The result was the City Council's unanimous approval on April 5, of legislation targeting so-called "predatory lending" practices. Known as Bill 715, it is already being labeled as one of the most restrictive predatory lending laws in the country. The ordinance, which becomes effective in ninety days, was automatically enacted into law on April 19, when the Mayor John Street declined to either sign or veto the ordinance.
Targeting predatory residential mortgage lending, the ordinance covers primarily non-banks and affiliates of banks, although depository financial institutions are covered by certain prohibitions. The ordinance seeks to protect consumer borrowers from, among other practices, loan flipping, equity stripping, balloon payments and mandatory arbitration clauses. It mandates pre-loan home counseling for certain loans and requires that lenders record a certification of compliance for each loan attesting that it is not predatory.
Like similar measures enacted across the country, the ordinance subjects violators to civil money fines and prohibits "high-cost lenders" and predatory lenders from receiving certain city deposits, contracts, investments and licensing privileges.
On April 19, the final date for the mayor to either sign or veto the ordinance, the mayor returned the ordinance to City Council without his signature, but with a cover letter criticizing the ordinance as "well intended but seriously flawed" and expressing "strong reservations" about the ability of the ordinance to "stop the destructive practice of predatory lending."
Though strident in his renouncement of predatory lending, the mayor shares the concerns of most lenders that the ordinance "raises the possibility that many valid and legitimate lenders [will] stop doing business in Philadelphia." The mayor invited City Council to make good use of the next 90 days to fashion legislation that will not "undermine the legitimate lending institutions that are essential to the city's well being and economic strength."
Will the ordinance herald the end of the otherwise legitimate and much needed "subprime lending market" (a term favored by lenders) in Philadelphia as lenders concentrate their efforts in jurisdictions that are more lender-friendly? Will lenders bring a legal challenge on the ground that a combination of existing state law and federal law pre-empts the ordinance? Is the ordinance really necessary, given the pervasive federal regulation of subprime lending and, in many cases, the supervision exercised by state licensing authorities? To help you answer those questions, here is a more detailed review of the ordinance.
WHICH LENDERS ARE COVERED?
As first introduced, the ordinance covered all lenders. Exemptions from coverage were added to the bill shortly before its passage. The exemptions exclude from coverage only certain entities and only as to certain provisions of the ordinance. State-chartered banks, bank and trust companies, savings banks, private banks or national banks, state or federally-chartered savings and loan associations, federally-chartered savings banks, and state or federally-chartered credit unions are exempt from the ordinance's prohibitions on:
- Making predatory loans
- Making certain loans without pre-loan home counseling
- Lending without due regard to repayment
- Making direct payments to home improvement contractors
These exemptions do not insulate the above-referenced deposit-taking financial institutions from the other restrictions of the ordinance, such as the prohibitions on predatory lenders or their affiliates enjoying certain city deposits, contracts, investments and licensing privileges.
DEFINITIONS
The key to understanding the ordinance is to review the way the definitional terms work together. Meeting the definition of a predatory loan, and thereby triggering certain prohibitions and penalties, requires that a "high-cost loan" or a "threshold loan" exist.
High-cost loans are loans secured by residential real property in Philadelphia containing a one to four family dwelling or condominium or cooperative unit, that meet one of two numerical tests.
The first numerical test considers the loan's annual percentage rate (as calculated under the Truth-in-Lending Act and Regulation Z) (APR). For first lien residential mortgage loans, a loan is a high-cost loan if the APR at any time over the life of the loan exceeds by 6 1/2 percentage points or more the yield on treasury securities with a comparable period of maturity.
A junior lien loan is a high-cost loan if the APR at any time over the life of the loan exceeds by 8 percentage points or more the yield on treasury securities with a comparable period of maturity. High-cost loans do not include business purpose loans and loans that exceed $150,000.
The second numerical test for whether a loan is a high-cost loan under the ordinance considers the loan's points and fees. A loan is high cost if the total points and fees equal or exceed:
- For a loan amount of $ 16,000 or greater, 4 percent of the total loan amount (less the amount of suchpoints and fees)
- Or, for a loan amount below $ 16,000, $ 800.
THRESHOLD LOAN
A loan may also be deemed predatory if it meets the definition of a threshold loan under the ordinance. A threshold loan is a loan secured by residential real property in Philadelphia containing a one- to four-family dwelling or condominium or cooperative unit if:
- For first lien loans, the APR at any time over the life of the loan exceeds by at least 4 1/2 percentage points up to 6 1/2 percentage points the yield on Treasury securities having a comparable period of maturity.
- Or, for junior lien loans, the APR at any time over the life of the loan exceeds by at least 6 1/2 percentage points up to 8 percentage points the yield on Treasury securities having a comparable period of maturity.
POINTS AND FEES
Points and fees, the second of the numerical tests discussed above for whether a loan is a high-cost loan, include the following five items:
- All items required to be disclosed under Section 226.4(a) and (b) of Regulation Z as finance charge, except interest.
- All real estate loan charges excluded from the finance charge as listed in Section 226.4(c)(7) of Regulation Z, but only if the lender receives direct or indirect compensation in connection with the charge or the charge is paid to an affiliate of the lender.
- All mortgage broker compensation, including that of a table-funded originator.
- Premiums for credit life, credit disability or credit unemployment insurance, or any other life or health insurance that is financed directly or indirectly by the loan.
- All document preparation fees, even if otherwise excluded from the finance charge under Regulation Z.
PREDATORY LOANS PROHIBITED
If a loan meets either of the above definitions, it becomes a prohibited "predatory loan" under the ordinance but only if it has any of the following qualities or characteristics:
- Fraudulent or deceptive sales practices involving high-cost loans.
- "Loan flipping" as defined in detail in the ordinance.
- A balloon payment that is more than twice as large as the average of earlier scheduled payments, or a loan which gives the lender the sole discretion to accelerate the indebtedness in the absence of a default by the borrower.
- Negative amortization.
- Financing of points and fees in an amount greater than the point and fees threshold for high-cost loans.l Increased interest rate after default.
- More than two advance payments.
- Modification or deferral fees.
- Mandatory arbitration clauses.
- Prepayment penalties.
- Financing of credit insurance premiums.
- Lending without mandated home loan counseling.
- Lending without due regard to repayment, as defined in significant detail in the ordinance.
In his letter to City Council, the mayor criticized this definition as "vague, unspecific and convoluted." He also predicted that "[t]his unnecessarily complex and confusing standard could make loans legal at the time they were consummated, illegal after the fact, thus exposing lenders, contractors, and other businesses to chilling penalties and private law suits."
PROHIBITING PREDATORY LOANS
"No person shall make, issue, or arrange a predatory loan, or assist others in doing so." However, certain deposit-taking financial institutions are exempt from this prohibition.
There are several corrective action vehicles available to lenders under the ordinance. The ordinance provides lenders with both a 30-day corrective action mechanism and a 60-day bona fide error mechanism to make restitution and amend the loan so that it will no longer be predatory. The ordinance recognizes the federal pre-emption power provided by the Alternative Mortgage Transaction Parity Act (AMTPA) for certain variable rate and balloon payment mortgage loans and seeks to accommodate lenders that might exercise this power.
Thus, the prohibition against predatory lending does not apply to any duly-licensed lender whose loan would be deemed predatory solely because of the existence of a balloon payment, negative amortization or prepayment penalty, provided that such loan terms are made in conformity with AMTPA and do not otherwise meet the definition of a predatory loan under the ordinance.The ordinance prohibition on making "predatory loans" also does not apply to any loan made under the Pennsylvania Consumer Discount Company Act or the Pennsylvania Secondary Mortgage Loan Act.
In addition to the prohibition against making or arranging "predatory" loans, the ordinance also establishes the following additional consumer protections:
- Mandatory pre-loan counseling.
Under the home counseling provision, no lender may originate a threshold loan or high-cost loan without first assuring that the borrower has received counseling from a housing counselor approved by the Office of Housing and Community Development.
Most lenders view mandatory counseling as an extreme measure that will slow the loan process tremendously and will serve only to frustrate the very borrowers that the drafters of the ordinance claims they are trying to help.The mayor expressed similar concerns in his letter to City Council, explaining that it is unclear whether mandatory pre-loan counseling would impose any costs on consumers and the mayor questioned whether the City has the resources to provide such mandatory pre-loan counseling.
- No lending without due regard to repayment.
The ordinance bans a practice often referred to as "equity stripping" by prohibiting a lender from originating a threshold loan or high-cost loan if the lender does not believe the borrower will be able to repay the loan based on his or her financial situation.
- Home improvement finance.
Based on the view of its drafters that home improvement finance is a typical forum for predatory lending practices, the ordinance establishes new procedures and prohibitions for home improvement financing.
First, the ordinance prohibits lenders from paying the proceeds of a high-cost or threshold loan to any home improvement contractor other than by an instrument payable solely to the borrower, or through a third party escrow account. Second, home improvement contractors are now required to provide a specified notice advising the customer to be careful about giving a mortgage to a lender and that pre-loan home counseling may be required. Third, regardless of the type of instrument used to disburse the proceeds of the home improvement financing, the ordinance prohibits the disbursement of more than 25 percent of the total proceeds of a loan at the time of closing.
- Mortgage Recording Certification
Perhaps the most invasive new procedure established by the ordinance is a new mortgage certification requirement that will burden Philadelphia's already overworked document recording system with more paper.Unless amended, it appears that the certification will be a significant burden on the title company industry and lenders. Expressing privacy concerns, the mayor commented that the ordinance "appears to be more far-reaching and problematic than laws enacted in other jurisdictions and may seriously test the outer limits of what local governments can do to attack this problem."The certification also appears to be applicable to all mortgages. Thus, it is possible that the certification could apply to a clearly commercial mortgage. Other unresolved issues raised by the certification include the consequences of an absent or incorrect certification.
CITY SANCTIONS
The ordinance makes doing business in Philadelphia more difficult for lenders. Note that the sanctions below do not apply to lenders that merely make threshold loans, unless the threshold loans possess any of the qualities or characteristics that the ordinance defines as "predatory."
High-cost or predatory lenders that do not avail themselves of the 90-day discontinuance provision face a number of City-imposed sanctions. These sanctions include:
- Loss of city contracts.
- Loss of business privilege license. The ordinance also provides for forfeiture to the city of any city grant money that is used to promote a high-cost or predatory loan.
- City deposit prohibition: City depositories must certify that neither they nor any affiliate are or will become a high-cost or predatory lender and must disclose to the city certain predatory lending information including refinance loans in minority census tracts and related information.
- City investments divestiture: Within six months of notice that a business entity or an affiliate is a high-cost or predatory lender, the Board of Pensions and Retirement must divest stock ownership of such business, and no future investments may be made.
FINES, PENALTIES AND PRIVATE ACTIONS
The ordinance also imposes a number of different penalties.
- Fines. Each day in which a borrower is charged interest on the principal amount of a predatory loan is treated as a separate violation. Each such violation is punishable by a fine of $ 100 up to $ 300.
- Private actions. Any individual who becomes obligated on a predatory loan may bring an action for damages or equitable relief for violations of the ordinance. A private litigant may also be able to rescind the loan in accordance with the rescission procedures of TILA and may obtain attorneys' fees and court costs.Most significant, the private action remedy is available only to an individual who has become obligated on a predatory loan, thus leading to the clear conclusion that class actions are not permitted. Courts have similarly read a provision in the Pennsylvania Loan Interest and Protection Law allowing private actions by an individual to deny the class action remedy to plaintiffs under that statute.
ENFORCEMENT
To enforce the provisions of the ordinance, the Director of Housing and Community Development is required to maintain and disseminate to all city agencies and city-related agencies a list of all business entities which have been determined to meet the definition of high-cost and predatory lender.
The director is empowered to promulgate regulations and develop enforcement procedures.Can subprime loans still be offered in Philadelphia? The answer is "yes," but it will be harder.
For example, if you bump up against a definitional threshold in the ordinance and meet one of the numerical tests above, your loan documents need merely include an arbitration clause and the predatory lending police will come. Ironically, the day before the mayor declined to sign or veto the ordinance, he announced a war on urban blight and responsible subprime lending was intended to be a part of the cleanup arsenal. Lenders are hoping that the city's "clean up" efforts will not cause the entire industry to be swept away from Philadelphia because of the misdeeds of a few.
Leonard A. Bernstein chairs the multi-office consumer financial services group of Reed Smith LLP. Bernstein is the past chair of the Philadelphia Bar Association's business law section and Young Lawyers Division and the past chair of the New Jersey State Bar Association's banking law section. Last year, he was elected to the American College of Consumer Financial Services Attorneys. He wishes to thank Michael Meehan, Barbara Mishkin and Kevin Toth for their contributions to this article.