Setting Up a Company in Hong Kong

Every year since 1995, Hong Kong has been voted the world’s freest economy by the Heritage Foundation and the Wall Street Journal’s Index of Economic Freedom. It also has one of the lowest tax rates in the world. According to the Paying Taxes 2013 study conducted by PricewaterhouseCoopers and the World Bank Group, Hong Kong is the fourth-easiest place in the world to pay taxes, just behind three countries in the Middle East. Hong Kong is ideally located in the heart of Asia and serves as a gateway to and from Mainland China. Moreover, Hong Kong signed the Closer Economic Partnership Agreement (CEPA) with Mainland China and is treated more favorably than other foreign investors in many aspects. These advantages make Hong Kong an attractive place for foreign investors. 

Hong Kong is an important location for U.S. interests. According to the U.S. Department of State, as of 2012, there are some 1,400 U.S. firms, including 840 regional operations (315 regional headquarters and 525 regional offices), and over 60,000 American residents in Hong Kong. According to the U.S. Department of Commerce, as of February 2013, Hong Kong is the United States’ seventh-largest trading partner in terms of imports from the United States, while Mainland China is third. 

This article gives an overview of the major issues that U.S. investors should consider when setting up a company in Hong Kong. 

The Companies Ordinance (the CO) is the main piece of legislation governing companies in Hong Kong. The CO is being completely rewritten, and the new CO will come into force in the first quarter of 2014. Where changes will be brought about by the new CO regarding the issues discussed in this article, the new CO provisions will be introduced as well. 

Types of Permitted Operations in Hong Kong

Depending on the scope of operations, foreign companies seeking to operate in Hong Kong have three alternative permitted forms of business presence. 

Representative Office 

A representative office is suitable for a foreign company that intends to conduct only minimal activities in Hong Kong. A representative office cannot conduct any trade, professional, or business activities or transactions in Hong Kong and cannot enter into any contracts in Hong Kong. A representative office is appropriate, for example, for acting as a liaison office without creating any binding business obligations. 

Branch Office 

If a foreign company establishes a place of business in Hong Kong, it will require registration as a foreign company under the CO. A “place of business” includes a place used by a company to transact any business that creates legal obligations. The foreign company is liable for the debts and liabilities of its Hong Kong branch, and a branch office cannot take full advantage of Hong Kong’s tax benefits. 

Hong Kong Subsidiary

Due to the limitations of a representative office and branch office as described above, a foreign company usually favors establishing a Hong Kong–incorporated company as a subsidiary to operate in Hong Kong. This is generally the preferred type of business structure because the entity may be sued only to the extent of the limited assets of the Hong Kong subsidiary.

Classification of a Company

Under the CO, a “private company” is a company that restricts the right to transfer its shares, prohibits public subscription for its shares or debentures, and limits the number of shareholders to 50. Any company which cannot satisfy all three requirements is a public company. A public company can be listed on a stock exchange or unlisted. This article does not discuss public companies. 

A company can also be classified by whether it is limited by shares or by guarantee, or is an unlimited company. This article focuses on a company limited by shares, which is the most common type and is usually referred to as a “limited company.” A company limited by guarantee in Hong Kong is usually a nonprofit organization. 

The new CO makes it clear that there are five types of companies that can be set up under the CO: 

  1. A public company limited by shares;
  2. A private company limited by shares;
  3. A public unlimited company with a share capital;
  4. A private unlimited company with a share capital; and
  5. A company limited by guarantee without a share capital. 

Requirements for a Hong Kong Private Company

At a minimum, a Hong Kong private limited company must have the following: 

  1. One shareholder;
  2. One director;
  3. A company secretary;
  4. A registered office address in Hong Kong;
  5. An auditor; and
  6. A business registration certificate.

Director

A director must be at least 18 years of age, must not be an undischarged bankrupt, must not be subject to a disqualification order, must comply with any share qualification requirement, and must consent to act. There is no restriction on the nationality of a director. 

A private company can have a director that is a corporation, but under the new CO, a private company must have at least one director who is a natural person (but a company that is a member of a group of companies of which a listed company is a member cannot have any corporate directors). 

Company Secretary 

A company secretary must be either an individual resident in Hong Kong or a company with a registered office or place of business in Hong Kong. 

Business Registration Certificate 

A one-stop Company and Business Registration Service has been launched by the Companies Registry and the Inland Revenue Department. Applications for both incorporation and business registration may now be undertaken simultaneously. 

In addition to the business registration certificate, certain types of businesses may need additional forms of licensing. For example, a company conducting regulated financial services activity (such as asset management, dealing in securities, or advising on securities) in Hong Kong requires licenses from the Securities and Futures Commission. 

Generally 

There is no prescribed minimum paid-up capital. Under the new CO, the concept of nominal or authorized share capital and nominal or par value will be abolished. Instead, the articles of the company with a share capital must include a statement of capital containing some prescribed information and the initial shareholdings. 

The same person can be the secretary, director, and shareholder of a company, except that the sole director of a company cannot also be the secretary of the company. 

A company’s statutory records should be kept at its registered office. If they are kept at a different place, a notice must be filed with the Companies Registry. 

Under the new CO, the memorandum of association will be abolished as the constitution of a company. The articles of association will be the sole constitutional document of the company. Moreover, it will no longer be compulsory for companies to have a common seal. There are new provisions for execution of documents by authorized signatories where the document would take effect as if executed under seal. 

Information Available to the Public

Compared to other jurisdictions (e.g., the British Virgin Islands and the Cayman Islands), Hong Kong companies are much more transparent in terms of information that is available to the public. In addition to basic information, one can search for all the documents filed with the Companies Registry in relation to a particular company. One can also search for the registered charges of a company and disqualification orders made. Moreover, one can search for all the companies in which an individual has directorships and the particulars of that director, such as his or her identity number and residential address. 

It was originally proposed under the new CO that the residential address of a director and the full identification numbers of any person would not be made available for public inspection. This new arrangement has been subject to a heated public debate over the balance between personal data privacy and information transparency. The implementation of this new arrangement has now been delayed, and will not come into force along with the other provisions under the new CO. 

Establishing a Private Company

There are two ways of establishing a private company in Hong Kong: incorporating a new company or buying a shelf (or existing) company. 

Incorporation involves applying to the Companies Registry, which then issues a certificate of incorporation within four working days after submission of the application by post (online applications may be processed within an hour). The newly incorporated company then needs to be activated by holding its first board meeting and a shareholders’ meeting, if necessary. 

Buying a shelf company is useful when a company is urgently needed. One just needs to acquire a shelf company and then activate it by effecting a change of shareholders and directors and holding a board meeting (and a shareholders’ meeting, if necessary). 

Continuing Compliance Requirements

A company should hold an annual general meeting (AGM) each year, and not more than 15 months from the previous AGM, unless everything that is required to be done at the meeting is done by written resolution and the relevant documents are provided to each member. The following matters are usually dealt with at the AGM: 

  1. Adoption of audited accounts comprised of the balance sheets, directors’ report, and auditors’ report;
  2. Declaration of dividends;
  3. Election of directors; and
  4. Appointment of auditors. 

The new CO provides that a company is not required to hold an AGM if it has only one member or the AGM is dispensed with by unanimous members’ consent. 

Other compliance requirements include, among others, the following: 

  1. A company should keep a register of members and a register of directors and secretaries;
  2. Various returns have to be filed with the Companies Registry within stipulated deadlines for changes in relation to the company, such as changes in directorship and secretary, registered office, share capital, etc.;
  3. A company must file an annual return;
  4. A company must have annual audited accounts. The CO prescribes detailed requirements regarding the types of accounts to be prepared. A directors’ report must also be prepared in conjunction with the annual accounts;
  5. Shareholders’ or board meetings should be held as may be necessary or required under the CO. The minutes or written resolutions should be filed in a minute book and resolutions or notices should be filed with the Companies Registry as required under the CO; and
  6. A company also needs to renew its business registration certificate before it expires and file profit tax returns for the company and the employer’s return for its employees with the Inland Revenue Department. 

If a company fails to comply with these requirements, the company and every officer of the company who is in default may be liable for a fine and/or imprisonment. 

Tax Issues

Profits Tax

Hong Kong adopts a territorial corporate tax system. Corporations are taxed on profits at a rate, for assessment year 2012/2013, of 16.5 percent. Profits tax is charged on Hong Kong–sourced profits and is collected by the Inland Revenue Department. The tax rate on profit derived in Hong Kong is the same for Hong Kong and foreign companies.

Specifically, domestic and foreign entities meeting the following three criteria are subject to profits tax:

  1. The entity carries on a trade, profession, or business in Hong Kong;
  2. The profits are from such trade, profession, or business carried on by the entity in Hong Kong; and
  3. The profits arose in, or were derived from, Hong Kong.

A Hong Kong resident may derive profits from abroad that are not subject to Hong Kong profits tax; conversely, a nonresident may be liable for tax on profits arising in Hong Kong. The question of whether a business is carried on in Hong Kong and whether profits are derived from Hong Kong is largely one of fact. Profits arising from activities conducted abroad, even if they are remitted into Hong Kong, are not subject to profits tax.

Salaries Tax

Income received by employees from Hong Kong–sourced employment is subject to salaries tax. Subject to certain exemptions, income subject to salaries tax includes salaries, wages, commissions, tips, bonuses, allowances, perquisites, leave pay, terminal/retirement awards, contract gratuities, and noncash benefits such as housing allowances and stock-based awards.

In determining assessable income, outgoings and expenses (other than expenses of a domestic or private nature and capital expenditure) wholly, exclusively, and necessarily incurred in the production of the assessable income and depreciation allowances in respect of the plant and machinery, the use of which is essential to the production of the assessable income, are deductible. Other permitted deductions include:

  1. Loss brought forward from previous years of assessment;
  2. Expenses of self-education paid;
  3. Elderly residential care expenses paid;
  4. Home loan interest paid;
  5. Contributions to recognized retirement schemes; and
  6. Donations to approved charities.

Salaries tax is computed on net chargeable income at scaled rates between 2 percent and 17 percent for assessment year 2012/13. Salaries tax will not in any event exceed (i.e., is capped at) 15 percent of net income before allowances.

Double Taxation

The United States is absent from Hong Kong’s otherwise comprehensive double-taxation treaty network. However, Hong Kong adopts the territoriality basis of taxation, whereby only Hong Kong–sourced income or profit is subject to tax and non–Hong Kong sourced income or profit is, in most cases, not subject to tax. Accordingly, Hong Kong generally does not double-tax its residents. The Inland Revenue Department allows a deduction for foreign tax paid on turnover basis in respect of an income that is also subject to tax in Hong Kong.

General Tax Benefits

Dividends or overseas branch profits repatriated to Hong Kong are not subject to Hong Kong tax. In addition, dividends paid by a Hong Kong company to its shareholders are not subject to Hong Kong tax in the hands of shareholders (tax already having been paid by the company on the profits underlying those dividends), nor is there any withholding tax on dividends paid to shareholders outside Hong Kong. Capital gains are also tax-exempt. A stamp duty is imposed on certain documents such as share transfers, leases of real property, and sale of real property. There is no sales tax, value-added tax, or estate tax in Hong Kong.

For 2012/2013, a one-off reduction of 75 percent of the final tax payable under the profits tax, salaries tax, and tax under personal assessment, subject to a ceiling of HK$10,000 per case, was proposed in the 2013–14 financial budget. This reduction is pending legislative approval.

FATCA Issues 

Under the new U.S. Foreign Account Tax Compliance Act (FATCA), all foreign financial services institutions have to report the activities of their U.S. clients to the U.S. Internal Revenue Service if assets in their offshore accounts reach US$50,000. FATCA was designed to catch tax evasion by U.S. taxpayers overseas. Foreign countries have until 2014 to come into compliance or risk sanctions by the U.S. government. As at this writing, Hong Kong does not have a FATCA compliance plan. 

Employment Issues

Protection Under the Employment Ordinance

Irrespective of their hours of work, all employees covered by the Employment Ordinance (Chapter 57 of the Laws of Hong Kong) are entitled to basic protections, which include wages and statutory holidays. Employees who are employed under “continuous contracts” are also entitled to benefits such as rest days, paid annual leave, sickness allowance, severance payment, and long-term payment. An employee who has been employed continuously by the same employer for four weeks or more (with at least 18 working hours each week) is regarded as being employed under a “continuous contract.” The definition of “continuous contract” is currently under review.

Minimum Wage

Starting from May 1, 2013, the minimum wage rate in Hong Kong is HK$30 per hour.

Mandatory Provident Fund 

In Hong Kong, all employers and their employees aged 18 to 65 must join an employment-based retirement pension scheme unless an exemption applies (e.g., if the employee earns less than HK$6,500 per month), or if the employee is an existing member of an overseas pension scheme. Mandatory contributions are calculated on the basis of 5 percent of an employee’s relevant income, up to a maximum mandatory contribution of HK$1,250 a month, with the employer matching the employee’s contribution.

Employment Visa Issues

As a general rule, any person, other than those having the right of abode or the right to land in Hong Kong, must obtain a visa before coming to Hong Kong for the purpose of taking up employment. This includes secondees from an overseas office.

Conclusion

This article gives an overview of the main issues relating to setting up a business in Hong Kong. One may also need to consider issues other than the ones discussed above, such as opening bank accounts, entering into leases for office premises, recruiting employees, arranging financing, and protecting trademarks and other intellectual property rights and establishing data protection policies.

Hong Kong has always been keen to attract foreign investment to reinforce its status as an international financial center. Government policies generally favor foreign investment. For example, Hong Kong and Mainland China regularly enter into new supplements to CEPA to give more advantages to Hong Kong. These are the advantages that Hong Kong has that foreign investors should consider when they decide where to establish their business.

 

 

 

Hong Kong as a Base for Doing Business in Mainland China

The Peoples’ Republic of China (PRC, China, or Mainland China) is the second largest economy in the world after the United States and is the world’s fastest-growing major economy, with growth rates averaging 10 percent over the past 30 years. Since the implementation of its open-door policy in the late 1970s, China has become the world’s premier destination for foreign investment. China was the largest recipient of global foreign direct investment in the first six months of 2012. Over 480 of the Fortune Global 500 firms are doing business in China. China joined the World Trade Organization (WTO) in 2001 to enhance its competitiveness in the global market, and by 2010, China’s exports amounted US$1.19 trillion. Its main export partners are the United States (17.7 percent), Hong Kong (13.3 percent), and Japan (8.1 percent). China’s trade surplus in March 2013 amounted to US$11.19 billion.

Hong Kong is the world’s 10th largest trading economy and 11th largest exporter of commercial services. It has always had a laissez-faire policy aimed at promoting barrier-free trade. Foreign direct investment (FDI) is very active in Hong Kong. According to UNCTAD World Investment Report 2012, Hong Kong is the second largest source of FDI in Asia after Japan, with an outflow of US$81.6 billion in 2011. Hong Kong is also the key entrepôt of China. According to Hong Kong government statistics, in 2011, China was the destination of 54 percent of Hong Kong’s re-exports. A majority of the direct investments in China are implemented through Hong Kong. 

Hong Kong’s Role in the Economic Development of China

In March 2011, the 11th National People’s Congress (NPC) passed the 12th Five-Year Plan for the National Economic and Social Development of PRC (12th Five-Year Plan). For the first time, PRC’s National Five-Year Plan contains a chapter on the role of Hong Kong in the development of China. It aims at:

  1. Further consolidating and elevating Hong Kong’s competitive advantages, including its status as an international center for financial services, trade, and shipping;
  2. Developing Hong Kong into an international asset management center and offshore renminbi (RMB) business center, so as to strengthen its global influence in the financial sector; and
  3. Nurturing emerging industries and facilitating extending their fields of cooperation and scope of service in China.

In response to the 12th Five-Year Plan, the Hong Kong government encourages its enterprises to tap into the China market with emphasis on promoting Hong Kong’s role as an offshore RMB business center. As for industrial development, the Hong Kong government set up the Financial Services Development Council to promote Hong Kong’s financial services industry and complement the internationalization of RMB and Mainland China’s financial market. 

Hong Kong has become a conduit to funnel capital, high-caliber talent, and technology into China from all over the world, while also introducing China’s enterprises, products, and services to the global market. In essence, Hong Kong provides a springboard to China’s strategy of “going out” and “bringing in.”

Advantages of Doing Business in China via Hong Kong

Hong Kong is the largest foreign direct investment source in China. As of June 2011, there were 3,752 regional headquarters and regional offices in Hong Kong representing their parent companies located outside Hong Kong, with an increase of 3.1 percent from the previous year. Of these companies, 81 percent were responsible for business in China, confirming Hong Kong’s role as a gateway to China.

Robust Legal System

Hong Kong was a British colony from 1842 to 1997. After the handover in 1997, the “Basic Law” has been the supreme law of Hong Kong. Its underlying principle of “one country, two systems” enacted by the NPC indicates that the prior colonial-era capitalist system and way of life are to remain unchanged for 50 years. The most prominent feature of the Basic Law is the upholding of the common law system and rule of equity. Also, all ordinances not contradicted by the Basic Law are to remain in force. Hong Kong has a robust legal system and an independent judiciary that provide a fair and just operating environment for businesses. Under the Basic Law, Hong Kong has its own final appellate body, the Court of Final Appeal, which is crucial in maintaining the independence of the judiciary. Over the years, it has invited distinguished overseas judges to sit on its court and assist in the development of local jurisprudence. For example, Sir Anthony Mason, a former chief justice of the High Court of Australia, frequently sits in the Court of Final Appeal. The same applies to many law lords from the United Kingdom. This arrangement, which is unprecedented, not only signifies Hong Kong’s determination to retain judicial independence, but, equally important, it adds an international dimension to Hong Kong’s legal system.

Availability of quality legal services is an important factor for corporations that use Hong Kong as a regional center. Hong Kong is a one-stop professional advisory services center with over 7,400 practicing solicitors, 1,100 barristers, and more than 33,000 certified public accountants. Over 1,400 foreign lawyers qualified in 29 different overseas jurisdictions are practicing in Hong Kong and are capable of counseling on matters pertaining to the laws of the United Kingdom, United States, China, and others. In recent years, leading U.S. law firms have established bases in Hong Kong, making it a true international legal hub. According to statistics published in the October 2012 issue of American Lawyer, out of the top 100 global law firms ranked by revenue, 65 have offices in Hong Kong, and 50 of them are practicing as local Hong Kong firms of solicitors. 

The in-depth knowledge of Hong Kong legal practitioners in the Mainland China market and Hong Kong’s regulatory framework facilitate transactions involving parties from China by acting as a bridge between clients from the international and China capital markets. Also, sophisticated legal services are provided for fund-raising, finance, securities, international trade, and cross-border transactions. 

Effective Dispute Resolution 

In addition to a fair and efficient judicial system, alternative dispute resolution mechanisms to deal with business disputes are available. Hong Kong provides highly cost-effective arbitration services. In June 2011, Hong Kong reformed its Arbitration Ordinance Cap. 609; it now has a unitary regime of arbitration based on UNCITRAL Model Law for all types of arbitration, abolishing the distinction between domestic and international arbitration. 

Under Mainland Judgments (Reciprocal Enforcement) Ordinance Cap. 597, certain commercial judgments by either the China or Hong Kong courts may be enforced reciprocally. Arbitration awards made in Hong Kong are enforceable in more than 140 jurisdictions through the New York Convention and the Arrangement Concerning Mutual Enforcement of Arbitral Awards between China and Hong Kong. 

In Noble Resources Limited v. Zhoushan Zhonghai Food and Oil Industrial Limited (2009), whereby the party applied for approval from the Supreme People’s Court of its denial of enforcement of a Hong Kong International Arbitration Centre award on the basis of public policy, the Zhejiang Higher People’s Court highlighted that “there has not been any precedent of denying enforcement of HKIAC awards in the Mainland.” The Supreme People’s Court enforced the award finding in favor of the foreign party. 

With sophisticated legal expertise, internationally recognized regulatory standards, an independent judiciary, and an effective alternative dispute resolution system, Hong Kong is truly a one-stop hub in Asia that provides efficient and wide-ranging services that meet the needs of different kinds of businesses at different stages of development.

Mainland–Hong Kong Closer Economic Partnership Arrangement

Hong Kong enjoys a unique advantage under the Mainland–Hong Kong Closer Economic Partnership Arrangement (CEPA), which was first concluded in June 2003, with the latest supplement effective on January 1, 2013. CEPA plays an important role in strengthening cooperation between Hong Kong and China in areas of finance, trade, and investment facilitation and in promoting joint prosperity and development of the two entities. Prominent preferential liberalizations for goods and services of Hong Kong to enter the China market were announced. It is expected that free service trade between the two entities will be further promoted in the coming supplements. The liberalizations under CEPA provide better terms than the WTO commitments of China, adding to the desirability of Hong Kong as a base for doing business in China.

All products “made in Hong Kong” complying with CEPA origin rules and upon application by local manufacturers, except for a few prohibited articles, can be exported to China tariff-free under CEPA. “Made in Hong Kong” means goods must be “substantially transformed” in Hong Kong with at least 30 percent of value added therein (including R&D and design costs). Since the implementation of CEPA, the number of goods eligible for tariff-free treatment increased from 273 to 1,739. 

International firms that incorporate in Hong Kong enjoy all the benefits available under CEPA, as well as the obvious geographic advantage of being located in Hong Kong, which facilitates connecting with suppliers and consumers in China.

Also, Hong Kong service suppliers enjoy preferential treatment and relaxed market access conditions when setting up business in China. Financial, geographical, and ownership constraints are reduced or removed, such as allowing wholly owned operations and reducing registered capital requirements, which facilitate entrance to the China market for small to medium enterprises. Free trade in services between Guangdong and Hong Kong is expected to be achieved in 2014. 

Any company can benefit from CEPA if it is incorporated in Hong Kong with three to five years’ operation (depending on the sector). Fifty percent of its staff must be employed locally and liable to pay Hong Kong tax. Overseas service providers can partner with, invest in, or buy into a CEPA-qualified company to acquire easier access to China. 

Languages and Accessibility 

Hong Kong has the root of Chinese cultures with British features from its colonial history. Chinese and English are both official languages in Hong Kong and are commonly used in business.

Hong Kong’s geographical location has made it the central hub of the Asia-Pacific region. It is within easy flying distance of China, Southeast Asia, India, and Australia. Hong Kong is the world’s third-busiest container port system. Hong Kong International Airport is the world’s busiest cargo gateway and two additional runways are planned to increase its capacity by 2020. 

Construction for the Hong Kong-Zhuhai-Macao Bridge is expected to be completed in 2016, enhancing the economic development of the region. The Hong Kong section of the Guangzhou-Shenzhen-Hong Kong Express Rail Link is expected to be completed in 2015, strengthening economic ties between the areas, accelerating the economic integration of the Western Pan River Delta and its neighboring provinces, and increasing Hong Kong’s competitiveness.

Banking and Finance in Hong Kong

As an important banking and financial center in the Asia-Pacific region, 70 of the world’s top 100 banks are based in Hong Kong. According to the Bank for International Settlements, Hong Kong is the third-largest foreign exchange market in Asia and the sixth-largest in the world. In 2011, Hong Kong was first in the world for initial public offerings (IPO) for a third year in succession and was a prominent offshore capital-raising center for China enterprises. As at December 2011, there were 640 China companies listed in Hong Kong, making up 55.5 percent (i.e., US$1.2 trillion) of the market total. Listed companies in Hong Kong are regulated by the Securities and Futures Commission and the Hong Kong Stock Exchange, which have strong reputations and high standards for listing.

Eight licensed China-incorporated banks and five representative offices operate in Hong Kong. Some of them have set up their branches in Hong Kong, such as the Bank of China, China Construction Bank, Industrial and Commercial Bank of China, and Agricultural Bank of China.

Benefits of Using a Hong Kong Holding Company

The Foreign Investment Industrial Guidance Catalogue (2011 Revision), amended by the Ministry of Commerce, came into effect on January 30, 2012. The Catalogue is a tool used by the China government to control foreign investors and divides foreign investment industries into three categories: (1) Encouraged; (2) Restricted; and (3) Prohibited.

For investment in the Encouraged category, foreign investors are generally allowed to establish wholly foreign-owned enterprises (WFOE). The Encouraged category includes mining and textile manufacturing. For investment in the Restricted category, foreign investors generally need to make their investment through a joint venture with a China partner. The foreign investor’s equity interest in the joint venture can be subject to limitation. As for industrial projects in the Prohibited category, foreign investment is not allowed, for instance, in postal services and media. 

On the other hand, Hong Kong provides foreign investors freedom of investment, as the restriction and limitation control by the Hong Kong government is minimal. For example, a foreign investor can set up a company in Hong Kong to hold 100 percent of a WFOE, or to incorporate in a joint venture in China. 

The benefit of this practice is that, by an appropriate shareholders’ agreement, stock option plan, or asset and business management agreement, the maintenance and management of a WFOE or joint venture can be operated at the Hong Kong holding company level, which is governed by the laws of Hong Kong, and any transfer of shareholding at the Hong Kong holding company level will not require approval by the China government. 

Second, as a benefit of Hong Kong’s mature banking and finance system, the Hong Kong holding company level can conveniently obtain loans and credits. 

Third, on August 21, 2006, the China and Hong Kong governments signed the Arrangement for the Avoidance of Double Taxation on Income and Prevention of Fiscal Evasion, which provides added incentives for international investors to enter the China market through Hong Kong. For instance, where a Hong Kong resident company disposes of less than 25 percent of shareholding in a China company and the assets of the China company are not comprised of mainly immovable property situated in China, gain derived from such disposal will be tax exempted. Without this preferential treatment, the gain would be subject to a 10 percent withholding tax. As for indirect income such as interest, dividends, and royalties, Hong Kong investors are provided with preferential treatment. 

Conclusion

In brief, we have set out the advantages of using Hong Kong as a base for doing business in China, including, but not limited to, a robust legal system, a simple tax regime, a leading capital market and financial center, a regional hub, quality manpower, proximity to China, an efficient government, free trade and a free market economy, global connections, and a logistic center with efficient transportation. 

In this mini-theme covering Hong Kong legal services, my fellow colleagues of the Law Society of Hong Kong will cover additional legal topics that will be of interest to you and your clients that wish to do business in China.

Lien “Strip Down” vs. Lien “Strip Off”: Dewsnup v. Timm Is Still the Law – Isn’t It?

The real estate collapse of 2008 hurt senior mortgage lenders, but it pummeled junior lenders, whose second liens went from above to below water, almost in a heartbeat. Some homeowners, however, saw an opportunity: if a home purportedly had no value above the amount of the senior lender’s claim, why not use Chapter 7 of the United States Bankruptcy Code to value the junior lender’s secured claim at zero – effectively stripping the junior lien off of the property and leaving the home closer to the water’s surface, where the borrower might more easily start re-building equity?

Bankruptcy professionals might have thought they knew the answer to that question. Over 20 years ago, the United States Supreme Court, in Dewsnup v. Timm, barred Chapter 7 debtors from stripping a creditor’s partially-secured claim down to the value of the collateral securing it.

However, a unanimous panel of the Eleventh Circuit Court of Appeals recently found Dewsnup to be irrelevant when applied to a junior lien on collateral of insufficient value to put the second lien holder in the money. The appellate panel instead relied on one of its own pre-Dewsnup decisions, a decision some bankruptcy courts thought had been abrogated by Dewsnup. Then, by refusing to publish its opinion, the Eleventh Circuit left debtors, lawyers, and judges in a quandary from which they have yet to emerge. (The case is In re McNeal, Appeal No. 11-11352, 2012 WL 1649853 (11th Cir. May 11, 2012).)

Under the Bankruptcy Code, an undersecured creditor with an “allowed” claim (that is, a claim that is entitled to be paid out of the bankruptcy estate) really has two claims: a secured claim in an amount equal to the value of the creditor’s collateral and an unsecured claim for the remainder. For example, a lender holding a $1 million mortgage claim secured by real estate worth $400,000 would have a secured claim for $400,000 and an unsecured deficiency claim for $600,000. Moreover, the same section of the Bankruptcy Code that provides for bifurcating the lender’s claim into secured and unsecured portions also provides that, to the extent a lien secures a claim that is not an allowed secured claim, that lien is void.

Before the Dewsnup decision, therefore, a homeowner in bankruptcy might ask the court to value his or her home at less than the full amount owed on the mortgage; if the court did so, the homeowner would then ask the court to void the lien to the extent that the lender’s claim exceeded that court-determined value – a procedure informally referred to as “stripping down” the lien. The debtor might then pay that value and extinguish the lien. Of course, if the court had undervalued the property or the property later appreciated in value, the debtor, not the lender, benefited from the additional value.

In 1991, the Supreme Court, in Dewsnup, put a stop to lien-stripping in Chapter 7 cases, finding that, so long as an allowed claim is secured by a lien – even one worth less than the full amount of the claim – a debtor could not strip down the lien. Instead, the lien would survive the bankruptcy, and the lender could foreclose it even after the Chapter 7 debtor received a discharge of his or her debts. While the discharge prevented the lender from collecting a deficiency from the former debtor, the lender would, at least, benefit from any increase in the value of the real estate itself, whether by appreciation or as a result of the court’s low-ball valuation. At least two considerations weighed heavily in the Court’s ruling: 

  • honoring the bargain between the borrower and the lender that the lien would stay with the property until foreclosure, thereby insuring that increases in property value would benefit the lender; and
  • observing the rule, established long before the enactment of the Bankruptcy Code, that liens survive bankruptcy.

The Dewsnup opinion may have given comfort to Lorraine McNeal’s junior lender. McNeal owed $176,413 to her first mortgage lender and $44,444 to her second, each of which held liens encumbering a home that, the parties agreed, was worth just $141,416 – less than the amount of the first mortgage, leaving the junior lien completely valueless. McNeal argued that, because the lien of the second mortgage holder did not actually secure any allowed secured claim – the junior lender’s claim was wholly unsecured – that lien was void and should be “stripped off” of her home completely.

Most courts, including bankruptcy courts within the Eleventh Circuit, had held that the Dewsnup rule against “stripping down” liens that had some value applied equally to “stripping off” liens that had no apparent value, and the bankruptcy and district courts both held against McNeal, forbidding her from stripping the second lien from her home.

However, the Eleventh Circuit found that Dewsnup did not control its decision, and it reversed, holding for the debtor. Without significant analysis, the panel decided that the case of a lien determined to have some value (Dewsnup) had no relevance to the case of a lien determined to have no value (McNeal), and, instead, applied a pre-Dewsnup Eleventh Circuit decision that had permitted a lien to be stripped off of collateral whose value was insufficient to support the second lien. The result is surprising, in part, because it splits from the opposite rulings of the Fourth and Sixth Circuits and departs from the understanding of Dewsnup found in opinions of some bankruptcy courts in the Eleventh Circuit. It also departs from the central policy arguments advanced by the Supreme Court in Dewsnup, which appear to apply equally to “strip down” and “strip off” cases: that courts should respect the lender’s bargain with its borrower and that they should preserve the long-standing practice of leaving liens unaffected by bankruptcy.

Perhaps even more confounding is the fact that the Eleventh Circuit chose not to publish its McNeal opinion. Under the Circuit’s rules, that means McNeal is not binding precedent, but may be cited as “persuasive authority.” One might sympathize with bankruptcy courts in Alabama, Florida, and Georgia as they try to determine the degree to which they should be “persuaded” by a unanimous panel decision from their controlling circuit that nonetheless is not strictly precedential. Some practitioners in those jurisdictions report that, where Chapter 7 debtors have filed contested motions to strip second liens off of their homes, the bankruptcy courts are simply holding the motions in abeyance, indefinitely, pending further guidance from the Eleventh Circuit. Meanwhile, debtors in jurisdictions outside the Eleventh Circuit have also sought to strip second liens from their property.

Guidance does not appear to be within ready reach. In January, debtor’s counsel asked the appellate panel to publish its opinion in McNeal and thereby put to rest the issue of McNeal‘s authority within the circuit. However, at the time of that request, both lender-appellees had commenced Chapter 11 bankruptcy cases, and, in February, the Eleventh Circuit therefore stayed all proceedings in the McNeal appeal, until it is notified that the bankruptcy court has granted relief from the automatic stay in the lenders’ cases.

For now, then, debtors with homes worth less than their total mortgage debt have found a friend in the Eleventh Circuit, while home equity lenders may impose stricter loan-to-value requirements as they try to weigh the risks posed by McNeal.

Robocalling and Wireless Numbers: Understanding the Regulatory Landscape

Key provisions of the Federal Communications Commission’s (FCC) Telephone Consumer Protection Act (TCPA) rule are scheduled to take effect in October of this year. These changes will require written consent for autodialed and prerecorded telemarketing calls and text messages to cell phones, and will require written consent for prerecorded telemarketing calls to landlines.

The TCPA has a private right of action, and recent class actions alleging violations of the law’s autodialer provisions have settled for tens of millions of dollars. The filing of TCPA complaints is on the rise, and recent court decisions have complicated the TCPA litigation landscape.

In this article, we discuss the TCPA and the FCC rules, the amendments to the FCC rules under the TCPA, and new litigation developments under the TCPA.

Background to the TCPA

Under the TCPA, it is “unlawful . . . to make any call (other than a call . . . made with the prior express consent of the called party) using any automatic telephone dialing system or an artificial or prerecorded voice . . . to any telephone number assigned to a . . . cellular telephone service.” This law was passed in 1991 and reflects the now-obsolete notion that some cell phone users must pay for incoming calls, and “automated” calls should therefore be limited.

The TCPA defines the term “automatic telephone dialing system” or “ATDS” as “equipment which has the capacity – (A) to store or produce telephone numbers to be called, using a random or sequential number generator; and (B) to dial such numbers.” It seems clear that Congress intended the law to apply to random sequential dialers and similar devices that dial numbers continuously until they obtain an answer. For example, the legislative history indicates that “automatic dialers will dial numbers in sequence, thereby tying up all the lines of a business and preventing any outgoing calls.”

In 2003, the FCC interpreted the term ATDS to include a predictive dialer, where the dialer has the capacity to randomly generate and dial sequential telephone numbers, even if that capacity has not been enabled: “A predictive dialer is equipment that dials numbers and, when certain computer software is attached, also assists telemarketers in predicting when a sales agent will be available to take calls. The hardware, when paired with certain software, has the capacity to store or produce numbers and dial those numbers at random, in sequential order, or from a database of numbers.” Many businesses use telephone systems to contact their customers that, if paired with certain software, are capable of generating and dialing sequential numbers at random.

The FCC’s TCPA Rule

The FCC has made a rule under the TCPA (TCPA Rule or Rule), which generally prohibits making telephone calls to cellular telephones using an ATDS or a prerecorded message without the prior express consent of the called party. These prohibitions apply to telemarketing calls as well as to purely informational or transactional calls such as flight updates, debt collection calls, surveys, and bank account fraud alerts.

The TCPA Rule also prohibits making a telemarketing call to a residential landline telephone using a prerecorded message without the prior express consent of the called party, unless the caller has an established business relationship with the called party.

Revisions to the TCPA Rule

The FCC has revised its TCPA Rule to require an automated, interactive opt-out mechanism for prerecorded telemarketing messages to both cell phones and landlines. The revision took effect on January 14, 2013.

In addition, effective October 16, 2013, the Rule will be revised to:

  • Require prior express written consent requirement for telemarketing calls made to cell phones using an ATDS or a prerecorded message, but will maintain the prior express consent requirement for non-telemarketing calls to cell phones;
  • Require prior express written consent for telemarketing calls made to residential landlines using a prerecorded message; and
  • Eliminate the established business relationship exception to the obligation to obtain consent for telemarketing calls made to residential landlines using a prerecorded message.

These revisions are intended to maximize consistency with the Federal Trade Commission’s (FTC) Telemarketing Sales Rule (TSR).

Automated, Interactive Opt-Out Mechanism

As of January 14, 2013, the TCPA Rule now requires that every prerecorded telemarketing message, whether delivered to a cell phone or a residential landline, provide an automated, interactive voice- and/or key press-activated mechanism for the consumer to request no further telemarketing calls from the seller. The mechanism must be presented, together with instructions on how to use it, within two seconds of the caller’s statement of identity at the beginning of the message. When a consumer uses the opt-out mechanism, his or her number must be automatically added to the seller’s do-not-call list, and the call must immediately terminate. When the message is left on an answering machine, it must also provide a toll-free number that the consumer may use to connect directly to the automated, interactive voice- and/or key press-activated opt-out mechanism. These new FCC requirements are consistent with those already imposed by the FTC’s TSR.

Prior Express Written Consent

Effective October 16, 2013, the TCPA Rule will require prior express written consent to deliver an autodialed or prerecorded telemarketing call to a cell phone, and will require prior express written consent to deliver a prerecorded telemarketing message to a residential landline. The Rule defines “prior express written consent” as a signed written agreement that clearly and conspicuously discloses to the consumer that:

  • By signing the agreement, he or she authorizes the seller to deliver, to a designated phone number, telemarketing calls using an automatic telephone dialing system or an artificial or prerecorded voice; and
  • The consumer is not required to sign the agreement or agree to enter into it as a condition of purchasing any property, goods, or services.

The required signature may be “obtained in compliance with the E-SIGN Act,” including via an e-mail, website form, text message, telephone key press, or voice recording.

Although these provisions do not apply to purely informational or transactional calls or messages, such as flight updates, debt collection calls, surveys, or bank account fraud alerts, an informational call that includes an upsell – such as a flight update followed by an offer inviting the consumer to upgrade to first class – would require written consent. The FCC has stated that “if the call, notwithstanding its free offer or other information, is intended to offer property, goods, or services for sale either during the call, or in the future, that call is an advertisement.”

It is also important to note that because both the FCC and courts consider a text message to be a “call” for purposes of the rules promulgated pursuant to the TCPA, the written consent requirement will apply to the delivery of telemarketing text message campaigns. It is already industry practice for companies to obtain prior express consent to the receipt of such messages; however, the signature requirement and disclosure obligations (described above) are new.

Litigation and Regulatory Actions

The TCPA allows private actions and provides for between $500 and $1,500 in statutory damages for each violation, with treble damages available for willful or knowing violations, as well as injunctive relief. The TCPA also can be enforced by the FCC and state attorneys general.

TCPA litigation has trended upward in recent years, with TCPA suits rising by 63% between 2011 and 2012. Several factors appear to be fueling this trend:

  • Increased consumer use of cell phones as primary phones: According to a recent Centers for Disease Control and Prevention Semi-Annual National Health Interview Survey, nearly 36% of American households used cell phones only and nearly 16% received all or nearly all of their calls on cell phones even if they also use landline telephones. Additionally, 60.1% of adults between the ages of 25 and 29 live in households that use cell phones only. Companies that rely on autodialers to contact consumers, therefore, are increasingly at risk of dialing numbers in violation of the TCPA’s autodialing prohibitions.
  • Increased ease of filing TCPA class action suits: In Mims v. Arrow Fin. Servs., LLC, the Supreme Court ruled that federal and state courts exercise concurrent jurisdiction over TCPA claims, thus weakening arguments that state law governs whether claims may be brought as class actions.
  • Defects in consent: For calls where only prior express consent is required to use an autodialer, a 1992 TCPA order by the FCC states that “persons who knowingly release their phone numbers have in effect given their invitation or permission to be called at the number which they have given, absent instructions to the contrary.” This view of what reasonably evidences prior express consent is reinforced by the TCPA’s legislative history. Nevertheless, a lack of robust controls around ensuring, for example, that prior express consent has been obtained to call a number with an autodialer may result in difficulty overcoming individual claims of a lack of consent.

Several recent court decisions have also complicated the TCPA litigation landscape, one of the most notable being the Seventh Circuit Court of Appeals decision in Soppet v. Enhanced Recovery Co., LLC, 679 F. 3d 637 (7th Cir. 2012). In Soppet, a debt collector used an autodialer to call two cell phone numbers on behalf of AT&T to collect debts owed. The numbers had been provided to AT&T by the debtors, but at the time of debt collection calls they had been reassigned to new subscribers who had not consented to receive autodialed calls. The new subscribers sued the debt collector for violating the TCPA’s prohibition on using an autodialer to call a cell phone number without the prior express consent of the “called party.” The debt collector argued that the term “called party” meant “intended recipient of the call.” The Seventh Circuit rejected this argument, holding that “called party” means the current cell phone subscriber at the time the call is made. The import of the holding is that consent to autodial a cell phone number can no longer be presumed valid day-to-day unless a reliable mechanism is in place for confirming ownership of the number prior to dialing it. At a minimum, the Soppet decision should prompt businesses to consider whether to alter their dialing strategies for consumers resident in Seventh Circuit states (Illinois, Indiana, and Wisconsin).

Chesbro v. Best Buy Stores, LP, 697 F. 3d 1230 (9th Cir. 2012), serves as a cautionary tale for businesses seeking to leverage artificial or prerecorded voice robocalls to deliver messages thought to be purely informational. After purchasing a computer from Best Buy, the plaintiff in Chesbro began receiving prerecorded phone messages about Best Buy’s rewards program. The plaintiff complained to Best Buy on several occasions about the calls and was eventually placed on its internal Do Not Call (DNC) list. Several months later, however, the plaintiff received another prerecorded phone message from Best Buy about its rewards program, which prompted the filing of a class action complaint in Washington State against Best Buy alleging violation of the TCPA’s ban on prerecorded message calls that include or introduce unsolicited advertisements or constitute telephone solicitations. The district court granted summary judgment in Best Buy’s favor, finding that the calls were purely informational courtesy calls about its rewards program. On appeal, the Ninth Circuit determined that because the calls encouraged the plaintiff to redeem rewards points, the calls were telephone solicitations, reasoning that redemption of rewards points “required going to a Best Buy store and making further purchases of Best Buy’s goods . . . [t]hus, the calls encouraged the listener to make future purchases at Best Buy.” Perhaps most significantly, the Ninth Circuit found that the TCPA did not require that telephone solicitations explicitly mention a good, product, or service “where the implication is clear from the context” and that “[a]ny additional information provided in the calls does not inoculate them.” The upshot of the ruling is that businesses should carefully review any outgoing prerecorded voice messages that are purported to be informational.

Text messaging is another area in which there has been active litigation. As previously noted, the issue of whether text messages constitute “calls” under the TCPA is well-settled, see, e.g., Lozano v. Twentieth Century Fox Film Corp., 702 F. Supp. 2d 999 (N.D. Ill. 2010); Abbas v. Selling Source, LLC, N.D. Ill. 2009; Satterfield v. Simon & Schuster, Inc., 569 F. 3d 946 (9th Cir. 2009). Recent cases have tested whether confirmatory texts – i.e., text messages sent to called party confirming the party’s choice to opt out of text messaging – violate the TCPA. Here, however, plaintiffs have not had success. As the court in Ryabyshchuck v. Citibank, 11-CV-1236 – IEG (WVG) (S.D. Ca. Oct. 30, 2012) noted, “a simple, confirmatory [text message] response to plaintiff-initiated contact can hardly be termed an invasion of plaintiff’s privacy under the TCPA. A finding to the contrary would stretch an inflexible interpretation beyond the realm of reason.” The FCC, in a declaratory ruling issued in November of 2012, generally agreed with the idea that confirmatory texts do not violate the TCPA, but included some important caveats in its ruling, including that (1) prior express consent to receive texts messages is required; (2) confirmatory texts must “merely confirm the consumer’s opt-out request and do not include any marketing or promotional information”; (3) confirmatory texts are to be the only additional messages sent to customers after they opt out; and (4) confirmatory texts should be sent within five minutes of the opt out request, as “the longer [the] delay [in sending confirmatory texts], the more difficult it will be to demonstrate that such messages fall within the original prior consent.” Significantly, the FCC did not entertain the petitioner’s argument that confirmatory texts do not violate the TCPA if an autodialer is not used to send them. Rather, the FCC implied in its order that obtaining prior express consent to receive text messages means confirmatory texts may be sent with or without an autodialer.

Given the perilous and quickly changing litigation landscape and the new FCC rules regarding consent, businesses are advised to examine their calling and text messaging practices to determine whether any changes to how they operate and obtain consent are necessary.

An Overview of the Consumer Financial Protection Bureau’s Ability-to-Repay and Qualified Mortgage Rule

Lenders made millions of mortgages during the decade of the 2000s, some of which were not rigorously underwritten, and for some of which the borrowers had no hope of repaying. As the loans went into default, lenders’ losses mounted and borrowers’ woes increased. The mortgage market’s collapse led to the second greatest economic recession in the last 100 years and nearly brought the United States’ economy to its knees.

To remedy this situation, Congress and various federal agencies required lenders to assess a consumer’s ability to repay a home loan before the creditor could extend the consumer the credit. To encourage responsible lending, Congress provided for penalties where a loan was made to a borrower who did not have the ability to repay it fully. Congress also permitted the regulators to create a “safe harbor” for creditors, where it would be presumed that the borrower had the ability to repay a mortgage loan.

On January 10, 2013, the Consumer Financial Protection Bureau (Bureau) released its final Ability-to-Repay and Qualified Mortgage Rule, effective January 10, 2014. This article will look at that rule by first exploring the background and financial situation that led to the release of the rule, Congress’ statutory enactments permitting the rule, and the final rule itself.

Background

In the early part of the last decade, as housing prices rocketed skyward, lenders began introducing products that permitted borrowers to take advantage of their increasing equity. Lenders moved away from the fully-amortizing, fixed-rate, 30-year loan, and offered hybrid adjustable-rate mortgages where the initial interest rate was set at a below-market rate for a fixed period, such as two, three, five, or seven years. Lenders offered fully adjustable rate loans, where the interest rate was adjusted on a monthly or yearly basis. As the demand for loans increased, both by borrowers and investors, lenders offered loans with an interest-only payment, deferring the repayment of principal for a period of years. This permitted borrowers to obtain larger loans than could be afforded if the loans had to be repaid in equal payments of principal and interest over 30 years. Finally, the industry offered option ARM loans, where a borrower could choose to repay a portion of the interest owed, adding the remainder to an increasing principal balance.

To facilitate these loans, lenders relaxed their underwriting standards. Low-document and no-document loans proliferated. Borrowers could state their income, without offering any verification of it, and lenders would rely on the representations. Lenders would check borrowers’ credit and the value of the property, and little else. As long as the property value elevator rode upward, lenders made the loans, borrowers obtained loans, and investors bought loans.

Many borrowers took advantage of these loans, obtaining cash-out refinances. The cash-out portion may not have been used to improve the value of the property, and was often lost to repayment of other (overextended) debts, or to fund new purchases of vacations, impermanent assets, or consumables. In addition, with the advent of easier-to-obtain loans, new borrowers entered the housing market and became first-time homeowners for a small or no down payment. These borrowers often obtained loans with adjustable rate features or limited principal repayment that exposed the market to risk as payments adjusted or property values declined.

In the middle to late 2000s, the housing market slowed and reversed, and many borrowers were unable to repay their loans. As loans went into default and foreclosures increased, lenders and servicers were overwhelmed, and investors began to take losses. With the collapse of the housing market, America, and the world, entered the most serious recession since the Great Depression.

Reaction to the Housing Crisis – Ability to Repay Consideration

In 2008, the Federal Reserve Board (Board) adopted a rule under the Truth in Lending Act which prohibited creditors from making “higher-price” mortgage loans without assessing consumers’ ability to repay the loans. Under the Board’s rule, a creditor is presumed to have complied with the ability-to-repay requirement if the creditor followed specified underwriting practices.

In 2010, when Congress enacted the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank), Sections 1411 and 1412 required lenders to assess consumers’ ability to repay all home loans before extending credit and provided that the regulators could create a safe harbor and presumption of compliance with the ability-to-repay requirement for “qualified mortgages.” Congress set forth the requirements in a new section of the Truth in Lending Act, Section 129C (link here), and permitted rulemaking to interpret the act and provide guidance to the industry and consumers.

The Bureau conducted extensive research and analysis on this issue. It sought public comment on new data and information, and the Bureau met with stakeholders on all sides in formulating the rule. On January 10, 2013, the Bureau released the final rule. (See “Ability to Repay and Qualified Mortgage Standards Under the Truth in Lending Act (Regulation Z)” at www.consumerfinance.gov. See also Ability-to-Repay and Qualified Mortgage Standards under the Truth in Lending Act, Final Rule, 78 Fed. Reg. 6408 (January 30, 2013), to be codified at 12 C.F.R. § 1026.) The Bureau stated that the rule protects consumers from risky practices that helped cause the mortgage crisis. It helps ensure that responsible consumers obtain responsible loans and that creditors can extend credit responsibly, without worrying about competition from unscrupulous lenders.

Under the statute, the ability-to-repay requirements are effective as of January 21, 2013. The final rule delays the implementation of the ability-to-repay requirements until January 10, 2014. If a successful challenge is mounted to the recess appointment of Richard Cordray as director of the Bureau, the ability-to-repay provisions are effective immediately. It is unknown whether they will have a retroactive effect.

Ability-to-Repay Rule

The Ability-to-Repay Rule, Regulation Z Section 1026.43, requires that a creditor make a “reasonable and good faith determination at or before consummation that the consumer will have a reasonable ability to repay the loan according to its terms.” The creditor must follow underwriting requirements and verify the information by using reasonably relied upon third-party records. The rule applies to all residential mortgages including purchase loans, refinances, home equity loans, first liens, and subordinate liens. In short, if the creditor is making a loan secured by a principal residence, second or vacation home, condominium, or mobile or manufactured home, the creditor must verify the borrowers’ ability to repay the loan. The section does not apply to commercial or business loans, even if secured by a personal dwelling. It also does not apply to loans for timeshares, reverse mortgages, loan modifications, and temporary bridge loans.

The creditor must consider and evaluate at least the following eight factors:

Current or reasonably expected income or assets. The creditor may consider borrowers’ assets and income that borrowers will use to repay the loan. The creditor may not consider the value of the secured property, including any equity in the dwelling. Because of seasonal work, or other factors that result in variable income, the creditor may consider current income and “reasonably” expected income. A creditor may also consider a joint applicant’s income and assets.

Current employment status. The creditor must consider borrowers’ current employment status to the extent that the creditor relies on the employment income to repay the loan. If borrowers’ intend to repay the loan with investment income, employment need not be considered.

Monthly payments on the covered transaction. The monthly payment obligation is based on the “full” payment. The payment must be considered on a monthly basis, and be at the fully adjusted indexed rate or the introductory rate, whichever is higher. In short, teaser rates and other “low” starting rates are not to be considered in the ability-to-repay analysis.

Monthly payments on a simultaneous loan. The creditor must consider the “full” monthly payments on any simultaneous loan that the creditor knows or has reason to know will be made on or before consummation when secured by the same dwelling. This includes piggy-back loans, concurrent loans, and open-ended home equity loans, even if made by another creditor. The rule applies to purchases and refinances.

Monthly payments for mortgage-related obligations. The creditor must consider payments for mortgage-related obligations, according to the loan’s terms, and all applicable taxes, hazard insurance, mortgage guarantee insurance, assessments, ground lease payments, and special assessments (if known). The creditor must consider these amounts whether or not an escrow is established. Where these charges are paid on an annual or periodic basis, they are to be calculated as if paid monthly. However, where the charge is a onetime, up-front fee, it need not be considered in the ability-to-repay calculation.

Current debt obligations, alimony, and child support. The creditor must consider borrowers’ other debt obligations that are actually owed. Each applicant’s obligations are to be evaluated, but the creditor does not need to consider other obligations of sureties or guarantors. Creditors are given significant flexibility in this area and may use reasonable means to consider other debt obligations.

Monthly debt-to-income ratio or residual income. The rule gives the creditor flexibility in defining “income” and “debt” based on governmental and non-governmental underwriting standards. The rule also gives the creditor flexibility in evaluating the appropriate debt-to-income ratio in light of residual income. For example, where the debt-to-income ratio is high and the borrowers have a large income, the borrowers should have sufficient remaining income to satisfy living expenses and therefore justify the loan. The determination is subject to a reasonable and good faith standard.

Credit history. A creditor must consider borrowers’ credit histories, but does not have to review a specific credit report or minimum credit score. Creditors may consider factors such as the number and age of credit lines, payment history, and any judgments, collections, or bankruptcies. The creditors must review borrowers’ credit histories and give various aspects as much or little weight as is appropriate to reach a reasonable, good faith determination of borrowers’ ability to repay the loan.

Creditors will typically use third-party records (not prepared by the consumer, creditor, mortgage broker, or any of their agents) to make a reasonable and good faith determination, based on verified and documented information, that a consumer has a reasonable ability to repay the mortgage loan. The rule requires that the creditor retain evidence of the ability to repay for three years. However, because of possible challenges by borrowers to the ability-to-repay determination, it is recommended that creditors and their successors maintain these records for the life of the loan.

The Ability-to-Repay Rule does not apply to every loan. Principally, the rule does not apply where a
non-standard mortgage (such as an adjustable rate loan, interest-only loan, or negative amortization loan) is refinanced into a standard mortgage, where the current creditor provides the refinance, the new payment will be materially (10 percent) lower, and most of the previous payments were timely. However, the ability-to-repay analysis implicitly applies to the new loan.

Qualified Mortgages

The Dodd Frank Act provided that “qualified mortgages” are entitled to a presumption that the creditor making the loan satisfied the ability-to-repay requirements. The Bureau’s rule establishes a safe harbor and creates a conclusive presumption for loans that meet certain criteria and are not high-priced loans that the creditor made a good faith and reasonable determination of the consumer’s ability to repay. Where the loan satisfies the requirements of a qualified mortgage and is a high-priced loan, there is a rebuttable presumption that the creditor complied with the ability-to-repay requirement. Borrowers may overcome the presumption when they can show that after making all mortgage related payments there is insufficient income left over to meet living expenses. The longer it takes for borrowers to default, the more difficult it is to overcome the presumption.

A qualified mortgage includes the following criteria:

Regular substantially equal periodic payments. This does not include negative amortization loans, interest only payments, and balloon payments. If the loan does not require monthly payments, the payments are to be calculated as if paid monthly.

Term is 30 years or less.

Total points and fees to not exceed 3 percent of the loan amount. Points and fees are broadly interpreted. The 3 percent cap is adjusted as the loan balance falls below $100,000. Points and fees include all items in the finance charge as defined in the Truth in Lending Act, other than interest. The points and fees include loan originator compensation paid by the consumer or creditor, as known at the time the interest rate is set, if attributable to the transaction, whether paid to the individual loan officer or a broker. The points and fees include charges paid to the creditor, originator, or affiliate, even if the same fees would not be included if charged by an independent third party. For example, title charges by an affiliated title company are included in the 3 percent calculation, but similar charges by an independent title company are not. The points and fees included other charges as detailed by the rule. The loan amount is the amount stated in the promissory note.

Monthly payment calculated based on the highest expected payment in the first five years. The creditor must underwrite the loan based on a fully amortized payment schedule taking into account the highest adjustment of any loan payment, and all other mortgage-related payments, including taxes and insurance, whether or not impounded by the creditor.

Consider current and reasonably expected income and expenses. This includes debt obligations, alimony, and child support. The income and expenses must be verified and documented, as discussed above. This eliminates low-document and no-document loans from being qualified mortgages.

Debt-to-income ratio does not exceed 43 percent. The debt includes all mortgage-related expenses, and simultaneous mortgage-related expenses that the creditor knows or has reason to know.

If these criteria are met and the loan is underwritten with good faith and reasonable reliance on verified third-party provided documentation, then the loan is a qualified mortgage entitled to a conclusive presumption that the loan meets the ability-to-pay requirements.

Alternative Qualified Mortgages

The Bureau established a second, temporary class of qualified mortgages based on the belief that certain consumers can afford loans with a higher debt-to-income ratio of 43 percent based on their particular circumstances. In addition, the temporary class of qualified mortgages may help overcome any initial reluctance of creditors to make loans that might not be qualified mortgages. These loans may be underwritten with more flexibility, but still require a reasonable and good faith belief in borrowers’ ability to repay the loans.

These alternative qualified mortgage loans must satisfy the general product feature prerequisites for a qualified mortgage and also satisfy the underwriting requirements of, and are eligible to be purchased, guaranteed or insured by (1) the GSEs while they operate under federal conservatorship or receivership or (2) the U.S. Department of Housing and Urban Development, Department of Veterans Affairs, or Department of Agriculture or Rural Housing Service. This temporary class will phase out as each agency issues its own qualified mortgage rules, or the GSE conservatorship ends, or seven years elapse.

Note that the rule does not define how the eligibility determination is made if the GSEs or federal agency does not actually purchase, guarantee, or insure the loan. Similarly, in light of the current state of repurchase litigation, even if the loan is purchased, guaranteed, or insured, it is unknown if that determination creates a qualified mortgage “presumption” that is conclusive or rebuttable.

Failure to Comply with Ability-to-Repay

A creditor must properly determine whether borrowers have the ability to repay their loans. Where a creditor does not act properly, the Bureau retains the ability to issue cease and desist orders, or impose civil monetary penalties.

The rule provides a private right of action to borrowers. They may seek actual damages, statutory damages, costs, and attorneys’ fees, and special damages equal to the finance charges and fees incurred. In short, where the creditor does not properly assess borrowers’ ability to repay loans, borrowers must repay the principal amount of the loan, less damages, and could end up with a “free” loan. Borrowers may also seek damages in class action litigation and individual cases. While current law provides for a one-year statute of limitation on damage actions, borrowers have three years to bring their ability-to-repay damage claims.

Borrowers may also assert the ability-to-repay defense in response to a foreclosure action and seek recoupment or set-off. The three-year statute of limitation does not apply, but borrowers are limited to three years of finance charges and fees as special damages. Assignees are liable for the errors of the original creditor.

Conclusion

Creditors must assess borrowers’ ability to repay a loan based on verifiable information. Creditors must act in a good faith and reasonable manner to determine whether borrowers can afford the loan(s) offered. To avoid liability under a faulty ability-to-pay determination, creditors may rely on the safe harbor of the qualified mortgage conclusive presumption. Qualified mortgages must be fully underwritten, at the maximum adjusted payment, based on verifiable information provided by third parties, to a high level of specification, even though the rule provides the creditor with discretion to make its determination. It is unknown what types of loans will be offered to borrowers and whether the loans will be purchased in the secondary market. However, it is expected that in the initial term, most residential mortgages will be low cost, fixed-rate loans, issued to very credit-worthy borrowers who meet all lending criteria. As GSEs and other agencies agree to purchase, guarantee or insure loans, the pool of available loans will expand, helping the Bureau meet its goal of ensuring that responsible consumers obtain responsible loans and that creditors extend credit responsibly, without worrying about competition from unscrupulous lenders.

 

The Impact of Corporate Restructuring on Foreign National Employees

We are only one quarter into 2013, but this year has already seen a flurry of multi-billion-dollar mergers and acquisitions from some of corporate America’s most recognizable names. In the past few months, airline giants American Airlines and US Airways announced they would be merging in an $11 billion deal, while Warren Buffett’s Berkshire Hathaway and global investment firm 3G Capital announced the acquisition of the H.J. Heinz Company for $28 billion. Those deals came just a week after Dell Inc. announced that company founder Michael Dell had partnered with global technology investment firm Silver Lake Partners to acquire and privatize the company in a transaction valued at $24.4 billion.

Managing the legal aspects of corporate restructuring is a difficult task. For companies that employ foreign nationals, that task is even more complicated as there are significant immigration-related consequences that must be addressed prior to sealing the deal on a merger or acquisition. Because most work visas are employer-specific, changes in a company’s structure could affect the validity of a foreign national employee’s nonimmigrant visa status or pending green card application. In addition, a company’s failure to recognize the immigration issues arising as a result of its restructuring activities can not only seriously impact its foreign national employees, but also have serious consequences for the company. Employers who fail to take the proper measures may find themselves being sued by foreign national employees for negligence in handling their immigration matters. For example, when a company’s actions cause the foreign national employees to fall out of legal status, have problems pursuing permanent residency, or even potentially face bars on reentering the United States after travel abroad, those employees may seek action against the employer. Additionally, employers with immigration violations potentially face:

  • Worksite raids and loss of business during the raid;
  • Compliance audits;
  • Significant fines;
  • Criminal sanctions;
  • Revocation of state business licenses and government contracts; and
  • Negative publicity.

Worksite enforcement has become increasingly aggressive over the past few years and there has been a noticeable shift from monetary fines to criminal prosecution of employers with unlawful hires and paperwork violations.

In view of the recent crackdowns by federal and state governments on immigration compliance, the steady stream of lawsuits being filed by affected employees, and the media hype surrounding immigration reform, it is critical for companies that hire foreign nationals to include potential immigration consequences of a corporate restructuring as part of the due diligence process.

Issues Affecting Nonimmigrant Visa Holders

In these situations it is important to determine whether the employer after a corporate restructuring is the same employer that filed the approved visa petition with the U.S. Citizenship and Immigration Services (USCIS) or Department of State (DOS). The consequences of a merger or acquisition depend upon the type of nonimmigrant visas that the company’s employees hold.

The most common temporary work visa is the H-1B visa, which is used by U.S. companies to temporarily hire foreign national workers for specialty occupations that require at least a bachelor’s degree or its equivalent to perform the job duties. H-1B workers are authorized to work for a specific company in a specific geographic location in a specific position and for a specific salary. Companies that hire an H-1B worker are required to make an attestation to the U.S. Department of Labor (DOL) that they will pay the worker a salary that meets or exceeds the prevailing wage for the listed occupation in the geographic area of intended employment for the duration of the employee’s status. This attestation is made in what is called a Labor Condition Application (LCA).

If an H-1B worker changes employers, the new employer must generally file a new H-1B petition with USCIS. However, if the new employer is a “successor-in-interest” to the previous employer, an amended petition may not be needed. USCIS requires an amended H-1B visa petition to be filed if there are any “material changes” in the terms and conditions of an H-1B worker’s employment or eligibility (for example, a major change in the employee’s job duties). However, USCIS does not automatically require the filing of a new LCA and amended H-1B petition where a new corporate entity succeeds to the interests and obligations of the original petitioning employer and where the terms and conditions of the employment remain the same but for the identity of the petitioner. In this situation, the new employer, called a successor-in-interest, must make available for public inspection a sworn statement that it accepts all the obligations and liabilities of the LCAs filed by the predecessor entity, a list of affected LCAs and their dates of certification by DOL, a description of the new entity’s actual wage system, and the federal employer identification number (EIN). The new entity must provide this sworn statement before the H-1B employees are transferred to the new employer. If, however, there is a material change in the terms of an H-1B worker’s employment as a result of a merger or acquisition, then a new LCA or amended H-1B petition may need to be filed. For example, if the new employer transfers an H-1B employee to another location, a new LCA may be required. In this case, the new LCA must be filed with DOL prior to the relocation of the employee in order to avoid filing an amended H-1B visa petition. Otherwise, if this issue is overlooked, an amended H-1B petition will need to be filed with USCIS, potentially costing the company thousands of dollars per employee.

One issue that often comes up in the situation of a successor-in-interest is when an H-1B employee needs to travel abroad. Generally, in order to reenter the United States, the employee must have a valid H-1B visa annotated with the petitioning employer’s name. However, in this case, the visa annotation would list the predecessor employer, which could cause the employee difficulty when trying to reenter the United States. In addition, a new visa may only be obtained when the successor employer files an extension or amended H-1B visa petition with USCIS, and that petition is subsequently approved on behalf of the employee. Collaboration with an experienced immigration attorney prior to finalizing the corporate reorganization can help prevent these issues from occurring, thereby minimizing the stress to employees and human resource specialists.

Another potential issue with regard to H-1B visas is whether a merger or acquisition results in the new entity becoming H-1B dependent. An employer is considered to be H-1B dependent if it has fewer than 25 full-time employees, more than 7 of whom are on H-1B visas; 26-50 full-time employees with more than 12 on H-1B visas; or more than 50 full-time employees where more than 15 percent are on H-1B visas. This is a critical determination to make because H-1B dependent employers are subject to additional compliance and attestation requirements. For example, prior to hiring an H-1B worker, an H-1B dependent employer must make a good faith effort to recruit U.S. workers for the offered position through advertising, job fairs, and other forms of industry-wide recruitment. Furthermore, the employer must offer the job to any equally or better qualified U.S. worker who applies for the position and must not favor current nonimmigrant employees who have not yet obtained H-1B status (such as students currently working pursuant to Optional Practical Training). Because of the arduous process that H-1B dependent employers have to go through prior to hiring a foreign national, most companies try to avoid becoming H-1B dependent at all costs.

Another visa category commonly affected by a corporate transaction is the L-1 temporary work visa. The L-1 visa is useful for multinational companies that wish to transfer managers, executives, and specialized knowledge employees to serve in similar positions at a qualifying organization in the United States. In order to qualify for an L-1 visa, the employee must have been employed for at least one year in the past three years by a foreign parent, subsidiary, affiliate, or branch of the U.S. company. Therefore, if the merger or acquisition of a company alters the organizational structure so that there is no longer a qualifying corporate relationship between the U.S. employer and the foreign entity, L-1 employees in the United States may lose their eligibility. It is important to note, however, that the foreign entity that actually employed the L-1 transferee does not have to remain in existence as long as there is another foreign entity that has a qualifying relationship with the U.S. employer. A merger or acquisition that does not destroy the qualifying relationship merely imposes an obligation upon the employer to notify USCIS of the change in the organizational structure at the time of filing a petition for the extension of the employee’s L-1 visa status. However, if the worker is moved to a different related entity, an amended L-1 petition may need to be filed with USCIS.

Mergers and acquisitions can also create qualifying relationships for purposes of the L-1 visa. In this situation, L-1 visa petitions may not be filed until the relationship has been formed, which usually involves the transfer of stock. An agreement to create a relationship is not sufficient to establish the qualifying relationship because it does not involve the necessary ownership and control.

A third visa category often used by multinational companies that could be affected by a corporate reorganization is the E visa category. The E-1 visa is used by citizens of countries with which the United States maintains a treaty of commerce and navigation who are coming to the United States to carry on substantial trade, principally between the United States and the treaty country (for example, an Israeli citizen who is coming to the United States to work for a company that imports security systems from Israel). The E-2 visa is used by citizens of countries with which the United States maintains a bilateral treaty who are coming to the United States to work for a company that is owned by nationals of the same treaty country as the employee (for example, a Swiss citizen coming to the United States to work for the Swiss cheese company, La Fromagerie).

In order for an E-1 or E-2 employee to work in the United States, the U.S. employer must qualify as a treaty company, either because a majority (more than 50 percent) of its trade is with the treaty country (E-1) or because it is at least 50-percent owned by nationals of the treaty country (E-2).

In the E-1 scenario above, if the U.S. company is acquired and the new employer continues to carry on a majority of its trade with Israel, then the Israeli E-1 employee may continue to work in the U.S. in E-1 visa status (although it is recommended that an amended E-1 petition be filed to reflect the change in corporate structure). However, if the new employer cannot show that more than 50 percent of its trade is with Israel, the E-1 employee will no longer qualify for E-1 visa status and will have to change to a different visa status.

In the E-2 scenario, the Swiss citizen may only obtain an E-2 visa if he or she works for a company in the United States that is at least 50 percent Swiss owned. Owners who are United States permanent residents or who are dual citizens of both the United States and the treaty country are treated as U.S. nationals for this purpose and their ownership interest is not counted toward the requirement for 50 percent ownership by treaty country nationals. Therefore, 50 percent ownership by the treaty country nationals must be maintained in any merger or acquisition; if the treaty company (La Fromagerie, in the example above) is acquired by a company that is not Swiss, E-2 employees will no longer meet the requirements for this category and will be forced to leave the United States if they are not eligible to apply for a different visa category.

Issues Affecting Pending Green Card Applications

The employment-based green card application process generally consists of three steps (see sidebar). In the case of pending green card applications, it is critical to first determine whether the new employer entity is considered a successor-in-interest. If not, the new employer will have to start the green card process over from the very beginning, potentially costing the company thousands of dollars in legal and filing fees and delaying the green card by several years. For purposes of the green card process, a new employer entity will be considered a successor-in-interest if (1) the job opportunity is the same as the job opportunity listed in the labor certification; (2) the new employer establishes its eligibility as a successor-in-interest in all respects, including providing evidence of the predecessor’s ability to pay the employee the offered wage as of the date of the filing of the Program Electronic Review Management (PERM) application; and (3) the new entity’s I-140 petition documents the transfer and assumption of the ownership of the predecessor entity.

In addition, an employee’s ability to continue with the permanent residence (green card) application depends on where in the process he or she is at the time of the corporate restructuring. If the labor certification is pending, it will remain valid as long as the new employer is a successor-in-interest to the employer that filed the original labor certification and there have been no changes in job position or location. Whether or not the new employer qualifies as a successor-in-interest is decided by USCIS at the time of the filing of the I-140 petition. Once the labor certification is approved by DOL, the new employer would then file the I-140 petition with USCIS along with evidence of the successor-in-interest relationship. However, if there are any changes in job position or location, or if the new employer does not qualify as a successor-in-interest, the pending labor certification will be invalidated and the new employer will have to file a new labor certification. This can have serious repercussions for employees who are relying on the pending labor certifications to continue extending their underlying nonimmigrant visa status. It will also delay the green card process significantly, especially for those employees concerned with priority dates due to immigrant visa backlogs.

If the I-140 petition is pending when the corporate restructuring occurs, but the adjustment of status application has not yet been filed, then the new employer will need to file an amended I-140 with USCIS showing that the requisite successor-in-interest relationship exists. The same is true if the I-140 has been approved but no adjustment of status application has been filed yet.

The best scenario for both the new employer and foreign national employees in the middle of the green card process is an approved I-140 and a pending adjustment of status application. This is because the American Competitiveness in the 21st Century Act (AC21) allows a foreign national to change employers if the I-140 has been approved and the adjustment of status application has been pending for 180 days or more, as long as the new position is in the “same or similar occupational classification.” In determining whether a new position is the “same or similar” as the position on the approved labor certification, USCIS looks at several factors including the job descriptions of both positions, the salaries, and the DOL’s Dictionary of Occupational Titles (DOT) and/or Standard Occupational Classification (SOC) codes for each position. While there is no requirement to notify USCIS of a change in employer with respect to a pending adjustment of status application, many attorneys recommend proactively notifying USCIS of the change in employer and showing that the new position is the “same or similar.”

Multinational managers and executive transferees (see L-1 visas above) do not have to go through the arduous labor certification process when applying for a green card. However, because their eligibility for permanent residence hinges upon the relationship between the foreign employer and the U.S. employer, a corporate restructuring can have negative consequences on these employees’ eligibility to qualify for permanent residence in this category.

When the U.S. company and the foreign company are affiliated through the ownership of a group of individuals, mergers and acquisitions become an issue because each group of individuals must own and control each business and each individual in the group must hold approximately the same proportion of each business (or the same shareholders must have a controlling interest in each business). Additionally, the U.S. employer must have been doing business in the United States for at least one year to be able to file this type of petition on behalf of one of its employees. Interestingly, there is no requirement that a qualifying relationship exist between the United States and the foreign entities for the one-year period, so a U.S. entity acquired by a foreign entity may immediately apply for an otherwise qualifying manager or executive. However, the foreign entity that actually employed the transferee must continue to exist in order to file an immigrant visa petition on behalf of a multinational manager or executive.

I-9 Compliance

One of the most important (but overlooked) issues that an employer should be concerned with at the time of a restructuring is the Form I-9. The Immigration Control and Reform Act of 1986 requires that a Form I-9 (Employment Eligibility Verification) be completed for each newly-hired employee, with some exceptions. A successor-in-interest may assume the I-9 liabilities of the predecessor employee; however, this means that the new employer is also liable for any mistakes in the I-9s previously completed by the predecessor. Therefore, before a transaction is undertaken, an examination of the organization’s I-9s should be conducted through either an audit or a review. If the successor organization does not assume I-9s of the predecessor, new I-9s may be completed for each of the organization’s employees within three days of the transaction to avoid any allegation of an unfair immigration-related employment practice such as document abuse or discrimination on the basis of citizenship or nationality.

Conclusion

It is critical for in-house counsel to be aware of immigration-related issues that may arise as a result of a restructuring between companies that employ foreign nationals. Companies should work with competent and experienced immigration counsel early on in any transaction to ensure that they are in compliance with immigration regulations and to ensure that foreign national employees remain authorized to work in the United States.

The Bureau’s Loan Originator Compensation Rule: Changes, Clarifications, Qualifications and More

On January 20, 2013, the Consumer Financial Protection Bureau (Bureau) released its final rule regarding the loan originator compensation requirements under the Truth in Lending Act (Rule). It followed up by publishing the Rule in the Federal Register on February 15, 2013. Despite the Bureau’s labeling of the Rule, it does more than implement statutorily required loan originator compensation changes. It also clarifies existing loan origination compensation requirements, including those based on prior informal interpretations rather than the plain language of Regulation Z or its commentary. Less obvious from the name of the Rule, it includes loan originator qualification requirements, requires the use of unique identifiers on certain loan documents, prohibits mandatory arbitration provisions and the financing of single-premium credit insurance for covered loans, and extends record keeping requirements. It also addresses the statutory prohibition on upfront points and fees in certain loans. The provisions regarding mandatory arbitration and the financing of single premium credit insurance have a stated effective date of June 1, 2013. The remainder of the Rule has a stated effective date of January 10, 2014.

The Rule revises the definition of the term “loan originator.” The term generally will mean a person, who in the expectation of compensation, does any of the following in connection with a residential mortgage loan: offers, arranges, negotiates, takes an application for, assists a consumer in obtaining or applying for, or otherwise obtains or makes a residential mortgage loan for another person. It will also include a person that advertises that the person can or will perform any of these activities. The Bureau will interpret this definition broadly and, consistent with prior informal interpretations, will include referral activity within the scope of covered loan origination activities. However, the Rule and related commentary provide some clarifications regarding the scope of covered referral activity. For example, covered referral activity will not include, among other things, providing general information in response to inquiries or, if the person is an employee of a creditor or mortgage broker, providing contact information for a loan originator in response to a request, unless the employee does so based on the inquiring person’s financial characteristics or discusses particular loan terms. Additionally, the Rule lists several categories of persons that will not be loan originators, including certain bona fide third-party advisors, certain licensed or registered real estate brokers, certain seller financers, and loan servicers and their employees when modifying or offering to modify an existing loan that is in default or is likely to go into default. It also clarifies when administrative and clerical staff members are not acting as loan originators.

The Rule continues the prohibition on basing loan originator compensation on any of the residential mortgage loan transaction’s terms or conditions, including any factor that is a proxy for a loan term or condition. The terms and conditions will include any right or obligation of the parties to a residential mortgage loan, except the amount of credit extended if the compensation is based on a fixed percentage. The Rule provides clarification regarding what constitutes a proxy. A factor will be a proxy if it consistently varies a term or terms over a significant number of loans and the loan originator has the ability to add, drop, or change the factor.

Consistent with prior informal interpretations of Regulation Z, the Rule clarifies that the prohibition includes not only compensation based on the terms or conditions of a single transaction, but also compensation based on the terms of multiple transactions by a single loan originator or multiple loan originators. Because the prohibition includes the terms or conditions of multiple loans by multiple originators, loan originator compensation cannot be based on the profits of a residential mortgage loan-related business. The Rule adopts this interpretation, but creates two exceptions. First, contributions to or benefits paid from designated tax-advantaged plans are permissible if they are not based on the terms of the individual loan originator’s transactions. Second, payments pursuant to certain non-deferred profits based compensation plans, as set forth in the Rule, could be permissible if they meet additional requirements, such as being limited to 10 percent or less of the loan originator’s total compensation or if the individual was the loan originator for 10 or fewer residential mortgage loans during the 12 months preceding the compensation determination date.

The Rule, similar to current Regulation Z, will generally prohibit reductions to loan originator compensation to offset costs if the terms of a transaction change. The reductions are prohibited because they are based on a term or condition of the transaction. However, the Commentary to the Rule states that reductions to compensation to offset unanticipated increases in certain settlement charges are permitted.

The Rule creates an exception to the Regulation Z prohibition on dual compensation. The Rule will allow a mortgage broker that receives compensation from the consumer to pay its employees or contractors commissions under certain circumstances.

For some, what is not in the Rule may be as important as what is in it. The Dodd-Frank Act would have prohibited certain loan originator compensation if the borrower paid upfront points and fees. For example, the Dodd-Frank Act would have generally prohibited a lender from paying individual loan originators certain commissions and other compensation in connection with a mortgage loan if the borrower paid up front points and fees. The Bureau had proposed creating a partial exemption. The proposal would have allowed a lender to charge up front points and fees and pay commissions and other compensation if the lender offered the borrower an alternative loan that did not include upfront points and fees. Rather than adopt this partial exemption, the Bureau decided to adopt a complete exemption to the statutory ban on upfront points and fees. The Bureau intends to assess the effects of the complete exemption and may take future action, including narrowing the exemption.

The Rule imposes obligations on creditors and mortgage brokers to ensure that the individual loan originators who work for them (i.e., employees, agents, contractors) are licensed or registered under other applicable laws, such as the Secure and Fair Enforcement for Mortgage Licensing Act of 2008. The Rule requires creditors and mortgage brokers that employ individual loan originators who are not required to be licensed or registered to ensure that these loan originator employees meet character, fitness, and background standards and receive training similar to licensed and registered loan originators. The Rule also requires that creditors and mortgage brokers include their unique identifiers and names on certain loan documents. The creditor or broker also must list the name and identifier of the individual loan originator primarily responsible for the origination of the loan.

The Rule prohibits loan terms that require the borrower to submit a dispute about a residential mortgage loan or certain home equity lines of credit (HELOCs) to binding arbitration. Additionally, under the Rule, no agreement relating to a residential mortgage loan or certain HELOCs could be applied to bar a borrower from bringing a court claim regarding an alleged violation of federal law. However, the parties could agree to arbitrate or otherwise settle a claim after a dispute arises.

The Rule prohibits the financing of any premiums for credit insurance in connection with a residential mortgage loan or certain HELOCs, but will permit premiums that are calculated and paid in full on a monthly basis.

The Rule expands recordkeeping requirements regarding loan originator compensation. The recordkeeping requirements apply to loan originator organizations, including both creditors and mortgage brokers. They will be required to keep evidence of compliance for three years. The increased time period will match the longer statute of limitations that will apply to claims for violations of the loan originator compensation requirements.

In conclusion, the Rule could affect several different aspects of a mortgage lender’s or broker’s operations, including hiring, employee training, compensation structures, referral activities, loan forms, litigation budgets, record retention schedules, and other policies and procedures. Going forward, lenders and brokers may be able to revise compensation structures. If they do so, they may need to consider other recently published rules that could affect loan originator compensation (e.g., Ability-to-Repay Rule). Depository institutions will have to provide additional training and background screening. Lenders and brokers will likely need to revise loan documents to provide identification information and revise their record retention schedules and other policies and procedures so that they are able to demonstrate compliance. The Rule is an example of the importance of reviewing not only the regulation but also the commentary and supplementary information. In this case, the Rule does not cover everything that one must know about upcoming loan originator compensation issues, but the commentary and supplementary information as well as the regulation clarify several important points from current Regulation Z’s requirements and cover several other issues on which mortgage lenders and brokers will need to be advised.

Recent Changes to HOEPA

On January 10, 2013, the Bureau of Consumer Financial Protection (Bureau) issued a final rule amending Regulation Z by expanding the types of transactions subject to the Home Ownership and Equity Protection Act of 1994 (HOEPA), revising and expanding HOEPA thresholds, and imposing additional requirements on HOEPA loans. The final rule also amends Regulation Z and Regulation X (RESPA) by imposing homeownership counseling requirements. These changes are effective for all loans applied for on and after January 10, 2014.

This article focuses on the final rule’s expanded coverage, thresholds, requirements, and its impact on creditors, brokers, purchasers, and consumers.

Expanded Coverage

Transactions eligible for HOEPA coverage now include purchase-money loans and home-equity lines of credit (HELOCs). Transactions excluded from coverage include: reverse mortgage loans, loans to finance the initial construction of a dwelling, loans originated by a Housing Finance Agency, and loans under USDA’s Section 502 Direct Loan Program. While this expanded coverage may improve consumers’ understanding of the terms and features of a high-cost mortgage, it also may limit their access to credit, since most lenders are reluctant to make high-cost mortgages. Further, creditors will incur additional costs in identifying these types of loans, including, but not limited to, those costs related to changing or upgrading automated systems and disclosures, legal and compliance review, and staff training. Creditors also may lose revenue as a greater number of their loans are subject to HOEPA, and there is limited secondary market demand for high-cost mortgages.

What is a High-Cost Mortgage?

A “High-Cost Mortgage” is a consumer credit transaction secured by a consumer’s 1-4 unit principal dwelling, including purchase and non-purchase money closed-end credit transactions and HELOCs, in which

  1. The annual percentage rate (APR) exceeds the average prime offer rate (APOR) for a comparable transaction by more than:
    1. 6.5 percentage points for first liens;
    2. 8.5 percentage points for first liens less than $50,000 secured by a dwelling that is personal property (e.g., manufactured home); or
    3. 8.5 percentage points for junior liens;
  2. The total points and fees exceed:
    1. 5 percent of the total loan amount if the loan amount is $20,000 or more; or
    2. The lesser of 8 percent of the total loan amount or $1,000 for a loan amount less than $20,000 (the $1,000 and $20,000 figures are adjusted annually); or
  3. A prepayment penalty may be charged more than 36 months after consummation or account opening, or may exceed, in total, more than 2 percent of the amount prepaid.

Although the thresholds seem straight-forward, the devil is in the details. Let’s dive into those details.

New High-Cost APR and Index

Creditors may use one of three methods to determine the interest rate for the APR calculation. For a fixed-rate transaction, a creditor must use the interest rate in effect as of the date the interest rate for the transaction was set. For a variable-rate transaction which varies according to an index, a creditor must use the higher of the index plus margin or the introductory interest rate in effect as of the date the interest rate for the transaction is set. For a variable-rate transaction which does not vary according to an index (e.g., step-rate mortgage), a creditor must use the maximum interest rate that may be imposed during the term of the transaction.

In order to determine the applicable rate threshold, a creditor must now use the APOR index for a comparable transaction. APOR tables and guidance are available at www.ffiec.gov/ratespread/aportables.htm and www.ffiec.gov/ratespread. There are three factors to consider when determining a “comparable transaction”: (1) whether the transaction is a fixed-rate or variable-rate, (2) the date the interest rate for the transaction was set, and (3) the term of the transaction. The “date the interest rate was set” means the date on which the loan’s interest rate is set for the final time before closing. If there is a rate lock agreement, it is the lock date specified in the agreement. If a rate is reset after execution of a rate lock agreement (e.g., float-down option exercise date), then the relevant date is the date the rate is re-set for the final time before closing. If there is no rate lock agreement, the relevant date is the date on which the rate is set for the final time before closing. In the case of a fixed-rate transaction, the “term of the transaction” is the transaction’s term to maturity. In the case of a variable-rate transaction, the “term of the transaction” is the initial fixed-rate period, rounded to the nearest number of whole years (or, if the initial fixed-rate period is less than one year, one year). A creditor originating a fixed-rate, evergreen HELOC should use a term of 30 years.

What is the potential impact of the revised APR threshold? First, the Bureau estimates a 20 percent increase in refinance and home improvement loans that will be High-Cost Mortgages. Second, FHA recently extended its monthly mortgage insurance premium requirement. This will cause the APR for FHA loans to be higher, since the APR reflects costs other than interest on closed-end transactions, which in turn could make more FHA loans High-Cost Mortgages. Third, the APR calculated from a fully-indexed rate will be higher than the composite APR calculated according to Regulation Z Section 1026.17.

New High-Cost Points and Fees Threshold and Definition

Which points and fees threshold applies depends on whether the face amount of the note, in a closed-end transaction, or the credit limit, in an open-end transaction, is $20,000 or more. In contrast, for the points and fees threshold calculation, the final rule uses a “total loan amount.” In a closed-end transaction the “total loan amount” is calculated by starting with the amount financed and subtracting (1) any financed item listed in 1026.4(c)(7) which is unreasonable or is paid to the creditor or an affiliate; (2) any upfront financed credit insurance premium; and (3) the prior loan’s prepayment penalty if it is financed, subject to certain limitations. The HELOC “total loan amount” is the credit limit.

The final rule also amends the definition of points and fees to remove certain items previously included (e.g., certain upfront mortgage insurance premiums and bona fide discount points) and to add other items (e.g., the maximum prepayment penalty). Under the final rule, “points and fees” mean the following fees or charges that are known at or before consummation:

  1. All items included in the finance charge under 1026.4(a) and (b).
  2. All compensation paid directly or indirectly by a consumer or creditor to a loan originator that can be attributed to the transaction at the time the interest rate is set. This requirement, as currently drafted, would double-count loan originator compensation under certain circumstances. There is a Concurrent Proposal that would address this issue. Stay tuned.
  3. All items listed in 1026.4(c)(7) if unreasonable, or the creditor or its affiliate receives compensation, direct or indirect, in connection with the charge.
  4. Upfront credit life, disability, unemployment insurance premiums.
  5. The maximum prepayment penalty. (Note: The following state high cost points and fees calculations also may include some or all of the prepayment penalty amount: Arkansas, Georgia, Massachusetts, New Jersey, New Mexico, North Carolina, and South Carolina.)
  6. The prior loan’s prepayment penalty, subject to certain limitations. (Note: Georgia, Massachusetts, New Jersey, and New Mexico have a similar requirement.)
  7. For HELOCs only, any participation fee payable at or before account opening and any minimum or per-transaction fee (assume at least one draw).

The following items known at or before consummation are excluded from the calculation of “points and fees”:

  1. Interest or time-price differential
  2. Any premium or similar charge imposed in connection with a federal or state agency program (i.e., FHA Mortgage Insurance, VA Funding Fee, or USDA RHS Upfront Guarantee Fee).
  3. Any premium or similar charge that protects the creditor against the consumer’s default or other credit loss (e.g., private mortgage insurance), but only to the extent the upfront amount does not exceed the FHA upfront mortgage insurance premium for a comparable loan and the upfront guarantee or premium is automatically refundable on a pro rata basis upon satisfaction of the mortgage.
  4. Any bona fide third-party charge not retained by the creditor, loan originator, or an affiliate of either, unless the charge is required to be included;
  5. Up to 2 bona fide discount points, if the undiscounted interest rate does not exceed the comparable APOR by more than 1 percentage point, or up to 1 bona fide discount point if the undiscounted interest rate does not exceed the APOR by more than 2 percentage points. For transactions secured by personal property, a creditor would use the average rate for a loan insured under Title I of NHA. A discount point is considered bona fide if it reduces the undiscounted rate by at least .25 basis points. (The following states have some form of bona fide discount point exclusion in their high cost thresholds: Indiana, New Jersey, New Mexico, North Carolina, South Carolina, and Tennessee.)

Based upon the lower points and fees threshold, smaller loan amounts may easily exceed the 5 percent threshold. If this occurs, access to small loan credit may be limited, as creditors and the secondary market have little appetite for High-Cost Mortgages.

New Prepayment Penalty Threshold

The new threshold limits when a penalty may be imposed to the first 36 months of the transaction, and limits the penalty amount to 2 percent of the amount prepaid. For purposes of this threshold, a prepayment penalty does not include (1) certain conditionally-waived upfront bona fide third-party closing costs; and (2) until January 21, 2015, interest charged consistent with the monthly interest accrual amortization method for FHA insured transactions.

The Bureau believes the number of transactions affected by the prepayment threshold will be small, since the maximum prepayment penalty is included in the points and fees calculation, and a creditor would have to forgo some or all of the other charges included in the points and fees calculation, in order to originate a “qualified mortgage” which caps points and fees at 3 percent. In addition, limiting the penalty to the first 36 months will impact lenders in California, Louisiana, Minnesota, New Hampshire, and Ohio, all of which allow prepayment penalties to be charged for a longer period (60/84, 60, 42, 60, and 60 months respectively). This threshold also impacts the allowable prepayment penalty amount in Illinois, 3 percent, and Louisiana, which allows a 5 percent penalty in the first year.

New High-Cost Mortgage Restrictions

Sections 1026.32 and 1026.34 provide that once a transaction is a High-Cost Mortgage:

  • Balloon payments are generally prohibited.
  • Prepayment penalties are prohibited.
  • Financing points and fees are prohibited.
  • Late fees cannot exceed 4 percent of the past due payment or be imposed until after 15 days past due.
  • Payoff statement must be provided within 5 days of request and fees are restricted.
  • Modification and Deferral Fees are prohibited.
  • Ability-to-Repay assessment is required for HELOCs. Closed-end loans must meet the 2013 Ability-to-Repay Final Rule requirements.
  • No default may be recommended or encouraged.

Revised High-Cost Mortgage Disclosures

Section 1026.32(c) revises the High-Cost Mortgage disclosure and distinguishes closed-end and HELOC requirements. A creditor must provide the disclosure to the consumer not less than 3 business days prior to consummation or account opening. “Business day” has the same meaning as the Regulation Z rescission rule. If the disclosure becomes inaccurate, a creditor must provide new disclosures and begin a new 3-day waiting period. A consumer may waive the waiting period to meet a bona fide personal emergency. A creditor may provide new disclosures by telephone if the consumer initiates the change and if, prior to or at consummation or account opening (1) the creditor provides new disclosures, and (2) the consumer and creditor sign a statement concerning the delivery and timing of telephone disclosures.

Corrections of Unintentional Violations

New Section 1026.32(h) allows a creditor or assignee, who, when acting in good faith, fails to comply with any Section 1026.32 requirement, to take steps to cure the “violation” by providing written notice of available choices. For notice to be adequate, the consumer should have at least 60 days to consider the options and communicate a choice. The creditor or assignee must satisfy either of the following sets of conditions:

  1. Within 30 days of consummation or account opening and prior to the institution of any action, the consumer discovers the violation or the creditor or assignee notifies the consumer, and the creditor or assignee (a) provides appropriate restitution within 30 days; (b) adjusts the transaction’s terms, within 30 days, by either, at the choice of the consumer (i) making the transaction satisfy Section 1026.32 requirements; or (ii) Changing the transaction’s terms so it will no longer be a High-Cost Mortgage.
  2. Within 60 days of the creditor’s discovery or receipt of notification of an unintentional violation or bona fide error and prior to the institution of any action, the creditor (a) notifies the consumer of the compliance failure; (b) provides appropriate restitution within 30 days; and (c) adjusts the transaction’s terms, within 30 days, by either, at the choice of the consumer (i) making the transaction satisfy Section 1026.32 requirements; or (ii) changing the transaction’s terms so it will no longer be a High-Cost Mortgage.

Regulation X (RESPA) Homeownership Counseling Organization List

12 CFR 1026.20 requires a lender to provide a written list of homeownership counseling organizations (the List) to the applicant of a federally related mortgage loan, which includes a loan (other than temporary financing, e.g., construction loan) secured by a 1-4 unit dwelling, including purchase and non-purchase money closed-end credit and HELOCs. The creditor must retrieve the List information from the Bureau’s website or from data made available by the Bureau or HUD no more than 30 days prior to delivery.

A lender must provide the List no later than 3 business days after the lender or mortgage broker receives an application. If there is more than one applicant, the lender may provide the List to the applicant with primary liability. If the lender does not provide the List in person, the lender must mail or deliver it by other means, including electronically, subject to the E-Sign Act. Although the lender is ultimately responsible for compliance, a mortgage broker or dealer also may provide the List. If there is more than one lender, only one List is required. Unless otherwise prohibited, the lender may provide the List with other required disclosures. For a HELOC subject to Regulation Z, a lender that provides the applicant with the List may comply with the timing and delivery requirements of either 1024.20(a) or 1026.40(b).

A lender does not need to provide the List if before the end of the 3 business days, the application is denied or withdrawn, or the application is for a reverse mortgage or loan secured by a timeshare.

High-Cost Mortgage Counseling Requirements

Section 1026.34(a)(5) requires a creditor, prior to making a High-Cost Mortgage, to receive written certification from an unaffiliated HUD-certified or -approved or state housing finance authority-certified or -approved counselor that the consumer received counseling on the advisability of the transaction. The certification must contain the elements specified in 1026.34(a)(5). The creditor may receive the certification by mail, e-mail, or facsimile. A creditor may process the application, order the appraisal or title search, prior to receiving the certification.

A consumer may not obtain counseling until after receiving the initial good faith estimate on a closed-end transaction or the initial HELOC disclosures required by Regulation Z. A creditor cannot direct a consumer to a particular counselor or organization. A consumer may pay a bona fide third-party counseling fee and it may be financed. A creditor may pay the fee, but cannot condition payment on loan consummation or account opening. A creditor may confirm counseling prior to paying the fee; however, if the consumer withdraws the application, a creditor may not condition the payment on receipt of the certification.

Negative Amortization Counseling Requirements

Section 1026.36(k) requires a creditor, prior to making a closed-end loan secured by a 1-4 unit dwelling which may result in negative amortization, to obtain confirmation that a first-time borrower received counseling on the risks of negative amortization from a HUD-certified or -approved counselor or counseling organization. Acceptable confirmation includes a certificate, letter, or e-mail. This requirement does not apply to reverse mortgages or loans secured by a timeshare. A creditor cannot direct a consumer to choose a particular counselor or organization. Although a creditor cannot make the loan prior to receiving this confirmation, a creditor may engage in other activities, such as processing the application or ordering the appraisal or title search.

Conclusion

Although originations of High-Cost Mortgages are a small percentage of the market as a result of special disclosure requirements, restrictions, enhanced borrower remedies, and assignee liability, the expansion of HOEPA coverage will increase the number of loans subject to HOEPA and the new and lower thresholds will increase the number of loans classified as High-Cost Mortgages. What percentage of loans this will include is difficult to determine.

This article just begins to scratch the surface of the issues this final rule raises for lenders, brokers, and their compliance or legal experts. Lenders will want to review 30 state and local high cost coverage and threshold requirements to determine any necessary changes. Lenders will want to review rates and fees on smaller loans, in order to determine how to price these loans appropriately to avoid a High-Cost Mortgage designation. Lenders and brokers will want to review their loan originator compensation policies. Lenders will want to review state prepayment penalty riders to ensure compliance with federal and state law. Lenders will want to consider creating new procedures to handle unintentional Section 32 violations, to meet the timing and other cure requirements. Finally, lenders will need to plan for the additional costs they will incur in updating automated systems, disclosures and documents, employee training, and outside legal advice. Will these HOEPA changes ultimately help consumers or reduce access to credit? Only time will tell.

 

The Future of Tribal Lending Under the Consumer Financial Protection Bureau

Some Indian tribes – particularly impecunious tribes located remotely from population centers, without sufficient traffic to engage profitably in casino gambling – have found much-needed revenue from consumer lending over the Internet.

In a typical model, the tribe forms a tribal lending entity (TLE) that is financed by a third party. The TLE then makes loans over the Internet to consumers nationwide, usually on terms that are unlawful under the internal laws of the states where the borrowers reside. Because the TLE is deemed an “arm” of the tribe, the TLE benefits from the tribe’s sovereign immunity. As a result, the TLE may be sued only under very limited circumstances; and, perhaps even more importantly, the TLE is exempt from most state-court discovery intended to unearth the economic relationship between the TLE and its non-tribal financier.

Because this model has, at least to date, provided a relatively bulletproof means to circumvent disparate state consumer-protection laws, the model has attracted Internet-based payday and, to a lesser extent, installment lenders. Although data are spotty, it is likely the fastest-growing model for unsecured online lending. Tribal sovereign immunity renders this model the preferred legal structure for online lenders desirous of employing uniform product pricing and terms nationwide, including for loans to borrowers who reside in states that prohibit such lending entirely.

The tribal model is increasingly being adopted by online lenders who had formerly employed other models. Yet the legal risks of the model to those who would “partner” with TLEs are rarely emphasized.

Introduction to the Tribal Model

Payday loans are designed to assist financially constrained consumers in bridging small ($100 to $1,000) cash shortages between loan origination and the borrower’s next payday. The permitted interest rates for such loans, where they are allowed, are high – generally in the APR range of 400 percent. Such permitted rates are, perhaps incredibly, less than the economic equilibrium price for such credit. A borrower who desires to extend a loan, or who is unable to repay a loan on the due date, may refinance, or “roll over,” the loan. State laws and the “best practices” of the storefront payday lenders’ trade association frequently limit such “rollovers” and permit a borrower with payment difficulties to demand an interest-free extended repayment plan.

TLEs are customarily tribally chartered. In the best embodiment, the TLEs have offices on tribal lands, operate payday-loan-decisioning computer servers there, and employ tribal personnel in various stages of the loan-origination process. But TLEs generally make extensive use of non-tribal subcontractors and typically receive substantially all of their financing from non-tribal financiers. As a result, the economic benefits of TLEs’ lending operations frequently flow primarily to the financiers and not to the tribes.

The principal benefit of the tribal model to the TLE is the ability to charge – at least to date, with relative impunity – market rates for payday loans, typically in excess of $20 per $100 advanced for a two-week loan (equivalent to an APR of 520 percent). These rates generally exceed permissible charges in borrowers’ states. Thirty-two states permit payday loans to their residents, but in most cases with maximum finance charges of $15 or less; the remaining states and the District of Columbia have applicable usury laws that either expressly or impliedly bar payday lending altogether.

Because TLEs deem themselves exempt from compliance with all borrower-state laws, a TLE engaged in payday lending usually charges a single rate nationwide and generally does not comply with state-law limitations on loan duration or rollovers. Online lenders generally seek to comply with federal laws applicable to consumer loans (e.g., TILA and ECOA).

Commercial payday lenders have entered into collaborations with Indian tribes in order to seek to benefit from the tribes’ sovereign immunity. As noted above, in many cases the non-tribal participant may preponderate in the finances of the TLEs, causing regulators and some scholars to call into question the bona fides of the arrangements. The popular press often refers to these arrangements as “rent-a-tribe” ventures, similar to the “rent-a-bank” payday lending ventures formerly in use until the latter were effectively ended by federal bank regulators in 2005.

Following President Obama’s putative recess appointment on January 4, 2012, of Richard Cordray as director of the Consumer Financial Protection Bureau (CFPB) – thereby enabling supervision of non-depository institutions – the CFPB is likely to subject the tribal model to increased scrutiny.

Tribal Sovereign Immunity

Indian tribes were sovereign nations prior to the founding of the United States. Thus, rather than grant sovereignty to tribes, subsequent treaties and legislative and juridical acts have served to recognize this inherent preexisting sovereignty. Because they are separate sovereigns, recognized Indian tribes are subject to suit only under limited circumstances: specifically, when the tribe has voluntarily waived its immunity, or when authorized by Congress. Kiowa Tribe of Oklahoma v. Manufacturing Tech., Inc., 523 U.S. 751, 754 (1998).

The extent of immunity is governed largely by the Supreme Court’s decision in California v. Cabazon Band of Mission Indians, 480 U.S. 202 (1987). Concepts of tribal immunity have been addressed extensively in prior articles and will not be belabored here. In brief summary, state and local laws may be applied to on-reservation activities of tribes and tribal members only under very limited circumstances generally inapplicable to tribal lending.

As recent examples of these principles, the appellate courts of California and Colorado were confronted with the assertion that tribal sovereign immunity prevents the use of state-court discovery methods to determine whether a tribe-affiliated Internet payday lender had a sufficient nexus with the tribe to qualify for sovereign immunity and, secondarily, to pursue discovery of the alleged sham relationship between the TLE and its financial backer. Relying in each case on the Supreme Court’s determination that tribal sovereign immunity prevents compelled production of information to assist a state in investigating violations of and enforcing its laws, both of those courts denied meaningful discovery.

Sovereign immunity applies not only to tribes themselves but also to entities that are deemed “arms” of the tribe, such as tribally chartered TLEs.

Because the immunity of TLEs is substantially beyond cavil, the “action” in litigation over the tribal model has moved on from the tribes and their “arms” to non-tribal financiers, servicers, aiders, and abettors. Discovery of the details of the financial relationships between TLEs and their financiers has been a key aim of these state-court proceedings by regulators, since the non-tribal “money partners” of the TLEs almost certainly cannot assert tribal immunity. The principal risk to such financiers is recharacterization as the “true” lender in one of these arrangements.

Pre-CFPB Federal Regulation of Payday Lending

Prior to the enactment of the Dodd-Frank Act (the Act), federal enforcement of substantive consumer lending laws against non-depository payday lenders had generally been limited to civil prosecution by the Federal Trade Commission (FTC) of unfair and deceptive acts and practices (UDAP) proscribed by federal law. Although it could be argued that unfair practices were involved, the FTC did not pursue state-law usury or rollover violations. Because of the relative novelty of the tribal lending model, and perhaps more importantly because of the propensity of FTC defendants to settle, there are no reported decisions regarding the FTC’s assertion of jurisdiction over TLEs.

The FTC’s most public (and perhaps its first) enforcement action against a purported tribal-affiliated payday lender was not filed until September 2011, when the FTC sued Lakota Cash after Lakota had attempted to garnish consumers’ wages without obtaining a court order, in order to collect on payday loans. The FTC alleged that Lakota had illegally revealed consumers’ debts to their employers and violated their substantive rights under other federal laws, including those relating to electronic payments. The case, as with nearly all of the other FTC payday-lending-related cases, was promptly settled. Thus, it provides little guidance to inform future enforcement actions by the FTC or the CFPB.

The Looming Battle Over CFPB Authority

Article X of the Act created the Consumer Financial Protection Bureau with plenary supervisory, rulemaking and enforcement authority with respect to payday lenders. The Act does not distinguish between tribal and non-tribal lenders. TLEs, which make loans to consumers, fall squarely within the definition of “covered persons” under the Act. Tribes are not expressly exempted from the provisions of the Act when they perform consumer-lending functions.

The CFPB has asserted publicly that it has authority to regulate tribal payday lending. Nevertheless, TLEs will certainly argue that they should not fall within the ambit of the Act. Specifically, TLEs will argue, inter alia, that because Congress did not expressly include tribes within the definition of “covered person,” tribes should be excluded (possibly because their sovereignty should permit the tribes alone to determine whether and on what terms tribes and their “arms” may lend to others). Alternatively, they may argue a fortiori that tribes are “states” within the meaning of Section 1002(27) of the Act and thus are co-sovereigns with whom supervision is to be coordinated, rather than against whom the Act is to be applied.

In order to resolve this inevitable dispute, courts will look to established principles of law, including those governing when federal laws of general application apply to tribes. Under the so-called Tuscarora-Coeur d’Alene cases, a general federal law “silent on the issue of applicability to Indian tribes will . . . apply to them” unless: “(1) the law touches ‘exclusive rights of self-governance in purely intramural matters’; (2) the application of the law to the tribe would ‘abrogate rights guaranteed by Indian treaties’; or (3) there is proof ‘by legislative history or some other means that Congress intended [the law] not to apply to Indians on their reservation . . . .'”

Because general federal laws governing consumer financial services do not affect the internal governance of tribes or adversely affect treaty rights, courts seem likely determine that these laws apply to TLEs. This result seems consistent with the legislative objectives of the Act. Congress manifestly intended the CFPB to have comprehensive authority over providers of all kinds of financial services, with certain exceptions inapplicable to payday lending. Indeed, the “leveling of the playing field” across providers and distribution channels for financial services was a key accomplishment of the Act. Thus, the CFPB will argue, it resonates with the purpose of the Act to extend the CFPB’s rulemaking and enforcement powers to tribal lenders.

This conclusion, however, is not the end of the inquiry. Since the principal enforcement powers of the CFPB are to take action against unfair, deceptive, and abusive practices (UDAAP), and assuming, arguendo, that TLEs are fair game, the CFPB may have its enforcement hands tied if the TLEs’ only misconduct is usury. Although the CFPB has virtually unlimited authority to enforce federal consumer lending laws, it does not have express or even implied powers to enforce state usury laws. And payday lending itself, without more, cannot be a UDAAP, since such lending is expressly authorized by the laws of 32 states: there is simply no “deception” or “unfairness” in a somewhat more pricey financial service offered to consumers on a fully disclosed basis in accordance with a structure dictated by state law, nor is it likely that a state-authorized practice can be deemed “abusive” without some other misconduct. Congress expressly denied the CFPB authority to set interest rates, so lenders have a powerful argument that usury violations, without more, cannot be the subject of CFPB enforcement. TLEs will have a reductio ad absurdum argument: it simply defies logic that a state-authorized APR of 459 percent (permitted in California) is not “unfair” or “abusive,” but that the higher rate of 520 percent (or somewhat more) would be “unfair” or “abusive.”

Some Internet-based lenders, including TLEs, engage in specific lending practices that are authorized by no state payday-loan law and that the CFPB may ultimately assert violate pre-Act consumer laws or are “abusive” under the Act. These practices, which are by no means universal, have been alleged to include data-sharing issues, failure to give adverse action notices under Regulation B, automatic rollovers, failure to impose limits on total loan duration, and excessive use of ACH debits collections. It remains to be seen, after the CFPB has concluded its research with respect to these lenders, whether it will conclude that these practices are sufficiently harmful to consumers to be “unfair” or “abusive.”

The CFPB will assert that it has the power to examine TLEs and, through the examination process, to ascertain the identity of the TLEs’ financiers – whom state regulators have argued are the real parties in interest behind TLEs – and to engage in enforcement against such putative real parties. This information may be shared by the CFPB with state regulators, who may then seek to recharacterize these financiers as the “true” lenders because they have the “predominant economic interest” in the loans, and the state regulators will also be likely to engage in enforcement. As noted above, these non-tribal parties will generally not benefit from sovereign immunity.

The analysis summarized above suggests that the CFPB has examination authority even over lenders completely integrated with a tribe. Given the CFPB’s announced intention to share information from examinations with state regulators, this scenario may present a chilling prospect for TLEs.

To complicate planning further for the TLEs’ non-tribal collaborators, both CFPB and state regulators have alternative means of looking behind the tribal veil, including by conducting discovery of banks, lead generators and other service providers employed by TLEs. Thus, any presumption of anonymity of TLEs’ financiers should be discarded. And state regulators have in the past proven entirely willing to assert civil claims against non-lender parties on conspiracy, aiding-and-abetting, facilitating, control-person or similar grounds, without suing the lender directly, and without asserting lender-recharacterization arguments.

The Future

Given the likelihood of protracted litigation regarding the CFPB’s authority over TLEs, it is not unthinkable that the CFPB will assert that authority in the near future and litigate the issue to finality; the CFPB cannot be counted on to delay doing so until it has concluded its economic research with respect to payday lending (in which TLEs cannot be expected to rush to cooperate) or until litigation over the recess appointment of Director Cordray has been resolved.

TLEs, anticipating such action, will wish to consider two distinct strategic responses. On the one hand, hoping to insulate themselves from direct attacks by the CFPB under the “unfair” or “abusive” standards, TLEs might well amend their business practices to bring them into line with the requirements of federal consumer-protection laws. Many TLEs have already done so. It remains an open question whether and to what extent the CFPB may seek to employ state-law violations as a predicate for UDAAP claims.

On the other hand, hoping to buttress their immunity status against state attacks (possibly arising from shared CFPB-generated information about their relationships with tribes), TLEs might well amend their relationships with their financiers so that the tribes have real “skin in the game” rather than, where applicable, the mere right to what amounts to a small royalty on revenue.

There can be no assurance that such prophylactic steps by TLEs will serve to immunize their non-tribal business partners. As noted below with respect to the Robinson case, the “action” has moved on from litigation against the tribes to litigation against their financiers. Because the terms of tribal loans will remain illegal under borrower-state law, non-tribal parties who are deemed to be the “true” lenders-in-fact (or even to have conspired with, or to have aided and abetted, TLEs) may find themselves exposed to significant liability. In the past, direct civil proceedings against “true” lenders in “rent-a-bank” transactions have proven fruitful and have resulted in substantial settlements.

To be clear, state regulators do not need to join TLEs as defendants in order to make life unpleasant for TLEs’ financiers in actions against such financiers. Instead, they may proceed directly against the non-tribal parties who finance, manage, aid, or abet tribal lending.

Nor does the private plaintiffs’ class action bar need to include the tribal parties as defendants. In a recent example, a putative class plaintiff payday borrower commenced an action against Scott Tucker, alleging that Tucker was the alter ego of a Miami-nation affiliated tribal entity – omitting the tribal entity altogether as a party defendant. Plaintiff alleged usury under Missouri and Kansas law, state-law UDAP violations, and a RICO count. He neglected to allege that he had actually paid the usurious interest (which presumably he had not), thereby failing to assert an injury-in-fact. Accordingly, since Robinson lacked standing, the case was dismissed. Robinson v. Tucker, 2012 U.S. Dist. LEXIS 161887 (D. Kans. Nov. 13, 2012). Future plaintiffs are likely to be more careful about such jurisdictional niceties.

In the past, online lenders have been able to count on some degree of regulatory lassitude, as well as on regulators’ (and the plaintiff bar’s) inability to differentiate between lead generators and actual lenders. Under the CFPB, these factors are likely to fade.

Perhaps the prediction of the CFPB’s early assertion of authority over TLEs is misplaced. Nevertheless, it is likely that the CFPB’s influence over the long term will cause tribal lending and storefront lending to converge to similar business terms. Such terms may not be profitable for TLEs.

Finally, because the tribal lending model relies on continued Congressional tolerance, there remains the possibility that Congress could simply eliminate this model as an option; Congress has virtually unfettered power to vary principles of tribal sovereign immunity and has done so in the past. While such legislative action seems unlikely in the current fractious environment, a future Congress could find support from a coalition of the CFPB, businesses, and consumer groups for more limited tribal immunity.

 

 

Recent Developments in Charging Orders

The economic crises sparked in 2008 have driven significant interest in the charging order. The 1990s saw the rise of the LLC as a preferred form for the organization of new business ventures across the country. In turn, the LLC, reflecting its roots in partnership law, incorporated the “charging order,” a mechanism by which the judgment-creditor of a member may make a claim on the distributions to be made by the LLC as a means of satisfying the judgment-debtor’s obligation. With the Great Recession, more and more creditors have dealt with judgment-debtors who were themselves members of LLCs. Hence, the newfound attention to these otherwise obscure statutes.

The three of us, at the 2012 LLC Institute sponsored by the Section of Business Law’s Committee on LLCs, Partnerships and Unincorporated Entities, were able to discuss a variety of issues of current currency involving LLCs, thoughts and comments here digested.

By way of background, although the statutory formulae are somewhat different between the various states, the charging order is a remedy provided to the judgment-creditor of a member or assignee of a member by which that creditor may attach the distributions (interim and liquidating) made to the member-assignee, thereby diverting that income stream to the satisfaction of the judgment. Essentially, the charging order is a lien attaching to any distributions that might be made to the member or assignee that is as well the judgment-debtor. The objective of the charging order is to secure the judgment-creditor’s receipt of those distributions while at the same time precluding that judgment-creditor from interfering with the activities of the LLC as a going concern. Precluding a claim by the judgment-creditor that it may somehow directly attach the assets of the LLC, the charging order buttresses the asset partition function of the LLC as a legal entity distinct from its members. Under most state formulae, the charging order is subject to redemption, and a lien upon the LLC interest created by the charging order is subject to foreclosure.

For a more comprehensive review of the charging order generally, see, e.g., Thomas E. Rutledge and Sarah S. Wilson, An Examination of the Charging Order Under Kentucky’s LLC and Partnership Acts (Part I), 99 Kentucky Law Journal Online 85 (2011); (Part II), 99 Kentucky Law Journal Online 107 (2011). Professor Bishop publishes a pair of resources regularly updated, that are particularly helpful with respect to remaining current with respect to developments in LLCs. The first is a tabular review of the charging order provisions that exist in the various LLC Acts, namely Fifty State Series: LLC Charging Order Statutes, available on SSRN.com. The second table, also available on SSRN, is titled Fifty State Series: LLC Charging Order Case Table, an invaluable resource in knowing the status of the law both in any individual state and across the country.

The Taxation of Distributions Diverted to the Judgment-Creditor

One of the more contentious issues with respect to charging orders, and a topic on which there has been published a great deal of misinformation, is taxation. It has been asserted by some that the judgment-creditor holding a charging order will bear the tax liability with respect to allocations and distributions made with respect to the judgment-debtor’s interest in the LLC, the net effect of which is to expose the judgment-creditor to the risk of phantom income should the LLC not make any distributions. Simply put, this is false.

Under Revenue Ruling 77-137, until such time as the judgment-creditor might foreclose on the charged LLC interest, thereby becoming an assignee thereof, it is the judgment-debtor who remains, for tax purposes, the member in the LLC. It is to the judgment-debtor who is the member in the LLC that the allocation of profits, losses, and other tax items on Form K-1 will be reported, and not the account of the judgment-creditor. This outcome is consistent as well with the principle that the judgment-debtor should satisfy the judgment with after-tax dollars; if the judgment-debtor were able to shift to the judgment-creditor the tax liability with respect to the funds ultimately distributed, the judgment-debtor could, effectively, satisfy the debt with pre-tax dollars. Whether the judgment-creditor will need to report as income the payments received pursuant to the charging order is a matter resolved elsewhere in the Code. For example, if the judgment involved the judgment-debtor’s personal injury of the judgment-creditor, under Code Section 104(2) the payments may not be taxable income.

Turning from tax law, a variety of decisions on charging orders have been released in the last year or so, and they illustrate the many ambiguities that exist. For example, the decision of the Federal District Court for Kansas rendered in Meyer v. Christie, 2011 WL 4857905 (Oct. 13, 2011), illuminates that court’s confusion regarding the status of the holder of an assignee interest in an LLC and the holder of a charging order. The court incorrectly conflated the two positions, an outcome especially pernicious in Kansas as that state has an atypical statute, it providing that the assignee of the sole member of an LLC has the right to participate in the LLC’s management and affairs.

The decision of a Montana bankruptcy court rendered in In re Jonas, No. 10-60248-11, 2012 WL 2994724 (July 3, 2012), reviewed the authority of a receiver appointed to enforce a charging order. Almost every statute allows the court issuing a charging order to appoint a receiver to receive the proceeds thereof. In the Jonas decision, it was unclear whether the charged judgment-debtors held 50 percent or 100 percent of the interest in the subject LLC, but it is clear that a receiver was appointed with respect thereto. However, the court went on to discuss the receiver taking control of the LLC and its assets, rather than simply receiving the distributions as made. In the context of a single member LLC, if in fact that is what was the situation, the court may have, at least subconsciously, applying the rule set forth in In re Albright. See also Thomas E. Rutledge and Thomas Earl Geu, The Albright Decision, Why an SMLLC is not an Appropriate Asset Protection Vehicle, 5 Bus. Ent. 16 (Sept./Oct. 2003). If, on the other hand, the LLC had another member, the charging order receiver taking control of the LLC itself was clearly inappropriate.

Turning to the decision of the Iowa Court of Appeals rendered in Wells Fargo Bank, N.A. v. Continuous Control Solutions, Inc., No. 2-431/11-1285 (Aug. 8, 2012), the court determined that the holder of a charging order does not, in that capacity, have the right to compel the LLC to disclose its books and records. In that an assignee of an interest in an LLC does not have document inspection rights, the holder of a charging order, being one step further removed from the LLC, will have no inspection rights. In a similar vein was the decision of the Nevada court rendered in Waddell v. H2O, Inc., 128 Nev. Adv. Op. No. 9 (March 1, 2012), to the effect that an entry of a charging order does not divest the judgment-creditor of the right to participate in the LLC’s management. Rather, in that the charging order does not transfer title to the charged interest, it is retained by the judgment-debtor and they may continue to exercise the rights of a member.

Leonard v. Leonard, 2012 WL 4558390 (N.J. J. super A.D. June 13, 2011), is a most curious decision in which the court directed that a “writ of execution” be issued in support of a charging order. Those who are regularly involved with charging orders found this decision most confusing in that it was not clear what was added to a charging order by a writ of execution. Having consulted with several practitioners in New Jersey, it became clear that, in light of the lack of familiarity with the charging order as compared with the effect of a writ of execution, the latter was entered as a “belt and suspenders” to the comparatively obscure charging order.

In a recent decision by the Federal District Court for the Central District of Illinois, it considered the rights of the receiver over limited partnerships controlled by, apparently, married taxpayers. Its reasoning, however, may lead to the conclusion that the charging order is ineffective in a single-member LLC in Illinois. United States v. Zabka, ___ F. Supp. 2d ___, 2012 WL 5246918 (C.D. Ill. Sept. 11, 2012).

Federal tax liens were assessed against Robert and Deborah Zabka for numerous years of their personal tax liability. Judgment having been entered in favor of the government, the matter before the court involved the appointment of a receiver to collect, manage, and ultimately sell the Zabka’s property in order to satisfy the federal tax liens. One argument made by the Zabkas was that the federal receiver must comply with the Illinois charging order statute under the Limited Partnership Act, namely 805 Ill. Comp. Stat. 215/703. This statute expressly provides that it is the “exclusive remedy” of a judgment-creditor.

In rejecting that argument, the court noted that the government’s lien attached to all of the Zabka’s property, which “property and rights to property included their 100 percent ownership interest in the Limited Partnerships.” 2012 WL 5246918, *5. The court went on to note that the statutory language addresses the rights of a judgment-creditor of “a” (i.e., a singular) partner or transferee. From there, the court wrote:

The plain language of that statute – which refers to a judgment-creditor of an individual partner – demonstrates that it was designed to protect other partners in a partnership when one, but perhaps not all of the partners, have become encumbered with a judgment-creditor. In that respect, the Court finds that the state statute is irrelevant to the circumstances of the instant case because the Government’s federal tax lien attached to the Zabka’s 100 percent ownership interest of the Limited Partnerships.

By this reasoning, if a judgment-debtor is the sole member of an LLC, the judgment-creditor is not restricted to a charging order. Whether, in that situation, the judgment-creditor is able to seize the entirely of the LLC transferable interest, thereby becoming an assignee of all the economic benefits of the venture, and seize as well the management rights in the company or something else, is left to be determined. What is clear, however, is that the dangerous step of eliminating the charging order in the single-member LLC, simply because it is a single-member LLC, appears to have been taken.

Bay Guardian and Choice of Law

Bay Guardian Company, Inc. v. New Times Media LLC is an important charging order decision in that the primary question involved in this litigation is whether it is the law of the jurisdiction in which a judgment is entered against a member of a LLC that will govern the scope and effect of the charging order versus a requirement that there be applied the law of the jurisdiction of the LLC’s organization. This choice of law question arises because there are, between the charging order provisions of the various states, important differences. For example, under the law of many states, it is provided that the judgment-creditor may foreclose on the charging order lien, thereby converting their lien interest into a title interest (assuming, of course, it is the judgment-creditor who purchases the lien upon the foreclosure sale). Other states expressly provide that there may not be a foreclosure on the charging order lien.

Memorably, at the LLC Institute, Mr. Adkisson suggested that the charging order bears the burden of illegitimacy (he actually utilized a somewhat more flowery term), and was able to share with the group some illuminating information. The charging order first arose under the British Partnership Act, there created as a mechanism to avoid the judgment-creditor invading the partnership and seizing certain of its assets in satisfaction of the judgment. As expertly reviewed in J. Gordon Gose, The Charging Order Under the Uniform Partnership Act, 28 Wash. L. Rev. & St. B. J. 1 (1953), the charging order was created to preclude the judgment-creditor invading the partnership and seizing all or a portion of its assets in order to satisfy the claim against only an individual partner. It is this concept that was then carried forward into American law and most notably the Uniform Partnership Act. But here, Jay suggests, it where the mistake was made. According to his research, at the time the charging order was incorporated into the English Partnership Act, the English law did not otherwise provide for a lien upon the distributional interest in the partnership. Hence, the charging order was created to fill that gap. When the charging order was incorporated into the American Uniform Partnership Act (and from that act into all of the subsequent unincorporated entity laws including those of LLCs), it was not recognized that American law already provided for a lien on the distributional interest. Consequently, there existed no lacuna in American law requiring that the charging order be created. Consequently, it would be possible to delete the charging order’s provisions from all of these various acts and rely upon generally available remedies law to address the rights of the judgment-creditor of a judgment-debtor who is either a member in an LLC or a partner in a partnership.

Turning from that point, the charging order is a remedy; for example, the Delaware LLC Act provides that “a charging order is the exclusive remedy by which a judgment-creditor. . . .” Del. Code Ann. tit. 6, § 18-703(d). Hence, the charging order is a question of the law of remedies and “the law of remedies is always local.” Applying this rule, the conflicts question is resolved, and it is appropriate for the court to apply the law of the jurisdiction in which it sits in determining what remedies, including the characteristics of any charging orders that may be entered, will apply irrespective of the law of the jurisdiction of organization. Assume a Delaware LLC with a member resident in Kentucky; Delaware does not allow for foreclosure on the charging order while Kentucky does. A judgment is entered in Kentucky against the member and a charging order is to be issued against the interest in the Delaware LLC. Is the Kentucky court justified in applying Kentucky law to the question of whether there may be foreclosure? Under the principle that all remedies law is local, the answer is “yes.”

Following from that path of analysis, efforts by various states to increase their rankings with respect to asset protection are somewhat misleading. While a state may gain an increased ranking by, for example, precluding the foreclosure on the charging order lien, that statutory limitation will be effective only in that individual state. If there is judgment against a member in another state, and that other state has more liberal laws, the asset protection objectives may be thwarted.

As charging orders exist in almost every state’s partnership, limited partnership and LLC acts, irrespective of distinctions between the various states, there likely is no policy basis for having different statutory formulae for the charging orders in a single state. Rather, in order to avoid judicial distinctions based upon what are likely unintended language distinctions, it would serve state drafting committees to provide a single formula that is used by each state. The exception to this might be additional language addressing single member LLCs used for asset protection purposes that are deemed abusive; of course, as the partnership or limited partnership require at least two owners, that language may be unique to the LLC Act.

Conclusion

The problem for practitioners is that numerous unresolved issues exist as to the application of charging orders. The courts are just beginning to scratch the conflicts-of-law issues, creditors are with mixed success are utilizing other theories of relief such as alter ego law to circumvent charging order protection, and the effectiveness of charging order protection in a bankruptcy proceeding is still less than certain. However, these challenges seem to be most successful in the single-member (or effectively single-member) context, and less successful in true multiple-member situations where the interests of the other, non-debtor members are substantial.

In other words, this area is still ripe for litigation, and planners for the time being should err on the side of the conservative use of partnerships and LLCs to the extent one is concerned about future creditor challenges to a member of such an entity. At the same time, there exists great opportunity to forestall these questions, at least to the degree they are dependent upon state law, by careful redrafting of the charging order provisions of the various acts.