State preemption

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In any federal system of law, preemption refers generally to the displacement of a lower jurisdiction's laws when they conflict with those of a higher jurisdiction.

  • Federal preemption, displacement of U.S. state law by U.S. Federal law
  • Federal preemption, displacement in the European Union of national law by the Law of the European Union
  • "Preemption" is also sometimes used in the United States to refer to the displacing effect state laws might have on ordinances enacted by municipalities, especially in the context of alcoholic beverage laws and gun laws

Contents

Dodd-Fank and preemption

The Dodd-Frank Act changes some of the rules, particularly in the procedural area, regarding preemption. Below are some frequently asked questions about these changes.

Did the Dodd-Frank Act eliminate preemption?

No. Federal law will still preempt a conflicting state law for national banks and federal thrifts.

Did Congress change the standard for when there will be a conflict?

No. Both before and after the Dodd-Frank Act takes effect, a state law will be preempted if it “prevents or significantly interferes” with the exercise of a national bank’s (or federal thrift’s) powers. That standard is a short-hand description for several tests used by the U.S. Supreme Court to determine when a state law will conflict with federal law. Congress said that those tests will continue to apply going forward.

What will change as a result of the Dodd-Frank Act?

The biggest change will be to the OCC’s process for deciding when a state law is preempted. Starting next July 21, preemption determinations by the OCC will have to be made on a case-by-case basis. That means the OCC will have to review a particular state law and make a determination based on whether that law conflicts with a federal power. Another significant change is that preemption will no longer apply to subsidiaries or agents of national banks or federal thrifts. Thus, subsidiaries and agents of national banks and federal thrifts will have to comply with applicable state laws.

Will the case-by-case determinations apply to similar laws in other states?

Yes, unless the OCC says otherwise. The statute defines “case-by-case basis” to refer to a determination regarding a law of a particular state and laws of any other state that have “substantively equivalent terms.”

What will happen to the OCC’s existing preemption regulations?

That’s not yet clear. However, those regulations were based on standards for preemption that will continue to apply. Thus it seems reasonable that a court would find a state law that is preempted under the existing regulations to be preempted even if there were no regulations.

What should a bank do if it believes that a state or local law is (or should be) preempted? Can it raise the defense on its own or in court, or does it need to seek an opinion from the OCC?

A bank does not need to get an opinion from the OCC. While an OCC opinion certainly is helpful, courts have the final say about whether a state law is preempted.

Conference Report rolls back federal preemption

If passed by the Senate and signed by the President, the revised Conference Report would become the Dodd-Frank Wall Street Reform and Consumer Protection Act. This alert focuses specifically on the effects of the Conference Report on federal preemption of state law, and provides an update to the alert that we published on May 10, 2010.

The Conference Report rolls back the preemption protection currently enjoyed by national banks and federal savings associations by:

  • Requiring that a state consumer financial law prevent or significantly interfere with the exercise of a national bank's powers before it can be preempted;
  • Mandating that any preemption determination be made on a case-by-case basis, rather than by a blanket rule;
  • Ending the applicability of preemption to subsidiaries and affiliates of national banks, which could force banks to reevaluate the activities they conduct through subsidiaries or risk their becoming subject to state lending and licensing laws;
  • Expressly subjecting federal savings associations to the same preemption standards applicable to national banks;
  • Clarifying that state attorneys general (or other chief law enforcement officers) may enforce applicable state law not related to visitorial powers (i.e., the power to conduct examinations, inspect records, etc.) against a national bank or federal savings association or seek relief and recover damages for a violation of any such law by a national bank or federal savings association; and
  • Clarifying that state attorneys general may bring civil actions in the name of a state against a national bank or federal savings association to enforce a "Bureau of Consumer Financial Protection" ("CFPB") regulation, provided that such attorneys general consult with the Office of the Comptroller of the Currency ("OCC") or the Office of Thrift Supervision ("OTS"), as applicable, prior to bringing such actions.

This erosion of the OCC's preemptive authority will significantly affect the industry's ability to rely on a long history of OCC orders and court cases interpreting this issue, and is sure to engender much confusion and litigation for many years ahead. Such erosion may also make state chartered financial institutions more viable as compared with national banks and federal savings associations.

To view the final Conference Report, as adopted by the Conference Committee, click here.

A. Background

In recent years, actions by the OCC and the OTS, the regulatory agencies that primarily regulate national banks and federal savings associations, respectively, reduced the applicability and enforceability of state consumer protection laws. The OCC, in particular, has expanded directly the preemptive powers of national banks under the National Bank Act to a similar extent as those granted to federal savings associations under the Home Owners' Loan Act ("HOLA"). The HOLA has traditionally been viewed as granting broader preemptive powers to federal savings associations than are granted to national banks under the National Bank Act, because section 5(a) of HOLA has been viewed as granting "field preemption" to federal savings associations whereas there is no similar provision in the National Bank Act.1

The expansion of preemptive powers of national banks has been supported by both Congress and the Supreme Court. The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 ("Riegle-Neal") permitted national banks to branch across state lines. In 1996, in Barnett Bank of Marion County, N.A. v. Nelson, Florida Insurance Commissioner,2 the Supreme Court ruled that a 1916 federal law preempted a state insurance law which prohibited national banks from selling insurance in certain small towns in Florida. The Court found that the state insurance law significantly interfered with a national bank's exercise of its powers and was therefore preempted. The OCC interpreted Barnett to require that consumer protection statutes be preempted on a case-by-case basis and to mean that the Supreme Court had adopted conflict preemption as the appropriate standard for preemption questions involving national bank laws. The OCC regarded Barnett as specifically setting forth certain tests that would make it easier for the OCC to persuade courts to preempt state law. Under Barnett, in order to preempt a state consumer protection statute, the OCC must show that the state law "prevents or significantly interferes" with a national bank's exercise of its powers.

The Barnett standard, along with the OCC's interpretation, became the basis for the expansion of federal preemption of state law applicable to national banks for over a decade. In 2004, the OCC justified the promulgation of preemption regulations (the "Preemption Rule")3 which preempted all state laws that obstructed or impaired the ability of a national bank to fully exercise its federally granted powers, by arguing that it was simply a distillation of the conflict preemption standards which were articulated by the Supreme Court in Barnett as well as other cases. The Preemption Rule sets forth a list of specific types of state laws which the OCC asserted were preempted by federal law, such as state laws concerning licensing, credit terms and loan disclosures, regardless of whether such state laws "significantly interfered" with the exercise of a national bank's exercise of its powers. In conjunction with the Preemption Rule, the OCC also issued a Visitorial Rights Rule, which asserted that only the OCC has the power to exercise visitorial powers (i.e., to conduct examinations, inspect records, etc.) upon national banks.

The OCC's broad expansion of a national bank's preemptive powers over state law was then ratified by the Supreme Court in 2007 in Watters v. Wachovia Bank, N.A.,4 in which the Court held that subsidiaries of national banks were entitled to the same preemptive powers as national banks themselves. Even prior to the Watters decision, the OCC had interpreted its laws to provide the same federal preemption to operating subsidiaries of national banks as the parent banks themselves. Watters effectively signaled the complete preemption of state consumer protection laws for national banks and their subsidiaries. The Wachovia decision, in combination with the Barnett decision and the Preemption Rule, marked the apex of federal preemption of state law in the banking industry.

B. The Conference Report

Critics of federal preemption have asserted that the preemption of state consumer protection laws by federal banking laws and regulations contributed significantly to the financial crisis. Critics alleged that while national banks preempted state and local laws, there was no equivalent federal regulation to take its place in many instances. Further, by removing consumer protection from the jurisdiction of state regulators, critics alleged that state regulators were helpless to oversee and regulate the types of predatory and abusive practices that were prevalent in the mortgage industry, which were overlooked by the industry friendly federal agencies. As a result, both H.R. 4173 and the Senate Bill created a new federal consumer protection regulator and sought to limit federal preemption by statute. Accordingly, the Conference Report contains provisions which would significantly erode the powers of both national banks and federal savings associations to preempt state law in specific areas.

1. Restoration of the Barnett Standard

The Conference Report significantly rolls back the broad preemptive authority that the OCC has claimed under its Preemption Rule and restores the Barnett standard by requiring that (1) a state consumer financial law "prevent or significantly interfere with" the exercise of a national bank's powers before it can be preempted and (2) any preemption determination be made on a case-by-case basis, rather than by a blanket rule. In doing so, the Conference Report effectively stops in its tracks and reverses the steady expansion of federal preemption which had been ongoing since the passage of Riegle-Neal and the Barnett decision, and which ultimately culminated with the Watters decision. In particular, Section 1044 of the Conference Report adds a new section to the National Bank Act and provides that state "consumer financial laws" are preempted only if, among other things,5 a court or the OCC, by regulation or order, makes a determination on a "case-by-case" basis that the state consumer financial law "prevents or significantly interferes with" the exercise of a national bank's powers. Significantly, the Conference Report does not include the "materially impairs" language which was originally included in H.R. 4173. The Conference Report defines the term "case-by-case" to be a determination made by the OCC concerning the impact of a particular state consumer financial law on a national bank that is subject to that law, or the law of any other state with substantively equivalent terms. Further, the Conference Report provides that if the OCC makes a determination that another state's consumer financial law has substantively equivalent terms as the law that the OCC is preempting, the OCC must first consult with the newly proposed-to-be-created CFPB and take the views of the CFPB into account when making the determination.

The Conference Report directs any court that is reviewing any of the OCC's determinations regarding preemption of state law to assess the validity of the determinations by looking at the thoroughness evident in the OCC's consideration, the validity of the OCC's reasoning, consistency with other valid determinations made by the OCC and other factors which the court finds persuasive and relevant to its decision. Significantly, the Conference Report states that no regulation or order of the OCC may be interpreted or applied so as to invalidate, or otherwise declare inapplicable to a national bank, a provision of a state consumer financial law unless there is substantial evidence supporting the specific finding regarding the preemption of such provision in accordance with the legal standard articulated in Barnett. The Conference Report requires the OCC to periodically conduct a review of each such determination of preemption at least once every five years and announce its decision to continue or rescind the determination or a proposal to amend the determination as well as make a report to Congress at that time.

2. Repeal of Watters and Applicability of Preemption to Operating Subsidiaries

The Conference Report effectively reverses the holding in Watters, and provides that subsidiaries and affiliates of national banks (other than a subsidiary or affiliate that is chartered as a national bank) will no longer enjoy the same preemptive rights as national banks. Instead, the Conference Report states that a state consumer financial law will apply to a subsidiary or affiliate of a national bank to the same extent that the law would apply to any person, corporation or other entity under state law. This provision would significantly impair the freedom from state regulations that operating subsidiaries of national banks currently enjoy in making different types of consumer loan products, including residential mortgage loans.

3. Target on Thrifts

With respect to federal savings associations, the Conference Report adds a new section to the HOLA which likewise requires the OTS (and the OCC as its successor agency) and any court to make federal preemption determinations in accordance with the laws and legal standards applicable to national banks regarding the preemption of state law. Further, the Conference Report specifically states that, "[n]otwithstanding the authorities granted under section 4 and 5, [the HOLA] does not occupy the field in any area of State law." (emphasis added). The language is significant because the broad field preemption authority that federal savings associations have enjoyed in the past derives directly from section 5(a) of the HOLA. By doing so, the Conference Report effectively "levels the playing field" between federal savings associations and national banks on the preemption issue so that both are now subject to the Barnett standard. Accordingly, this provision is a "game changer" for thrifts.

4. Visitorial Powers v. Enforcement Authority

The Conference Report codifies the Supreme Court's decision in Cuomo v. Clearing House Association, L.L.C.6 by which the Supreme Court held that, under the National Bank Act, the federal government's exclusive visitorial power over national banks is limited to the right to oversee corporate affairs, such as inspecting books and records, and does not include the exclusive right to enforce the law. The Conference Report specifically clarifies that no provision of the National Bank Act or the HOLA may be construed as limiting or restricting the authority of any attorney general (or other chief law enforcement officer) of any state to bring any action to: (i) enforce any provision of applicable state law; or (ii) on behalf of the residents of such state, to enforce any applicable state law against a national bank or federal savings association or to seek relief and recover damages for a violation of any such law by a national bank or federal savings association. However, with regard to enforcing any CFPB regulation, the Conference Report requires state attorneys general to consult with the OCC or OTS, as applicable, prior to bringing a civil action or, in the case of any emergency action, upon the commencement of such action, to enforce a CFPB regulation.

5. Rate Exportation Not Affected

One area of federal preemption that the Conference Report does not affect, however, is the ability of national banks to charge interest at the rate allowed by the laws of the state where the bank is located, thereby preserving the "most favored lender" doctrine. Under that doctrine, a national bank located in a particular state may charge "interest" at the maximum rate permitted to any state-chartered or licensed lending institution by the law of that state, i.e., the "most favored lender." It is unclear how this may affect the related doctrine of "rate exportation" under which national banks may "export" the interest rate of the state in which they are located to the other states in which the banks operate, thereby providing preemption of the other state's interest and usury statutes as well as other statutes that may be affected by the definition of "interest." This is important because the OCC has aggressively interpreted what is permitted to be exported as "interest" under Section 85 of the National Bank Act,7 allowing the OCC to define "interest" to include not only interest on the loan but a host of other fees such as late charges and non-sufficient funds fees. As a result, if "rate exportation" is permitted to continue, this may undermine the Conference Report's attempt to make state consumer financial laws apply to national banks as this would de facto preempt those state consumer financial laws that apply to such fees.

C. Analysis

Federal preemption of state law is one of the most important consumer protection issues in financial regulatory reform, and the changes made by the Conference Report will significantly affect how national banks, federal savings associations and their subsidiaries and affiliates do business across the country. While federal preemption will still be available to national banks and federal savings associations, their subsidiaries and affiliates may suddenly find themselves subject to a panoply of state consumer financial laws, including state licensing and other requirements, which will require a large scale and costly rethinking of business plans and operations. As a result, banks should consider moving their lending operations out of subsidiaries or risk such operations becoming subject to state lending and licensing laws. Alternatively, such subsidiaries and affiliates may need to consider either obtaining federal charters themselves or becoming divisions of their national bank parents or affiliates in order to continue "business as usual" to the extent that is possible. The Conference Report will also throw into disarray the heretofore settled body of OCC and OTS administrative actions and orders as well as case law that has defined the parameters of preemption for the industry by essentially invalidating these actions, orders and cases which had been the building blocks leading up to the OCC's Preemption Rule and the Watters decision.

With respect to the national banks and federal savings associations themselves, notwithstanding the preservation of federal preemption, the requirement for the OCC, OTS or a court to affirmatively determine that a state law "prevents or significantly interferes" with federal law in order for such state law to be preempted will add another layer of uncertainty and complexity to the ordinary conduct of business, given that the determination process may take months or years to resolve. Preemption will become a piecemeal process and, as a result, choosing not to comply with a potentially applicable state law on the grounds that it is preempted will require banks to assume increased risk or curtail certain activities or practices. Further, once resolved, it is unclear whether the determination of a particular state law would suffice to permit preemption of another state's law, even if those laws have "substantially equivalent terms," a term that is not defined in the Conference Report. It is also unclear how much "substantial evidence" will be needed to be shown by the OCC in order to make a determination of preemption. This is in marked contrast to the current practice, under which national banks and federal savings associations make this preemption determination internally, subject to OCC, OTS or a court review. As a result, national banks and federal savings associations will face an expensive uphill battle in engaging in business nationwide, as they try to navigate the interaction between state law and federal preemption while contending with a dense patchwork of OCC and OTS opinions and orders, new state consumer protection laws and substantial additional litigation.

Although the Conference Report contains a savings clause which grandfathers contracts which are entered into by national banks, federal savings associations and their subsidiaries prior to the effective date of the legislation, any new business will be subject to a long period of uncertainty, as long relied-on precedent is extinguished and new standards forged.

Finally, the erosion of the preemptive authority of the OCC and the OTS may have the affect of making state chartered financial institutions more viable as compared with national banks and federal savings associations.

D. Next Steps

The Conference Report must be passed by the Senate before it can be sent to the President to be signed into law. With announcements by Senators Susan Collins (R-Maine) and Maria Cantwell (D-Wash.) shortly after the June 30 House passage of the Conference Report that they each will support the revised Conference Report, the Senate Democratic Leadership is getting close to securing the votes required to end debate on the Conference Report and pass it.

Because the Conference Report cannot be amended by the Senate when it votes on the final regulatory reform bill, if the Conference Report is passed by the Senate, it will become law in its current form. The Conference Report is currently expected to be considered by the Senate during the week of July 12. However, because the vote of a new Senator from West Virginia will be critical to obtaining the 60 votes required to end debate on the Conference Report and move toward a vote on its passage, the timing for consideration of the Conference Report will depend, in large part, upon when a temporary replacement is appointed to succeed Senator Byrd.

Analysis of federal preemption prior to conference

B. The Senate Approach

1. Roll Back to the Barnett Standard

The Revised Dodd Bill explicitly endorses a return to the Barnett standard. Section 1044 of the Revised Dodd Bill adds a new section to the National Bank Act and provides that state "consumer financial laws" are preempted only if, among other things,7 a court or the OCC, by regulation or order, makes a determination of preemption on a "case-by-case" basis in accordance with the legal standard set forth in Barnett. The Revised Dodd Bill defines the term "case-by-case" to be a determination made by the OCC concerning the impact of a particular state consumer financial law on a national bank that is subject to that law, or the law of any other state with substantively equivalent terms. Further, the Revised Dodd Bill provides that if the OCC makes a determination that another state's consumer financial law has substantively equivalent terms as the law that the OCC is preempting, the OCC must first consult with the newly proposed-to-be-created "Bureau of Consumer Financial Protection" ("CFPB") and take the views of the CFPB into account when making the determination.

The Revised Dodd Bill directs any court that is reviewing any of the OCC's determinations regarding preemption of state law to assess the validity of the determinations by looking at the thoroughness evident in the OCC's consideration, the validity of the OCC's reasoning, consistency with other valid determinations made by the OCC and other factors which the court finds persuasive and relevant to its decision. Significantly, the Revised Dodd Bill states that no regulation or order of the OCC may be interpreted or applied so as to invalidate, or otherwise declare inapplicable to a national bank, a provision of a state consumer financial law unless there is substantial evidence that the state provision prevents, significantly interferes with, or materially impairs the ability of a national bank to engage in the business of banking. Further, the Revised Dodd Bill states that the OCC may not prescribe a regulation or order preempting state law unless the OCC, in consultation with the CFPB, makes a finding that a federal law provides a substantive standard that is applicable to a national bank which regulates the particular conduct, activity or authority that is subject to such provision of the state consumer financial law. The Revised Dodd Bill requires the OCC to periodically conduct a review of each such determination of preemption at least once every five years and announce its decision to continue or rescind the determination or a proposal to amend the determination as well as make a report to Congress at that time.

2. Repeal of Watters and Applicability of Preemption to Operating Subsidiaries

The Revised Dodd Bill effectively reverses the holding in Watters, and provides that subsidiaries and affiliates of national banks will no longer enjoy the same preemptive rights as national banks. Instead, the Revised Dodd Bill states that a state consumer financial law will apply to a subsidiary or affiliate of a national bank to the same extent that the law would apply to any person, corporation or other entity under state law. This provision would significantly impair the freedom from state regulations that operating subsidiaries of national banks current enjoy in making different types of consumer loan products, including residential mortgage loans.

3. Rate Exportation Not Addressed

One area of federal preemption that the Revised Dodd Bill does not affect, however, is the ability of national banks to charge interest at the rate allowed by the laws of the state where the bank is located, thereby preserving the "most favored lender" doctrine. Under that doctrine, a national bank located in a particular state may charge "interest" at the maximum rate permitted to any state-chartered or licensed lending institution by the law of that state, i.e., the "most favored lender." It is unclear how this may affect the related doctrine of "rate exportation" under which national banks may "export" the interest rate of the state in which they are located to the other states in which the banks operate, thereby providing preemption of the other state's interest and usury statutes as well as other statutes that may be affected by the definition of "interest." This is important because the OCC, as well as the OTS, have defined "interest" to include not only interest on the loan, but a host of other fees such as late charges and non-sufficient funds fees. As a result, if "rate exportation" is permitted to continue, this may undermine the Revised Dodd Bill's attempt to make state consumer financial laws apply to national banks as this would de facto preempt those state consumer financial laws that apply to such fees.

4. Target on Thrifts

With respect to federal savings associations, the Revised Dodd Bill adds a new section to the HOLA which likewise requires the OTS (and the OCC as its successor agency) and any court to make federal preemption determinations in accordance with the laws and legal standards applicable to national banks regarding the preemption of state law. Further, the Revised Dodd Bill specifically states that, "[n]otwithstanding the authorities granted under section 4 and 5, [the HOLA] does not occupy the field in any area of State law." (Emphasis added). The language is significant because the broad field preemption authority that federal savings associations have enjoyed in the past derives directly from section 5(a) of the HOLA. Accordingly, this provision is a "game changer" for thrifts, consistent with the overall effect of the Revised Dodd Bill to gradually eliminate the thrift charter.

5. Visitorial Powers v. Enforcement Authority

The Revised Dodd Bill specifically provides that no provision of the National Bank Act or the HOLA may be construed as limiting or restricting the authority of any attorney general (or other chief law enforcement officer) of any state to bring any action to: (i) enforce any provision of federal or state law; or (ii) on behalf of the residents of such state, to enforce any applicable federal or state law against a national bank or federal savings association or to seek relief and recover damages for a violation of any such law by a national bank or federal savings association. However, the Revised Dodd Bill requires attorneys general to consult with the OCC or OTS, as applicable, prior to bringing such actions.

C. The House Approach

H.R. 4173 also contains sweeping reforms with respect to federal preemption for national banks and federal savings associations, but in contrast to the Revised Dodd Bill, does not contain an explicit reference to the Barnett standard. Instead, H.R. 4173 only requires that a state law "significantly" interfere with the business of banking before it may be preempted. This distinction is significant because, as discussed above, the OCC views Barnett as specifically setting forth certain tests that would make it easier for the OCC to persuade courts to preempt state law, which H.R. 4173 does not contain.

Unlike the Revised Dodd Bill, Section 4404 of H.R. 4173 instead provides that "state consumer financial laws" are preempted only if, among other things,8 a court or the OCC, by regulation or order, makes a determination of preemption on a "case-by-case" basis that the state consumer financial law "prevents, significantly interferes with, or materially impairs" the ability of a national bank to engage in the business of banking. The remainder of H.R. 4173's provisions relating to preemption of state laws is largely identical to the Revised Dodd Bill, including: (i) the provisions on periodic review of the OCC's preemption determinations; (ii) the applicability of state consumer financial laws to subsidiaries and affiliates of national banks; (iii) the preservation of the "most favored lender" doctrine; and (iv) the clarification of state visitorial powers upon national banks. H.R. 4173 reiterates these same laws and legal standards with respect to the OTS (and the OCC as its successor agency) and federal savings associations, and like the Revised Dodd Bill, clarifies that the HOLA does not occupy the field in any area of state law.

D. Analysis

Federal preemption of state law is one of the most important consumer protection issues in financial regulatory reform and its ultimate resolution will significantly affect how national banks, federal savings associations and their subsidiaries and affiliates do business across the country. While federal preemption will still be available to national banks and federal savings associations, their subsidiaries and affiliates may suddenly find themselves subject to a panoply of state consumer financial laws, including state licensing and other requirements, which will require a large scale and costly, re-thinking of business plans and operations.

With respect to the national banks and federal savings associations themselves, notwithstanding the preservation of federal preemption, the requirement for the OCC, OTS or a court to affirmatively determine preemption of a state law will add another layer of uncertainty and complexity to the ordinary conduct of business, given that the determination process may take months or years to resolution. Further, once resolved, it is unclear whether the determination of a particular state law would suffice to permit preemption of another state's law, even if those laws have "substantially equivalent terms," a term that is not defined in either the Revised Dodd Bill or H.R. 4173. This is in marked contrast to the current practice, under which national banks and federal savings associations make this preemption determination internally, subject to OCC, OTS or a court review. As a result, national banks and federal savings associations will face an uphill battle in engaging in business nationwide, as they try to navigate the interaction between state law and federal preemption while contending with a dense patchwork of OCC and OTS opinions and orders, new state consumer protection laws and substantial additional litigation.

Although both the Revised Dodd Bill and H.R. 4173 contain savings clauses which grandfather in contracts which are entered into by national banks, federal savings associations and their subsidiaries prior to the effective date of the legislation, any new business will be subject to a long period of uncertainty, as long relied-on precedent is extinguished and new standards forged.

E. Next Steps

With the passage of comprehensive health care legislation, the White House and Congressional leaders have both stated that enacting financial regulatory reform is now their top domestic policy priority. Following three days in which Senate Republicans and Senator Ben Nelson (D-NE) voted to block the Senate from considering financial regulatory reform legislation, on April 28, a unanimous consent agreement was reached to proceed to consideration of the Revised Dodd Bill and debate on S. 3217 began on April 28. While the debate on amendments has proceeded slowly, several amendments to S. 3217 have now been considered and voted on.

This week, a revised substitute amendment to S. 3217 was adopted that memorializes the agreement between Chairman Dodd and Ranking Member Richard Shelby (R-AL) to remove from the bill the $50 billion pre-funded resolution authority and strengthen the bill's taxpayer protections. The Revised Dodd Bill is likely to be on the floor for about two weeks. Most amendments offered are expected to require 60 votes for approval. Majority Leader Harry Reid (D-NV) insists that the Senate must complete consideration of S. 3217 by the end of this week and has stated his intention to move soon to end debate on the bill if necessary to adhere to this timetable. It will be difficult for the Senate to meet Leader Reid's timetable for finishing the bill.

Given the number of amendments that have been filed, if the Senate is to conclude debate within two weeks, Leader Reid will either have to persuade the Senate to pass a motion ending debate or negotiate an agreement with Senate Republicans limiting both the number of amendments that are debated and the time available for debate on each amendment. Near the conclusion of debate, Chairman Dodd is expected to offer a Manager's Amendment incorporating other amendments acceptable to him. The inclusion of various Senators' amendments in the Manager's Amendment will play a key role in Chairman Dodd's efforts to persuade Republican Senators to agree to end debate on the bill. Sixty Senators will have to vote to end debate before a vote on final passage of the bill can occur.

The Revised Dodd Bill, as amended, is currently expected to pass the Senate before Memorial Day and will then be subject either to a formal conference committee or an informal conference to reconcile the bill with the House-passed financial regulatory reform bill, H.R. 4173. Once a such a conference report is prepared and passed by both the House and the Senate, this legislation will then be sent to the President and become law unless vetoed. The effort by some in the Senate to slow down consideration of Chairman Dodd's bill and the press of other legislative business may extend the timetable for enactment of financial regulatory reform legislation beyond the White House's aggressive goal of having a bill on the President's desk by Memorial Day, but most observers continue to believe that financial regulatory reform legislation will become law this year. In fact, just today, House Financial Services Committee Chairman Barney Frank (D-MA) reiterated his belief that the President will sign a financial regulatory reform bill into law by the 4th of July.

The Senate March draft and state regulators

In the latest version of Sen. Christopher Dodd's bill to overhaul financial regulation, state securities regulators failed to gain the oversight of private placements and Regulation D offerings they had sought.

The North American Securities Administrators Association, which represents state and provincial agencies, “didn't get what it wanted” in the legislation, said spokesman Rex Staples.

He noted, however, that NASAA “is not completely disappointed” with the Senate Banking Committee chairman's bill, which is officially known as the Restoring American Financial Stability Act of 2010. In fact, when it comes to Reg D deals, Mr. Staples labeled Mr. Dodd's proposal an improvement. “But it's not perfect,” he added.

The Connecticut Democrat's revised legislation cedes some oversight of Reg D offerings to the states. It requires the SEC to review a Reg D offering within 120 days. If the SEC does not meet that deadline, the offering loses its coverage status and the states can therefore examine it.

Nevertheless, the offering can be once again covered by the SEC if the commission reviews it.

State securities cops, notably Denise Voigt Crawford, Texas securities commissioner and president of the NASAA, and Joseph Borg, director of the Alabama Securities Commission, have made strongly worded comments in the past six months about the lack of screening and oversight Reg D deals receive.

Last fall, NASAA proposed the full return of oversight of Reg D deals to the states. Reg D deals are now filed with the Securities and Exchange Commission. Mr. Staples also said his group wanted a “bad boy provision,” meaning that individuals convicted of certain crimes would be excluded from offering Reg D deals. The bill contains no such provision.

Indeed, it appears that Sen. Dodd was not interested in turning back the clock on the approval and oversight of Reg D deals.

When the SEC created Reg D offerings in 1982, the intention was to simplify capital raising for small-business owners. The goal was to cut some of the red tape of filing with the commission.

When Congress passed the National Securities Markets Improvement Act of 1996, however, it stripped state regulators of their power to screen Reg D offerings and private placements. Now, the state regulators want that authority back, claiming that they have better knowledge of dubious individuals who might try to sell a bogus offering.

And in fact, certain Reg D offerings and private placements have blown up recently, hurting thousands of investors.

In July, the SEC charged two firms with fraud related to large private-placement deals with an estimated value of $2.7 billion

On July 7, the SEC charged Provident Royalties LLC and a number of its related entities with operating a fraud and a Ponzi scheme in the sale of $485 million of preferred stock and limited-partnership offerings in oil and gas deals.

The deals were sold from 2006 to 2009.

About a week later, the SEC charged Medical Capital Holdings Inc. with fraud in the sale of $77 million of private securities in the form of notes.

In total, Medical Capital sold $2.2 billion in notes from 2003 to 2009.

The Senate March draft and financial advisors

Sen. Christoper Dodd, D-Conn., today introduced his much-anticipated — and much-revised — bill for reforming the financial markets.

The ‘‘Restoring American Financial Stability Act of 2010” draft bill runs well over 1,300 pages, but Title IX will be of most interest to financial advisers.

In it, Mr. Dodd calls for a study by the Securities and Exchange Commission on whether brokers should be subject to the same fiduciary standard that applies to registered investment advisers. Under the bill, the SEC would have one year to report to Congress on what it finds and another year to implement any necessary changes.

That proposal, first enunciated by Sen. Tim Johnson, D-S.D., a Banking Committee member, ended up replacing Mr. Dodd's original — and much stricter — idea to move ahead with applying the fiduciary standard to any broker who offers financial advice to clients.

The Dodd bill was praised by Tim Ryan, president and CEO of the Securities Industry and Financial Markets Association. “We hope today's announcement by Senator Dodd brings us another step closer to enacting the reforms that are vital to strengthening our financial system, this year,” he said in a statement. “We remain committed to supporting responsible reform that balances stronger regulatory transparency and oversight with the industry's ability to finance America's economic recovery and job creation.”

Insurance groups have fought hard against the fiduciary provision, arguing that it would be difficult for agents to operate on a commission-based model if they are held to the fiduciary standard, which makes selling proprietary products more complicated. In the past Mr. Johnson has sponsored legislation important to the insurance industry, most notably a bill that would create an optional federal charter for insurers.

But some groups will no doubt be disappointed by Mr. Dodd's revisions. Many had expressed alarm over the past few months that calling only for an SEC study means that language in previous drafts that would requiring brokers acting as advisers to be registered investment advisers will never see the floor.

“It's an unfortunate backsliding on the part of the banking committee,” said Mercer Bullard, president and founder of Fund Democracy Inc., a consumer group that has been battling to no avail to make a fiduciary standard of care applicable to anyone who offers financial advice. “This bill doesn't change the law. We need the law to be modified to provide that retail investment advice is subject to fiduciary duty, whether it's provided by a broker or not.”

In addition, Mr. Dodd's bill takes a pass on a proposal from Sen. Herb Kohl, D-Wis., that would require all advisers who hold themselves out as financial planners to register with an oversight board administered by the Securities and Exchange Commission .

A statement that Senator Kohl made indicated he is not abandoning his original effort to regulate financial planners. “Currently, there is no nationwide standard governing the fiduciary responsibilities of financial planners,” said Mr. Kohl, chairman of the Special Committee on Aging. “I will continue to work with Chairman Dodd in the coming weeks to enhance consumer protection and increase the accountability and oversight of this profession as part of regulatory reform.”

Indeed, Sen. Dodd's revised legislation did offer some nods to consumer advocate groups. For starters, the bill seeks to establish an investor advisory committee that would report directly to the chairman of the Securities and Exchange Commission.

The committee would be comprised of an investor advocate, a representative of state securities regulators, and up to 22 others. The investor advocate would be charged with, among other things, assisting retail investors in resolving problems they may have with the SEC or with self-regulatory organizations, and identify problems that investors have with financial service providers and investment products.

The agency would be a "strong and independent consumer watchdog," Mr. Dodd said at a press conference today. He added that the investor advisory committee would have the "independence and authority to get the job done."

In addition, the revised Dodd bill would ramp up protection to older investors. Mr. Kohl joined with other senators from the Special Committee on Aging today in praising that provision.

The filing deadline for proposed amendments to the Dodd bill is Friday, according to a Senate Banking Committee staffer.

H.R. 4173 state exemption provisions

One of the most controversial subjects in banking law over the past decade has been federal preemption of state laws for federally-chartered banks (i.e., national banks and federal thrifts) and their operating subsidiaries. Under current law, regulations issued by the Office of the Comptroller of the Currency (“OCC”) and the Office of Thrift Supervision (“OTS”) preempt almost all state consumer protection laws for national banks and federal thrifts, respectively. When a federal law “preempts” a state law for an institution, it effectively exempts that institution from having to comply with the state law. This preemption has also been extended to operating subsidiaries of national banks and federal thrifts as well as (in certain situations) agents and other third parties acting on behalf of those institutions.

Many state officials, consumer advocates, and members of Congress—including, most notably, Chairman Barney Frank of the House Financial Services Committee—have argued that this preemption of state laws has hobbled the ability of states to protect consumers from abusive lending practices, and that these abusive lending practices contributed to the current financial crisis. In response to pressure from these critics, most of the major proposals in Congress to overhaul the financial regulatory system have included provisions that would significantly curtail the extent to which federal law preempts state consumer financial protection laws for federally-chartered banks and their operating subsidiaries.

The version of H.R. 4173, The Wall Street Reform and Consumer Protection Act of 2009 (the “Bill”), that the House passed last week contained a compromise set of preemption provisions offered by Chairman Frank to address the concerns of some members of his caucus who were wary of scaling preemption back too far. These compromise provisions would narrow the scope of federal preemption, but are significantly more favorable to national banks and federal thrifts than previous versions of the Bill. As passed by the House, the Bill provides that federal law preempts a state consumer financial protection law for a national bank or federal thrift only in limited situations, the most important of which being where the relevant federal banking agency (i.e., the OCC for national banks and the OTS for federal thrifts) or a court determines that the state law “prevents, significantly interferes with, or materially impairs the ability of” a national bank or federal thrift “to engage in the business of banking.”

Analysis of Provisions

1. Process for Determining Preemption. Preemption determinations could be made by a court or by regulation or order of the OCC or OTS on a case-by-case basis. The Bill would permit preemption determinations to be made only where federal law provides a “substantive standard” that regulates the “particular conduct, activity, or authority” that is subject to the state law that would be preempted. This provision seems to be an effort to prevent a preemption determination from resulting in complete deregulation of a subject matter.

The primary interpretive issue in applying this requirement is how broadly or narrowly to define the “particular conduct, activity, or authority” of a particular state law. For example, a state law might prohibit a lender from making a “high-cost mortgage loan” unless the borrower first meets with a housing counselor. Before determining that this state law is preempted for a national bank or federal thrift, a court or the relevant agency would first have to find that a federal law regulates the conduct, activity, or authority that is subject to the state.

Any such determination would depend, at least in part, upon the level of specificity with which the subject matter of the state law is defined. For example, if the court or agency concludes that the subject matter regulated by this state law is “mortgage loan origination,” then it might find that a federal law provides a substantive standard regulating the subject matter of the state law, since myriad federal laws regulate mortgage loan origination. By contrast, if the subject matter of the state law were defined more narrowly as “counseling requirements in connection with high-cost home loans,” preemption would seem unlikely, given the lack of any generally applicable federal housing counseling requirements.

2. Courts Can Determine State Laws to Be Preempted in First Instance. Prior versions of the Bill’s preemption provisions appeared to suggest that state law provisions could be preempted only where the OCC or OTS had determined that the law significantly interfered with the ability of federally-chartered banks to engage in the business of banking. The current version makes clear that a court may determine that a state law is preempted even if the OCC or OTS has never addressed the state law at issue.

3. Court Review of Agency Determination. Prior versions of the Bill had provided that courts should undertake a de novo review of OCC and OTS preemption determinations. The current Bill would require courts to “assess the validity of such determinations depending upon the thoroughness evident in the agency’s consideration, the validity of the agency’s reasoning, the consistency with other valid determinations made by the agency, and other factors which the court finds persuasive and relevant to its decision.” Courts may interpret this unique standard for judicial review as permitting them to give less deference to agency determinations than they would under the more familiar “arbitrary and capricious” standard of the Chevron and Skidmore cases — even though these same factors are typically considered by courts in evaluating whether agency action is arbitrary or capricious.

4. Preemption for Other Parties. Like prior versions, the Bill would eliminate preemption for operating subsidiaries of national banks and federal thrifts. This would significantly impact the operations of these companies. Many operating subsidiaries surrendered licenses required by state law and stopped complying with many state substantive laws after the Supreme Court held in 2007 that federal law preempted state laws for operating subsidiaries of national banks to the same extent that federal law preempts state law for the national banks themselves. See Watters v. Wachovia Bank, N.A., 550 U.S. 1 (2007). In fact, many operating subsidiaries had stopped complying with state laws even before the Supreme Court decided Watters, relying on agency interpretations and lower court decisions. It may prove costly and burdensome for these operating subsidiaries to reacquire all these state licenses, and some will have to make substantial changes in their operations to bring them into compliance with state laws.

Unlike prior versions of the Bill, however, the current version would not eliminate preemption for agents and other third parties associated with national banks and federal thrifts. In seeking to eliminate preemption for agents and other third parties, proponents sought to overturn the OTS’s controversial State Farm letter and several court decisions holding that in some situations state laws would be preempted for agents of federally-chartered institutions. Given the dependence of many such institutions on agents and other third parties to provide banking services, such as mortgage loan origination by mortgage lenders, the elimination of such preemption would effectively eviscerate preemption for the institutions themselves, enabling states to regulate their activities. Although the Bill in its present form does not eliminate preemption for these parties, this issue will undoubtedly remain contentious until final legislation is enacted.

Conclusion

The battle over preemption provisions in the pending financial reform bills is far from over, but the current version provides a glimmer of hope that the final result will preserve some degree of federal preemption for federally-chartered banks. Some legislators support the industry on preemption issues, and key legislators like Barney Frank are willing to work with these members to find an acceptable compromise.

House debates financial overhaul, reins in state powers

The U.S. House debated legislation today to toughen rules policing Wall Street after leaders quelled a Democratic revolt by members seeking to scale back states’ power to regulate national banks.

The New Democrat Coalition of 68 pro-business lawmakers won concessions after demanding consideration of a proposal to bar states from overriding federal consumer-protection rules for banks. Financial companies support pre-emption, to avoid a patchwork of state laws, while consumer groups and state attorneys general want states to impose tougher rules on banks as part of the overhaul of Wall Street regulations.

The legislation “makes it very, very unlikely that we’ll see a repeat of the economic problems we had before,” House Financial Services Committee Chairman Barney Frank, the bill’s sponsor, told reporters.

The measure is central to lawmakers’ effort to end government rescues of firms deemed too big to fail, which led to last year’s bailouts of New York-based American International Group Inc. and Citigroup Inc. The banking industry, Republican lawmakers and the nation’s biggest business lobby are fighting to scale back the legislation.

“This is about a big change,” House Speaker Nancy Pelosi said today. “We will prevail with this legislation.”

The Wall Street Reform and Consumer Protection Act adopts priorities President Barack Obama set out in June for strengthening financial rules. The bill would let regulators unwind failed systemically important firms, set up a council to monitor companies for systemic risk and give regulators power to break up large firms. The measure would rein in the derivatives industry and create a Consumer Financial Protection Agency.

35 Amendments

Lawmakers will consider 35 amendments tonight with leaders aiming for a final vote tomorrow. A House committee had reviewed 238 proposals to amend the bill.

House leaders and Frank yesterday agreed to include pre- emption language proposed by Representative Melissa Bean, an Illinois Democrat and member of the New Democrat Coalition, ending a stalemate that delayed debate until last night.

The agreement would add a provision into the broader bill that lets federal regulators override state consumer laws that interfere with a national bank’s ability to operate. It preserves the power of the Treasury Department’s Office of the Comptroller of the Currency, regulator of national banks, to interpret this standard and makes it easier for national banks to challenge pre-emption decisions in court.

Reining In Derivatives

A proposal to rein in the $600 trillion over-the-counter derivatives market will be a central topic of debate. A group of 171 companies that use swaps to hedge commodity prices and currencies is lobbying to revise language requiring them to post margins on their trades.

Such a provision “will tie up millions of dollars of capital for margins that companies otherwise could use to grow their businesses and create jobs,” said Ryan McKee, senior director for capital markets at the U.S. Chamber of Commerce.

Delta Air Lines Inc., agriculture company Cargill Inc. and farm equipment maker Deere & Co. are among companies lobbying for changes to the legislation.

“We’re not trying to eliminate the benefits of hedging,” said Representative Chris Van Hollen, a Maryland Democrat. “We want to make sure legitimate hedging doesn’t become rampant speculation.”

Frank said a proposal by Representative Walt Minnick, an Idaho Democrat, to create a council of regulators to oversee financial consumer protections in place of a standalone consumer agency would “damage” the bill’s intent.

Lawmakers are clashing over an industry-supported $150 billion fund the government would use when unwinding failed systemically important firms.

Republicans said the provision creates a perpetual bailout while Democrats defended it as a way to prevent taxpayers from propping up ailing financial firms in the future.

“There is no bailout fund,” Frank said yesterday. “If a company fails, it will be put to death.”

State preemption and the CFPA

"Reaching a compromise on an issue that threatened to derail financial regulatory legislation, the House Financial Services Committee voted on Wednesday to give the federal government the power to block the states from regulating large national banks in some circumstances, The New York Times’s Stephen Labaton and David Stout report from Washington.

The Obama administration had opposed any efforts by the federal government to preempt state officials from imposing higher banking standards. A group of Democrats with close ties to the banking industry had sought a complete federal pre-emption, which would have the effect of sharply limiting the states from any regulation of bank practices.

Under the compromise offered by two Democrats, Representative Melvin Watt of North Carolina and Dennis Moore of Kansas, and approved by voice vote, the office of the comptroller of the currency, which regulates national banks, would be able to override the states only if it found that the state law “significantly interferes” with federal regulatory policies.

The compromise cleared the way for the House Financial Services Committee to move ahead with plans to approve the creation of a new federal agency to protect consumers from abusive or deceptive credit cards, mortgages and other loans. That vote was expected to take place on Thursday.

Adoption of the compromise proposal was a partial setback for the banking industry, which would like to avoid having to comply with state laws that are sometimes stricter than federal rules.

Still, President Obama and the committee chairman, Representative Barney Frank, Democrat of Massachusetts, would have gone further and subjected banks to state laws with no chance for appeal.

The proposed consumer-protection bill on financial issues is one outgrowth of the months-long financial crisis. So is a proposal expected to be voted on later Wednesday by the House Agriculture Committee to regulate the arcane financial instruments known as derivatives. (The agriculture panel has jurisdiction because many derivatives involve trading in farm commodities.)

While its authors said they were reasonably happy with their compromise, some Democrats on the committee have their doubts. Representative Melissa Bean, an Illinois Democrat, issued a statement saying she would have voted against it, but that flu in her family prevented her from attending..."

State preemption, fraud and the national banks

"Newly empowered by the Supreme Court, the attorneys general of several states hit hard by the housing collapse are exploring consumer fraud suits against major mortgage lenders.

Frustrated by the banks’ inability or unwillingness to stop an avalanche of foreclosures, the states are considering lawsuits over the creation and marketing of millions of bad loans as well as the dismal pace of mortgage modifications.

Such cases would have been impossible until recently, because federal regulators had exclusive oversight of national banks. But a 5-to-4 Supreme Court decision in June allowed the states to exercise their own supervision, giving them significant leverage.

“We tried to use the tool to be persuasive with the banks,” Arizona’s attorney general, Terry Goddard, said in an interview. “But their waterfall of excuses, the abysmal numbers of modifications, tells us persuasion is not working.”

As a result, he said, “we’re moving much closer to litigation.”

While statutes vary, those of every state prohibit fraud in consumer lending. The attorneys general are considering the theory that the banks essentially perpetrated a vast fraud on consumers by marketing exotic loans that would prove impossible to pay back.

During the boom, the banks earned short-term fee income from generating the loans, then quickly resold most of them to investors or to Fannie Mae and Freddie Mac, two government-sponsored housing agencies that eventually required costly taxpayer bailouts.

The Mortgage Bankers Association, a trade group, declined to comment on the possibility of state fraud lawsuits. A spokesman, John Mechem, warned that consumers would end up paying for any campaign of stepped-up legal activity.

“Lawsuits add to the patchwork of regulations that increases compliance costs for lenders, which in turn increases the cost of credit for borrowers,” Mr. Mechem said.

The states’ new power to sue banks arose from an effort in 2005 by Eliot Spitzer, then the New York attorney general, to discover whether several banks had violated the state’s fair-lending laws.

The banks balked at surrendering any information. The Clearing House Association, a consortium of national banks, and the federal Office of the Comptroller of the Currency filed suit, asserting the states had no authority over national lenders.

Mr. Spitzer’s successor, Andrew M. Cuomo, took up the battle. Lower courts agreed with the banks, but the Supreme Court, narrowly, did not.

Already, the states’ victory in Cuomo v. Clearing House is beginning to affect the legal landscape. “The handcuffs are off,” said Ann Graham, a professor of banking law at Texas Tech University. “The states can pursue justice now.”

In July, the Illinois attorney general, Lisa Madigan, filed a civil rights case accusing Wells Fargo of predatory lending. While the case was in the works for 18 months, Ms. Madigan said “it would have been much more difficult to bring” without the favorable Clearing House ruling.

The impact goes beyond housing issues. In West Virginia, a case brought by the state against Capital One, charging deceptive marketing of credit cards, was blocked by a judge in June 2008. The judge said the state did not have authority to pursue the case. After the Clearing House decision, West Virginia filed a request to reinstate the case.

Other states say they are just beginning to explore their new powers.

“We’re back on the field,” said Iowa’s attorney general, Tom Miller. “That’s really important. Certainly there will be some litigation.”

In Arizona, the number of state lawyers working on mortgage issues went from one to eight after Clearing House. “Before the court’s decision, we wouldn’t waste our time looking at national banks,” said Robert Zumoff, senior litigation counsel for Mr. Goddard.

The Clearing House ruling rolled back an expansion of federal authority that began more than five years ago. In January 2004, the Comptroller of the Currency, the agency responsible for regulating national banks, issued two rule changes that had a far-reaching effect on the ability of state banking regulators and law enforcement to pursue violations of state law by large banks and their subsidiaries.

The rule changes broadened the protections afforded to national banks against prosecution for violations of state civil rights and predatory lending laws and other banking statutes. In a statement announcing the regulations, then-comptroller John D. Hawke Jr. said that his agency would take the lead on preventing lending abuses by the banks.

“Predatory lending is a very significant problem in many American communities, but there is scant evidence that regulated banks are engaged in abusive or predatory practices,” Mr. Hawke said then. “Our regulation will ensure that predatory lending does not gain a foothold in the national banking system.”

Rose on Multi-Enforcer Approach to Securities Fraud Deterrence

The Peril and Promise of a Multi-Enforcer Approach to Securities Fraud Deterrence: A Framework for Analysis, by Amanda M. Rose, Vanderbilt University Law School, was recently posted on SSRN.

Here is the abstract:

Participants in the United States’ national securities markets face potential fraud liability at the hands of the SEC, class action plaintiffs, and state regulators. Does this “multi-enforcer” approach to securities fraud deterrence make sense? How does one even go about answering that? This Article tackles the second question, filling a current void in the securities fraud literature by elucidating the circumstances that must prevail in order for a multi-enforcer approach to serve the cause of optimal deterrence. It thus situates debates over the preemption of state securities fraud enforcement authority and the desirability of private Rule 10b-5 enforcement within a framework of rational inquiry, and clarifies the empirical questions that must ultimately drive their resolution.

References

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