The Justice Department is pressuring banks under investigation for their ties to online lenders to reach a settlement soon, according to four industry sources familiar with the matter.
The investigation concerns electronic payments that banks process for online lenders suspected of fraudulently accessing their customers' bank accounts.
Roughly 50 banks and third-party payment processing firms have received subpoenas from the Justice Department, according to sources. The Justice Department's strategy is to reach a settlement in the coming weeks with one of the banks and then to use the terms of that agreement as a template in talks with other banks, the sources said.
A Justice Department official declined to comment on settlement talks. But the official said that the department's investigation first disclosed publicly in March has had an "immediate effect" on the ability of certain lenders to access customer funds through the banking system. The DOJ says it is zeroing in only on fraudulent online lenders, though many in the banking and payment-processing industries take issue with that characterization.
"Banks are lining up to self-disclose wrongdoing to DOJ and have proactively cut off their relationship with suspect payment processors," the Justice Department official said. "As a result, legitimate payment processors are volunteering to stop processing debits against consumers' bank accounts on behalf of scammers. The banks are being forced to look closely at relationships and their own business conduct."
"The banks we are investigating are represented by many of country's leading law firms, and news of our investigations is beginning to drift into the industry conversation," the Justice Department official said. "The system is working, and as a result, banks are cutting off processors, processors are cutting off scammers, and scammers are starting to get desperate for a way to access consumers' bank accounts."
The Justice Department's investigation of online lenders and their access to customers' bank accounts is part of a broader effort by the department to crack down on mass-market consumer fraud, including Medicare scams, Internet pharmacy scams, and others.
The DOJ effort also comes at a time when the Federal Deposit Insurance Corp. has stepped up its scrutiny of banks that process payments for online lenders. Both the Justice Department and the FDIC are members of the Financial Fraud Enforcement Task Force, which has played a role in coordinating related efforts by different federal agencies.
In a March speech, Michael Bresnick, who was then the task force's executive director, detailed its efforts with respect to online lending. One issue that he flagged was whether specific online lenders are violating the laws of the states where their customers live.
"Understandably, it may not be so simple a task for a bank to determine whether the loans being processed through it are in violation of the state law where the borrower resides," Bresnick acknowledged, before adding: "Yet, at a minimum, banks might consider determining the states where the payday lender makes loans, as well as what types of loans it offers, the APR of the loans, and whether it make loans to consumers in violation of state, as well as federal, laws."
The relevant legal issues are complicated by the fact that many online lenders a category that includes both payday lenders and installment lenders maintain they are not required to hold licenses in every state in which their borrowers live.
Online lenders that are making such legal arguments include, but are not limited to, firms owned by Indian tribes. Firms owned by tribes maintain they are not subject to state law because of tribal sovereignty. Many online loans are so expensive that the companies making them would be unable to get licensed in states with strict caps on interest rates.
Under the proposed settlement terms being shopped by the Justice Department, a subpoenaed bank would agree to stop processing certain types of payments and pay a fine, according to the four industry sources.
Some of the sources said that additional settlement terms are possible: an independent review to ensure that the bank remains in compliance with the settlement's terms, a stipulation to a set of facts that could then be used in future civil litigation against the bank, or both of those provisions.
Many of the banks that have received subpoenas are small institutions, but some large banks have gotten them as well, sources said.
One implication that banks are taking from their talks with the Justice Department, according to sources, is that banks that reach a settlement sooner will get a better deal than those that wait.
So far, the only bank to acknowledge publicly that it has come into the Justice Department's crosshairs is the $342 million-asset National Bank of California in Los Angeles. In a Sept. 16 press release, the bank disclosed that its $25 million recapitalization is contingent on resolving pending inquiries by the DOJ related to its relationships with companies that may have processed payments for payday lenders.
In a brief interview last week, National Bank of California President Henry Homsher said that he was working to reach a settlement, but declined to comment further.
In settlement talks between banks and the Justice Department, one key issue will be the breadth of the language barring the bank from processing certain payments. Some online lenders are licensed in every state in which their borrowers reside, so there is no ambiguity about the legality of their businesses.
"I think it's important to note that this is at base an attack on fraudulent conduct," says Bresnick, who recently left the Financial Fraud Enforcement Task Force and is now in private law practice in Washington, D.C. "It's not an attack on an entire industry."
But officials in the banking industry as well as at third-party payment processors are chafing at the Justice Department's methods for ferreting out fraud.
The DOJ has established the following benchmark, according to numerous sources: a specific merchant, such as an online lender, that has at least a 3% return rate on electronic transactions, should raise a red flag for the bank. In other words, the Justice Department is telling banks to be wary of online lenders if at least 3% of their requests to withdraw cash from a customer account get returned. The return rate for all electronic payments was just under 1% in 2012, according to Nacha, the bank-owned group that runs the ACH network.
Officials in the banking and payment processing industries argue that a 3% threshold is too low because a returned transaction does not necessarily mean the lender was making an unauthorized withdrawal.
For example, the return rate includes instances where the customers do not have sufficient funds in their accounts a situation that likely happens more frequently with high-interest rate online loans than for many other forms of online commerce, because the loans tend to go to cash-strapped consumers.
Using a 3% return rate as a threshold is "ridiculous," argues Marsha Jones, director of the Third Party Payment Processors Association, which was formed last month in response to the heightened regulatory scrutiny of the industry. "It's just not something that supports evidence of fraud."
But Bresnick, the former head of the financial fraud task force, says that elevated return rates are "a significant red flag," and that even high return rates that stem from the depositor having insufficient funds can be an indication of fraud.