Courts in California delivered some important banking developments in two recent decisions, with a federal court finding a charge for failing to replenish an overdrawn account constituted interest while the state's highest court dealt a blow to tribal immunity for payday lenders.

What happened

In 2003, the California legislature enacted the California Deferred Deposit Transaction Law regulating payday lending, placing limits on the size of each loan and the fees that payday lenders may charge. In response, some payday lenders sought affiliation with federally recognized Indian tribes which are generally immune from suit on the basis of tribal sovereign immunity.

Three years later, the California Department of Business Oversight (DBO) (at the time known as the Department of Corporations) issued desist and refrain orders to various online deferred deposit lenders, including the Miami Nation Enterprises (MNE) Services and SFS, Inc., arms of two federally recognized tribes, the Miami Tribe of Oklahoma and the Santee Sioux Nation.

The Commissioner directed the recipients to cease "engaging in unlicensed deferred deposit transaction business." When the defendants did not heed the order, the Department filed suit in California state court seeking injunctive relief, restitution, and civil penalties. MNE Services and SFS moved to quash service of the complaints based on lack of jurisdiction, arguing that they were immune from suit.

After conducting discovery regarding the relationship among the tribes, their subsidiary business entities, and the online deferred deposit lenders to determine whether the lenders were sufficiently related to the tribes to benefit from the application of sovereign immunity, the trial court granted the motion to quash. An appellate court affirmed and the Commissioner appealed to the California Supreme Court.

The state's highest court first established the legal standard and burden of proof for determining arm-of-the-tribe immunity. An entity asserting immunity bears the burden of showing by a preponderance of the evidence that it is an "arm of the tribe" entitled to such immunity, the court said, and courts should apply a five-factor test that considers: "(1) the entity's method of creation, (2) whether the tribe intended the entity to share in its immunity, (3) the entity's purpose, (4) the tribe's control over the entity, and (5) the financial relationship between the tribe and the entity."

These factors incorporate the understanding that tribal immunity should extend to arms of the tribe when such immunity would further the federal policy of tribal self-governance as a practical matter, the court emphasized, cautioning that tribal immunity should not become "a doctrine of form over substance," and courts need to "carefully examine how such arrangements function as a practical matter."

Applying the standard to MNE Services and SFS, the court reversed the order to quash, finding the lower courts gave "inordinate weight" to the formal considerations and not enough consideration of the actual relationship between the tribes and the entities.

"The record reveals a nominally close relationship between SFS and the Santee Sioux, and between MNE Services and the Miami Tribe," the unanimous California Supreme Court wrote. "But it contains scant evidence that either tribe actually controls, oversees, or significantly benefits from the underlying business operations of the online lenders. On the record before us … we are unable to conclude that defendants have carried their burden of showing that a denial of immunity would appreciably impair either tribe's economic development, cultural autonomy, or self-governance."

While the tribes' subsidiary entities were created pursuant to tribal law and the tribes expressed their intent to extend tribal immunity to the entities, both companies relied heavily on outsiders to manage their online payday lending businesses since those businesses were founded, the court said.

For example, both SFS and MNE Services contracted with a company investigated by the Federal Trade Commission (FTC). The FTC found that the third party company signed every single check for the payday lending business, more than 10,000, with none signed by members of the tribe. In addition, the bulk of the operations were conducted in Kansas, outside the boundaries of either tribe. And most significant, "neither SFS nor MNE Services has stated with clarity the proportion of profits from the lending operations that flow to the tribes or the proportion of tribal revenue that those profits comprise," the court wrote. "Moreover, there is evidence to suggest that the economic benefit to the tribes of the various lending businesses is minimal."

Reversing the order to quash, the court remanded the case to the trial court.

In a second case, a California federal court judge added to banking law in the state by determining that the fees charged to consumers for failing to replenish an overdrawn account constituted interest.

Joanne Farrell wrote checks against insufficient funds in her checking account. Pursuant to the terms of the Deposit Agreement, the bank charged her a $35 fee for not having sufficient funds. The Agreement also provided the bank with discretion as to whether to honor an overdrawn check and in the event it does so, the deposit account holder is obligated to pay back the bank's advance and any fees incurred.

Failure to do so within five days triggers an extended charge, an amount levied as a percentage of the negative account balance. Farrell claimed that the extended charge exceeded the interest rate permitted by Section 85 of the National Banking Act (NBA) and filed a putative class action in California federal court. Her $35 extended balance charge for the $284.86 overdraft she did not restore for 13 days represented an annualized interest rate between 897 percent and 71,170 percent, she claimed.

The bank moved to dismiss, arguing that the extended charge was not interest but an authorized deposit account service charge.

The court had no trouble finding that the initial $35 charge did not constitute interest, as it involved no extension of credit and was charged by the bank regardless of whether or not it honored an overdraft check. "[T]he Initial Charge seems to be more of a 'fee that the bank charges for its deposit account services' than it is a fee in consideration for the extension of credit," U.S. District Court Judge M. James Lorenz wrote.

But the extended charge should be treated differently, he concluded, for four different reasons. First, substantive differences existed between the initial charge and the extended charge, as "the Bank levies the Extended Fee only if it did in fact advance funds to cover an overdraft," the court said. "This suggests that the Extended Fee, unlike the Initial Fee, is more of a charge in consideration for the time value of money."

Simply because the extended charge was a flat fee did not remove it from the definition of interest, the court added, and neither did the contingent nature of the extended charge. Although the bank argued that customers had "complete control" over whether to pay the overdrawn balance before triggering the extended charge and therefore the bank could not know whether the ultimate rate on any given account would exceed the interest ceiling provided by law, the court did not find this position persuasive.

In Smiley v. Citibank, the U.S. Supreme Court ruled that a $15 fee levied for failure to timely pay a credit card bill constituted interest under Section 85 of the NBA, Judge Lorenz noted, and he saw "no reason to distinguish between the contingent nature of the fee at issue in Smiley and the Extended Charge at issue here."

Finally, the court rejected a contention that a fee arising from a deposit agreement (rather than a more classical credit arrangement) was per se not interest. A transaction governed by a deposit agreement can still be a credit transaction, the judge wrote, because when the depositor's account stands at a negative value as the result of overdraft coverage, the deposit account holder is necessarily a debtor and the bank the creditor.

"As a matter of plain language, 'the provision of money, goods, or services with the expectation of future payment' amounts to an extension of credit," Judge Lorenz wrote, citing the Merriam-Webster Dictionary. "Here, the Bank provided money to cover Plaintiff's bad check and did so with the expectation that [s]he pay them back. It follows that this provision of money amounted to an 'extension of credit.'"

This interpretation found support in Regulation O, the court added, which provides that "an advance by means of an overdraft …" is an extension of credit.

"Plaintiff's complaint alleges that the purpose of the Extended Charges is to compensate the bank for this extension of credit," the court said. "Construing this allegation as true, the Court finds Plaintiff has adequately alleged that the Extended Charge constitutes 'interest' under [Section 85]. The Court therefore denies Defendant's Motion to Dismiss."

To read the decision in People v. Miami National Enterprises, click here.

To read the order in Farrell v. Bank of America, click here.

Why it matters

The California Supreme Court's opinion establishes how arm-of-the-tribe sovereign immunity should be considered by the courts, taking a practical approach to focus on the day-to-day operations of entities affiliated with federally recognized tribes and relying less heavily on formal considerations. The ruling may affect entities attempting the "rent-a-tribe" strategy to circumvent regulatory authority, as noted by DBO Commissioner Jan Lynn Owen. "This ruling is an important win for California's payday loan consumers," she said in a statement about the decision. "It strengthens our ability to enforce laws prohibiting excessive fees and unlicensed activity by denying payday lenders' ability to inappropriately use tribes' sovereign immunity to avoid complying with state law." As for the Farrell case, the decision creates a split among district courts to consider the question. Three other federal courts (in Florida, Oklahoma, and South Carolina) have concluded extended charges do not constitute interest under Section 85, which split ultimately may be resolved at the appellate court level.