Proposed Limitations on Terms of Credit to Service Members and Dependents

by Mary Beth Guard and John Burnett

This article provides a detailed summary of the proposed rules of the Department of Defense (DoD) on limitations on terms of consumer credit extended to service members and dependents.

This law is totally separate from the Servicemembers Civil Relief Act. The terms of that Act remain intact and unchanged.

• Background
• Crucial definitions
• Substantive requirements
• New disclosures
• Limitations/prohibitions
• Related Links

In a separate document, we have gathered the questions posed by DoD throughout the preamble to the proposed rule to guide you in writing your comment letter.

Background
In October 2006, Congress tucked an extra section into a routine Defense spending bill. Public Law 109-364, the John Warner National Defence Authorization Act for Fiscal Year 2007, included § 670, "Limitations on Terms of Consumer Credit Extended to Service Members and Dependents." Rulemaking authority was granted to the Department of Defense and that agency has just issued the proposed rules summarized below. DoD says it plans to issue final rules by September 1, to cover credit extended on or after October 1, 2007.

What was the driving force behind the legislation and the proposed regulation? Predatory lending practices adversely affecting members of the military and their dependents. Here's the chronology of events:

• In February 2001, President Bush issued a call to improve the quality of life for service members and their families. The Department of Defense (DoD) developed a social compact that made a DoD commitment to care for service member's needs in exchange for their commitment to serving in the Armed Forces.
• In 2005, DoD surveyed service members to rate the "stressors" in their lives. Finances and financial problems were counted as more significant than deployments, health concerns, life events and personal relationships. DoD developed a plan to:
  • Reduce stressors related to financial problems.
  • Encourage and increase savings.
  • Decrease dependence on unsecured debt to reduce vulnerabilities associated with living from paycheck to paycheck.
  • Reduce the prevalance of predatory practices that take advantage of service members when they are vulnerable.
• The military services and partner organizations, including banks and credit unions located on military installations, provide regular >In August, 2006, DoD made a report to Congress on Predatory Lending Practices Directed at Members of the Armed Forces and Their Dependents. In that report, DoD expressed concern that some service members had been so stressed, and had gotten into such financial straits, as to become unqualified for strategic security clearances, thereby affecting the ability of the armed forces to conduct their missions.

Elements of Predatory Lending
DoD summarized varying opinions on the elements of predatory lending in its report to Congress. They included:

• high interest rates and fees
• little or no responsible underwriting
• loan flipping - repeat renewals yielding fees to the lender, with little principal reduction
• loan packing - adding high-cost ancillary products
• loan structures or terms that make the loan highly secured
• fraud or deception
• waiver of meaningful legal redress
• avoidance of state usury and small loan laws and regulations.

The five types of lending targeted by DoD all include one or more of the predatory lending elements. All include high interest rates and fees:

• payday loans
• vehicle title loans
• military installment loans
• tax refund anticipation loans
• rent-to-own (not considered credit under the Truth-in-Lending Act)

Crucial definitions
It's quite obvious the Department of Defense is trying to make the best of a bad situation. To put it bluntly, the new public law has problems and it could have resulted in fewer good borrowing options for military personnel and their families. Fortunately, the DoD has recognized that and is trying to ameliorate the situation by using its rulemaking authority to define terms in such a way as to lessen the adverse impact. That means the definitions in the proposed rules are vitally important.

The DoD notes that it has learned of the potential unintended consequences of the limitations in the statute that could potentially preclude service members and their families from receiving a multitude of nonharmful credit products, so they attempt to limit the potential unintended consequences of the rule and adverse impact by carefully crafting the definitions of key terms.

Creditor -- person (broad definition, includes entities, as well as natural persons) who:

• is engaged in the business of extending consumer credit; and
  
• meets such additional criteria as are specified for such purpose in the regs; [for example, it says a person would be a creditor only if the person is also a "creditor" for purposes of the Truth in Lending Act, or
• who is an assignee of such a person with respect to any consumer credit extended.

Covered borrower - This definition makes it clear that it's not just the service member who is protected. The term "covered borrower" includes a person with the following status at the time he/she becomes obligated on a consumer credit transaction under this rule:

1. a regular or reserve member of the Army, Navy, Marine Corps, Air Force, or Coast Guard, serving on active duty under a call order that does not specify a period of 30 days or less, or such member serving on Active Guard and Reserve duty as that term is defined under 10 USC 101(d)(6); OR
   
2. the member's spouse, the member's child (defined in 38 USC 101(4), or an individual for whom the member provided more than one-half of the individual's support for 180 days immediately preceding an extension of consumer credit covered by this part.

Consumer Credit -- This is a key term because the restrictions, disclosures and prohibitions only apply to "consumer credit." It includes credit offered or extended to a covered borrower primarily for personal, family or household purposes (same test as in Reg Z), but, more specifically, it includes the following types of credit, each of which is specifically defined in the proposal:

• Payday loans
• Vehicle title loans
• Tax Refund Anticipation loans

Consumer credit does NOT include:

• a residential mortgage; or
• a purchase money loan or lease on a car or other personal property that is secured by the car or the personal property being purchased.
  
• credit secured by a qualified retirement account as defined in the Internal Revenue Code.

(The exclusion for residential mortgages covers any credit transaction secured by an interest in the covered borrower's dwelling, including transactions to finance the purchase or initial construction of a dwelling, refinance transactions, home equity loans or lines of credit and reverse mortgages. The term "dwelling" is defined as a residential structure containing one to four units, whether or not attached to real property, so it includes condos, coops, mobile homes and manufactured homes.)

Plus, this may sound insignificant, but it's not -- the term "consumer credit" also doesn't include any credit transaction that is not subject to disclosure requirements for purposes of Reg Z. Some people had feared the scope of this law would encompass overdraft programs, but if they are structured to avoid Reg Z, they'll avoid this law and reg, too, thanks to this carve-out.

Payday Loans -- closed end credit with a term of 91 days or less in which the amount financed does not exceed $2,000 and which also meets one of the following additional criteria:

• the covered borrower receives funds from and incurs interest and/or is charged a fee by a creditor, and contemporaneously provides a check or other payment instrument to the creditor who agrees with the covered borrower not to deposit or present the check or payment instrument for more than one day; or
• the covered borrower receives funds from and incurs interest and/or is charged a fee by a creditor and contemporaneously authorizes the creditor to initiate a debit or debits to the covered borrower's deposit account (by EFT or remotely created check) after one or more days. [They are not talking about the normal right of offset that takes place after delinquency/default here.]

Vehicle title loans -- are defined as closed-end credit with a term of 181 days or less that is secured by the title to a motor vehicle owned by a covered borrower, other than a purchase money transaction described in the exemptions.

Tax Refund Anticipation Loans -- are defined as closed-end credit in which the covered borrower expressly grants the creditor the right to receive all or part of the borrower's income tax refund or agrees to pay the loan with the proceeds of the borrower's refund.

Military Annual Percentage Rate (MAPR) -- This special rate is one of the key disclosures under the new law. The MAPR is the cost of the consumer credit transaction expressed as an annual rate, but it's different from the APR under Reg Z. It is calculated and disclosed following the rules for calculating the APR on closed-end transactions under Reg Z, EXCEPT that it's done based on the costs in this definition described below. The MAPR includes in its calculation the following cost elements IF the loan is consumer credit as defined in this reg, the borrower is a covered borrower AND the fees are deduced from the proceeds of the credit or otherwise required to be paid as a condition of the credit:

• interest
• fees
• credit service charges
• credit renewal charges
• credit insurance premiums, including charges for single premium credit insurance
• fees for debt cancellation or debt suspension agreements
• fees for credit-related ancillary products sold in connection with and either at or before consummation of the credit transaction.

The MAPR doesn't include contingent-type fees that might occur after consummation of the transaction (such as for unanticipated late payments). It also doesn't include tax return prep fees associated with a Refund Anticipation Loan.

Substantive requirements
There are specific requirements relating to terms of consumer credit extended to covered borrowers. They are as follows (assuming in each case you're dealing with "consumer credit," a "creditor" and a "covered borrower":

• Can't require the member or dependent to pay a MAPR except as agreed to under the terms of the credit agreement or promissory note, authorized by applicable state or federal law, and not prohibited by this law or reg.
• Can't impose an MAPR greater than 36%.

Covered Borrower Identification Statement
So, how do you know if an individual would be considered "covered" under this regulation as a covered borrower? You provide each applicant a clear and conspicuous "Covered Borrower Identification Statement" to complete. There is model language in the proposed rule. The form is short and self-explanatory.

There are optional verification procedures that can be used instead. For example, the creditor may verify the status as a covered borrower by requesting a current military leave and earning statement or a military identification card. In the case of Guard members or Reservists, a copy of the orders and any extensions may be requested. Another option is to verify the status on the Web, using the service member's full name, SSN and DOB. https://www.dmdc.osd.mil/scra/owa/home

If a creditor is refinancing or consolidating an extension of credit that was not subject to the regulation because the applicant(s) originally stated that they were not active duty service members or dependents of active duty service members, and the creditor has not otherwise determined that a borrower is covered by the regulation, the new transaction will also not be subject to the regulation.

New disclosures
In addition to the disclosures already mandated by Regulation Z, sections 232.5 and 232.6 of the DoD proposal would add four additional pieces of information that must be disclosed in writing before finalizing the credit transaction. The added disclosures must be separated from disclosures required under Regulation Z, although it appears they may appear in the same document. The four additional disclosures include:

1. A "covered borrower identification statement" designed to help the lender determine whether the DoD regulation applies to an applicant, and to provide the lender a qualified safe harbor from violation of the regulation if an applicant states that he or she is not an active duty member of the armed forces or a dependent of such a member. It is likely that such a disclosure would be completed in conjunction with an application for credit, rather than being made a part of a loan document. This requirement will likely affect all lenders, since the written statement of the applicant will determine whether or not the rest of the regulation applies to the requested transaction.
   
   
2. The Military Annual Percentage Rate (MAPR - see Crucial definitions, above), and the total dollar amount of all charges included in the MAPR. It is likely that the MAPR and total of charges will be greater than the APR and total Finance Charge disclosed under Regulation Z.
   
   
3. A clear description of the payment obligation of the borrower. This requirement can be met with a payment schedule disclosed under Regulation Z.
   
   
4. The statement: "Federal law provides important protections to active duty members of the Armed Forces and their dependents. Members of the Armed Forces and their dependents may be able to obtain financial assistance from Army Emergency Relief, Navy and Marine Corps Relief Society, the Air Force Aid Society, or Coast Guard Mutual Aid. Members of the Armed Forces and their dependents may request free legal advice regarding an application for credit from a service legal assistance office or financial counseling from a consumer credit counselor."

Oral disclosures
Items 2, 3 and 4 in the list above must be disclosed both in writing and orally. For internet and mail transactions, the proposal would permit a lender to provide with the written disclosures a toll-free telephone number that a consumer can use to obtain the oral disclosures. Note that the payment schedule must be included in those oral disclosures even though it may not be written separately from the Regulation Z disclosures.

Limitations/prohibitions

Section 232.7 of the proposal creates a "best protection" standard with regard to state and federal laws and regulations. The proposed DoD rule would preempt inconsistent federal or state laws and regulations, except to the extent that the other federal or state law or regulation provides a service member or dependent more protection.

The proposal also prohibits a state from

• Permitting creditors to impose charges on service members and dependents than the legal limit for residents of the state, or
  
  
• Allowing the waiver or violation of any state consumer lending protection that applies to state residents, on the basis of a covered borrower's nonresident or military status, regardless of the covered borrower's domicile or permanent home of record.

There are seven actions that a creditor (or creditor's assignee) may not take with respect to credit to a covered borrower (active duty member of the Armed Forces or his/her dependent):

1. Rolling over, renewing, refinancing or consolidation by the same creditor, unless the new transaction results in terms more favorable to the covered borrower, such as a low MAPR.
   
   
2. Requiring or allowing the covered borrower to waive his or her right to legal recourse under any state or federal law, including the Servicemembers Civil Relief Act (50 U.S.C. App. 527).
   
   
3. Requiring a covered borrower to submit to arbitration or imposing onerous legal notice provisions in case of disputes.
   
   
4. Demanding unreasonable notice from a covered borrower as a condition for legal action.
   
   
5. Using a check or other method of access to a financial account of the covered borrower, or uses the title of a vehicle as security for an obligation, except, if the MAPR is permitted under section 232.4 (permitted by federal or state law, but not greater than 36%),
   • the creditor may require an EFT to repay a consumer credit transaction, unless prohibited by Regulation E;
   • the creditor may require direct deposit of the consumer's salary as a condition of eligibility for consumer credit, unless prohibited by law; or
   • the creditor may take a security interest in funds deposited after the extension of credit in an account set up in connection with the loan transaction.

   Note: Requiring preauthorized EFTs to repay a loan transaction violates Regulation E. That prohibition, however, would not apply to a single authorization (for a single-payment loan obligation, for example).
   
   

6. Requiring that the borrower establish an allotment to repay the obligation as a prerequisite to the extension of credit; or
   
   
7. Preventing a borrower from prepaying the extension of credit, or imposing a penalty fee for partial or full prepayment.

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