The Dodd-Frank Act Redefines Federal Preemption Law
By: KARLA L. REYERSON
On July 21, 2010, President Obama signed into law what is possibly the most important and far-reaching financial reform law of our time, the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act). This new law touches both traditional and nontraditional financial institutions in numerous ways. The full impact of the Dodd-Frank Act will not be known for several years, after the multitude of regulations it calls for have been implemented and, most likely, the meaning of its provisions have been tested in the courts.
One of the areas in which the Dodd-Frank Act makes significant changes is in federal preemption of state consumer protection law. These changes are included in the Consumer Financial Protection Act (CFPA) in Title X of the new law, which also creates the Bureau of Consumer Financial Protection (Consumer Protection Bureau). The new preemption laws take effect beginning on the “Designated Transfer Date,” which is currently July 21, 2011; however, the Treasury Secretary has the option to extend the effective date to as late as January 21, 2012.
Elimination of Protection for Subsidiaries of Federally Chartered Banks
One of the most substantial changes made to federal preemption law is that it will no longer protect nonbank subsidiaries or affiliates of federally chartered banks. Section 1044 of the Dodd-Frank Act specifically states that neither the CFPA nor Section 24 of the Federal Reserve Act (12 U.S.C. § 371) preempts, annuls, or affects the applicability of any state law to any subsidiary or affiliate of a national bank, unless the subsidiary is itself a national bank. Section 1046 of the Dodd-Frank Act states that the same rules apply for federal savings association subsidiaries and affiliates. Therefore, the subsidiaries and affiliates of national banks and federal savings associations, beginning on the Designated Transfer Date, must be compliant with state consumer protection and licensing laws.
This is significant because many national banks and federal savings associations conduct their mortgage lending activities through operating subsidiaries, which, prior to the Dodd-Frank Act, had been immune from state licensing and reporting laws. Sections 1044 and 1046 implicitly override the United States Supreme Court’s 2007 decision in Watters v. Wachovia Bank, in which the court held that the National Bank Act preempted the application of state laws to state-chartered operating subsidiaries of national banks in the same way such state laws were preempted with respect to the bank itself.
Once the preemption provisions of the Dodd-Frank Act become effective, the Watters analysis will no longer be valid. National banks and federal savings associations that currently conduct mortgage activities or other activities regulated by state law through subsidiaries will need to decide whether to keep their organizational structure the same and comply with the newly applicable state licensing and other legal requirements or roll the activities into the bank to obtain greater protection from state laws. Complying with numerous state laws that have differing requirements would inevitably be costly for operating subsidiaries and result in additional operational complexities. Conversely, moving these activities into the bank would also result in reorganization costs and operational headaches, as well as loss of risk limitations that are realized by keeping different business divisions in separate corporate entities.
Interaction of State and Federal Consumer Protection Laws
Additionally, the Dodd-Frank Act provides that the creation of the Consumer Protection Bureau under Title X does not alter, affect, or exempt any person subject to Title X from complying with state laws, except where state laws are inconsistent with federal law. The new law specifies that a state law will not be found to be “inconsistent” if it provides greater protection to consumers than its federal counterpart.
Under the Act, state consumer financial laws shall be preempted only if (a) they would have a discriminatory effect on federally chartered banks in comparison with state-chartered banks in the state; (b) the law prevents or significantly interferes with the exercise by the federally chartered bank of its powers (the standard set forth in Barnett Bank of Marion County, N.A. v. Nelson, Florida Insurance Commissioner); or (c) the law is preempted by a provision of another federal law.
A “state consumer financial law” is defined as a state law that does not directly or indirectly discriminate against federally chartered banks and that directly and specifically regulates the manner, content, or terms and conditions of any financial transaction, or any account related thereto, with respect to a consumer.
A state consumer financial law may be found to prevent or significantly interfere with the exercise of federally chartered bank powers by a court, by the OCC on a case-by-case basis, or in accordance with applicable law. Where the OCC makes such a determination, a court reviewing the determination must assess its validity based on the thoroughness evident in the OCC’s consideration, the validity of the reasoning of the OCC, its consistency with other valid determinations by the OCC, and other factors the court finds persuasive and relevant to its decision. This standard of judicial review is less deferential to the OCC than the deferential standard generally afforded federal agencies.
Further, the OCC may not declare a state consumer finance law inapplicable to a federally chartered bank unless substantial evidence, made on the record, supports the specific finding regarding the preemption of the law in accordance with the legal standard set forth in the Barnett Bank decision.
Every five years after making a determination that a provision of federal law preempts a state consumer financial law, the OCC is required to review the determination through notice and public comment. Such reviews must be reported to Congress. The OCC must also publish its preemption determinations no less frequently than quarterly.
States’ Rights to Enforce Consumer Protection Laws
The Act also affects the ability of states to enforce consumer protection laws. The Act provides that any state attorney general may bring a civil action against a state-chartered financial institution in any state or federal district court located in the attorney general’s state to enforce the provisions of the CFPA or its implementing regulations. However, attorneys general may only bring civil actions against national banks or federal savings associations to enforce Consumer Protection Bureau regulations—not the provisions of the CFPA itself. A state regulator also is authorized to bring a civil action to enforce the provisions of the CFPA or its regulations, but it can only do so against state-chartered institutions.
The Consumer Protection Bureau must receive notice of any civil actions state attorneys general or state regulators intend to bring, and it has the authority to intervene as a party and remove actions to federal district court. The Consumer Protection Bureau is required to prescribe regulations to implement these provisions.
The Dodd-Frank Act also preserves the United States Supreme Court’s ruling in Cuomo v. Clearing House Association, L.L.C., which allows states to prosecute national banks for violations of state laws that are not otherwise preempted by federal law. Further, the Act allows states to prosecute federal savings associations for such violations.
The Good News
While the Dodd-Frank Act narrows the scope of federal preemption of state law, it does keep certain principles of preemption intact. First, the Act does not supersede federal laws that specifically provide for preemption over state laws. Second, the Act specifically provides that any regulation, order, interpretation or guidance by the OCC or OTS regarding the applicability of any state or federal law to any contract entered into on or before July 21, 2010 shall not be affected by the Act’s provisions.
Finally, and perhaps most significantly, the Act continues to allow national banks and federal savings associations to charge interest at the rate allowed by the state where the bank is located, even when making loans to borrowers in other states.
Except for the clearly significant loss of preemption protection for operating subsidiaries of federally chartered financial institutions, the depth and breadth of the Dodd-Frank Act’s changes to federal preemption law likely will not be known for some time. This lack of clarity creates substantial challenges for financial organizations as they attempt to conduct business in other states.