Global Financial Market Watch : Global Financial Lawyer & Attorney : K&L Gates Law Firm : Government Enforcement, Investment Management

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.