Commercial financing in California will be subject to a new rule prohibiting unfair, deceptive, and abusive acts and practices (UDAAPs) effective October 1, 2023. The prohibition extends federal UDAAP restrictions to small business financing. The rule also establishes an annual reporting requirement for certain persons offering commercial financing. The California Department of Financial Protection and Innovation (DFPI) promulgated the rule pursuant to its rulemaking authority under the California Consumer Financial Protection Law (CCFPL).
The CCFPL gives the DFPI broad enforcement authority, including authority to take action against providers of financial products and services for UDAAPs. In addition to granting oversight and enforcement authority, the CCFPL gives the DFPI rulemaking authority to implement, interpret, and make specific its provisions, including in connection with the offering or provision of commercial financing or other financial products and services to small businesses, nonprofits, and family farms. The statute, however, does not specify the standards, if any, that must be used in determining whether an act or practice is unfair, deceptive, or abusive. The law further authorizes the DFPI's rulemaking to include data collection and reporting on the provision of commercial financing or other financial products and services.
Coverage of Commercial Financing and Application
The rule applies to "covered providers" of "commercial financing" or other "financial products and services" to small businesses, nonprofits, and family farms whose activities are principally directed or managed from California. Banks, credit unions, and other depository institutions, as well as those acting pursuant to a CFL license granted by the DFPI, are exempted.
The rule further provides that for the purpose of determining whether activities are "principally directed or managed from California," a "covered provider" may rely on any relevant written representation by the small business, nonprofit, or family farm, including a business address provided in any application or agreement for commercial financing or other financial product or service.
The rule defines "covered providers" as any person engaged in the business of offering or providing "commercial financing" or another "financial product or service" to a "covered entity."
The rule's definition of "commercial financing" borrows from the state's commercial financial disclosure law and includes accounts receivable purchase transactions, factoring agreements, asset-based lending transactions, commercial loans, commercial open-end credit plans, and lease financing transactions that are intended for use primarily for other than personal, family, or household purposes.
The rule borrows its definition of "financial products or services" from a section of the Financial Code, which applies to consumer financial products or services. The rule clarifies that references to consumers also apply to various business entities.
The rule defines a "small business" as an entity organized for profit with annual gross receipts of no more than $16 million as periodically adjusted. Covered providers are permitted to rely on the representations made by the business applying for financing when determining if a small business has $16 million or less in annual gross receipts.
The rule's UDAAP prohibition imports verbatim concepts of "unfair," "deceptive," and "abusive" acts or practices found in the Consumer Financial Protection Act and employed by the Consumer Financial Protection Bureau. An act or practice also can be unfair or deceptive under California's Unfair Competition Law and case law interpreting it.
Specifically, the rule provides that "[i]t is unlawful for a covered provider to engage or have engaged in any unfair, deceptive, or abusive act or practice in connection with the offering or provision of commercial financing or another financial product or service to a covered entity."
Under the rule:
An act or practice is unfair if either: (1) the act or practice causes or is likely to cause substantial injury to covered entities, the injury is not reasonably avoidable by covered entities, and the injury is not outweighed by countervailing benefits to covered entities or to competition; or (2) the act or practice is unfair in accordance with Business and Professions Code section 17200 and the case law thereunder.
An act or practice, including a representation or omission, is deceptive if either: (1) the act or practice misleads or is likely to mislead the covered entity, the covered entity's interpretation of the act or practice is reasonable under the circumstances, and the act or practice is material; or (2) the act or practice is deceptive in accordance with Business and Professions Code section 17200 and the case law thereunder.
An act or practice is abusive if either: (1) the act or practice materially interferes with the ability of a covered entity to understand a term or condition of commercial financing or another financial product or service; or (2) the act or practice takes unreasonable advantage of a lack of understanding on the part of the covered entity of the material risks, costs, or conditions of the commercial financing or other financial product or service; the inability of the covered entity to protect its interests in selecting or using commercial financing or another financial product or service; or the reasonable reliance by the covered entity on a covered provider to act in the interests of the covered entity.
Beginning March 15, 2025, covered providers will also be required to file an annual report with the DFPI that includes:
- the covered provider's identifying and contact information
- for each type of commercial financing offered, the total number and dollar amount (i.e., the amount financed) of commercial financing transactions with covered entities
- for each type of commercial financing offered, the number of commercial financing transactions where the amount financed falls within several predefined dollar amount intervals and
- for each type of commercial financing offered and dollar amount interval, the minimum, maximum, average, and median APRs included in disclosures required to be provided by regulation
The annual reporting requirement does not apply to covered providers that make only one commercial financing transaction to covered entities in a 12-month period or to covered providers that make five or fewer commercial financing transactions to covered entities in a 12-month period that are "incidental" to the business of the covered entity. The annual reports likely will be a source for future DFPI investigations.
Enforcement and Statute of Limitations
The rule empowers the DFPI to bring enforcement actions and proceedings against a covered provider engaging in any unfair, deceptive, or abusive practice in connection with the offering or provision of "commercial financing" or "another financial product or service," which not only encompasses traditional commercial loans, but also includes financial products and services such as real estate settlement services, check cashing, check collection, debt collection, credit counseling, and any other financial product or service enumerated in Cal. Fin. Code § 90005(k).
The DFPI's enforcement authority is limited by Cal. Fin. Code § 90014(a), which provides that no civil action may be brought under the consumer financial protection law, which now encompasses commercial financing as well, more than four years after the date of discovery of the violation to which an action relates. Once the rule becomes effective, it will be interesting to see how the DFPI will use this new authority and whether the DFPI will bring commercial UDAAP actions where the underlying conduct occurred before the effective date of the rule. It is possible that the DFPI will bring enforcement for conduct occurring before the rule is effective, given that the California Unfair Competition Law (UCL), which already prohibits unlawful, unfair, or fraudulent business acts and practices, applies in both the consumer and commercial contexts.
It seems likely that the DFPI would try to utilize its UDAAP enforcement authority for conduct occurring before the effective date of the rule, given that the rule allows the DFPI to impose penalties under Cal. Fin. Code § 90012, which include civil penalties that mirror the CFPB's UDAAP civil penalties and include a per-day violation. If challenged, the DFPI will likely argue that certain commercial entities must comply with the UCL and that they have already been on notice that deceptive or unfair acts are prohibited, but it will be interesting to see how courts would approach a challenge to the abusiveness provision, given the challenges to the CFPB's abusiveness authority.
It is clear that in promulgating this rule the DFPI is looking to treat certain small business lending in the same manner as consumer lending. In its Initial Statement of Reasons for the rule, the DFPI claimed that extending consumer UDAAP standards to the small business context was sensible because small businesses and other covered entities are "managed and operated by individuals and are consumers of financial products and services just like individual consumers."
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Given that the DFPI routinely enforces the laws under its purview against entities it supervises, it is expected that DFPI will use this new enforcement authority as soon as it becomes effective to start bringing UDAAPs into the commercial space. To prepare as a provider of commercial financing, reviewing prior DFPI enforcement actions concerning unfair or deceptive practices in the consumer loan space may be helpful to understand how the DFPI may use this new commercial UDAAP authority, and how UDAAP has been used by the CFPB and other enforcement agencies.