In a highly anticipated decision regarding the treatment of Guaranteed Asset Protection (“GAP”) under the Military Lending Act (“MLA”), a federal appellate court has ruled that a hybrid loan that finances GAP coverage along with a motor vehicle purchase is exempt from the MLA’s restrictions.  The 2-1 decision on April 12, 2023 by the U.S. Court of Appeals for the Fourth Circuit in Davidson v. United Auto Credit Corporation includes a vigorous dissent, which argues that the majority ignored the Congressional intent behind the MLA in arriving at their decision.  While the decision is only binding in the Fourth Circuit, it provides a degree of clarity – for now – as to the MLA’s coverage of such hybrid loans, an issue that has been the subject of mixed messages from federal regulators over the past several years.

The dispute in Davidson involved the MLA’s definition of “consumer credit.”  Under the MLA, the term “consumer credit” specifically excludes “(A) a residential mortgage, or (B) a loan procured in the course of purchasing a car or other personal property, when that loan is offered for the express purpose of financing the purchase and is secured by the car or personal property procured.” 10 U.S.C. §987(i)(6)(emphasis added).  Accordingly, while a loan to finance the purchase of a car is clearly not “consumer credit” and therefore excluded from MLA coverage, the parties in Davidson sought clarity as to whether financing something in addition to  a car purchase – here, GAP coverage  – rendered the exclusion inapplicable.

The underlying case involved an active duty servicemember, Jerry Davidson, who purchased a car at a Virginia dealership, which he financed through a loan from United Auto Credit Corporation.  The loan financed the car purchase as well as GAP coverage for the difference in value between the amount owed on the loan and the value of the vehicle if it was totaled or stolen.  Davidson sued in federal court, alleging that the loan violated the MLA because it mandated arbitration and failed to include required MLA disclosures.  The Eastern District of Virginia dismissed the case, holding that the Davidson’s loan was not “consumer credit” as defined in the MLA because the car loan exception was satisfied.

In its decision affirming the lower court’s dismissal, the Fourth Circuit found that the case rested entirely on the meaning of the phrase “offered for the express purpose of financing the purchase” of the car.  If the phrase “for the express purpose” meant “for the specific purpose,” United Auto would win.  If it meant “for the sole purpose,” Davidson would win.

To resolve this interpretational dilemma, the court looked to definitions of the term “for the express purpose” in dictionaries published close to the time that the MLA was enacted.  Finding support for both interpretations, the court then concluded that the context of the phrase within the MLA was conditional – the condition for a loan not to be “consumer credit” is that it was used to purchase a car.  Because the MLA uses “for the express purpose” as a condition, the court determined that “for the express purpose” should be read to mean “for the specific purpose” and not “for the sole purpose.”  As for the fact that the loan also financed GAP protection, the court concluded “[w]e do not care and we do not ask.  The conditions have all been satisfied and the conclusion must follow.  The loan is exempted from the Act, no matter what else is financed.”

In a strongly worded dissent, Judge J. Harvie Wilkinson III disagreed with the textual analysis, finding that a loan must be made “for the express purpose” of financing a car to be exempt, and noting that the MLA was intended to protect servicemembers, not accommodate the interests of lenders.  Judge Wilkinson noted a slippery slope of including GAP coverage within the exemption as it is “related to” the vehicle purchase, positing that pre-paid service contracts, a year’s supply of car washes, or a parking spot may also be related to a vehicle purchase and included within the MLA exemption under this theory.  Ultimately, Judge Wilkinson concluded that GAP coverage is a standalone financial product distinct from and unrelated to any car that a servicemember purchases.

When the MLA was first enacted and Department of Defense (“DOD”) rules were promulgated, the plain language of the statute and regulations seemed to indicate that a purchase money loan that also financed a GAP waiver would be exempt if secured by the car.  In 2017 the DOD issued a “clarifying” Q&A in an Interpretive Rule which stated, among other things, that “a credit transaction that also finances a credit-related product or service rather than a product or service expressly related to the motor vehicle or personal property is not eligible for the exceptions under [32 CFR] § 232.3(f)(2)(ii) and (iii).  For example, a credit transaction that includes financing for Guaranteed Auto Protection insurance or a credit insurance premium would not qualify for the exception under § 232.3(f)(2)(ii) or (iii).” See December 2017 Interpretive Rule Q&A #2.

However, in 2020 the DOD withdrew that Q&A guidance specific to GAP insurance so that it could further analyze the issue in light of concerns that creditors might not extend credit to servicemembers if they would not qualify for an exception from the MLA when taking a security interest in a car to finance the purchase of the car and GAP.  The withdrawal seemed to signal a potential change in the DOD’s position, but no further Interpretive Rule has been issued.  Moreover, the DOJ, DOD, and the CFPB filed an amicus brief in Davidson asking the court to find that a hybrid loan that included financing for GAP coverage would not qualify for the exception.  In the amicus brief, the agencies pointed out that earlier interpretive guidance, issued in 2016 by DOD, stated that hybrid loans for the purchase of personal property that also provided an additional extension of credit in an amount greater than the purchase price would not be entitled to the exception.

Last year, California passed a law that essentially prohibited the sale of GAP waivers to servicemembers.  That law, SB 1311, voids any security interest in a motor vehicle if it would cause a loan procured by a servicemember in the course of purchasing the motor vehicle to be exempt from the MLA and if the loan also funds the purchase of a credit insurance product or credit-related ancillary product.

While the Davidson decision, at least temporarily, resolves the ambiguity that has existed since DOD withdrew its guidance in 2020, the decision may spur DOD to issue its long-awaited revised guidance.  In its amicus brief, DOD asserted that the withdrawal of its guidance regarding GAP coverage in 2020 was for technical reasons, and did not reflect a change in DOD’s substantive position.  Judge Wilkinson’s dissent could provide a roadmap for another court to reach a result that is contrary to the result in Davidson.  Ultimately, the issue may make its way to the Supreme Court.

Further, despite the Davidson decision, we believe that courts are likely to hold that state laws like SB 1311 in California, which provide an independent statutory basis for protections beyond those provided under the MLA, are enforceable.  It is possible other states may pass similar laws, although we question whether restraints on servicemembers’ ability to purchase GAP coverage actually benefit those consumers.