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THE LATEST ON GOVERNMENT INQUIRIES AND ENFORCEMENT ACTIONS

Government Investigations and White Collar Litigation Group
Financial Institution Regulation

CFPB Issues Proposed Revisions to GLBA Annual Privacy Notice Requirement

By Ashley B. Matthews

Earlier this month, the Consumer Financial Protection Bureau (CFPB) issued its proposed rule amending the Gramm-Leach-Bliley Act’s annual privacy notice requirement set forth in Regulation P.

The rule is in response to Congress’ December 2015 amendment to the act, which eliminated the need for certain companies to provide annual privacy disclosures to consumers.  Under the amendment, the annual notice requirement is eliminated for any financial institution that:

  1. Limits it sharing so the customer does not have the right to opt out; and
  2. Has not changed its privacy notice since the one most recently delivered to the customer.

If adopted, the proposed rules would create a 60-day deadline for financial institutions to provide an annual notice if they have changed their policies and practices so as to lose the annual notice exception.  The proposed changes would also remove the rule implemented in 2014 that permits alternative annual notice delivery methods because any party that meets the criteria for alternative delivery will also meet the criteria set forth in the new rule that permits the institution to forego providing the annual notice altogether.

The proposal does not affect the requirement that financial institutions provide an initial privacy notice to new customers, and it does not exempt the financial institution from providing any disclosures required by the Fair Credit Reporting Act in association with affiliate information sharing.

Comments may be submitted electronically or by mailing or delivery to the CFPB.

Enforcement and Prosecution Policy and Trends

Prison Sentence for Executives in Contaminated Egg Case Highlights Food Safety Risks

By Government Investigations Group

Las77006468.jpegt Thursday, July 7, 2016, a divided panel of the U.S. Court of Appeals for the 8th Circuit upheld a three-month jail sentence against Austin “Jack” DeCoster and his son Peter, the CEO and COO respectively of Quality Egg LLC.  The CDC determined that Quality Egg was responsible for a salmonella outbreak that ultimately sickened thousands of Americans.  Both men pled guilty to unknowingly introducing adulterated food into interstate commerce, a misdemeanor violation of the Food, Drug and Cosmetic Act (the “FD&CA”)

DeCoster both illustrates the power of the government’s prosecutorial reach in this area, and provides some hope that the Supreme Court may change the law to rein in excessive prosecutorial zeal where Congress has not.  The FD&CA remains essentially a strict liability criminal statute.  The seminal food safety case of United States v. Park permits prosecutors to seek, and courts to impose, jail sentences against food and drug executives who did not know about safety problems at their company, did not participate in the problematic operations but instead merely supervised them, and were not even negligent for failing to prevent problems. And DOJ’s renewed focus on prosecuting individual executives in cases of supposed corporate wrongdoing raises the stakes.

Park was less troublesome when the government used it judiciously.  But in 2011, the FDA changed its procedures manual to permit field agents to recommend criminal investigations and prosecutions of responsible executives who have no knowledge of, and did not personally participate in, the adulteration.  Before that change, prosecution was reserved for executives who had some warning or knowledge about specific unsanitary conditions.  The 2011 policy embraced more aggressive enforcement under the Park doctrine, dramatically expanding the range of prosecutable cases from knowing violations to negligent and even strict liability offenses.  More recently, we’ve noted the government’s efforts to obtain decades-long sentences in other, more aggravated food safety prosecutions ,[1] as well as the increased investigative and enforcement resources the government is devoting to the food and beverage industry in areas besides food safety.

But DeCoster also provides a few reasons to hope that the Supreme Court will revise or clarify “responsible corporate officer” liability under Park.  Two of the three panel judges interpreted Park and the FD&CA as requiring the government to prove negligence or more culpable intent even in misdemeanor cases.  That’s an unorthodox reading – the consensus view is that Park permits strict criminal liability against executives for failure to prevent contaminated food from being distributed, even if his or her conduct was not negligent or otherwise blameworthy.

We can expect the DeCosters to seek Supreme Court review, as they were represented by prominent appellate counsel in the Eighth Circuit, and enjoyed the benefit of multiple amici filings from industry groups.  We can also expect the United States to oppose certiorari because the circuits are not truly split: the district court and two of the three Eighth Circuit judges believed the DeCosters were indeed negligent, so the unorthodox reading of Park had no effect on the outcome even though shared by a panel majority.

The recent news that major criminal justice reform bills have stalled in both Houses of Congress may add wind to the DeCosters’ sails.  Mens rea reform was a sticking point in criminal justice reform efforts, as industry-friendly groups sought Congressional repudiation of regulatory crimes that required no proof of culpability, like the Park doctrine.  Congress’s unwillingness to address mens rea reform comprehensively may influence the Court to reexamine specific doctrines that enable overreach.  And the Court has proved increasingly receptive to arguments that prosecutorial discretion cannot be trusted to ensure broad criminal laws are enforced only against blameworthy individuals.

DeCoster remains a case to watch for the industry.  In the meantime, we continue to recommend that food and beverage companies prepare in advance to mitigate the risk of adulteration, and maximize the chances of quick remediation if it happens.

[1] In the prosecution of peanut company executive Stewart Parnell for knowingly shipping salmonella-contaminated peanuts, the government sought a life sentence and obtained a twenty-eight year sentence.

 

Immigration and Worksite Enforcement

Increased Fines on the Horizon for Immigration Law Violations

By Alex J. Brackett

Passport-mapThe Department of Justice has raised the bar on penalties for violations of federal immigration law.  On June 30, 2016, DOJ issued an interim final rule that goes into effect on August 1, 2016.  This rule, implemented as an inflation adjustment, increases the fines for employing unauthorized workers, for Form I-9 paperwork violations, and for immigration-related discrimination.  These new fines increase the penalties from 35% to 96% depending on the nature and severity of the violation.

The Immigration Reform and Control Act of 1986 makes unlawful three general categories of activity:

  1. Knowingly hiring or continuing to employ an unauthorized worker;
  2. Violating the Form I-9 paperwork rules; and
  3. Engaging in unfair immigration-related employment practices.

The impact of these newly increased fines can be severe.  Where before, employing a single unauthorized worker resulted in a fine ranging from $375 – $3,200 for a first offense, the new rule adjusts the range to $539 – $4,313.  And for third-time and subsequent offenses, a company now faces a fine range of $6,469 – $21,563 per violation, up from the prior range of $4,300 – $16,000.

Moreover, Form I-9 paperwork violations will nearly double under the new rule.  The prior fine range of $110 – $1,100 per violation will increase to $216 – $2,156 per violation.  Under this adjustment, what some companies may have viewed a tolerable risk of a $30,000 to $50,000 fine for having poor I-9 documentation now jumps to around a $60,000 to $100,000 fine for the same set of I-9s.

Violations for immigration-related unfair employment practices have similarly increased.  These fines are implemented for discrimination, for document abuse, and for document fraud.

This increase in fines presents companies with an incentive to review their workforce and Form I-9 files and process.  A Form I-9 audit conducted internally or with the assistance of outside counsel can shed light on areas of concern and allow companies to correct violations before they become fines.  To aid such a review, Immigration and Customs Enforcement and DOJ recently provided joint guidance to assist companies in conducting internal audits.  In addition, training employees who conduct the I-9 and onboarding process in tandem with an audit can position a company to avoid these increased fines going forward.

While compliance with federal immigration law is sometimes an afterthought amid the constant demands of business, it cannot be ignored.  DOJ’s new rule provides a reminder that corrective action now can mitigate potential fines and reputational harm in the future.

Compliance, Financial Institution Regulation

Parties in PHH Case Argue the Impact of Recent Supreme Court Decision

By Government Investigations Group

In the780536981 latest development in PHH Corp. v. Consumer Financial Protection Bureau (CFPB), PHH and the Bureau have both filed letters addressed to the D.C. Circuit arguing over the impact of a recent Supreme Court decision on the case.  At issue is whether the Supreme Court’s decision in Encino Motorcars, LLC v. Navarro, No. 15-415 (U.S. June 20, 2016) eliminates the usual deference courts would give to the CFPB’s interpretation of the Real Estate Settlement Procedures Act (RESPA), under which the Bureau penalized PHH to the tune of $109 million.

As we previously reported, PHH is appealing the penalty imposed on it by the Bureau under Director Richard Cordray’s June 4, 2015 decision for alleged violations of RESPA related to mortgage reinsurance.  Among the issues on appeal in PHH is Cordray’s decision not to follow the Housing and Urban Development’s (HUD) previous interpretation of RESPA as it relates to mortgage reinsurance arrangements.  HUD was the agency responsible for enforcing RESPA before the CFPB assumed responsibility for enforcement in 2011.  In a 1997 letter, HUD opined that captive reinsurance arrangements are permissible under RESPA so long as the payments are for services actually performed, and are bona fide compensation that does not exceed the value of the services.  In making this determination, HUD read Section 8(c)(2) of RESPA to provide an exemption to Section 8(a), which generally prohibits the exchange of any fee or thing of value pursuant to an agreement to refer settlement service business.

Based in part on the HUD letter, the administrative law judge who first heard the PHH case also interpreted Section 8(c)(2) to provide an exemption to Section 8(a).  Cordray, however, rejected that interpretation, instead concluding that Section 8(c)(2) merely clarifies Section 8(a) in situations where there is some question whether the parties actually entered into an agreement to refer settlement service business, and does not provide an exemption to Section 8(a).

On June 23, PHH called the D.C. Circuit’s attention to Encino, where the Supreme Court held that the U.S. Department of Labor’s interpretation of the Fair Labor Standards Act (FLSA) should not receive Chevron deference.  Chevron deference—to which the CFPB claims it is entitled in the PHH case—is given to an agency’s interpretation of a statute that the agency is responsible for enforcing, so long as the statute is ambiguous and the agency’s interpretation is reasonable.  In Encino, the Department of Labor reversed its long-standing interpretation that automobile dealer service advisors are covered by an exemption from overtime pay requirements in FLSA.  In issuing its interpretation, the Department of Labor “offered barely any explanation” for its changed position, despite the fact that its new interpretation “could necessitate systemic, significant changes” in the industry.  The Supreme Court noted that an “unexplained inconsistency” in an agency’s interpretation can render its interpretation arbitrary and capricious, in which case the interpretation “is itself unlawful and receives no Chevron deference.”  Ultimately, the Court held that the Department of Labor needed “a more reasoned explanation” for its decision to depart from its existing policy, and noted that agencies must “be cognizant that longstanding policies may have ‘engendered serious reliance interests that must be taken into account.’”

In its letter to the Court, PHH argues that Cordray likewise “reversed a longstanding interpretation” of RESPA “on which the entire industry had relied for years” and that he “barely acknowledged” PHH’s reliance interests on the previous policy, “spurning them as ‘not particularly germane.’”  The Director’s summary rejection of HUD’s interpretation, PHH argues, renders the CFPB’s policy arbitrary and capricious, and it should receive no deference under Chevron.

In its response letter filed on June 27, the CFPB remained dismissive of PHH’s arguments, commenting that the 1997 HUD letter was “nothing more than an unofficial staff interpretation,” and that industry members “relied on it at their own risk.”  Otherwise, the CFPB argues that Director Cordray’s interpretation of RESPA was reasonable, and that the court should give it Chevron deference.

PHH was argued on April 12, 2016, and the decision of the D.C. Circuit is still pending.

Anti-Bribery and Corruption, Compliance, Securities and Commodities

DOJ’s First Corporate Enforcement Action Under Pilot Program

By Government Investigations Group

ForeignCorruptIn April 2016, the Department of Justice (DOJ) announced its Foreign Corrupt Practices Act Enforcement Plan and Guidance, which includes a one-year pilot program to incentivize individuals and companies to voluntarily self-disclose Foreign Corrupt Practices Act-related (FCPA) misconduct, cooperate with DOJ investigations and remediate controls and compliance programs.  Under the guidance, the DOJ may extend credit up to a 50% reduction off the bottom end of the U.S. Sentencing Guidelines and may not require the appointment of a monitor for those companies that meet the standards set forth by the pilot program.  Additionally, when certain conditions are met, including disgorgement of all profits from the FCPA misconduct, the DOJ may decline prosecution.

Earlier this month, the DOJ issued letters to two companies, Akamai Technologies Inc. and Nortek, Inc., indicating that investigations of FCPA violations at the companies were closed.  The DOJ stated that each company’s self-disclosure and cooperation ultimately led to its decision not to prosecute.  In parallel, as we reported, the SEC entered into non-prosecution agreements (NPAs) with each of the companies as a result of their disclosure, cooperation and remedial measures, and required the companies to disgorge profits plus interest.  These two cases presented the first public instances in which the DOJ declined to prosecute since the announcement of its pilot program.

More recently, on June 21, the DOJ concluded its first corporate enforcement action under its pilot program, offering clues on how companies can cooperate with government investigations to benefit from available mitigation credit in the event of an FCPA violation. This enforcement action was targeted at Analogic Corp. (Analogic), a Massachusetts-based medical tech company, its Danish subsidiary, BK Medical ApS (BK Medical) and BK Medical’s former CFO, all of which settled FCPA violations with the SEC and DOJ.  Analogic’s subsidiary, BK Medical, engaged in hundreds of sham transactions with distributors that funneled $20 million to third parties, including individuals in Russia, and apparent shell companies in Belize, the British Virgin Islands, Cyprus and Seychelles.  These transactions included the issuance of invoices to distributors that falsely inflated the sales and prices of the medical equipment sold, with the excess amount from those transactions then transferred to third parties as directed by the distributors.  BK Medical admitted that creating and maintaining these false invoices, representing to its parent company that BK Medical was complying with all Analogic accounting policies and signing SOX subcertifications, caused Analogic to falsify its books, records and accounts in violation of the FCPA.

The SEC settled the matter via an administrative order; Analogic agreed to pay $7.67 million in disgorgement and $3.8 million in prejudgment interest to settle the SEC’s charges that the company failed to keep accurate books and records and maintain adequate internal controls.  The SEC noted that it considered Analogic’s self-reporting, remedial acts and general cooperation with the investigation as part of the settlement.  Additionally, Lars Frost, BK Medical’s former CFO and a Danish citizen, agreed to pay $20,000 in penalties to the SEC to settle charges that he knowingly circumvented the internal controls in place at BK Medical and falsified its books and records.

The DOJ entered into an NPA with BK Medical, citing positively the company’s self-reporting, cooperation and remedial efforts, leading to the DOJ’s decision to provide the company with a discount of 30% off the bottom of the U.S. Sentencing Guidelines.  As a result, BK Medical was required to pay a monetary penalty of $3.4 million under the NPA.  Furthermore, BK Medical also agreed to continue to cooperate with the DOJ and foreign authorities in any ongoing or future investigations to enhance its compliance programs, and to periodically report to the DOJ on the implementation of its enhanced compliance programs.

As noted above, BK Medical did receive credit for its self-reporting and remediation, which included terminating the officers and employees responsible for the corrupt payments.  The DOJ explained that the company received only partial credit for its cooperation because BK Medical did not initially disclose certain relevant facts that it learned during the course of its internal investigation:

…the Company’s cooperation subsequent to its self-disclosure did not include disclosure of all relevant facts that it learned during the course of its internal investigation; specifically, the Company did not disclose information that was known to the Company and Analogic about the identities of a number of the state-owned entity end-users of the Company’s products, and about certain statements given by employees in the course of the internal investigation…

By way of contrast, the SEC NPAs entered into with Akamai and Nortek on June 7 noted comprehensive, organized and real-time cooperation by the companies during the course of their respective internal investigations. Specifically, the companies provided the SEC with summaries of witness interviews and made witnesses available to the SEC staff.  This cooperation led to the DOJ’s decision not to prosecute Akamai and Nortek under the FCPA.  The DOJ’s NPA with BK Medical specifically addressed a lack of disclosure of information gleaned from the company’s internal investigation.  This failure to disclose led to BK Medical receiving less mitigation credit.

When faced with FCPA misconduct, companies should work with outside counsel during internal investigations to assess whether a disclosure strategy is in the company’s best interests. Assuming the answer is yes, there are a number of important steps to be taken early on to provide prompt disclosure of discovered facts to the Government, as well as to keep the Government informed as to the progress of the internal investigations, ensure maximum cooperation and address any and all FCPA-related control and compliance issues.

Fraud, Deception and False Claims

Supreme Court Hands Down Opinion in Universal Health Services v. Escobar

By David Pivnick and Brett Barnett

Recently, the 87790287_jpgSupreme Court handed down its much-anticipated opinion in Universal Health Services, Inc. v. United States ex rel. Escobar et al.—a case addressing the viability of the implied certification theory in FCA litigation.  Justice Thomas, writing on behalf of a unanimous Court, found that the implied certification theory can in fact serve as a basis for FCA liability where a defendant has misleadingly failed to disclose its noncompliance with material statutory, regulatory, or contractual obligations.

The Court first addressed whether Universal Health Services, Inc. (“Universal Health”) impliedly certified that it had complied with Massachusetts Medicaid regulations by submitting claims for payment. Although the Court concluded that it did, the holding is narrowly drafted.  The Court held that the act of submitting a claim for payment is an actionable misrepresentation where two conditions are satisfied: (i) in addition to requesting payment, the claim also makes specific representations about the goods or services provided; and (ii) the failure to disclose noncompliance with material statutory, regulatory, or contractual requirements renders the representations “misleading half-truths.”  The Court expressly declined to address “whether all claims for payment implicitly represent that the billing party is legally entitled to payment.”As discussed in a previous article, Escobar is a qui tam case in which two relators allege that Universal Health submitted claims for reimbursement that failed to disclose violations of Massachusetts Medicaid regulations governing the qualifications and supervision requirements for staff at a mental health facility.  The Court determined that when Universal Health submitted reimbursement claims for mental health services using certain payment codes, “anyone would [wrongly] conclude that Universal Health complied with core state Medicaid requirements regarding the qualifications and licensing requirements of its staff members.”  By submitting claims for payment without disclosing the alleged violations, the Court found that Universal Health’s claims constituted actionable misrepresentations.Although many will be disappointed that the Court did not reject the implied certification theory, the Court’s limited ruling gives defendants room to argue that not all claims for payment implicitly represent compliance with statutory, regulatory, and contractual requirements. The Court looked to the common law to determine when nondisclosure constitutes an actionable misrepresentation, which is typically a fact-dependent, case-by-case inquiry.  The Court’s limited ruling leaves a lot of work left to be done in the lower courts and is sure to generate significant litigation.  Given that most jurisdictions had already adopted the implied certification theory, however, the Court’s limited ruling can be seen as a silver lining.The second question the Court addressed was whether the implied certification theory is limited to instances where compliance with a statute, regulation, or contractual provision was a condition of payment. Most lower courts had adopted this bright-line rule to prevent nearly unchecked liability under the FCA for minor regulatory violations and contractual breaches.  The Court addressed this issue solely as a question of materiality, and concluded that “[w]hether a provision is labeled a condition of payment is relevant to but not dispositive of the materiality inquiry.”In a bid to give some teeth to the materiality standard, the Court called the FCA’s materiality standard “rigorous” and “demanding” and reiterated that the FCA is not to be used as “an all-purpose antifraud statute.” The Court again turned to the common law, suggesting that materiality should be measured by whether noncompliance with a regulatory violation would influence the government’s decision to pay a claim.  The Court’s holding on this point was less precise, but it did reject the government’s argument that noncompliance with a regulatory violation is material simply because the government would be entitled to refuse payment.  Additionally, the Court appeared to suggest that defendants must have knowledge that noncompliance would be material.

From a litigation perspective, Escobar has swept away years of precedent on the bright-line rule.  Despite the Court’s effort to bolster materiality as a defense in implied certification cases, the loss of the bright-line rule will make it more difficult for defendants to win motions to dismiss.  The Court addressed this problem in a footnote, arguing that the pleading standards require the government and relators to plead facts to support their allegations of materiality.  No doubt the pleading standards will be an avenue to attack materiality on a motion to dismiss, but the Court may be overly optimistic.  Materiality is generally a mixed question of law and fact, meaning trial courts will be reluctant to dismiss a case before discovery.  As a result many cases that would have previously been dismissed will now go through expensive discovery.

Anti-Bribery and Corruption, Enforcement and Prosecution Policy and Trends

SEC Highlights Model Response to Evidence of FCPA Violations, Announces Non-Prosecution Agreements

By Government Investigations Group

On June 7, the Securities and Exchange Commission (SEC) announced two non-prosecution agreements (NPAs) following a pair of investigations into alleged violations of the Foreign Corrupt Practices Act (FCPA).  Both companies were ensnared by the FCPA through the conduct of their foreign subsidiaries.  The way the companies responded to the apparent violations provides a potential roadmap for a company that uncovers wrongdoing within the firm.

The Alleged Misconduct

Akamai Technologies, a global internet services company based in Massachusetts, owned a subsidiary that operated in China.  A sales manager at the subsidiary bribed employees at state-owned Chinese companies to purchase up to 100-times more network capacity than the companies actually needed.  Additionally, employees at the subsidiary routinely provided improper gifts to Chinese government officials in order to obtain or retain their business.

The second company, Nortek, Inc., also owned a subsidiary in China.  The subsidiary manufactured products for Nortek’s business, which consisted of selling products for residential and commercial construction.  Officers and employees at Nortek’s subsidiary made or approved improper payments and gifts to Chinese officials to obtain business and preferential treatment, including more favorable regulatory oversight and reduced taxes and fees.  Subsidiary employees made at least one improper payment every month in a five-year period.

The Investigation and Reporting to the SEC

Neither Akamai nor Nortek had adequate accounting controls to detect the bribery schemes as they unfolded.  Akamai uncovered the scheme only when a lower level sales representative filed a complaint against the manager.  Although Nortek discovered the bribery at its subsidiary during the course of an audit, the scheme had by that time been going on for five years.

Once the schemes were uncovered, both companies launched internal investigations.  A key component of that process was notifying the SEC of potential violations.  The companies notified the SEC early on and kept the SEC informed as the investigation developed.  Additionally, the companies disclosed summaries of witness interviews and made witnesses available to the SEC staff, including witnesses located in China.

Both companies also undertook extensive remedial measures.  Akamai named a Chief Compliance Officer and established a global team of compliance professionals.  It also strengthened its anti-corruption and training policies.  Nortek did the same.  It established a new Compliance Committee to oversee the implementation of its remedial efforts.  The companies terminated those who participated in the schemes and severed their relationships with problematic local partners.

The Non-Prosecution Agreements

As a result of these measures, the SEC determined it was appropriate to enter into NPAs with Akamai and Nortek.  The SEC required Akamai to disgorge over $650,000, plus interest.  Nortek disgorged nearly $300,000.  However, both companies escaped charges under the FCPA because of how they handled the discovery of the potential violations and the ensuing investigation.

The SEC attributed the decision not to pursue an FCPA case against the companies to prompt self-reporting and extensive cooperation with the investigation that followed.  It was critically important to the SEC that the companies laid “all their cards on the table.”  The SEC was also satisfied with the remedial measures the companies put in place.  One SEC official noted: “They handled it the right way and got expeditious resolutions as a result.”

The Akamai and Nortek cases lay out a roadmap to an NPA for companies that uncover clear evidence of a potential FCPA violation.  The companies (1) promptly disclosed the issues they uncovered to the SEC; (2) kept the SEC informed as the internal investigations proceeded; (3) fully cooperated with the SEC, including making witnesses available to be interviewed; and (4) took a hard look at their existing compliance programs and changed them to address the problem.  Experienced counsel can help companies navigate their way through the internal investigation process and craft a compliance regime responsive to the SEC’s concerns.

Compliance

Department of Education Proposes Rules Increasing Student Loan Risk to Schools

By Government Investigations Group

Government-Regulatory-and-Criminal-Investigations.jpg

On June 13, the Department of Education (DOE) proposed new rules relating to effective discharges of student loans. The proposed rules should be of note and concern to all schools, nonprofit and for-profit alike, because of significant new provisions and the broadening of defense to repayment rules.

Since 1995, DOE regulations have permitted borrowers to seek a defense to repayment, which currently requires a showing that the student has a state law cause of action against the school. In accompanying commentary to the proposed rules, DOE observes that the existing provisions have been relatively rarely used, and it acknowledges both that the standard is difficult to apply consistently and that there is no existing process for obtaining a defense to repayment. DOE justified the need for the new rules in the fallout from the bankruptcy of Corinthian Colleges, which resulted in thousands of former students seeking student loan relief. In that process, DOE concluded that new borrower defense rules were necessary.

The DOE rulemaking process began last year, with the publication of a notice that it intended to establish a negotiated rulemaking committee. After public hearings and an opportunity for the public to nominate committee members, a committee of approximately 30 members and alternates was established. The members of the committee represented a number of interests including state regulators, lenders, students, consumer advocates, two-year colleges, public schools, four-year public and private schools, and for-profit schools. The committee met in February and March of this year, but did not reach a unanimous consensus on any language for proposed rules. DOE’s press release states that it took into account the recommendations of the committee.

Although the rule changes were motivated by the Corinthian bankruptcy, the majority of the proposals apply equally to for-profit and not-for-profit schools. Among the provisions that apply to all schools are the following:

  • A requirement that private schools identified as financial risks, including those with high levels of borrower defense claims or an ongoing suit by state or federal regulators, must in some circumstances provide DOE a letter of credit equal to, in the case of ongoing suits, at least 10 percent of all federal loan funds received by the school in the most recent year. If the requirement for a letter of credit is triggered, it is mandatory. If the letter of credit is not provided within 30 days of a request by DOE, DOE may offset loan funds due to the school and hold them in an escrow account for the same purpose. Schools that are required by DOE to provide this financial protection must notify both enrolled and prospective students.
  • A provision prohibiting the use of all arbitration clauses and class action waivers between students and schools going forward, and rendering unenforceable any existing ones.
  • A provision forbidding schools from requiring students to first use an internal complaint process before making complaints to accreditors and government agencies.
  • Language clarifying that DOE can recover its losses from discharged loans from schools, including loans discharged because of borrower defenses.

One of the most significant aspects of the proposed rules is the new set of standards established for borrower defense, which would become effective for all loans first disbursed after July 1, 2017. Under the new rules, a borrower would have a defense to repayment and a claim for previously repaid amounts when (a) the school breached the terms of a contract with the student; (b) the student, a class of which the student was a member, or a government entity on behalf of the student won a favorable contested judgment against the school in court or before an administrative tribunal; or (c) the school or its agents made a substantial misrepresentation that the borrower reasonably relied on in deciding to attend the school.

Under the proposed rules, a student may submit an application to DOE seeking a defense to repayment on any of these bases. The student’s loans are automatically placed into forbearance while DOE considers the application. A DOE official decides whether the student is entitled to a defense to repayment, under a preponderance-of-evidence standard. The school must be notified and may submit a response. The rules do not provide for an appeal process for either students or schools. There are also procedures for DOE to initiate a consideration of potential defenses to repayment for an entire class of students.

The criteria allowing for a defense to repayment may potentially be implicated in many situations, for both for-profit and not-for-profit schools. In particular, the “substantial misrepresentation” prong could potentially be used against schools that are accused of misrepresenting the opportunities available to students, graduation rates, job placement rates, or graduate salary data. DOE has provided some factors that may be evidence of the reasonableness of the borrower’s reliance, but little guidance on what is a substantial misrepresentation. The proposed rules do alter the existing definition of misrepresentation to clarify that it encompasses any communication that has the likelihood or tendency to mislead under the circumstances.

Given recent news regarding allegations that nonprofit schools, including law schools, have misrepresented information that caused students to attend, many schools have reason to examine the proposed rules closely. Any allegation or suit against a school, particularly a putative class suit, poses additional risks that students may seek to use the suit as a defense to repayment.

In addition, the potential implications of settled cases are unclear. Even under the current standard, the Massachusetts Attorney General has said it will use admissions in a recent consent judgment to urge DOE to cancel loans that were taken out to attend certain programs at American Career Institute. Under the new regulations, a settlement does not qualify as a favorable judgment automatically entitling the student to a defense to repayment, but it is not clear whether a consent judgment would qualify as a favorable judgment. Further, the DOE discussion of the proposed rules expressly states that a settlement can be used as evidence establishing one of the other defenses to repayment criteria, such as a substantial misrepresentation. It is also not clear whether language in the settlement disclaiming liability or denying the allegations would have its intended effect or whether the DOE official could look beyond such language and find a substantial misrepresentation on the basis of a settlement. At a minimum, schools should be aware that if the proposed rule goes into effect as written, the language of any related settlements are likely to be scrutinized for potential support for a defense to repayment claim.

The proposed new rules are open to public comment until August 1, and DOE intends to publish the final rule by November 1.

Compliance, Financial Institution Regulation

CFPB Proposes Rule on Small Dollar Lending

By Justin Opitz

On JunMoneye 2, 2016, the Consumer Financial Protection Bureau (“CFPB”) released its proposed rule on small dollar lending during its scheduled field hearing in Kansas City, Missouri. The controversial proposed rule will affect payday loans, single-payment vehicle title loans, deposit advance products, and certain-high cost loans.

Under the proposed rule, lenders would be responsible for making sure that borrowers take on only debt that they can afford to repay. The proposed rule would require lenders to make a “full-payment test” before making most small dollar loans. This test would verify that the borrower can afford to make each payment and still meet all major financial obligations including basic living expenses. The proposed rule further limits the number of times and under what conditions loans can be rolled over each month. For example, payday and single-payment vehicle title loans would be capped at three successive loans followed by a mandatory 30-day cooling off period before the borrower could take out a new loan.

The proposed rule includes some limited exceptions to the full payment test requirement if certain criteria are met. Under the “principal payoff option,” lenders could make short term loans up to $500 in low-risk situations if the debt is repaid in a single payment or with up to two extensions without fully verifying the borrower’s ability to repay. For longer term loans, the proposed rule gives lenders two options to avoid the full payment test. Lenders would be allowed to offer loans that meet the National Credit Union Administration’s “payday alternative loan” criteria of capping interest rates at 28 percent with an application fee of not more than $20. Additionally, lenders could also offer loans payable in equal installments with a term not to exceed 24 months as long as the lender’s projected rate of default on the loans was 5 percent or less. But, if the lender’s default rate exceeded 5 percent in a given year, the lender would be required to refund its origination fees.

The proposed rule, however, is not just focused on the types of loans lenders offer. Rather, the rule will also regulate how lenders attempt to collect payment from consumers’ accounts. Specifically, under the new rule, lenders would be required to give borrowers written notice three days before debiting a borrower’s account for any loan covered by the rule. After two straight unsuccessful attempts, the lender would be prohibited from attempting to debit the account unless the borrower specifically consented to a further attempt. According to remarks by CFPB Director Richard Cordray, this gives “consumers a chance to question or dispute any unauthorized or erroneous payment attempts and to make arrangements for covering payments that are due.”

But despite CFPB claims that this new rule “would put an end to the risky practices in these markets that trap consumers in debt they cannot afford,” the new regulation is not without controversy. As previously reported, an earlier outline of the proposed rule was harshly criticized. Consumers and members of the finance industry voiced concern that the proposed rule could harm small businesses, take away options from consumers, and possibly infringe on authority of states and tribal nations. Members of Congress also introduced legislation last November directed at curtailing the CFPB’s rulemaking. If enacted, the proposed Consumer Protection and Choice Act would drastically limit the strength of the regulation by delaying the rule for two years and excluding states that already have certain payday lending laws from the CFPB’s regulation.

The CFPB is currently accepting comments on its proposed rule, and a final rule is expected to follow.

Financial Institution Regulation

CFPB Sues Payment Processor for Facilitating Fraudulent Transactions

By Justin Opitz

The CFPB sued payment processor Intercept Corporation, its owner, and its CEO on June 6, 2016, for allegedly enabling unauthorized withdrawals and other illegal activities of Intercept’s clients.  The complaint, filed in district court in North Dakota, accuses Intercept of processing transactions for its clients that it knew or “consciously avoided knowing” initiated fraudulent or illegal transactions.  Based on Intercept’s conduct, the CFPB alleges Intercept violated the Consumer Financial Protection Act (“CFPA”).

Intercept is a third-party payment processor that processes electronic fund transfers through the ACH network.  Intercept counts among its clients payday lenders, debt collectors, and auto title lenders.  The complaint described Intercept’s typical transaction:  Intercept’s client instructs Intercept to withdraw loan repayments from a borrower’s bank account; Intercept instructs its bank to contact the borrower’s bank to withdraw the money; the borrower’s bank debits the account, remits the money to Intercept’s bank, and Intercept remits the money to its client.

The CFPB alleges that Intercept violated the CFPA by engaging in unfair acts and practices by failing to heed warnings from banks and consumers; failing to adequately monitor and respond to high return rates; and failing to investigate red flags when vetting its clients.  The CFPB further contends that Intercept’s owner and CEO violated the CFPA by providing substantial assistance to Intercept.  According to the CFPB, Intercept falls under the CFPA for two reasons: (1) it provides payments or other financial data processing products or services to consumers by technological means; and (2) it provides services to cover persons.

Intercept’s banks notified it on multiple occasions that it was concerned with Intercept’s clients’ high return rates of disputed transactions, which the CFPB contends can be indicative of illegal or fraudulent activity.  But Intercept allegedly ignored its own banks’ warnings.  When one of Intercept’s banks would end its relationship with Intercept, Intercept would move on to another bank, never stopping to investigate the banks’ concerns or take a look at its relationships with its trouble clients.  Intercept’s clients’ rates of return for unauthorized transactions exceed industry standards.

The CFPB cited to industry rules and guidelines requiring participants in ACH transactions to monitor return rates and other suspicious activity.  The implication in the complaint is that Intercept should have investigated or terminated its relationships with clients with high return rates.

Intercept also allegedly failed to act in the face of significant numbers of consumer complaints to its banks about unauthorized withdrawals by Intercept’s clients and legal action taken against its clients.  Consumer complaints and legal action should have also triggered an investigation by Intercept of its clients, according to the CFPB.

Notwithstanding Intercept’s alleged failure to investigate high return rates or consumer complaints and legal action against its clients, the CFPB alleges that Intercept should have been more thorough in its due diligence of potential clients.  Intercept disregarded government investigations and negative Better Business Bureau rankings during the client intake process.

While CFPB v. Intercept Corp., et al. involves extreme facts, its implications for payment processors may be more broadly applicable.  It is evident that the CFPB expects payment processors to be proactive in monitoring their clients’ transactions.  It is not evident where the CFPB will draw that line.

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