PREPAYMENT PENALTIES AND FEDERAL PREEMPTION: A LEGAL ENIGMA
by Joshua Stern, ATG Law Clerk

EDITOR'S NOTE: The Office of the Comptroller of the Currency recently published its final rule, mentioned in this article. The following Legislative Update summarizes the rule.

With interest rates at historic lows in the last two years, for many homeowners the refinancing of mortgages may seem like a no-brainer. However, the presence of prepayment penalties, especially prevalent in sub-prime mortgage loans (80 percent of sub-prime loans contain prepayment penalties, as compared with just a two percent rate for conventional loans), can make refinancing more expensive, draining an individual's home equity, or even trapping a homeowner at the higher interest rate, increasing the risk of foreclosure. Debbie Goldstein and Stacey Strohauer Son, Why Prepayment Penalties are Abusive in Sub-Prime Home Loans, Center for Responsible Lending Policy Brief, April 2, 2003. A prepayment penalty is a charge for the early payment of a mortgage. It is not exclusive to refinancing and can be levied whenever a homeowner decides to pay off a mortgage containing prepayment penalty provisions earlier than the agreed loan termination. These penalties have a devastating effect on individual borrowers, and according to the Center for Responsible Lending, 850,000 families lose $2.3 billion of home equity wealth annually because of these penalties.

Many states, including Illinois, have taken the position that such penalty provisions are targeted in a predatory manner at unsophisticated borrowers with little bargaining power. These states have enacted legislation, which in some cases is more stringent than existing federal legislation, to prevent the use of such penalties. While most states have restrictions on prepayment penalties, federal preemption often makes these statutes inapplicable. It should be noted that while normatively speaking state predatory lending law might be considered more stringent, the federal system does have various statutory schemes in place to guard against predatory practices. These include the various provisions of the Home Ownership and Equity and Protection Act, the Truth in Lending Act, and the Federal Trade Commission's regulations.

To those who think that they already understand the federal preemption of state prepayment penalty law, a recent change in the Code of Federal Regulations (CFR), effective July 1, 2003, and also a recent request for a 30-day comment period by the Office of the Comptroller of the Currency (OCC), puts the current state of the law into flux and makes this article worth reviewing.

Federally Chartered Creditors

Federal Savings Associations
Section 4(a) and 5(a) of the Home Owners Loan Act, 12 USC §§ 1463(a), 1464(a), authorizes the Office of Thrift Supervision (OTS) to promulgate regulations that preempt state laws affecting the operations of federal savings associations. The OTS regards its powers in preempting state law with regards to federal savings associations as exclusive and plenary. 12 CFR § 545.2 Using these powers, the OTS has issued regulations for federal saving associations with the averred purpose of achieving "maximum flexibility to exercise their lending powers in accordance with a uniform federal scheme of regulation" and "efficiently delivering low cost credit to the public free from undue regulatory duplication and burden." 12 CFR § 560.2. Accordingly, the OTS permits federal savings associations to extend credit, in conformity with federal law, without regard to state laws. Id. The OTS defines state law as "any state statute, regulation, ruling, order or judicial decision" but does not include such things as contract, property, tort or criminal law in the exemption. 12 CFR § 560.2 (c). Specifically, the OTS illustratively lists state laws "purporting to impose requirements regarding" prepayment penalties as being preempted. 12 CFR § 560.2 (b)(5). Prepayments are specifically permitted, so long as they are subject to the terms of the loan contract and "any prepayment on a real estate loan must be applied directly to reduce the principal balance." 12 CFR § 560.34.

National Banks
The OTS has recently reaffirmed that state laws attempting to regulate prepayment penalties issued by federal savings associations are preempted, recently declaring that the Georgia Fair Lending Act, which contained provisions prohibiting prepayment penalties, as is preempted. See January 22, 2003, OTS News Release "OTS Says Georgia Law Doesn't Apply to Federal Thrifts," 2003 WL 151806 (OTS) and January 21, 2003, Legal Opinion by Chief Counsel Carolyn Buck, P-2003-1- http://www.ots.treas.gov.

Nevertheless, the issue has yet to be formally resolved for the OCC and national banks. With regard to an inquiry concerning the same Georgia law that the OTS recently said was preempted, the Georgia Fair Lending Act, the OCC has declined making an immediate ruling and asked for comment for a period of 30 days relative to this issue. See February 21, 2003, OCC Press Release "OCC Issues Guidelines to National Banks to Guard Against Abusive Lending Practices; Invites Comments on Request to Determine that Georgia Law is Preempted," NR-2003-08 and OCC Notice of Request for Preemption Determination Order, Docket No. 03-04. Although the OCC has said that its ruling will be applied only to the specifics of the Georgia law, it is quite clear that its decision will have ramifications for the preemption of other state prepayment regulations.

The power of the OCC to regulate national banks is derived from 12 USC § 371, which vests the "comprehensive authority to regulate and restrict the real estate lending activities of national banks." OCC, Docket No. 03-04- Notice of Request for Preemption Determination or Order. Section 371 specifically provides that:

"[a]ny national bank association may make, arrange, purchase or sell loans or extensions of credit secured by liens on interests in real estate, subject to section 1828(o) of this title, and such restrictions and requirements as the Comptroller of the Currency may prescribe by regulation and order."

The powers granted by Section 371 are not conditioned by any state requirement and the OCC, through the issuing of 12 CFR § 34.4(b), has sought to apply the "recognized principles of federal preemption in considering whether State laws apply to other aspects of real estate lending by national banks." According to the OCC, this means that "State laws apply to national banks unless the State law expressly conflicts with federal law, the State law stands as an obstacle to the accomplishment of the full purposes and objectives of the federal law, or federal law is so comprehensive as to evidence a congressional intent to occupy a given field." See Federal Register: March 20, 1996, (Volume 61, Number 55) - OCC Real Estate Lending and Appraisals. This standard is also spelled out inBarnett Bank of Marion County v Nelson, 517 US 25, 116 S Ct 1103, 134 L Ed 2d 237 (US Sct 1996). The OCC will decide in the coming months whether the prohibition of prepayment penalties by Georgia law falls within these recognized principles of federal preemption. Until then, we must wait to see whether national banks are subject to state prepayment penalty restrictions.

Adjustable Rate Mortgages
In the area of adjustable rate mortgages (ARMs), the OCC has already decided that state prepayment penalty laws are preempted. The OCC defines an ARM loan as "an extension of credit made to finance or refinance the purchase of, and secured by a lien on, a one-to-four-family dwelling, including a condominium unit, cooperative housing unit, or residential manufactured home, where the lender, pursuant to an agreement with the borrower, may adjust the rate of interest from time to time." 12 CFR § 34.20. Specifically, in 12 CFR § 34.23, titled Prepayment Penalties, the OCC declared, "a national bank offering or purchasing ARM loans may impose fees for prepayments notwithstanding any state law limitations to the contrary."

Federal Credit Unions
Federal credit unions are banned from using prepayment penalties under 12 USC § 1757(5)(A)(viii) and therefore state laws that permit federal credit unions to make use of prepayment penalties are preempted. See March 2, 2001, NCUA Opinion letter Re: Applicability of State Lending Regulation to Federal Credit Unions,http://www.ncua.gov/ref/opinion_letters/2000/00-0827.html.

Non-Federally Chartered Lending Institutions

Federal preemption of state law, as it relates to non-federally chartered institutions, is not as broad as for national credit institutions, and was undertaken for different purposes. Also, the statutory authority is different than the previously discussed preemption for national credit institutions. Preemption for state institutions is based on the "Alternative Mortgage Transaction Parity Act," 12 USC §§ 3801-3806 (Parity Act). The Parity Act was passed in 1982 during a period of increasingly volatile and dynamic changes in interest rates. Congress believed that the only way to provide for an adequate credit supply was to encourage the use of alternative mortgage transactions. 12 USC § 3801. The Act defines an alternative mortgage transaction as:

"A loan or credit sale secured by an interest in residential real property…in which the interest rate or finance charge may be adjusted or renegotiated; involving a fixed-rate, but which implicitly permits rate adjustments by having the debt mature at the end of an interval shorter than the term of the amortization schedule; or involving any similar type of rate, method of determining return, term, repayment, or other variation not common to traditional fixed-rate, fixed-term transactions, including without limitation, transactions that involve the sharing of equity or appreciation." 12 USC § 3802(1).

The most common types of these alternative mortgage transactions are balloon payments and adjustable rate mortgage loans.

The Parity Act specifically confers on non-federally chartered housing lenders the right to make alternative mortgage transactions on the same terms as federal lenders, hence the use of the term "parity" in the title. 12 USC § 3803(c). According to the Parity Act, state chartered commercial banks and state chartered credit unions wishing to make an alternative mortgage transaction must comply with regulations of the OCC and National Credit Union Administration (NCUA), respectively. Housing creditors, other than state chartered commercial banks and credit unions, must comply with the regulations of the OTS. The Parity Act "does not place non-federally chartered housing creditors under the supervision of the federal agencies, but instead merely enables them to follow a federal program as an alternative to state law." 48 Fed.Reg. 23032, 23053.

The Parity Act accomplishes its goals of achieving parity between state and federal lenders making alternative mortgage transactions by granting the various agencies (NCUA, OCC, and OTS) the power to preempt state law, which puts state credit institutions on a disadvantaged playing field. 12 USC § 3803(c). The Parity Act is not explicit as to which types of state law regulation are preempted, and leaves that decision up to the various federal regulators. It should be pointed out that at the time of the 1982 passage of the Parity Act, Congress allowed states to opt out if done so within three years after its October 1982 passage. 12 USC § 3804(a). Maine, Massachusetts, New York, and South Carolina opted out of all provisions of the Parity Act, with Arizona opting out of the federal preemption as it related to balloon payment, and Wisconsin opting out of the law as it relates to consumer credit transactions under the Wisconsin Consumer Act.

Non-Federally Chartered Savings Associations

Rules pertaining to the preemption of state law under the Parity Act as it relates to non-federally chartered savings associations are proffered by the OTS. In 1996 the OTS adopted 12 CFR § 560.220, which made clear that state chartered savings associations were permitted to charge prepayment penalties even if they contravened state law. Recently the OTS has reversed course, and on September 26, 2002, it published a new final rule identifying the kinds of state limitations that would be preempted by the Parity Act. 67 Fed.Reg. 60542. The OTS decided this time that prepayment penalties were not essential to achieving parity and therefore did not require preemption to effectuate the stated goals of the Parity Act. These new rules went into effect July 30, 2003, and lenders are now bound by state prepayment penalty restrictions. However, the OTS emphatically states, "there is no basis for arguing that the final rule applies retroactively to transactions consummated before the effective date." Id.

While the OTS has held that its revised Section 560.220 will come into effect non-retroactively, the New Jersey appellate court, relying on the OTS's statements in its final rule summary (67 Fed. Reg. 60542), ruled that the federal preemption of prepayment penalties was arbitrary and capricious and exceeded the authority of the OTS.Glukowsky v Equity One, Inc, 821 A 2d 485 (2003). According to the court, "we agree with the reasoning set forth in the OTS's Notice of Proposed Rulemaking. In accordance with that reasoning, we find that 12 CFR § 560.220 is invalid."Id. at 507. Therefore the New Jersey court refused to apply the rule revision post-hoc, and instead invalidated the OTS's previous preemption as exceeding the scope of authority delegated to the OTS by Congress. This ruling opened up the possibility that prior reliance on preemption of state law might be in jeopardy.

It is not at all clear if other jurisdictions will follow New Jersey's lead, but prior federal case law has on numerous occasions upheld the federal preemption of state prepayment penalty restrictions. SeeShinn v Encore Mortgage Serv, Inc, 96 F Supp 2d 419 (D NJ 2000). New Jersey, inGlukowsky, attempted to distinguish prior case law on the grounds that the previous cases did not have OTS's explicit admission that it exceeded Congressional authority, at least that is how the New Jersey court interpreted OTS's final rule summary. Most recently though, an Illinois federal court, which ruled after the publication of the final rule but before its enactment refused to employ the same New Jersey logic and upheld the OTS's preemption of state law. More case law is perhaps needed on this issue before it can be definitively resolved.

State-Chartered Commercial Banks
The OCC, which has the authority to issue regulations as they relate to state-chartered commercial banks and the Parity Act, has determined that federal preemption of state predatory lending rules, including prepayment penalties, shall apply only to adjustable rate mortgage lending. 12 CFR § 34.24. This is consistent with the prior OCC decisions to allow national banks to enter into prepayment penalties notwithstanding state law. 12 CFR § 34.23. The OCC's definition of an ARM is, "an extension of credit made to finance or refinance the purchase of, and secured by a lien on, a one-to-four family dwelling, including a condominium unit, cooperative housing unit, or residential manufactured home, where the lender, pursuant to an agreement with the borrower, may adjust the rate of interest from time to time." 12 CFR § 34.20.

State Credit Unions
The NCUA bans prepayment penalties on federal credit unions, 12 USC § 1757(5)(A)(viii), and a state chartered credit union that decides to invoke the Parity Act is not allowed to use prepayment penalties even if the state laws on prepayment penalties are less stringent. 12 CFR § 701.21(a). In such a situation the more restrictive federal provision preempts the state provision. Id.

Conclusion and Implications for Future Change

Prepayment penalties, once seen as a necessary facet of lending practice, are increasingly viewed with suspicion. The recent change in the OTS's regulations and the initiation of a comment period by the OCC reflect a paradigm shift in the way federal regulation treats prepayment penalties. Federal agencies have begun to look more and more to the state law in helping ameliorate these lending abuses. As such, it would not be surprising if the state of prepayment penalty law, already in flux, continues to remain so. Therefore, while this article provides an up-to-date analysis of prepayment penalty preemption, it may become outdated. You should continue to pay attention to this changing area of the law. We will continue to monitor this changing area of the law and encourage readers to do the same.

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