Predatory Small Loans
A Form of Loansharking
The Problem, Legislative Strategies, A Model Act

I.  Enormous Growth of Payday Loans a/k/a Deferred Deposit Loans [1]

In recent years, the majority of mainstream lenders have left the small loan market, leaving a vacuum being filled by companies offering payday loans. [2]   These are extremely high interest loans that extend until the borrower's next pay check. Many institutions prefer not to write small loans because, while the return on a $5,000 loan is greater than if only $500 is borrowed, the originating and servicing costs are not significantly different.  The national finance companies, which were initially founded to meet precisely this credit need, have moved out of this type of small lending.  As a result, the availability of small-sum, short-term credit has been severely curtailed. [3]   

Much of the market for small unsecured loans today has been replaced by checking account overdraft loans and credit cards, even for relatively lower income households.  From 1993 to 1996, the proportion of households with incomes under $20,000 who received credit card offers rose from 40% to 50%. [4]   This still leaves a large number of consumers without sufficient credit card limits or bank overdraft protection to meet their needs for relatively small unsecured loans, and who no longer have access to traditional sources of small loans. At the same time as traditional lenders were exiting the small loan market, the elimination of interest rate caps that began in the 1980's made this niche attractive to new entrants.  The move to deregulate interest rates was fostered by Congress passing several laws pre-empting state usury caps on first lien mortgages. [5]   Many states have raced to the bottom in their haste to respond to industry pressure to de-regulate (or "I will take my business elsewhere" -- presumably to Delaware or South Dakota.) [6] One result -- an explosion in what is now called payday loans.

The industry itself estimates the potential market for payday loans at approximately 35 million households. [7]   It is difficult to estimate the growth in the industry as a whole since 1990 but information from several states is illuminating.  Since 1990, the number of outlets offering such loans in Colorado rose from about 12 to an estimated 188 and Colorado officials estimate that payday lenders make up 20% of all licensed lenders. [8]   In its 1997 annual report, the Attorney General of Colorado noted that these lenders made 374,477 such loans totaling $42,823,089.  The average annual percentage rate (APR) charged on these loans was 485.26%.  Missouri reports that this is a growing business and licenses about 450 lenders.  Florida has registered 368 payday lenders since 1994.  Idaho now has about 74 payday lenders in its state, up from just 2 in 1993.  North Carolina licenses approximately 203 lenders while it neighbor, South Carolina, accommodates 325.  In 1998, Tennessee was home to about 257 companies operating 605 offices statewide.    Information from the state of Washington reveals that 562,031 loans were made by check cashers for a total of $144,923,986 in 1997.  Lenders collected $21,541,338 in fees.  In Indiana, the number of payday lenders leaped from 15 in 1994 to 115 (with 454 outlets) in 1998.  The loan volume grew from $12,688,599 in 1995 to about $296,098,015 in 1998.  Since 1998 alone, Mississippi has issued about 625 payday loan licenses.        

II.  Payday Loans Described

Payday loans work like this: the consumer provides the lender (typically a company that also offers check-cashing services) a post-dated check and receives less cash than the face amount of the loan. [9]   The check is then held for one to four weeks (usually until the customer's payday), at which time the customer redeems the check by paying the face amount, allows the check to be cashed, or writes another postdated check and pays another fee. The loans are short-term and at triple-digit interest rates. [10] Such a loan is an extension of credit created by the exchanging of cash for a postdated check, with a service charge ranging from 10% to 25% of the check amount withheld from the cash returned. The effective annual yield on a $256 check with a payout of $200 that is redeemed in two weeks is 681%.  These loans are marketed as a quick and easy way to get cash until the next pay day.  To qualify, consumers need only be employed for a period of time with the current employer, maintain a personal checking account, and show a pay stub and bank statement.  Credit checks or  other inquiries about ability to repay are not routinely performed.  The abuses occur in the making and collection of payday loans in a variety of ways.  Cash-strapped consumers rarely have the ability to repay the entire loan when their pay day arrives because that leaves little or nothing on which to live until the next pay check.  Lenders then encourage consumers to rollover or refinance one payday loan with another.  The result is that the consumer pays another round of charges and fees and obtains no additional cash in return.  For example, if a consumer is charged 15% on the face amount of the check of $200, the consumer receives only $170 in cash and the lender pockets a $30 fee.  The APR is 458% if this loan is repaid in two weeks.  If, instead, it is rolled over into a new payday loan, an additional fee of $30 is tacked on which raises the loan amount to $230.  The APR jumps to 917%.  These loans are exorbitantly expensive and can drive consumers ever deeper into debt. Further, payday lenders often threaten to use the criminal system to collect these debts or routinely file criminal charges when a check is returned for insufficient funds.  These in terrorum tactics are only possible because the lenders are holding negotiable checks.  This fact makes the collection process easier and more reliable than when consumers only sign a promissory note to repay.  Though payday loans are technically unsecured transactions, the use of the check, in effect, gives these lenders a huge advantage up in getting a return on their loan.  

III.  Are These Loans Legal? 

The answer is: it depends.  The manner in which states regulate payday loans falls into three categories. 

Category one: Twenty states and the Virgin Islands and Puerto Rico require payday lenders to comply with the state’s small loan or criminal usury laws which maintain interest rate caps of up to 36% per annum. [11]    These laws typically contain extensive provisions specifying the maximum loan amount, the maximum and/or minimum term, the maximum interest rate and permitted charges, penalties for the charging of excessive interest and other violations, licensing requirements, prepayment rebate formulas, the conditions under which lenders can require insurance, if annual reports must be filed, required contract provisions, and prohibited contract provisions. [12]   In essence, since the allowable interest rates and fees are substantially below that which the payday industry charges, the lenders in these states are usually operating illegally. [13]

Category two: The small loan laws of eight states permit payday lenders to operate and charge any interest rate or fees which the parties to the loan agree to pay.  The lenders in these states must comply with other provisions of the state’s small loan act. [14]  

Category three: Twenty-three states and the District of Columbia have passed statutes specifically authorizing payday lending. [15]   Generally, these laws require either licensing or registration.  Some mandate that the lenders put up a bond and/or maintain a certain level of net assets or worth.  They typically specify a maximum term and maximum amount of the loan and fix the interest rate or fees to be charged.  While these fees seem small in the abstract, they translate into enormous annual percentage rates.  For example, North Carolina permits a 15% charge on a maximum loan amount of $300.  This means that the consumer will receive $255 in cash and the lender will pocket a $45 fee.  If a $300 loan at this rate is repaid in two weeks, the APR is about 458%! 

Where payday loans are authorized in category three states, many obligate the lender to provide a written agreement to the consumer.  About half of these states prohibit rollovers, i.e., the refinancing or repaying of one such loan with another, at which time the consumer incurs another round of charges.  Others set a maximum number of such loans that a consumer may have outstanding at any one time.  Additionally, most states create some type of criminal or administrative penalties.  However, only seven states provide for some type of limited private right of action allowing the consumer to obtain relief against the lender.  Only a small number prohibit the lender from threatening to file or filing criminal charges against a consumer as a mechanism to collect on the debt.  Finally, these payday loan laws apply only to check cashers in seven of the nineteen states.

In addition, several states expressly prohibit check cashers from accepting post-dated checks, making loans, or failing to immediately deposit the check for payment. [16]    

IV.  Legislative Strategies: A Menu of Options to More Effectively Regulate Payday Lenders

A.  Ban Payday Loans Outright

No matter what category the states falls into regarding regulation, advocates can push to prohibit the making of loans based on personal checks.  The use of personal checks is desirable by the industry for a variety of reasons: 1) collection costs are reduced or eliminated because the presentment of the check at a bank makes payment of the debt quick and easy for the lender; 2) lenders threaten to use the criminal process to collect on checks which scares consumers into repaying these debts more readily than others (such threats cannot be made by lenders regarding loans not involving use of a check as a payment device); 3) lenders use the criminal process when a check is returned for insufficient funds which provides the lender with much greater leverage than it would otherwise have over the consumer; 4) some lenders treat the check as security for the loan for bankruptcy and other purposes which may create a payment priority.

In Georgia, advocates attempted to amend the Georgia Code relating to deposit account fraud by inserting the following provision: It shall be unlawful for any person as part of a single transaction to accept one or more checks, drafts, or orders drawn upon any financial institution as collateral for a loan of any value less than the face value of the instrument when the drawer or maker of such checks, drafts, or orders is required to leave such check, draft, or order on deposit and repay the sum advanced within a period exceeding 24 hours.  Any person who violates this code section shall be punished by a fine of not more than $5,000 or by imprisonment for not less than one year nor more than five years, or both. While this effort was unsuccessful, the proposed legislation provides a good example for advocates in other states.

B.  Education and Investigation in Category One States

Because there exists strong regulation and a reasonable interest rate and fee caps in twenty-two states, advocates may wish to educate the public and press about the exorbitant costs associated with these loans, become aware of any lenders who may be operating illegally and report them to the appropriate enforcement agency,  and be on guard for any bills which the industry may introduce to exempt themselves from the reach of small loan laws.  If the industry initiates legislation, then the advocates can counter with the model act described below.  

C.  Re-impose Interest and Fee Caps in Category Two States.

In addition to appropriate education and investigation, advocates may wish to  press the legislature to close the loopholes that permit exorbitantly priced payday loans in these twelve states.  This can be done by recommending that an interest rate and fee cap be re-imposed under the state small loan law either for all loans to which the act is applicable or for only those loans for which abuse may be rampant, i.e. payday loans.  However, if the industry pushes an agenda, advocates can then counter with the model act.

D.  Push to Improve the Payday Loan Acts in Category Three States

None of the states which have passed laws specifically tailored to payday or other “micro” loans provide sufficient protections against the most egregious abuses created by this business.  The model act discussed below is designed to reduce or eliminate the most serious problems while allowing the industry to operate in a reasonably profitable but more responsible way.  

V.  Description of the Model Deferred Deposit Loan Act

The most outrageous abuses that the act intends to reduce or eliminate include the charging of exorbitant fees, the rolling over or refinancing of one payday loan with another, and the use or threatened use of the criminal courts to collect on these loans.  In addition, tightly regulating the industry is important to prevent it from evading the consumer protection provisions contained in the model act.  The creation of a licensing and regulatory scheme is, therefore, included in the act.  Finally, the act provides for a private right of action so consumers can obtain realistic remedies when the law is violated.  

What follows is a section by section discussion of the act.  

A.  Section 1A: Purpose

This section sets the stage for the remainder of the act by clearly announcing that the legislature intends that: the act must be liberally construed to effectuate its purpose; it enunciates a specific purpose; and it is a consumer protection law.  These directives will give flesh to the act and guidance to the courts when its provisions are applied and interpreted.

B.  Section 1: Definitions

Only six terms are defined but they are critical.  A “deferred deposit loan” [17] includes a loan involving two types of checks: one that is dated on the date written but which is held until a date in the future (the date that payment on the loan is due) when it is to be deposited; and the other that is dated for a date in the future at which time payment is due and it is deposited to cover the debt.  Some state payday loan laws only apply to transactions involving post-dated or presently dated checks, e.g. South Carolina and Wyoming.  This act provides the broadest coverage.  The use of the word “loan” is important because the industry tries to characterize these transactions as “services” and the fees involved as “service fees” to attempt to circumvent state small loan laws and the federal Truth-In-Lending Act. A “licensee” includes not only those “persons” who make these types of loans but also banks and other financial institutions who need not obtain a license under this act but whose actions are, nevertheless, regulated under most of the provisions of the act. [18]

A    “person” refers to the lender and includes natural persons and business or other entities or any facilitator (discussed below in Section 2). A “consumer” includes any natural person who enters into a deferred deposit loan. The “Commissioner” is the head of the agency charged with the responsibility of enforcing the act.   A “check” is defined as a negotiable instrument as defined in Article 3 of the Uniform Commercial Code which is drawn on a bank and is to be payable on demand at maturity of the deferred deposit loan.  

C.  Section 2: Applicability

In addition to the lenders themselves, the act reaches those who facilitate, enable, or act as a conduit for another person who is or may be exempt from licensing but who makes deferred deposit loans.  The purpose of expanding coverage to include such persons is to require those who act as conduits for entities, such as banks, other financial institutions, or finance companies, to be licensed and make sure that the true lender follows the law. 

An example of the problem this subsection is designed to address is the following: out-of-state bank in a state where there is little or no regulation of these loans arranges with in-state check cashing company or retail store to make these loans.  The loan is in the name of the out-of-state bank and the bank uses the local place of business as the conduit.  The bank can legally charge whatever it wishes under the law of its home state due to what is known as the “exportation doctrine” that exists under federal law. [19]  

However, this act mandates that the local conduit be licensed and ensure that the out-of-state lender complies with local law.  This provision should reduce the incidence of out-of-state businesses exporting their lack of interest rate and fees cap and other protections of its home state to this state.  

D.  Section 3: Exemptions

Most state payday acts exempt certain retail sellers who only incidentally cash checks as well as certain financial institutions.  This section tracks those exemptions with the exception that banks and other financial institutions need not obtain a license but must otherwise comply with this act where applicable.  

E.  Section 4: Licensing

The act puts the burden on the Commissioner to make certain findings following a public hearing before issuing a license.  The most critical findings are those that relate to whether the applicant has ever been convicted of a crime, has unencumbered assets of at least $25,000 per location, and has ever threatened or used the criminal process to collect the payment of a deferred deposit loan.  The public hearing is crucial as it gives the community the opportunity to provide relevant information regarding the necessity of such businesses in its neighborhood.  Licensees must renew annually.

This section also mandates that the applicant post a bond in the amount of $50,000 per location which must be available to pay damages and penalties to consumers harmed by any violations of the act.  In tandem with the asset requirement, the bond provides a source of compensation to harmed consumers.  Without these protections, these businesses could sell, transfer, or skim off their assets and leave nothing from which a consumer could satisfy a judgment obtained due to the illegal acts of the company.

Other important provisions include the powers given to the Commissioner to establish a complaint process for consumers, to revoke or suspend a license under certain circumstances, and to promulgate regulations to carry out the provisions of the act.

Finally, the public is also given the right to review the list of licensees and to have access to complaints that have been f and the resulting decision of the Commissioner.  

F.  Section 5: Information and Annual Reports

Licensees are mandated to keep certain books and accounts which can be examined by the Commissioner at any reasonable time.  In addition, licensees must file an annual report in which they must list, among other things, the number of deferred deposit loans, the volume of loans in dollars, the average APRs on the loans, and other important information which will compiled by the Commissioner and made available to the public, the governor, and the legislature.  This information is critical in gauging the growth of the industry and in determining if the act serves the purposes for which it is intended. 

Critically, this section also requires licensees to verify that they have not used the criminal process or caused the criminal process to be used in the collection of any deferred deposit loans during the prior calendar year.  This is one of the most egregious abuses in the industry.  By adding this provision and others throughout the act aimed at the same abuse, it is  hoped that this practice will be severely curtailed.

Finally, each licensee must file a copy of the loan documents and fee schedules with the Commissioner.  In this way, the Commissioner can evaluate compliance with Sections 6, 7, and 8.  

G.  Sections 6: Required Acts

The teeth of the consumer protections in the act appear in Sections 6-10.  This particular section obligates licensees to provide that the term of the loan be no less than two weeks per $50.  This allows consumers a better chance of paying off the loan rather than defaulting and possibly facing criminal charges or renewing at exorbitant rates.  Also, the section sets the maximum amount of the loan at $300 and the minimum at $50.  This is fairly typical of other state payday loan laws.

What is not common is a provision in this Section which requires the licensee to immediately stamp the back of a check taken from the consumer in the course of a deferred deposit transaction with an endorsement that states fundamental information for two different audiences: first, it is to state that the check is being negotiated as part of a deferred deposit loan.  This lets the courts and prosecuting attorneys know that this check cannot be the subject of a criminal prosecution since this is prohibited under Section 9.  Second, the endorsement states that any holder of the check takes it subject to all claims and defenses of the maker.  In other words, if the check is sold to an assignee, the consumer can still raise claims and defenses it had with the original lender against any subsequent holder. This provision is similar to the Federal Trade Commission rule which limits the holder in due course rule in credit transactions involving the sale of goods.   

H.  Section 7: Required Disclosures

This section describes the disclosures which must be given to consumers prior to entering into a deferred deposit loan.  These include:

1) an informational pamphlet notifying the consumers of their rights in both English and Spanish and how to contact the Commissioner to investigate a lender or to file a complaint;

2) a written agreement, in English and in the language in which the loan was negotiated,  informing the consumer about the terms of the loan, including an itemization of the fees and charges to be paid, Truth-In-Lending disclosures, a clear description of the consumer’s repayment obligations, and a bolder statement informing the consumer that he or she cannot be criminally prosecuted if the check does not clear the bank;

3) posted notices in various languages informing consumers that the licensee cannot use criminal process against them to collect the debt and a schedule of interest and fees to be charged.