"PREDATORY LENDING, CRIMINAL OFFENDING!" This was but one of the battle cries of a small but vocal army of consumer advocates that descended upon Philadelphia City Council at a hearing held late last year. The result was the City Council’s unanimous approval on April 5, 2001 of legislation targeting so-called "predatory lending" practices. Known as Bill 715 (the "Ordinance"), it is already being labeled as one of the most restrictive "predatory lending" laws in the country. The Ordinance, which becomes effective in 90 days, was automatically enacted into law on April 19, 2001 when the Mayor 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, 2001, 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 cautioned City Council that the Ordinance as it now exists "could lead to the counterproductive effect of reducing access to credit for those struggling to buy or improve their homes, particularly in lower-income and minority neighborhoods." 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 the Ordinance stop the complaints of alleged abuses that various consumer groups voiced to City Council? Will lenders bring a legal challenge on the ground that a combination of existing state law and federal law preempts 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:

I. 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: (i) making "predatory loans;" (ii) making certain loans without pre-loan home counseling; (iii) lending without due regard to repayment; and (iv) 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.

Among the most controversial features of the Ordinance is that it provides no exemptions to finance-company affiliates of the above-referenced depository institutions. Thus, it has been argued that the Ordinance does not establish a level playing field in the subprime lending arena. The Mayor echoed this sentiment in his letter to City Council, which complained that "the exemptions are limited and questions remain regarding the legality of such provisions and whether this legislation would have a deleterious effect on the economic strength of the city."

II. 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.

A. High Cost Loan

"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 meets 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 6-½ 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. Lenders making adjustable rate mortgage loans are concerned that a loan could become "high cost" at some future point after closing.

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 a "high cost loan" if the "total points and fees" equal or exceed:

B. 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: (i) for first lien loans, the APR at any time over the life of the loan exceeds by at least 4 ½ percentage points up to 6 ½ percentage points the yield on Treasury securities having a comparable period of maturity; or (ii) for junior lien loans, the APR at any time over the life of the loan exceeds by at least 6 ½ percentage points up to 8 percentage points the yield on Treasury securities having a comparable period of maturity.

C. 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:

1. all items required to be disclosed under § 226.4(a) and (b) of Regulation Z as finance charge, except interest;
2. all real estate loan charges excluded from the finance charge as listed in § 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;
3. all mortgage broker compensation, including that of a table-funded originator;
4. 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; and
5. all document preparation fees, even if otherwise excluded from the finance charge under Regulation Z.

III. PREDATORY LOANS PROHIBITED

A. Predatory Loans Defined

If a loan meets either of the above definitions of a "high cost loan" or "threshold loan," such loan becomes a prohibited "predatory loan" under the Ordinance but only if the loan has any of the following qualities or characteristics:

1. Fraudulent or deceptive sales practices involving high cost loans;
2. "Loan flipping" as defined in detail in the Ordinance;
3. 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;
4. Negative amortization;
5. Financing, rather than direct payment, of points and fees in an amount greater than the points and fees threshold for "high cost loans" defined above;
6. Increased interest rate after default;
7. More than two advance payments;
8. Modification or deferral fees;
9. Mandatory arbitration clauses;
10. Prepayment penalties;
11. Financing of credit insurance premiums;
12. Lending without mandated home loan counseling (which is required under the Ordinance and is described in more detail below); or
13. 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 lawsuits."

B. Prohibition Against Making Predatory Loans

The heart of the Ordinance is contained in the following prohibition: "No person shall make, issue, or arrange a predatory loan, or assist others in doing so." As mentioned above, certain deposit-taking financial institutions are exempt from this prohibition.

Several corrective action vehicles are 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."

In addition, the Ordinance recognizes the federal preemption 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 a "predatory loan" 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, 7 P.S. § 6201 et seq. ("CDCA") or the Pennsylvania Secondary Mortgage Loan Act, 7 P.S. §6601 et seq. ("SMLA") solely because the loan contains any provision authorized by the CDCA or the SMLA, provided the loan does not otherwise meet the definition of a "predatory loan" under the Ordinance.

IV. OTHER CONSUMER PROTECTIONS

In addition to the prohibition against making or arranging "predatory" loans, the Ordinance also establishes the following additional consumer protections:

A. 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. Note that this notice requirement is very broad: a loan need not be a "predatory loan" to trigger mandatory pre-loan counseling. The housing counselor must provide the lender with notice that the borrower has received counseling on "the advisability of the loan transaction and the appropriateness of the loan for the borrower based upon the information provided by borrower and lender to the counselor at the time counseling is provided to the borrower." Again, the requirement of pre-loan counseling does not apply to deposit-taking financial institutions.

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 claim 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.

B. No More 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. A presumption of the borrower’s ability to repay the loan arises if: (i) the scheduled loan payments (including principal, interest, taxes, insurance and assessments) are less than 50 percent of the borrower’s documented and verified monthly gross income; and (ii) the borrower has sufficient residual income to pay remaining monthly expenses and debts. This provision is limited to borrowers with a stated income of not more than 120 percent of the median family income in Philadelphia.

C. Home Improvement Finance – Joint Checks; Notice

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 "threshold loan" or "high cost loan" at the time of closing.

D. New Cumbersome 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. All mortgages recorded in Philadelphia, and not just "high cost" loans, must be accompanied by a lender’s certification of compliance (the "Certification") attesting in part that: (i) the mortgage is or is not a "threshold loan" or "high cost loan" under the Ordinance; (ii) the borrower has or has not received housing counseling, if applicable; and (iii) the mortgage does or does not violate any provisions of the Ordinance. The lender must also attach to the Certification a copy of the document evidencing that the borrower received the required pre-loan home counseling.

Unless amended, it appears that the Certification will be a significant burden on the title company industry and lenders. First, the lender or mortgage broker must include on the Certification numerical information about the loan such as the APR, the points and fees, and other data needed to apply the "high cost loan" and "threshold loan" definitions. The Department of Records "shall make the information contained in such certifications available to the public in the most usable form the department practicably can provide." While this provision is intended to enable interested parties to collect aggregate lending data, it also raises privacy concerns since the data required by the Certification typically does not find its way into a publicly recorded loan document. Expressing precisely the same 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."

Second, the Certification appears to be applicable to all mortgages, not just "high cost" and "threshold" loans. 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.

V. CITY SANCTIONS

In addition to the prohibitions described above, the Ordinance makes doing business in Philadelphia more difficult for lenders that meet the definitions of a "high cost lender" or "predatory lender." 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."

A. High Cost Lender

A "high cost lender" is a lender that itself, or through an affiliate, has made within any 12-month period "high cost loans" as defined above that comprise the lesser of: (i) 5 percent of the lender’s annual loans, or (ii) 10 individual loans. However, an otherwise "high cost lender" is relieved of this designation if it submits a plan to discontinue the making of high cost loans within 90 days after the plan is submitted.

B. Predatory Lender

A "predatory lender" is a lender that itself, or through an affiliate, has made within any 12-month period "predatory loans" as defined above that comprise the lesser of: (i) 5 percent of the lender’s annual loans; or (ii) 10 individual loans. The Ordinance does provide a form of safe harbor or amnesty for predatory lenders that commit to discontinuing the making of predatory loans. A predatory lender is relieved of this designation if it submits a plan to the Director of Housing and Community Development to discontinue the making of predatory loans within 90 days after the plan is submitted.

C. Sanctions:

"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: No business shall be awarded a contract with the City or a City agency if such business or any affiliate is a "high cost" or "predatory lender."
• Loss of Business Privilege License: Any possessor of a business privilege license that promotes the services of a "high cost lender" or "predatory lender" in connection with a home improvement contract faces revocation of the license. The Ordinance also provides for forfeiture to the City of any City grant money that is used to promote a "high cost loan" 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 defined "predatory lending information" including refinance loans in minority census tracts and related information. The City Treasurer may not keep City funds deposited in a bank that is, either directly or through an affiliate, a "high cost" lender or "predatory lender."
• City Investments Divestiture: Within 6 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. Significantly, the divestiture and ban on future investments extends to securities collateralized by loans originated or purchased by a "high cost" or "predatory lender."

VI. FINES, PENALTIES AND PRIVATE ACTIONS

In addition to the City-imposed sanctions described above, the Ordinance also imposes a number of different penalties.

A. Fines

Each day in which a borrower is charged interest on the principal amount of a "predatory loan" is treated as a separate violation. (Recall that either a "high cost loan" or a "threshold loan" can turn into a "predatory loan" if any one of many conditions is present.) Each such violation is punishable by a fine of $100 up to $300. The bill as originally introduced provided for a maximum period of 90 days incarceration, but this provision was removed shortly before the bill was approved by City Council.

B. 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. The Ordinance provides that the minimum measure of actual damages that may be awarded is the amount of home equity lost as a result of the "predatory loan." 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.

This private-action-damages provision is narrower than the private action provision originally contained in the bill, which would have granted a private cause of action to any individual aggrieved by a violation of the Ordinance or any "community-based organization" (which was defined very broadly). This broad language was removed shortly before the bill was approved by City Council. The measure of damages has also changed from the proposal, which called for exemplary damages of $300 per day in addition to actual damages but established no minimum amount of actual damages.

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.

VII. 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.

VIII. CAN YOU STILL OFFER SUBPRIME LOANS 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 clean-up 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.