A California federal district court recently denied the motion filed by the California Department of Financial Protection and Innovation (DFPI) seeking to dismiss a lawsuit filed by an advocacy organization seeking to enjoin DFPI from enforcing its final regulations (Regulations) implementing California’s commercial financing disclosure law. SB 1235, which was signed into law in 2018, requires consumer-like disclosures to be made for certain commercial financing products, including small business loans and merchant cash advances. The Regulations became effective on December 9, 2022.
The plaintiff, the Small Business Finance Association (SBFA), alleges in its complaint that the Regulations violate the First Amendment rights of its members. More specifically, SBFA alleges that the compelled disclosures do not accurately inform customers about the terms of a provider’s products because they misleadingly indicate that sales-based financing (SBF) transactions and open-end credit (OEC) function like traditional bank loans. SBFA also alleges that the Regulations are preempted by the Truth in Lending Act (TILA) because they mandate disclosure of the “APR” and “finance charge” but define and calculate those terms differently than TILA.
SBFA’s members offer SBF transactions in which the provider purchases a portion of a business’s future receivables at a discount and collects the receivables as generated by the business. SBFA alleges that although an SBF transaction is a purchase and not a loan, the Regulations require providers to disclose an estimated payment and estimated term “even though there is no required payment given that the transaction is a purchase and sale.” According to SBFA, such disclosures are inaccurate or misleading because they “materially undercut the value proposition of the [SBF] transactions” since a “key differentiator of [SBF] products is that they have no fixed payment term or amount.”
SBFA’s members also offer OEC in the form of a line of credit with a specified limit. For OEC transactions, the Regulations require a provide to disclose the “actual cost of the financing,” with the actual cost calculated by assuming that the borrower “will make an initial draw of their full approved credit limit, that the recipient will choose to make only minimum monthly payments, and that the recipient will not make any subsequent draws.” SBFA alleges that this assumption is misleading and “effectively destroys the value” of an OEC because a reasonable borrower would not treat an open-end credit line in this way since it would inflate the ultimate cost of an OEC .
DFPI argued that SBFA had failed to state a First Amendment claim because the Regulations compel commercial disclosures in a constitutionally permissible manner. According to DFPI, the disclosures are not misleading because the terms are either consistent with their plain meaning or clearly disclose that they are based on estimates and assumptions. In ruling on DFPI’s motion to dismiss, the court determined that for a law compelling commercial speech to survive First Amendment scrutiny, the government must show that the disclosure is purely factual, noncontroversial, and not unjustified or unduly burdensome. The court found that SBFA had plausibly alleged that the Regulations compel speech that is not purely factual based on its allegations that small businesses could be misled by the required disclosures. It stated that “whether or not small business owners may be misled is a factual matter that the Court will not resolve on the pleadings.”
With regard to SBFA’s TILA preemption claim, the court concluded that the Regulations were not subject to express preemption because they apply to a different set of transactions (i.e. business purpose) than those to which TILA applies (i.e. consumer purpose). However, the court found that SBFA had sufficiently alleged that the Regulations may be subject to conflict preemption. The court highlighted SBFA’s allegations that (1) small business owners often finance their businesses through a combination of commercial and consumer finance products and therefore routinely compare products subject to TILA with products that are not subject to TILA, and (2) because the Regulations require disclosure of two key TILA terms for non-TILA products but define or calculate those terms differently from TILA, small business owners considering TILA products are likely to be confused.
The court found these allegations sufficient to show that the Regulations may obstruct TILA’s purpose of “avoid[ing] the uninformed use of credit.” According to the court, “resolution of the factual issues necessary to determine preemption–whether small business owners in fact mix-and-match consumer and commercial credit options, and whether they would be confused by the differing terms—is inappropriate at this time.”
The court’s determination that the Regulations could be preempted by TILA as a matter of conflict preemption stands in stark contrast with the CFPB’s recent determination that California’s commercial financing disclosure law is not preempted by TILA. The CFPB concluded that California’s law did not stand as an obstacle to the accomplishment of TILA’s purposes, stating that commenters advocating preemption had not shown “that consumers when shopping for consumer-purpose credit would somehow be prevented from understanding the terms of credit available to them for those purposes by State disclosures provided in different (business-purpose) transactions.”