Mike & Co. —
During the lull on the Hill with the Senate in recess this week, attention shifted to the regulatory front, with two agencies making news with major proposed rules addressing issues at opposites ends of the financial industry spectrum.
On Tuesday, the Fed issued the long-awaited rule on the treatment of qualified financial contracts (QFC) in the event of a G-SIB default. And today, CFPB released proposed rule to prohibit banks from requiring customers to sign an arbitration agreement that waives their rights to join a class-action lawsuit.
Details on these two high-stakes rules below.
CFPB: Arbitration and Class Actions
This afternoon, the Consumer Financial Protection Bureau unveiled a rule disallowing banks from including arbitration clauses in their contracts with customers prohibiting them from joining class-action lawsuits.
Most contracts with big American banks, from loan documents to credit card agreements, contain a clause allowing both the customer and bank to pursue arbitration as a method for settling disputes. It helps banks save costs of defending disputes in a court and is a useful remedy available to customers as well.
But arbitration clauses have increasingly included language barring customers from pursuing a class-action lawsuit in lieu of arbitration. For example a credit card agreement may contain:
“There will be no right or authority for claims to be arbitrated on a class action basis or on bases involving claims brought in a purported representative capacity on behalf of the general public, other card members, or other persons similarly situated.”
The clause limits the legal options available to customers who have a problem with their bank. Arbitration without a class-action option can be exceedingly expensive for the customer. If they’re trying to recoup a small amount of money then it’s rarely worth the cost to pursue arbitration. Few customers ever make it to arbitration as their legal costs begin to add up — and those that do seem to rarely win cases.
A class-action lawsuit is the legal vehicle designed for customers to recoup small amounts of money — like a $35 overdraft fee. By preventing customers from entering into such lawsuits banks can protect themselves from costly judgements and settlements, as well as from agreements which require they amend business practices.
Implications for Banks, Non-Banks
Banks have objected to the rule, saying that it will prevent customers from being able to pursue arbitration in the future. It’s unlikely that the rule would affect the incidence of arbitration cases when a customer wants to pursue it. CFPB is preventing arbitration agreements which prohibit class action lawsuits, not preventing arbitration agreements full stop:
“the proposed rule would prohibit covered providers of certain consumer financial products and services from using an agreement with a consumer that provides for arbitration of any future dispute between the parties to bar the consumer from filing or participating in a class action with respect to the covered consumer financial product or service”
Other important details to keep in mind:
- the rule will only affect institutions that CFPB has authority to regulate (lenders, credit card companies, and banks)
- it would apply to new contracts only – customers with existing arbitration agreements in their contracts may still be prevented from joining or initiating a class-action law suit.
The Fed: Contracts in a Crisis
On Tuesday, the Federal Reserve issued a rule limiting the rights of parties to a Qualified Financial Contract (QFC) in the event that a counterparty goes into default. It expands on the resolution frameworks within the Federal Deposit Insurance Act and Dodd-Frank and will apply those frameworks to all QFCs entered into by American GSIBs (global systemically important banks), as well as domestic subsidiaries of foreign GSIBs.
The rule will limit certain rights afforded counterparties to a QFC, such as the termination of the contract and seizure and liquidation of the counterparty’s collateral. The Fed rule aims to prevent “runs” on big banks in the event of default. QFC counterparties, under current rules, don’t have to wait in line with other creditors to receive payment. Big banks already agreed to waive these rights in 2014, but hedge funds and asset managers have not.
The most controversial provision of the rule may be its retroactive nature — if requires that banks’ QFCs be brought into compliance with the rule for them to continue trading. The scope of the rule is noteworthy. By requiring the biggest banks to comply with these rules the Fed is essentially forcing investment funds and other firms to adopt these contracts as well – or else cease trading with the country’s largest banks.
When Lehman Brothers collapsed during the 2007 crisis, its trading partners terminated thousands of swaps and effectively sent huge amounts of cash tumbling out of Lehman to its counterparties before authorities could get a grip on its default process. These payments were financed by asset sales that later constrained the bankruptcy process.
The rule strives to forestall this kind of run in the future by injecting clarity regarding claims and increasing flexibility in the resolution of large financial firms under Dodd-Frank.
According to Fed Chair Janet Yellen, the new rule “will help manage the risk when a very large firm fails and will thus strengthen the resiliency of the financial system as a whole.” Fed officials have claimed that the cost of the rule would be relatively small, and that the benefits to the financial system would massively outweigh them.
Both of the rules proposed this week are subject to open comment periods, ending in about 90 days. Moving forward, we should expect to see a companion to the Fed’s QFC rule come out of OCC shortly, which would extend the Fed requirements beyond the largest banks to national banks and thrifts.
Thereafter, the coming weeks may see a number of additional rules from regulators. The SEC may release its own fiduciary rule to complement DOL version. And the Fed has solicited feedback from banks on how to expand mobile banking access to underserved customers.