In a ruling that could prove costly to some national banks, the Ninth Circuit has ruled that the National Bank Act (NBA) does not preempt California state law mandating that financial institutions pay borrowers interest on funds held in their escrow accounts.

What happened

In July 2008, Donald Lusnak purchased a home in Palmdale, CA, with mortgage financing. A national bank assumed control over Lusnak’s mortgage; he later refinanced, agreeing to modify certain terms.

The refinance agreements provided that Lusnak’s mortgage “shall be governed by federal law and the law of the jurisdiction in which the Property is located.” As a condition for obtaining a mortgage, Lusnak was required to maintain a mortgage escrow account into which he paid $250 each month.

Enacted in 1976, California’s escrow interest law requires financial institutions to pay borrowers at least 2 percent annual interest on the funds held in the borrowers’ escrow accounts. The bank does not comply with the state escrow interest law, contending that no federal or “applicable” state law requires it to pay interest on Lusnak’s escrow account funds.

Pursuant to the “unlawful” prong of California’s Unfair Competition Law (UCL), Lusnak filed a putative class action alleging the bank violated the state’s escrow interest law, California Civil Code section 2954.8(a). He also asserted a breach of contract claim.

The bank moved to dismiss the putative class action, arguing that the NBA preempted California state law. A district court judge agreed, finding that the state law “prevents or significantly interferes with” banking powers and was therefore preempted by the federal statute.

On appeal, the Ninth Circuit began with a review of banking history in the United States, noting the passage of the NBA in 1864 and the resulting dual banking system that has continued to operate since that time. The passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act in 2010 brought about a “sea change” in banking law, affecting nearly every corner of the nation’s financial markets, the panel added.

In multiple places in the law, “Congress aimed to undo broad preemption determinations, which it believed planted the seeds ‘for long-term trouble in the national banking system,’” the court said.

The panel focused on section 1639d(g)(3), which amended the Truth in Lending Act (TILA) and states: “(3) Applicability of payment of interest. If prescribed by applicable State or Federal law, each creditor shall pay interest to the consumer on the amount held in any impound, trust, or escrow account that is subject to this section in the manner as prescribed by that applicable State or Federal law” (emphasis added).

On appeal, Plaintiff argued that the plain language of this section makes clear that Congress perceived no conflict between state laws like California Civil Code section 2954.8(a) and the powers of national banks. The bank countered that such state laws are preempted because they prevent or significantly interfere with the exercise of its banking powers and therefore are not “applicable” under Section 1639d(g)(3).

Long before Dodd-Frank, in Barnett Bank of Marion County, N.A. v. Nelson,a 1996 decision, the U.S. Supreme Court held that states were not “deprive[d] … of the power to regulate national banks, where … doing so does not prevent or significantly interfere with the national bank’s exercise of its powers.”

Although many differing perspectives on preemption emerged in jurisprudence and in financial regulation, Dodd-Frank chose to incorporate the Barnett Bank legal standard. The Ninth Circuit therefore affirmed “that Barnett Bank continues to provide the preemption standard,” but stated it more narrowly, concluding that “state consumer financial law is preempted only if it ‘prevents or significantly interferes with the exercise by the national bank of its powers.’” The “only” language is not in the Barnett Bank ruling. In light of this, the Ninth Circuit gave little deference to a regulation from the Office of the Comptroller of the Currency (OCC) that adopted what the Ninth Circuit claims to be broader than that in Barnett Bank.

Based on the above, the Ninth Circuit not surprisingly concluded that, under both Barnett Bank and Dodd-Frank, California Civil Code section 2954.8(a) does not prevent or significantly interfere with the bank’s exercise of its national bank powers. “Minor interference with federal objectives is not enough,” the court continued. While Dodd-Frank does not define the term “applicable,” the court found that “in the context of section 1639d(g)(3), [the term] would appear to include any relevant or appropriate state laws that require creditors to pay interest on escrow account funds.”

In reaching this result, the Ninth Circuit commented on what would seem to be the significant number of states that have addressed escrow interest, and in different ways. However, rather than conclude that this was significant impairment, the court argued that just 13 other states have escrow interest laws similar to California’s. “Through its requirement that creditors pay interest ‘in the manner as prescribed by’ the relevant state law, Congress demonstrated an awareness of, and intent to address, the differences among state escrow interest laws. ... and that it used the term ‘applicable’ to refer to state escrow interest laws where they exist.”

Legislative history confirmed this interpretation of section 1639d(g)(3), the court said, citing a passage in a House Report setting forth the purpose behind the provision: “Servicers must administer such accounts in accordance with the Real Estate Settlement Procedures Act (RESPA), [Flood Disaster Protection Act], and, if applicable, the law of the State where the real property security ... is located, including making interest payments on the escrow account if required under such laws” (emphasis in original). “This passage shows Congress’s view that creditors, including large corporate banks like [defendant], can comply with state escrow interest laws without any significant interference with their banking powers.”

No legal authority supported the bank’s preemption position, the court said, reiterating its rejection of the OCC’s pre-Dodd Frank (2004) preemption rule and finding the bank’s cited cases inapposite.

“Because California Civil Code section 2954.8(a) is not preempted, [the bank] was required to follow that law, and Lusnak may proceed on his UCL claim on the theory that [the bank] violated the UCL by failing to comply with section 2954.8(a),” the panel wrote. “Lusnak may also proceed on his breach of contract claim.”

To read the Ninth Circuit’s opinion, click here.

Why it matters

The Ninth Circuit ruling is a shot across the preemption bow. Banks seeking to take continued advantage of a broad reading of preemption based on the 2004 OCC preemption guidance should examine this opinion carefully to determine whether immediate changes may be required, including but not limited to potential customer reimbursements. Indeed, the opinion could prove costly, with the court noting that the bank’s obligation to pay interest on any funds in Lusnak’s escrow account was triggered from the point at which it assumed control of his account going forward—almost a decade ago.