Each of the five models is based on a different legal justification, some of which seem to have more traction than others. A great deal is at stake here both for the online lenders, whose ultimate ability to stay in business hinges on the strength of their legal claims, and for banks that process the companies' payments, since they are coming under increased pressure from their regulators.

What follows is a guide to the various licensing models for online consumer lending.

Companies that hold licenses in multiple states

Many of the companies that fall into this category began as licensed storefront payday lenders but in recent years branched out into online lending. No one disputes that their operations are lawful.

The publicly traded payday lender Cash America (CSH) began making loans online in 2006, and today about half of its loan volume comes through that channel, according to the company's presentation at a recent investor conference.

Likewise, payday lending chain Advance America says that it's licensed to make online loans to borrowers in 25 states. If you visit the firm's website and enter a Zip code from a state where the company is not licensed, you can't get a loan.

Many of the companies that take this state-by-state approach to online lending are members of the Community Financial Services Association of America.

That trade group recently reported that one of its members, a storefront lender that is licensed in every state where it makes loans, received a termination notice from its payment processor. But that snag, which was quickly resolved, appears to have been the result of an overreaction by the payment processor, rather than any targeted action by regulators.

"I think it would be unfortunate if any legitimate, legally licensed lender was negatively affected," says Jamie Fulmer, senior vice president of public affairs at Advance America, referring to the regulatory crackdown on unlicensed lenders.

Despite that concern, lenders that use the state-by-state model have taken solace from recent congressional testimony by CFPB Director Richard Cordray, who said: "My stance on online lending, as with all lending: it should be done legally. It should be done by folks who are licensed and qualified to do it. It should be done in compliance with federal and state law."

Companies that are owned by an American Indian tribe

There are a few reasons why lots of online lenders have decided against the state-by-state licensing model. First, getting licensed in dozens of states can be arduous and time-consuming. Second, even many of the more permissive states cap annual percentage rates at levels below what online lenders are charging. And third, there are roughly 15 states that don't license high-cost consumer lenders at all.

Rosenblum views any approach that avoids state-by-state licensing as falling under the "choice of law" doctrine — a general legal concept allowing parties residing in two different jurisdictions to choose which one applies to their transaction — and said each variation of that has confronted some form of legal challenge.

"It's fair to say that there is a clear demarcation between the state-by-state online companies, and all the companies that operate some kind of 'choice-of-law' model," he said.

In the last couple years, much of the unlicensed online consumer lending has migrated to the tribal model — likely at least in part because industry lawyers are convinced this arrangement has the best chance of standing up to legal scrutiny.

Under the tribal model, the lending company is owned by a tribe that asserts sovereignty immunity from laws both in its own state as well as the state where the borrower resides. The Otoe-Missouria Tribe in Oklahoma and the Chippewa Cree Tribe of Rocky Boy's Reservation in Montana are among the tribes that have dipped their toes into the lending business.

Some states, including New York, which has one of the strictest usury laws in the country, have asserted that tribally owned companies must adhere to their laws.

Oregon, which has a law capping annual percentage rates at 36%, is taking a less combative approach. "The view right now is that if they are truly a tribal entity, then the laws and rules of Oregon don't apply," says Brian Light, deputy administrator of the Oregon finance division.

But there's an important wrinkle here. Tribes that are asserting sovereign immunity from state laws generally have business relationships with non-tribal companies, and state officials often suspect that most of the firms' profits are leaving the tribal reservation.

Light said his state will attempt to make case-by-case determinations about whether a lender that is a subject of a consumer complaint is in fact legitimately affiliated with a tribe.

"We have to look at every complaint that comes in and verify the facts," he said. "Just because someone says they're a tribal lender doesn't mean that they are a tribal lender."

How much benefit the tribe is actually getting matters because courts may weigh that factor against the benefits the state gets by insulating its residents from high-cost loans. Key questions may become: Is the tribe putting up its own capital? Is it taking risk? And who is keeping the lion's share of the profits?

"It may be a lender that is hiding behind a tribe's sovereignty when in reality there is no tribe involved, or there is, but just barely," says Nathalie Martin, a law professor at the University of New Mexico.

Two tribes that have come into the crosshairs of New York regulators noted in recent court filings that their lending businesses employ tribal members, are supervised by tribal regulators, and provide revenue for various tribal programs. But the court papers did not reveal key details of the companies' financial ties with outside firms.

Companies that are licensed in one state but make loans to borrowers in other states

These lenders tend to look for states that have comparatively lax rules about how high they can charge interest rates, such as Delaware or South Dakota, and then base their operations on that state's soil.

"Some argue they already have a license in their home state, and they don't need one here," explains Deborah Bortner, director of consumer services at the Washington State Department of Financial Institutions.

Lawyers representing companies that use this model advance various arguments as to why the laws of the state where the borrower lives should not apply. They may argue, for example, that the lender and borrower can stipulate in their contract which state's laws will apply. But authorities in states with strict interest-rate caps have not tended to buy their arguments. In a well-known court case, Quik Payday Inc. v. Stork, the 10th Circuit Court of Appeals said the Utah-based Internet lender could not ignore Kansas laws essentially because borrowers had not traveled to the lender's home state to obtain loans.

This business model has become harder to sustain as more states have made clear that their borrower protections apply to loans made over the Internet. But it has not gone away; many of the companies that New York regulators targeted in their recent moves against online lenders fall into this category.

Companies that are based, or claim to be based, overseas

These firms generally maintain that they are in compliance with relevant federal laws, including truth-in-lending requirements, and they argue that the states don't have jurisdiction over their businesses.

They may also hold licenses in other countries. Cash Jar, another lender targeted recently by New York authorities, lists a Belize address on its website, and maintains that it lends in accordance with Belize regulations.

In some cases, companies that claimed to be based overseas have turned out to be running their operations out of the United States.

Mycashnow.com and certain affiliated companies purported to be located abroad, but they actually ran their essential business operations from Tennessee, according to a cease and desist order issued by the state of Maryland in September. The companies recently shut down their websites.

Offshore companies, and those that purport to be, have benefited for years from the limited reach of state regulators. In effect, the firms seemed to be saying to the states: let's see if you can find us and shut us down.

But industry lawyers expect that stepped-up federal oversight of banks' relationships with online consumer lenders will make it harder for offshore companies to maintain their access to the mainstream payments system.

Companies that are owned by a member of an American Indian tribe

So far, this business model appears to have been tried only once, and at this stage its chances of long-term success appear slim.

Western Sky Financial is an online lender owned by Martin Webb, a member of the Cheyenne River Sioux Tribe in South Dakota; the tribe itself has no ownership interest in the company.

Western Sky recently suspended its lending operations after being targeted by New York regulators. But the firm maintains in recently filed court papers that New York is not entitled to apply its laws to conduct that occurs on the tribe's reservation.

The company's legal arguments are being pooh-poohed by the Native American Financial Services Association, which represents tribally owned lenders. "Western Sky was a big target," says Barry Brandon, the organization's executive director.

But Western Sky is not going down without a fight. In a 61-page legal brief, the company's lawyers recently mounted a detailed case for why New York overstepped its bounds. Part of that argument involves the physical distance between the Empire State and the company's South Dakota headquarters.

"I have never physically entered the state of New York, either for business or personal reasons," Webb, the company's owner, stated in court papers. "The nearest airport to my home with service to New York is Pierre Regional Airport. It takes more than two hours to drive from my home to Pierre Regional Airport. To my knowledge, there are no direct flights from Pierre to any airport in the New York region."