In a shot across the bow for national banks, the U.S. Court of Appeals for the Ninth Circuit ruled that such banks may not avoid paying interest on funds held in California escrow accounts. The reason? The California law does not significantly interfere with or impede a national bank’s exercise of its banking powers.
The decision will most certainly will have a material impact on those national banks doing business in California (and elsewhere within that Circuit) that relied on National Bank Act (NBA) preemption to avoid a number of consumer banking laws, and not just those that currently require interest on customer escrow accounts.
For many years, national banks have relied on preemption to exempt potential obligations, not just under state escrow laws, but more broadly. Indeed, national banks have relied extensively on the 2004 pre-emption determination of the Office of the Comptroller of the Currency (OCC) that, “except where made applicable by Federal law, state laws that obstruct, impair, or condition a national bank’s ability to fully exercise its Federally authorized real estate lending powers do not apply to national banks,” 12 C.F.R. Section 34.4(a) (effective Jan. 13, 2004).
All that changes for national banks, in the Ninth Circuit states at least, after Lusnak v. Bank of America. The decision arises out of plaintiff’s 2008 purchase of a home in Palmdale, California. The plaintiff’s mortgage and later refinance through Bank of America provided that it “shall be governed by federal law and the law of the jurisdiction in which the Property is located.” The mortgage terms also required that Lusnak pay $250 per month into his mortgage escrow account. Despite the California location, Bank of America offered no interest on escrow accounts. But California’s escrow interest law (California Civil Code Section 2954.8(a)), requires that financial institutions pay borrowers at least 2 percent annual interest on funds held in the borrowers’ escrow accounts. Further, section 1639d(g)(3) of the federal Truth in Lending Act (TILA), requires that banks pay interest on escrow accounts if “prescribed by applicable state or federal law … in the manner as prescribed by that applicable State of Federal law.”
As a national bank, Bank of America contended that it was not required to comply with the California escrow interest law because no federal or “applicable” state law requires it to pay interest on Lusnak’s escrow account funds. That is, there is no “applicable” state law because California law is pre-empted.
Lusnak filed a putative class action in 2014, asserting violations of the “unlawful” prong of California’s Unfair Competition Law (UCL), and breach of contract. The Central District of California dismissed the suit, ruling that the NBA pre-empted California law.
But the Ninth Circuit reversed and revived the putative class action. Citing the Supreme Court’s 1996 decision in Barnett Bank of Marion County v. Nelson, the court held that states were not “deprive[d] … of the power to regulate national banks, where … doing so does not prevent or significantly interfere with the national bank’s exercise of its powers.”
At the time, the OCC and other regulators (especially the now-defunct Office of Thrift Supervision) took an expansive view of federal preemption. Congress attempted to bring certainty to the preemption standard when, in 2010, it enacted the Dodd-Frank Wall Street Reform and Consumer Protection Act. Dodd-Frank expressly incorporated the Barnett Bank preemption standard.
Looking primarily to Barnett, the Ninth Circuit pointed out “that Barnett Bank continues to provide the preemption standard,” but then recharacterized it narrowly, concluding that “state consumer financial law is preempted only if it ‘prevents or significantly interferes with the exercise by the national bank of its powers.’” That “only” language is not in the Barnett Bank ruling. Further, the Ninth Circuit expressly rejected the broad OCC guidance from 2004, concluding that such position is inconsistent with Barnett.
Dodd-Frank, said the Ninth Circuit, presented a “sea change” in banking law through which “Congress aimed to undo broad preemption determinations, which it believed planted the seeds ‘for long-term trouble in the national banking system.’” The panel cited TILA’s “applicable” state law provision as one such example. While Dodd-Frank itself does not define the term “applicable,” the panel found that “in the context of section 1639d(g)(3), [the term] would appear to include any relevant or appropriate state laws that require creditors to pay interest on escrow account funds.”
The panel also found that legislative history confirmed its interpretation, citing a passage in a House Report setting forth the purpose behind the provision as requiring that servicers administer accounts in accordance with “the law of the State where the real property security … is located, including making interest payments on the escrow account if required under such laws” (emphasis in original). “This passage shows Congress’s view that creditors, including large corporate banks like [defendant], can comply with state escrow interest laws without any significant interference with their banking powers.”
The Ninth Circuit ruling is not only a direct attack on preemption, but also runs contrary to California Supreme Court jurisprudence, such as Parks v. MBNA American Bank, 54 Cal. 4th 376 (2012), in which the states’ highest court held that a California law concerning disclosures on preprinted checks issued by credit card companies was preempted. The Ninth Circuit’s decision that the NBA does not preempt California’s law could have wide-ranging effects, both with respect to escrow laws and other state laws purporting to regulate lenders. This issue seems poised for Supreme Court review as it is likely this issue will be brought before a different circuit court which might view the issue differently, teeing up a circuit split. Moreover, there might be continued litigation in California (and nationwide) as to what constitutes “significant interference” with a bank’s ability to engage in business.
For now, the opinion is the law of the land in California (and the rest of the Ninth Circuit states) and could prove costly, with the court noting that the bank’s obligation to pay interest on any funds in Lusnak’s escrow account was triggered from the point at which it assumed control of his account going forward—almost a decade ago. Financial institutions should consider whether revising lending agreements governed by California law is warranted in order to account for obligations triggered by the state escrow interest law.
Richard Gottlieb is co-chair of the financial services group at Manatt, Phelps & Phillips in Chicago.
Diana Eisner is a litigation associate in the firm’s Washington, D.C., office.