A court ruling against a two-year-old Connecticut restriction on tax refund anticipation loans may set a precedent for banks making these loans elsewhere.
Connecticut had tried to get around the national bank exemption from state consumer protection laws by going after the tax preparers instead of the banks. But the U.S. Court of Appeals for the Second Circuit said in a ruling last month that because tax preparation companies work on behalf of the banks, the preparers and the lenders can ignore the law.
The ruling upheld a lower court's decision in August 2006 allowing national banks to disregard the law, which caps the annual percentage rate on refund anticipation loans at 60%. Banks making these short-term loans typically charge fees ranging from $29 to $120, which amounts to an APR ranging from 40% to 700%, depending on the size of the refund.
Pacific Capital Bancorp of Santa Barbara, Calif., filed the original lawsuit against the state of Connecticut. The $7.5 billion-asset company's biggest subsidiary, Santa Barbara Bank and Trust, is one of a handful of banks in the country that fund the loans made through tax preparers. Others include the $177 billion-asset HSBC Bank USA, a unit of London-based HSBC Holdings Plc, and Republic Bank and Trust Co., a unit of the $3 billion-asset Republic Bancorp Inc. in Louisville.
The Connecticut law did not directly target banks. Instead, it applied the rate cap to tax preparers such as H&R Block Inc. and Jackson Hewitt Tax Service Inc. The appeals court agreed with the lower court's ruling that tax preparers are only working on behalf of national banks that originate the loans. Therefore, the preparers may ignore the Connecticut law, the appeals court said, because the National Bank Act exempts national banks from state consumer protection laws.
The appeals court's ruling sets a "strong precedent" that will likely discourage other states from trying to "creatively bypass preemption" by enacting similar laws, said Howard N. Cayne, a partner at Arnold & Porter LLP in Washington, who wrote an amicus brief for the case on behalf of the American Bankers Association.
A Pacific Capital spokeswoman, wrote in an e-mail, "We are very pleased with the ruling." She would not comment further. John Rippy, Republic Bank and Trust's risk management officer, said in an interview that it is "really happy for the industry" that Santa Barbara Bank and Trust "won this preemption case, but beyond that, we are not going to comment." HSBC would not discuss the ruling.
Historically, refund anticipation loans have generated a substantial portion of Pacific Capital's annual profits. Aaron Deer, an analyst at Sandler O'Neill & Partners LP in San Francisco, said the business line is particularly important this year as the company struggles with deteriorating credit quality in residential construction loans.
Pacific Capital originates most of its refund anticipation loans and get most of its income from the specialized loans in the first quarter of every year. This year its first-quarter pretax income from the business rose 92% from a year earlier, to $108 million. That more than offset a 72% decline in pretax income from Pacific Capital's core banking operations excluding refund anticipation loans, which fell to $8.3 million, because of a $15.6 million loan-loss provision. Overall first-quarter net income rose 43%, to $72.5 million. In the second quarter pretax income from refund anticipation loans was predictably more modest, rising 13.6% from a year earlier, to $10 million. It was not enough to offset a sevenfold increase in Pacific Capital's provision, to $37.2 million, which caused the company to swing to a $5.9 million loss. It had earned $33.2 million in a year earlier.
Chi Chi Wu, a staff attorney for the National Consumer Law Center in Boston, said groups like hers would continue to call for restrictions on these loans, because they have "triple-digit APRs." Ms. Wu wrote an amicus brief for the case on behalf of the state of Connecticut. Consumer advocates are paying particularly close attention to a proposal the Internal Revenue Service made in January that would prohibit tax preparers from disclosing or using taxpayer return information for the purpose of marketing refund anticipation loans. That proposal is still in the public comment period.