CashCall Inc. made loans for years at illegally high interest rates, a judge ruled last week, dealing a blow to the Orange County company and raising questions about the validity of loans from other online lenders.
In a ruling handed down Aug. 31, a Los Angeles federal judge sided with the Consumer Financial Protection Bureau in a long-running case against CashCall, finding that loans made from 2009 to 2013 violated the laws of 16 states.
The case against CashCall, filed in 2013 by the federal regulator, raised fundamental questions about modern finance: Who is really making a loan and what rules do lenders have to follow?
CashCall, headquartered in Orange, argued that the loans were not subject to laws that cap interest rates in some states because they were issued by Western Sky Financial, a partner company based on the Cheyenne River Sioux Tribe's reservation in South Dakota. Tribal lenders are not subject to state usury laws.
But U.S. District Court Judge John Walter called the relationship between CashCall and Western Sky a sham, which could have implications for other lenders that originate loans through different third parties, such as banks.
"This case is another example of the potential risks for these loan origination models," said Alan Birnbaum, an analyst at ratings firm Moody's. "There is legal risk here — the potential for finding that these loans are void or unenforceable."
The CFPB argued that loans originated by Western Sky Financial were really made by CashCall. The agency said loans were marketed and serviced by CashCall and made using CashCall's money. Moreover, CashCall purchased all loans made by Western Sky.
The loans, which carried interest rates as high as 319%, went to borrowers in 16 states — California not among them — with laws that do not allow such high rates. The CFPB argued that because CashCall was the true lender, the loans should have complied with state laws.
Walter said that the deal between CashCall and Western Sky was structured in such a way that Western Sky never really had skin in the game.
"CashCall, and not Western Sky, placed its money at risk," Walter wrote in his judgment. "CashCall, and not Western Sky, had the predominant interest in the loans."
Because CashCall was the real lender, Walter said that the loans were illegal and CashCall could not collect on them.
Attorneys for CashCall raised a bevy of other issues in the case, arguing that the CFPB has no authority to enforce state lending laws and that the agency was trying to essentially create a federal interest-rate cap. Walter ruled that the CFPB was not overstepping its bounds.
Thomas Nolan, an attorney for CashCall, a private company owned by businessman J. Paul Reddam, said he was disappointed by the ruling but did not indicate whether the company will appeal Walter's decision.
Lending Club is facing a similar challenge from a New York man, who filed a class-action suit saying that the publicly traded San Francisco company loaned him money at an interest rate higher than allowed in New York state.
Lending Club, Prosper and other lenders work with banks, which are allowed to make loans in any state, as long as those loans comply with the lending laws in their home state. In Utah, home to WebBank, which originates loans for Lending Club and Prosper, there are no interest rate limits.
In the pending class-action suit, plaintiff Ronald Bethune alleges that Lending Club's relationship with WebBank is "a pretext and a sham" that exists only to allow Lending Club to charge higher rates.
Nat Hoopes, executive director of the Marketplace Lending Assn., a new trade group founded by lenders Funding Circle, Prosper and Lending Club, said the CashCall ruling is not a threat to his group's members since they charge lower interest rates.
"This case is an example of regulators policing payday lenders charging consumers extortionate rates that can eclipse 300%," Hoopes said. "Marketplace lenders offering consumer friendly fixed-term, fixed-rate products have not typically been subject to these types of actions"
But analysts who follow online lenders say the CashCall ruling highlights the legal uncertainty over how these lenders operate, so much so that Lending Club and Prosper have both tweaked their deal with WebBank.
Jody Shenn, a Moody's analyst, said that WebBank now shares in the losses if borrowers stop paying. That gives WebBank an ongoing interest in each loan, something Western Sky apparently didn't have. Shenn said the new arrangements could insulate online lenders from the risk of a CashCall-like court ruling — but that's far from a sure thing.
"We're not quite ready to call the fine tuning they're doing a silver bullet to protect against these challenges," Shenn said. "It will be hard for these marketplace lenders to come up with a silver bullet. We don't have clear guidance on what that would look like."
As long as online lenders rely on banks or other third parties to originate loans for them, Shenn said, "it raises questions about who the true lender is."
Jefferson Harralson, an analyst at investment bank and brokerage Keefe Bruyette & Woods, said the Bethune and CashCall cases, along with a handful of others, make him think that online lenders might have to start complying with state rate caps or risk more litigation.
"It does seem like the national digital lenders are going to have to think more about state usury laws," Harralson said. "This case is another step in a transition to those laws becoming more important."
Questions over the validity of loans are just one of several concerns that have weighed on Lending Club and other firms over the last several months. Since the beginning of the year, investors who buy loans from online lenders have pulled back amid concerns over borrower defaults and how loans might perform in a downturn.
The industry was also rocked this spring by Lending Club's dismissal of its founder and former chief executive, Renaud Laplanche, over his lack of disclosure of connections to an investment firm that did business with his company and other problems.
Lending Club, a leader in the online lending industry, went public at $15 a share in late 2014, but its stock price has steadily tumbled since then. Shares closed Wednesday at $5.41.
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