10.06.2015 Operation Choke Point: Lawsuit Against Federal Bank Regulators Survives Motion to Dismiss, Proceeds to Discovery
For years, the federal government has used its bank regulatory power to deny unlawful actors the use of US banks. As early as 1998, federal regulators proposed a “know your customer” rule, although ultimately this rule was not adopted. In 2001, Congress enacted the USA Patriot Act, which required banks to adopt customer identification programs, and throughout the succeeding decade, federal bank regulators required banks to accept some level of responsibility for monitoring their customers’ account activities in order to prevent the use of the US banking system for unlawful means. Beginning in 2008, the FDIC began issuing guidance that warned banks about the risks of doing business with third party payment processors, stating that banks that fail to adequately manage such relationships could be viewed as facilitating unlawful activity by their customers.
Meanwhile, Operation Choke Point was implemented, in which the DOJ used Section 951 of the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (“FIRREA”) to bring civil penalty claims against banks whose customers engage in unlawful activity. Under Section 951 of FIRREA, the DOJ may impose fines on anyone who commits a crime against a bank or who commits wire or mail fraud affecting a bank. Under the DOJ’s theory as applied in Operation Choke Point, a bank participates in fraud if it knows that one of its customers is using the bank’s services to defraud someone else and yet continues to do business with the customer.
Up until 2011, the focus of federal bank regulation in this area was on the prospect that specific bank customers might be engaging in unlawful activity. However, in 2011, the FDIC developed a list of “high risk” industries. This list included industries that likely would be engaged in unlawful activity, such as “escort services” and “drug paraphernalia.” But, lumped in with such enterprises were perfectly lawful businesses, such as firearms and ammunition sellers, tobacco retailers, and payday lenders. The FDIC informed banks in 2012 that failure to manage relationships with third-party payment processors could be viewed as facilitating fraudulent or unlawful activities. This was followed with direct communications and public statements by bank regulators that certain industries—including payday lenders—were too risky to bank. Regulators’ statements on this subject did not identify specific unlawful activities that were occurring within the targeted industries and instead focused on the riskiness of industries generally.
The concept that banks should not do business with “high risk” industries also became blended with the concept of banks’ “reputational risk.” “Reputational risk” is not a well-defined term, but it generally means that a bank could put itself at risk by taking actions that drive away customers. Within the context of Operation Choke Point and “high risk” customers, federal regulators implied that, when a bank does business with certain industries, the bank puts itself at risk.
The FDIC recently issued a clarification of its policies regarding “high risk” industries, essentially advising banks that they should do business with their customers on a case-by-case basis, taking into account ordinary risks posed by the specific customers. However, the recent policy pronouncements still left open certain issues, because the FDIC instructed banks to manage relationships to ensure that bank customers were complying with “applicable law.” Moreover, any damage already done by banks severing relationships with lawful members of “high risk” industries had already been done.
The Payday Lenders Lawsuit
Payday lending operates on a simple concept. A customer goes to a payday lending office to borrow money. The customer completes an application and writes a postdated check or an electronic debit authorization to the lender, and the lender then advances funds to the customer. The customer must return to the lender to pay back the funds by the due date. However, if the customer does not return by the due date, the lender cashes the check or runs the electronic debit authorization. Lenders therefore must have access to a bank in order to effect such transactions.
Having experienced the loss of banking relationships, and thus a threat to their continued business, the payday lenders sued in 2014. In the lawsuit, the plaintiffs alleged that federal bank regulators had unlawfully created a de facto rule that banks could not do business with the payday lending industry. The plaintiffs also contended that the regulators had denied them due process by taking away a protected interest of theirs—banking services—without due process of law.
One of the key issues in the case was whether the payday lenders had “standing.” Standing, as a legal concept, means that a plaintiff will be able to show that it suffered an actual injury, that the defendant caused the injury, and that the lawsuit can redress the injury that the plaintiff complains about. In the payday lenders’ case, the plaintiffs contended that the regulators’ actions against third parties - the payday lenders’ banks - caused injury to the plaintiffs. In effect, this theory would “skip a step” between the payday lenders, their banks, and the regulators, so that the payday lenders could sue the regulators directly for taking action against a party not involved in the lawsuit.
Other key issues in the case included whether the court had the authority to review the alleged de facto rule that banks may not do business with payday lenders and whether the payday lenders’ right to banking services was a right protected by the Constitution’s due process clause. The regulators challenged the payday lenders’ lawsuit on these grounds, asking the judge to dismiss the case even before discovery could be explored.
The Court’s Decision Allows The Payday Lenders Claims to Proceed and Discovery to Begin
The District Court issued a detailed opinion spanning 48 pages in which it held that the plaintiffs’ claims for due process violations could proceed. The Court first held that the plaintiffs had standing, discussing at length the issue of whether the regulators’ conduct caused injury to the payday lenders. The defendants’ primary argument was that the banks’ independent decisions were the cause of any injury alleged by the plaintiffs. The Court rejected this argument, noting that, if the regulators’ actions were a “substantial motivating factor” in banks’ decisions to terminate relationships, then the regulators could be liable. The key issue, in the Court’s view, was the degree of the regulators’ alleged involvement in or influence over bank’s decisions to terminate banking relationships with the payday lenders.
The Court discussed the plaintiffs’ allegations, in which they described a two-step regulatory campaign that was designed to cripple and ultimately eliminate the payday lending industry. The first step was the regulators’ development of informal regulatory guidance about “reputational risk.” The plaintiffs alleged that the regulators expanded this concept from its safety and soundness foundation, which addresses doing business with unlawful actors, and transformed “reputational risk” into a concept that includes bad publicity or doing business with industries that some may view as unsavory. Second, plaintiffs alleged that defendants relied upon this expanded definition to wage a campaign of back room regulatory pressure on banks to coerce them to terminate their relationships with the payday lending industry. The plaintiffs also alleged that the regulators acted in concert with the US Department of Justice to pressure the banks with the express purpose of eliminating banking relationships with the payday lending industry. Based upon these allegations, the Court concluded that the plaintiffs had standing because sufficient facts were alleged that the defendants’ conduct was a “substantial motivating factor” in the banks’ decisions to cut off banking services to the payday lending industry.
The Court also addressed whether it had the power to review the de facto rule that the plaintiffs alleged the regulators created, which barred banks from doing business with the payday lending industry. On this point, the Court rejected the plaintiffs’ argument and dismissed a portion of their case. Specifically, the Court determined that the de facto rule alleged by the plaintiffs was not “final agency action,” which is the only action reviewable by a federal court under the federal Administrative Procedures Act. The Court noted that the de facto rule that the plaintiffs alleged was actually phrased by the regulators as guidance, using language such as banks “should” do certain things. Without mandatory language that actually restricted the banks’ conduct on its face, the Court reasoned that no final agency action had been taken. And, because of the Administrative Procedures Act only allows a court of law to review final agency action, that aspect of the plaintiffs’ case was dismissed.
The Court did, however, allow the due process claim to proceed. When a plaintiff claims that the government violated its due process rights, the plaintiff must show (1) that it has a protected interest, (2) that the government deprived the plaintiff of that interest, and (3) that the government failed to provide procedural protections prior to deprivation of this protected interest. This concept is older than the Constitution, and we find the concept expressed throughout the United States founding documents. At its most basic, this concept prohibits the government from taking away life, liberty, or property without providing a person notice of the proposed government action and an opportunity to be heard before the action is taken.
In this case, the plaintiffs alleged that the regulators’ actions stigmatized them by creating a banking environment that shunned payday lenders and that, as a result, the regulators deprived them of their ability to have bank accounts, and thereby threatened the plaintiffs’ ability to engage in their chosen line of business. Evaluating these allegations, the Court weighed whether the regulators’ actions were more akin to general policy making, to which due process rights usually do not apply, or more akin to proceedings that are designed to adjudicate particular cases. The Court reasoned that the plaintiffs’ allegations portrayed a situation in which the agencies were adjudicating specific cases by targeting the payday lending industry. The Court noted that the plaintiffs alleged that the regulators took direct action against the banks with the specific intended effect of disrupting the plaintiffs’ banking relationships. On this basis, the Court reasoned that the plaintiffs had adequately alleged the deprivation of an interest.
What does this mean for the Industries and for Banks?
As noted above, payday lenders were not the only ones on the “high risk” industries list, and the payday lending case could serve as a roadmap for others that lost banking relationships. For example, when the United States House of Representatives conducted hearings on Operation Choke Point, the materials produced in those hearings showed that the firearms and ammunition industries were somehow caught up in the regulators’ belief that these industries had a higher than normal risk of fraudulent transactions. Moreover, the evidence adduced in these hearings, along with confirmed reports of firearms industry members suffering the termination of their banking relationships, point to a stigma attached to the firearms industry and created through bank regulatory activity. The evidence likewise could show that tobacco sellers and others who engage in legitimate businesses were the intended targets of the regulators’ attempt to choke off banking services to industries that are, according to some, unsavory.
Perhaps the most interesting regulatory concept at play in this case is the concept of reputational risk. Banking professionals have noted that reputational risk is not a well-defined term, and the concept does not have logical boundaries that allow banks to make informed decisions about how to avoid such risk. For example, the FDIC put out a “high risk” industries list, which included industries such as tobacco, firearms, ammunition, and payday lenders. Banks were then told that they must take into account, as a general matter, the risks that such industries pose. In such a circumstance, banks cannot gauge exactly what regulators believe are the “do’s and don’ts” of banking such customers. And, of course, if a bank is faced with undefined (and undefinable) risk, it probably will not undertake such a risk. The likely result is that industries identified as “high risk” will lose access to banking services.
It remains to be seen whether reputational risk will be litigated in this case. If so, the case could present an opportunity to define this concept and provide greater certainty to banks. The plaintiffs attempted to have the court review the de facto rule that they allege the regulators created barring banks from doing business with the payday lending industry. The court did not accept the plaintiffs’ argument, and the review of the alleged de facto rule is no longer an issue in the case. However, based upon the allegations of the complaint, it seems that discovery and proof in the case must necessarily ask the question of what regulators mean by “reputational risk.” This case therefore may provide the opportunity to develop evidence and the law regarding reputational risk, perhaps giving the banking industry a more solid definition of reputational risk than has been provided by federal regulators to date.
Another effect of this case might be a greater emphasis on federal bank regulators’ primary mission. The federal bank regulatory regime is focused on the safety and soundness of the nation’s banks. If the payday lenders’ allegations are proven to be true, then it means that federal bank regulators strayed from their core mission by targeting non-bank industries. At a minimum, this case likely will prompt regulators to look more carefully at whether regulatory initiatives are adequately tied to promoting the safety and soundness of banks.
The Court issued its order on the motions to dismiss on September 25, 2015. Under ordinary federal procedures, the parties should be meeting to plan out the discovery in the case in the next several weeks. Assuming they do so, the discovery period likely would take several months, with additional motions to be filed sometime next year. If the case follows this course, then by this time next year we may have a clear indication of what proof the plaintiffs are able to muster to support their claims. However, there are a number of procedural maneuvers that may ensue, including an immediate appeal by the defendants. Although this is rare, there is potential for an additional delay in the case.
 This conclusion is particularly perplexing as it relates to the sales of firearms. All sales of firearms by Federal Firearms Licensees – the businesses within the firearms industry that sell to consumers and use the banking system – are subject to background checks in which a purchaser’s personal information and the seller’s information are run through the FBI’s National Instant Criminal Background System. How sales conducted through such a system present a high risk for fraud, and why federal bank regulators would draw such a conclusion, remain unanswered.