Over the last few years, consumers have seen a proliferation of lending programs over the Internet offering all sorts of lending products, ranging from payday loans to title loans. Regulators in some states have taken action to challenge these virtual lending programs, arguing that the offering of a loan to a consumer in their states subjects the lender to the licensing and substantive law of that state, even if the lender has no staff or physical location in the state. Some of these complaints have found success, such as the Quick Payday, Inc., lawsuit against the Kansas Office of the State Bank Commissioner in 2007. In the Quick Payday case, the Kansas Office of the State Bank Commissioner sanctioned Quick Payday for making loans in Kansas without the license required by the Uniform Consumer Credit Code (“UCCC”), a uniform law adopted in roughly identical forms by about a dozen states. Quick Payday filed suit under 42 U.S.C. Section 1983, a federal statute that allows lawsuits against the government for deprivations of one’s constitutional rights. Quick Payday claimed that that the UCCC’s licensing and substantive requirements, as applied to it, violated the Commerce Clause of the U.S. Constitution. The U.S. District Court for the District of Kansas sided with the state regulator, finding that state law expressly provides that loans are “made” in Kansas if they involve a Kansas resident and are induced by solicitation in Kansas – even if the lender has no location in Kansas. The fear generated by the Quick Payday case that state regulators will target an Internet lender prompted different responses from Internet lenders, ranging from “business as usual” operations without regard to state law to diligent reviews of potentially applicable state licensing requirements and compliance with such requirements.
Now, the highly influential U.S. Court of Appeals for the Seventh Circuit has issued a pro-business decision in a case involving a traditional brick-and-mortar lender that could sanction an Internet lender’s decision to not obtain state law licenses for its lending activities. In Midwest Title Loans, Inc. v. Mills, the Indiana Department of Financial Institutions sought to require Midwest Title Loans to obtain a license under that state’s version of the UCCC. Although not an Internet lender, Midwest Title Loans, like Quick Payday before it, advertised its loans in Indiana, a bordering state. The Indiana UCCC, like the Kansas version of the UCCC applied in the Quick Payday case, has a “territorial application” provision that deems a loan made in Indiana if a resident of Indiana enters into a consumer credit transaction with a lender located in another state where the lender advertises the loan in Indiana or otherwise solicits Indiana consumers to enter into the transaction by any means, including by mail telephone, radio, television or the Internet.
Like Quick Payday before it, Midwest Title Loans sued the Indiana regulator under Section 1983. In the Quick Payday case, the federal trial court in Kansas expressly rejected the lender’s argument that this provision of the UCCC violated the U.S. Constitution. With respect to the Commerce Clause, the Quick Payday court found that the UCCC does not discriminate against or unduly burden interstate commerce, noting that states have a valid interest in restricting maximum interest rates and establishing uniform rules for credit transactions.
This time, the lender’s Section 1983 found a receptive audience, and the Seventh Circuit – in a decision authored by highly-influential Judge Richard A. Posner – disagreed with the Quick Payday court. The Seventh Circuit first recounted the perceived social ills caused by title lending programs, paying specific attention to the fact that many of these lending programs come with high rates and fees. Noting that a state has “a colorable interest in protecting its residents from” these types of expensive loans, the court turned to Midwest Title Loans’ Section 1983 claim alleging a violation of its rights under the Commerce Clause. The Commerce Clause provides that Congress has the power to regulate interstate commerce, a provision that courts have applied to prohibit states from establishing barriers to trade across state lines.
The Seventh Circuit first highlighted that, on its face, the UCCC territorial application provision does not make Indiana law treat a title lender located in a state other than Indiana any worse than it treats Indiana lenders. However, although all lenders must comply with the same interest-rate ceilings under the UCCC, a state can still violate the Commerce Clause even when state law does not “outright” discriminate in favor of local business. Such a violation can occur when a state actually attempts to regulate activities in other states. Here, Midwest Title Loans complied with all licensing and substantive requirements of Illinois, the state in which it actually operated. Despite this, Indiana attempted to reach across state lines to regulate the activities of this Illinois business. This, the Seventh Circuit concluded, a state cannot do, as the Commerce Clause protects interstate commerce from being impeded by extraterritorial regulation. Because Midwest Title Loans actually “made” the loans in Illinois, in that the lender gave the consumer a check for the loan proceeds drawn on an Illinois bank in its Illinois offices, Indiana was, in violation of the Commerce Clause, interfering with a commercial activity that occurred in another state. The court was not swayed by the fact that the consumer was an Indiana resident or would likely spend the loan proceeds in Indiana. “If Indiana cannot prevent Midwest from lending money to Hoosiers in Illinois, it cannot prevent Midwest from truthfully advising them of this opportunity,” the court concluded. “A state may not ‘take the commercial speech that is vital to interstate commerce and use it as a basis to allow the extraterritorial regulation that is destructive of such commerce’.”
What does this mean for Internet lenders? As an initial matter, the Seventh Circuit decision did not address Internet lending specifically, so Internet lenders should give the Midwest Title Loans decision a careful read to determine whether its position supports a decision to not obtain a license. Although the logic of the Midwest Title Loans decision should apply to an Internet lending program, courts have demonstrated considerable wariness of such virtual lending programs. Additionally, the decision itself will only bind lenders in the states that make up the Seventh Circuit, which include Illinois, Indiana, and Wisconsin. We anticipate, however, that the Midwest Title Loans decision will be viewed as favorable precedent by other courts grappling with these issues, as the Seventh Circuit is one of the most respected circuits in the country. Finally, an Internet lender should – at the very least – obtain all necessary licenses in the state in which it is located or in which it “originates” its loans. Internet lenders traversing this difficult maze of both state and federal regulation are wise to proceed with caution.
Catherine M. Brennan is a partner in the Maryland office of Hudson Cook, LLP. Basis Points readers can reach Cathy at 410-865-5405 or cbrennan@hudco.com.