The California Department of Business Oversight (DBO) has issued its long-awaited draft regulations to implement SB 1235, a 2018 law requiring consumer-like disclosures for commercial financing in California. The DBO has requested public comment on these draft regulations, giving interested stakeholders until September 9, 2019, to weigh in.
What happened
As we reported previously, Governor Jerry Brown signed SB 1235 into law in September 2018. SB 1235 requires that “providers” of commercial financing make disclosures similar to those required by consumer finance laws such as the federal Truth in Lending Act. The term “providers” excludes depository institutions like banks, but includes commercial lenders operating under the California Financing Law (CFL) or bank sponsorship arrangements, including many “FinTech” companies. And “commercial financing” is not limited to loans under the CFL, but also covers arrangements not viewed as loans, including factoring and merchant cash advances (MCAs). Although SB 1235 broadly outlines what must be disclosed, it delegated to the DBO the task of specifying the form and timing of the disclosures in the statute’s implementing regulations. The DBO began this process in late 2018 by requesting public comment, which closed in January 2019. Providers of commercial financing are not required to comply with SB 1235 until the DBO’s regulations become effective.
On July 26, 2019, the DBO published a first draft of its proposed regulations and issued a second invitation for comments. Key provisions include:
Disclosure formatting and content requirements—The regulations provide general disclosure requirements for commercial financing, as well as specific instructions and model forms for six types of financing: (1) closed-end transactions; (2) open-ended credit plans; (3) factoring; (4) sales-based financing; (5) leasing; and (6) asset-based lending. The disclosure instructions are detailed, spanning several pages of explanation for each transaction type.
Rules for calculating or estimating the cost of credit and other terms—The DBO previously sought public comment on whether to use annualized percentage rate (APR) or annualized cost of capital (ACC) as the annualized rate disclosure required by the statute. The draft regulations use APR and provide guidelines for calculating it for different types of financing. For some transaction types, such as factoring and sales-based financing, the regulations provide rules for estimating the APR and other items such as periodic payment amounts and the term.
Our initial read of the proposed regulations confirms that further comments are imperative. The disclosure requirements are often vague and confusing, and the regulations contain a number of provisions that, while certainly well-intentioned, will make compliance impossible. For example, some of the rules allowing the use of estimates require companies using such estimates to conduct periodic self-audits to determine whether the estimates were accurate on an aggregate basis, and they prohibit the continued use of estimates if the self-audits show that prior estimates in the aggregate were off by 5% or more over the last three audits, or 10% over five audits. This poses a serious problem, as the nature of these transactions is such that the estimates are virtually certain to vary substantially from actuality, and the disclosures cannot be made at all without using estimates. Also, as required by SB 1235, the proposal includes disclosures for non-credit arrangements such as factoring, but such disclosures for non-credit products are unprecedented, including under the Truth in Lending Act, and these first-of-their-kind disclosures present many questions and challenges.
Why it matters
California is the first state to impose consumer-like disclosure requirements on commercial loans and other financing, and other states may soon elect to follow California’s lead. We believe it is critical for the DBO to get these regulations right, because otherwise the new regulations will cause borrower confusion rather than a clearer understanding of the cost of commercial credit. Changes also are needed to allow companies to comply as a practical matter. Commercial finance companies and their trade associations, including in particular fintech companies operating under the CFL or bank sponsorship arrangements, or offering factoring or MCA products, therefore should carefully review the proposed regulations with counsel and submit comments by the September 9 deadline.