A California state court has overruled the demurrer filed by Opportunity Financial, LLC (OppFi) to the cross-complaint filed by the California Department of Financial Protection and Innovation (DFPI) in which OppFi asked the court to reject the DFPI’s “true lender” challenge.  In its cross-complaint, the DFPI alleges that California usury law applies to loans made through OppFi’s partnership with FinWise Bank (Bank) because OppFi, and not the Bank, was the “true lender.”

In 2019, California enacted AB 539 which, effective January 1, 2020, limited the interest rate that can be charged on loans less than $10,000 but more than $2,500 by lenders licensed under the California Financing Law (CFL) to 36% plus the federal funds rate.  In March 2022, OppFi filed a complaint seeking to block the DFPI’s attempt to apply the CFL rate cap to loans made through its partnership with the Bank.  OppFi’s complaint recites that prior to 2019, the Bank entered into a contractual arrangement with OppFi  (Program) pursuant to which the Bank uses OppFi’s technology platform to make small-dollar loans to consumers throughout the United States (Program Loans).  It alleges that in February 2022, the DFPI informed OppFi that because it was the “true lender” on the Program Loans, it could not charge interest rates on the Program Loans that were higher than the rates permitted to be charged by lenders licensed under the CFL.

OppFi’s complaint alleges that because the Bank and not OppFi is making the Program Loans and the Bank is a state-chartered FDIC-insured bank located in Utah, the Bank is authorized by Section 27(a) of the Federal Deposit Insurance Act to charge interest on its loans, including loans to California residents, at a rate allowed by Utah law regardless of any California law imposing a lower interest rate limit.  It also alleges that loans made by a state-chartered bank are exempt from the CFL’s rate cap pursuant to the usury exemptions for state-chartered banks in the state’s Constitution and the CFL.  The complaint seeks a declaration that the CFL interest rate caps do not apply to Program Loans and an injunction prohibiting the DFPI from enforcing the CFL rate caps against OppFi based on its participation in the Program.

In response to the complaint filed by OppFi seeking to block the DFPI from applying California usury law to loans made through the partnership, the DFPI filed a cross-complaint seeking to enjoin OppFi from collecting on the loans and to have the loans declared void.  In the cross-complaint, the DFPI alleges that “OppFi is the true lender of [the Program Loans]” based on the “substance of the transaction” and the “totality of the circumstances,” with the primary factor being “which entity—bank or non-bank—has the predominant economic interest in the transaction.”  In the cross-complaint, the DFPI identifies various characteristics of the Program to demonstrate that OppFi holds the predominant economic interest in the Program Loans.  The DFPI claims that the Program Loans are therefore subject to the CFL and that OppFi is violating the CFL and the California Consumer Financial Protection Law by making loans at interest rates that exceed the CFL rate cap.

In its demurrer to the cross-complaint, OppFi did not raise Section 27(a) of the FDI Act.  It argued that the DFPI’s claim that the Program Loans violate the CFL fails as a matter of law because the Program Loans were made by the Bank and loans made by a state-chartered bank are exempt from the CFL’s rate cap pursuant to the usury exemption for state-chartered banks in the state’s Constitution and the CFL.  It also argued that the DFPI’s attempt to avoid this result by asserting that OppFi is the “true lender” on the Program Loans has no basis in California statutes or common law. 

After reviewing numerous California decisions, the court characterized the demurrer as a request by OppFi for the court “to ignore the substance of the loan transactions as alleged in the cross-complaint.”  It then recited various characteristics of the Program alleged by the DFPI in its cross-complaint and stated that “[a]s alleged, the substance is that OppFi is the lender.”  The court then concluded that “[i]n light of long-standing California law, at this early stage, the court cannot rule as a matter of law that FinWise is the lender of the loans at issue.” 

In our view, the court’s analysis is misguided.  The court effectively ignored two California federal court cases cited by OppFi, Sims v. Opportunity Financial, LLC and Beechum v. Navient Solutions, Inc., stating that it did not find them “to be persuasive.”  In both cases, the district courts rejected “true lender” challenges, specifically the plaintiffs’ argument that the court should look to substance over form to assess whether a loan that was non-usurious on its face was in fact usurious and also to assess whether a loan was structured with an intent to evade California usury law.  The district courts, relying on California case law, concluded that a “substance over form” analysis is only appropriate when a court is assessing whether a transaction satisfies the elements of usury or falls under a common law exemption from a usury prohibition.  According to both courts, a “substance over form” analysis is inappropriate when assessing whether a transaction or a party to the transaction falls under a constitutional or statutory exemption from the usury prohibition.  Since banks were the named lenders on the plaintiffs’ loans, both district courts were unwilling to look beyond the face of the loan agreements to determine whether the loans fell within the exemptions claimed by the banks (which in one case was the California Constitution’s exemption for loans made banks and in the other case was the CFL’s bank exemption.)

In Sims and Beechum, the California cases relied on by both federal district courts were Jones v. Wells Fargo Bank and WRI Opportunity Loans II LLC v. Cooper. Both cases involved challenges to shared appreciation loans in which the plaintiffs argued that the loans did not qualify for California’s statutory exemption from usury limits for shared appreciation loans.  In ruling on OppFi’s demurrer, the court found that “OppFi’s reliance [on Jones and WRI] is misplaced.”  It distinguished those cases by stating:

Here, the terms of the transaction with the borrower [in OppFi’s loans] are not at issue as they were in Jones and WRI nor is there a shared appreciation agreement to be scrutinized. In Jones and WRI, the focus was on the transactions to determine whether the lender’s additional contingent deferred interest was actually at risk for purposes of the shared appreciation loan exemption.  The identity of the real lender was not at issue.  Thus, there was no doubt in Jones that [a national bank] was the actual lender and that [the national bank] qualified for an exemption from the usury restrictions.  In WRI, the shared appreciation exemption did not apply because the lender’s contingent deferred interest was not at risk.  Here, a different question is presented: who actually assumed the risk and made the loans at issue in light of the Commissioner’s allegations that all was structured with OppFi as the lender….As alleged the Commissioner is not attempting to regulate the transfer of loans in the secondary market.  Rather, the focus here is on the identity of the lender in the primary market.  Based on Jones and WRI, on demurrer, OppFi fails to persuade that the loans as a matter of law are immune from scrutiny under California law.  OppFi’s demurrer does not present a question about a modern statutory exemption; just a question regarding the identity of the actual lender under the usury laws that cannot be resolved on demurrer.

We do not find the court’s explanation for why OppFi’s reliance on Jones and WRI is “misplaced” to be persuasive.  As the court noted, instead of involving true lender challenges, Jones and WRI involved challenges to shared appreciation agreements.  However, the court appeared to overlook that Jones and WRI involved challenges to the substantive terms of the agreements—whether they were valid shared appreciation loans or disguised usurious transactions.  Jones and WRI both contain language indicating that a “substance over form” analysis is appropriate for such challenges.  But neither Jones nor WRI provide any basis for concluding that a “substance over form” analysis is appropriate for a “true lender” challenge, and indeed, should be read to foreclose the use of a “substance over form” analysis for a “true lender” challenge.

We believe this case is extraordinarily important.  Unless it settles, it creates a risk to the viability of bank model online lending that is structured like OppFi’s Program.  It would be helpful if the FDIC were to submit an amicus brief supporting OppFi’s position regarding federal preemption of California usury law under Section 27(a) of the FDI Act.  Unfortunately, however, that seems unlikely given that after the OCC’s adoption in 2020 of a “true lender” rule for national banks and federal savings associations, the FDIC was unwilling to adopt a similar “true lender” rule for state-chartered banks.  The FDIC’s view at that time was that state law controls when a loan is made by a state bank and the FDIC could not preempt state law on this issue.

In light of the threat posed by this case, banks and non-banks that are engaged in bank model online lending should now take a fresh look at the structure of their bank model and consider what steps they can take to mitigate risks.  We have helped several banks and non-banks engage in this exercise.