House Committee Agrees on JOBS Act 3.0

On July 16, 2018, Republican and Democratic leadership of the House Financial Services Committee announced that they have reached agreement to advance a package of financial services reforms known as the “JOBS Act 3.0,” consisting of 32 pieces of legislation that have passed the Committee or the full House with bipartisan support.

While much of the package is focused on capital markets regulation, several of the component bills relate to prudential or consumer financial services matters.

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FSB Develops Framework for Monitoring Crypto Risks

On July 16, 2018, the Financial Stability Board (“FSB”) issued a report to the G20 Ministers of Finance and Central Bank Governors summarizing the work that the FSB and other international standard-setting bodies have undertaken regarding crypto-assets.  The FSB notably reported that it has developed a framework for monitoring financial stability risks related to crypto-assets, including proposed metrics based largely on public sources.  The FSB also acknowledged that crypto-assets and crypto-asset platforms do not pose a material risk to global financial stability at this time.

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Hiring of Administrative Law Judges to Change

A recent United States Supreme Court case and new executive order will change the way federal agencies hire administrative law judges (“ALJs”), and together are expected to increase ALJs’ accountability to the heads of their agencies. On June 21, 2018, the United States Supreme Court held in Lucia v. Securities and Exchange Commission that the SEC’s administrative law judges (ALJs) are “Officers of the United States” who must be appointed, pursuant to the Constitution’s Appointments Clause, by the President, courts of law or a head of a department. The SEC’s staff members (rather than the Commission) had been appointing the agency’s ALJs, which the Court held does not satisfy the constitutional requirement.

The case started when the SEC instituted an administrative proceeding against petitioner Lucia. The ALJ who heard the case determined that Lucia had violated the Investment Advisers Act. On appeal to the SEC, Lucia argued that the ALJ deciding his matter had not been properly appointed, but the SEC rejected the argument, as did the D.C. Circuit.

Lucia filed a petition for certiorari before the Supreme Court. Up until then, the U.S. government had defended the SEC’s position, but in filing its response to Lucia’s petition, the government switched its position and encouraged the Supreme Court to grant review. The Supreme Court therefore appointed an amicus curiae to defend the SEC’s position. As a result of its decision, the Supreme Court decided that Mr. Lucia was entitled to a new hearing, before a different ALJ. The case left open the question of how its ruling affects other administrative judges at other agencies.

Following the Supreme Court’s decision, on July 10, 2018, President Trump issued an executive order that changes the process by which federal agencies select ALJs, which has typically involved the Office of Personnel Management (“OPM”) screening ALJs based on fixed criteria, including performance on a civil service exam, and hiring ALJs within the competitive service. Under President Trump’s order, federal agencies will make their own hiring decisions and not use the OPM screening process, and will appoint ALJs under the excepted service. An OPM memorandum issued with the executive order clarifies that the order applies only to new appointments beginning July 10, 2018, and incumbent ALJs will remain in the competitive service so long as they remain in their current positions.

Vice Chairman Quarles Re-Affirms the Fed’s Commitment to International Cooperation

In a little noticed, but important, speech, the Federal Reserve’s Vice Chairman for Supervision, Randal K. Quarles, reaffirmed late last month that the Fed remains committed to continued collaboration with international financial regulators.

International cooperation through, for example, the Basel Committee and the Financial Stability Board (FSB), has been a key pillar of post-financial crisis prudential regulation.  The value of such cooperation was vocally and strongly defended by former Fed Governor Daniel K. Tarullo, who served as the Fed’s previous point person on regulatory matters.

Shortly before Governor Tarullo announced his resignation in February of last year, however, the Fed’s track record of international cooperation became a target of Congressional criticism.  The Vice Chairman of the House Financial Services Committee, Patrick McHenry (R-NC), wrote a letter to the Fed stating that its participation in “international forums on financial regulation” was “unacceptable” and inconsistent with “the clear message delivered by President Donald Trump [on] prioritizing America’s interest[s].”

While Fed Chairman Yellen publicly rejected the premise of Representative McHenry’s letter, the letter nevertheless led to speculation that the Fed, under new Trump administration appointees, might in the coming years reduce its engagement with international fora.

Vice Chairman Quarles’ speech is thus notable as a robust rejection of the view that U.S. interests would benefit from the Fed turning away from its international partners.

Speaking before a group of leaders from mostly smaller banks at the Utah Bankers Association 110th Annual Convention, Vice Chairman Quarles emphasized that “America’s active participation in the FSB is important to our nation.”  Vice Chairman Quarles pointed to several examples of how even small banks benefitted from the Fed’s participation in the FSB, which Quarles described as serving in part as a forum for ensuring that other countries adopt similar high regulatory standards to the U.S.

Vice Chairman Quarles’ speech, which was in the tradition of earlier pro-cooperation speeches by Governor Tarullo, should calm any lingering concerns that the Fed’s new leaders — Chairman Jerome Powell and Vice Chairman Quarles — intend to take a fundamentally different approach to participation in international cooperative bodies from the approach the Fed adopted in the first decade after the financial crisis.

Square Temporarily Withdraws ILC Application

On July 5, 2018, Square, Inc. (“Square”) announced (paywall) that it had temporarily withdrawn a pending application with the FDIC to obtain deposit insurance for a proposed industrial loan company (“ILC”), in order to strengthen the application before reapplying. The company stated that a parallel application with the Utah Department of Financial Institutions for the ILC charter is still pending.

Although obtaining a federal regulator’s approval on a major bank application is nearly always an iterative process by nature, the announcement is noteworthy in that it comes at a time when numerous fintechs are weighing whether to seek bank charters – and if so, what kind – and at a time when state and federal banking regulators are still exploring the scope of their relationships with the rapidly growing fintech sector.

Student loan servicer Nelnet has an active application to charter an ILC, and either of these companies, if approved, would be the first fintech company to obtain an ILC charter.

At the same time, industry participants have expressed interest in a proposal by the Office of the Comptroller of the Currency (“OCC”) to approve fintechs for a special purpose national bank charter. The OCC is expected to make an announcement regarding the future of that proposal soon. Varo Money submitted an application to charter a full-service national bank in July 2017. The application remains pending. Accordingly, a fintech has yet to obtain a national bank charter.

The answer to whether a fintech company will succeed in chartering an ILC or a national bank may set off a domino effect in the industry, as an approval would create a template for other companies to follow and eliminate a set of associated “first-mover” costs.

As a result, developments in efforts by companies like Square may provide valuable insight for how the FDIC will, in the future, assess fintech applications related to chartering an ILC and certain fintech applications related to chartering a national bank.

Fifth Circuit to Consider Constitutionality of the BCFP’s Structure

On July 2, 2018, All American Check Cashing, Inc., Mid-State Finance, Inc., and the president and owner of both companies (collectively, “All American”) filed a brief asking the U.S. Court of Appeals for the Fifth Circuit to find the Bureau of Consumer Financial Protection (“BCFP” or the “Bureau”) (formerly known as the CFPB) unconstitutionally structured and to strike down the Consumer Financial Protection Act (“CFPA”), which created the agency, in its entirety.

The appeal follows a 2016 complaint filed by the Bureau in the U.S. District Court for the Southern District of Mississippi against the two check cashing and payday loan companies and their principal for alleged unfair, deceptive, and abusive acts and practices. In that case, All American moved for a judgment on the pleadings on the basis that the BCFP is unconstitutionally structured as an independent agency with a single head whom the president can remove only “for cause.”

In March 2018, the district court denied the motion by adopting the reasoning of the U.S. Court of Appeals for the D.C. Circuit’s recent en banc majority decision upholding the Bureau’s structure in PHH Corp, et al. v. Consumer Financial Protection Bureau. (Our coverage of the PHH decision is available here.) All American moved to appeal the denial of the motion.

Since then, the only federal court to reach the issue of the BCFP’s structure – the U.S. District Court for the Southern District of New York (“S.D.N.Y.”) – ruled against the Bureau, adopting portions of the PHH dissents written by D.C. Circuit judges Karen Henderson and Brett Kavanaugh. Notably, the recent S.D.N.Y. decision went further than the PHH dissents and ruled that the CFPA’s defect could not be remedied merely by invalidating its for-cause removal provision. Rather, the entire CFPA, which is Title X of the Dodd-Frank Act, would have to be struck in its entirety. (More of our coverage on the S.D.N.Y. decision is available here.) Accordingly, All American’s brief to the Fifth Circuit argues for ruling against the Bureau and for striking down the agency’s organic statute entirely.

The Fifth Circuit appeal is particularly noteworthy given that the circuit is considered to be generally more skeptical of the administrative state than the D.C. Circuit. A decision in line with the S.D.N.Y. opinion, or even a more modest decision in line with the PHH dissents, would create a circuit split, greatly heightening the likelihood of the issue of the Bureau’s constitutionality reaching the U.S. Supreme Court. The case is also a timely reminder that Judge Kavanaugh, if confirmed to the Supreme Court, would be a strong voice for the unconstitutionality of the current Bureau structure. If his view as expressed in PHH were to ultimately prevail, the Bureau Director would be subject to termination by the President without cause.

Federal District Court Judge Declares Bureau Unconstitutional

On June 21, 2018, U.S. District Judge Loretta A. Preska (S.D.N.Y.) ruled that the structure of the Bureau of Consumer Financial Protection (the “Bureau”) was unconstitutional and, therefore, the Bureau lacked authority to bring claims under the Consumer Financial Protection Act (“CFPA”). The ruling rejected the D.C. Circuit’s en banc opinion in PHH that upheld the Bureau’s constitutionality. If the decision is appealed to the Second Circuit and affirmed in whole or in part on the constitutional issue, it could create a circuit split that paves the way for the Supreme Court to rule on the constitutionality of the Bureau.

In rejecting the PHH en banc opinion, Judge Preska adopted portions of Judge Kavanaugh’s dissent, which concluded that the Bureau “is unconstitutionally structured because it is an independent agency that exercises substantial executive power and is headed by a single Director,” and because the single director is protected by the CFPA’s for-cause removal provision. But Judge Preska’s ruling went further than this dissent—which would have invalidated only the for-cause removal provision in the CFPA—and held that, because the for-cause removal provision “is at the heart” of Title X of the Dodd-Frank Act, Title X should be struck in its entirety. In reaching this conclusion, Judge Preska adopted a portion of Judge Henderson’s dissent in PHH, which concluded that the presumption of severability was rebutted and did not apply. As a result of this reasoning, Judge Preska found that the Bureau “lack[ed] authority to bring this enforcement action because its composition violates the Constitution’s separation of powers,” and dismissed the Bureau from the action and the Bureau’s claims.

Although the Bureau is no longer a party to the lawsuit, the case will continue. The Bureau had joined with the N.Y. attorney general to bring this action for alleged scams by RD Legal and related entities that targeted NFL concussion victims and 9/11 first responders. Judge Preska denied the defendants’ motion to dismiss on the grounds that the N.Y. attorney general had independent authority to bring claims under the CFPA and New York law.

HUD to Reconsider Disparate Impact Rule

On June 20, 2018, the Department of Housing and Urban Development (“HUD”) published an advance notice of proposed rulemaking (“ANPR”) seeking comment on proposed changes to HUD’s 2013 regulations concerning the Fair Housing Act’s “Disparate Impact Rule” (the “Rule”).  The changes are primarily intended to ensure the Rule is consistent with the U.S. Supreme Court’s 2015 decision in Texas Department of Housing and Community Affairs v. Inclusive Communities Project, Inc.  The proposed rulemaking is also driven in part by the Department of the Treasury’s recommendation in 2017 for HUD to reconsider application of the Rule as it relates to the insurance industry.

The Fair Housing Act (42 U.S.C. § 3601) prohibits discrimination on the basis of race, color, religion, sex, disability, familial status, or the presence of children when individuals are renting, buying, or securing financing for any housing.  In 2013, following a notice and comment period, HUD published the Disparate Impact Rule (24 C.F.R. § 100.500), which creates liability for covered entities based on whether their business practices have a discriminatory effect, even if those practices were not motivated by discriminatory intent.

HUD supplemented the Rule in 2016 with responses to insurance industry requests for categorical exemptions or safe harbors from liability for insurance practices.  In its supplement, HUD determined that such exemptions for insurers were “unworkable and inconsistent,” and that application of the Rule to insurance practices should be addressed on a case-by-case basis.

HUD’s request for comment earlier this week follows the Supreme Court’s 2015 decision in Inclusive Communities.  Although the Supreme Court’s ruling – that disparate impact claims were cognizable under the Fair Housing Act – did not rely on the Rule, HUD opted to review and evaluate potential changes to the Rule to better align it with the Court’s decision.

HUD is also seeking comment in response to the Department of Treasury’s 2017 recommendation that it reconsider the use of the Rule.  Specifically, Treasury requested that HUD examine whether the Rule would have a “disruptive effect on the availability of homeowners insurance and whether the rule is reconcilable with actuarially sound principles.”

In addition to seeking comments on “appropriate changes” to the Rule, HUD identified questions it is particularly interested in addressing, including:

  • Whether the Rule should clarify the requirements for “stating a prima facie case under Inclusive Communities” and other rulings;
  • Whether the Rule should provide defenses or safe harbors to claims of disparate impact liability “(such as, for example, when another federal statute substantially limits a defendant’s discretion or another federal statute requires adherence to state statutes)”; and
  • If there are revisions to the Rule that could reduce uncertainty, decrease regulatory burden, or assist the public in determining what is lawful.

Public comments on the Rule are due no later than August 20, 2018.

Judge Denies Request to Stay Payday Rule Compliance Date

On June 12, 2018, a federal judge in the Western District of Texas denied a joint motion by the Bureau of Consumer Financial Protection (“Bureau”), the Community Financial Services Association of America, Ltd. (“Community Financial Services Association”) and the Consumer Alliance of Texas (“Consumer Alliance”), to stay the compliance date of the substantive provisions of the Bureau’s payday lending rule (“Payday Rule”), which is August 19, 2019, for most provisions. The Community Financial Services Association and Consumer Alliance are suing the Bureau over the Payday Rule, alleging, among other things, that the Bureau’s rulemaking process was fatally flawed and that the rule constituted agency overreach. The court did grant a simultaneous joint motion to stay the litigation itself pending completion of the rulemaking process.

The Bureau and the plaintiffs had argued that a stay of both the litigation and the rule’s compliance date were necessary because of the Bureau’s January announcement that it intends to reconsider the Payday Rule. The litigation should be stayed, they argued, because the reconsideration of the Payday Rule could render the case moot or require amending the complaint. In addition, they asked the court to stay the compliance date to “prevent irreparable injury” to affected companies that would have “no way to know whether Plaintiffs’ members will ultimately need to comply with the Payday Rule, a modified payday rule, or no rule at all.” In the absence of a stay, the parties agreed, lenders would have to begin costly preparations well before the Bureau might take action to significantly change or repeal the rule. Several consumer advocacy groups objected to the Bureau’s joining the motion, and filed an amicus brief with the court opposing the joint motion. Ultimately, the judge agreed to stay the litigation, but not the rule’s compliance date. With the decision, the Bureau may have to find another way to provide the industry with relief from the costs of preparing for a rule that may be changed. In its Spring 2018 rulemaking agenda, the Bureau targeted February 2019 for proposing a modified rule.

German Federal Financial Supervisory Authority Publishes Guidance on the Regulatory Framework for Cloud Services

The German Federal Financial Supervisory Authority (“BaFin”) recently published an article that provides guidance on the regulatory framework for cloud computing.  This is a follow-up to the circular letter Minimum Requirements for Risk Management (“MaRisk”), which was published in German in October 2017 and the circular letter Supervisory Requirements for IT in Financial Institutions (“BAIT”), which was published in German in November 2017, with its English version released recently.

BaFin outlines the regulatory framework for cloud computing in this article.  In particular, BaFin makes clear that supervised entities must refer to BAIT for general guidance.  Furthermore, it is stated that the requirements of section AT 9 MaRisk also apply if the cloud service is a material outsourcing (“wesentliche Auslagerung”) in the meaning of section AT 9 MaRisk.  If this is the case, the cloud service is required to be evaluated on a case-by case basis.  If the cloud service constitutes a material outsourcing, supervised entities must comply with the supervisory requirements for outsourcing pursuant to Section 25b of the German Banking Act and the more specific requirements of section AT 9 MaRisk.

BAIT requires supervised entities to perform a risk assessment prior to the procurement of cloud services.  Supervised entities are afforded flexibility in defining the nature and the scope of a risk assessment, and the results of the risk assessment must be taken into account in developing contractual arrangements between supervised entities and their cloud service providers.

If the procurement of cloud services constitutes a material outsourcing, BaFin makes clear that supervised entities, such as financial institutions and insurance companies, must ensure they have unrestricted information rights and audit rights with their cloud service providers.  These rights include the rights of access to the business premises, data centers, servers, and employees of the cloud service provider.  Such unrestricted rights must also be granted to BaFin via the outsourcing contract between the supervised entity and its cloud service provider, as a way to make sure BaFin would have the ability to monitor the outsourced cloud computing activities and processes.  BaFin also indicates that it plans to release more detailed guidance on the issue of cloud computing over the course of this year.

BaFin requires supervised entities to incorporate the information rights as well as the audit rights maintained by BaFin and the supervised entity into the contractual agreements between the supervised entities and cloud service providers.  BaFin would be granted the same level of rights, which would allow BaFin to monitor the outsourced services, including the option to perform on-site inspection.  BaFin emphasizes that such rights of information and audit must be unrestricted: phased information and audit procedures would constitute a restriction and would not be compliant with relevant regulatory requirements.  The audit right should also not be dependent on the concept of commercial reasonableness.

BaFin plans to publish special guidance that will provide market participants with greater details regarding the supervisory requirements related to the use of cloud services.  It will also publish a circular specifying the supervisory requirements for insurance companies and pension funds in the coming months.