Debt cancellation contracts were approved by the Comptroller of the Currency for national banks in 1963. They were upheld for national banks by a federal court in Arkansas and by the U.S. Court of Appeals for the Eighth Circuit in the First National Bank of Eastern Arkansas case. But they have not taken off.
The reasons debt cancellation contracts have not been widely used by national or state-chartered banks is that neither the Office of the Comptroller of the Currency nor the courts have addressed the myriad questions that must be answered before a debt cancellation program can be safely undertaken for installment loans, credit cards, or other credit products without regulatory and legal risk.
While this article is limited to contracts that parallel credit life insurance, and it does not specifically relate to other credit insurance type products such as disability and unemployment, many of the issues raised here are relevant to these products.
Forgiving a Debt
In a debt cancellation contract, the bank agrees that in return for a payment, it will forgive the debt if the borrower dies.
This looks like credit insurance and "quacks" like credit insurance. Under the Eighth Circuit opinion, debt cancellation contracts are not "the business of insurance" but may be treated or considered as insurance for certain regulatory purposes.
Rather, the contracts are viewed as "incidental" to the business of banking.
State Versus Federal Authority
The court further holds that even though these contracts were perhaps insurance for state law purposes, the Arkansas insurance commissioner was nevertheless unable to prohibit a national bank from offering debt cancellation agreements.
Finally, the court comments that the comptroller conceded that particular state insurance regulations, such as those limiting premium rates, may apply to national banks because they do not " conflict" with, that is, essentially prohibit, the exercise of national banking powers.
Ford Barrett, a senior attorney with the Office of the Comptroller of the Currency, commenting on the district court decision in American Banker in 1989, speculated that a particular insurance activity could be both the "business of banking" and the "business of insurance."
In this event, the appropriate solution from a public policy standpoint would be for the states to regulate the activity but not prohibit it.
Hence, the debate continues: Are debt cancellation contracts insurance or not? Are these contracts insurance for some regulatory purposes and not for others? If so, for what purposes are these contracts insurance?
The Eighth Circuit Court has suggested that rates ceilings by states on credit life insurance may apply to a national bank's debt cancellation contracts. A question rises concerning Section 85 of the National Bank Act, which limits national banks to the highest rate of interest permitted a competing lender.
Is the amount paid by the debtor to the bank interest under state law? Is it material to the determination of the interest rate under the comptroller's interpretation of Section 85? Since the cost of funds now is low, this may not for the moment be a crucial question, but it may become so for usury purposes in the future.
Another troubling area is how the amount paid for the debt cancellation agreement should be treated under Truth-in-Lending. Truth-in-Lending provides special treatment for premiums for credit life insurance.
If certain steps are taken, insurance premiums for credit life can be excluded from the finance charge. If, on the other hand, the amount paid for the debt cancellation contract is not a premium and the contract is not insurance, then presumably the amount paid would have to be included in both the finance charge and the annual percentage rate, no matter what is disclosed.
Risking Absurd Results
The staff of the Federal Reserve Board, the group to whom such Truth-in-Lending matters are entrusted, seems to be leaning toward leaving the question of whether the fee for a debt cancellation contract is an insurance premium up to state law.
While this may appear to be a solution, in fact it produces absurd results. For example, it will not be very helpful to interstate issuers of credit cards. Issuers would face the prospect of offering a different annual percentage rate, depending on a state characterization of what is insurance.
Furthermore, it may not be helpful in any given state. For example, the Oklahoma Banking Department has ruled that debt cancellation contracts are not insurance and therefore may be offered by state banks. The Oklahoma Department of Consumer Credit, on the other hand, ruled that the contracts were insurance.
Similarly, the federal Equal Credit Opportunity Regulation permits differences in rates, availability, and terms in credit-related insurance products. If a debt cancellation contract is not insurance, would age rating, for example, violate the Equal Credit Opportunity Act?
Which Law Prevails?
Assuming national banks can offer these contracts because they are incidental and necessary to banking, what about state banks? If a state bank is prohibited under the State Banking or Insurance, Code from offering insurance, but is permitted to engage in any activity that a national bank can offer under the so-called wild-card statute, which prevails?
This question has not been addressed by the courts but it has been addressed by many state attorneys general. They appear to favor prohibiting the contracts for state banks.
There are several other state issues. The Circuit Court made it clear that the prohibition on the exercise by state agencies of visitorial powers over national banks, and the status of national banks as "federal instrumentalities" would prevent extensive state regulation.
It did not address many other state-oriented issues. For example, if state law requires a credit life insurance contract to be filed or approved, does that apply to a debt cancellation contract issued by a state or a national bank? What about an AIDS exclusion prohibited by a state? What about state premium taxes? And so it goes with other lesser state requirements.
There are also several tax issues relating to both the bank and the debtor. The bank under the comptroller's ruling is supposed to take a certain amount into reserve to protect against amounts which would be forgiven in the event of death.
Is this treated differently as fee income too a bank as compared to premium income to an insurance company? The tax accounting for both premium income recognition and deductions for policy reserves and claim liabilities apply only to insurance companies as defined in the Internal Revenue Code. Banks do not qualify as insurance companies.
Lacking access to the applicable Internal Revenue Code sections reserved for bona fide insurance companies, banks would appear to be subject to normal corporate tax treatment where general tax principles would appear to force immediate tax recognition of the income and defer deduction of claims until paid.
With respect to the debtor, if the amount forgiven is the proceeds of insurance, presumably it is not taxed as income to the estate of the debtor.
If, on the other hand, it is a simple debt forgiven and not insurance, then presumably it is income and taxed as such to the debtor's estate. Does this raise withholding and reporting questions?
More Questions than Answers
Debt cancellation contracts ostensibly have been a legal activity for national banks for 30 years. Credit life insurance has been regulated by the states even longer. The questions surrounding these contracts seem to have proliferated faster than answers. The Eighth Circuit Court of Appeals decision leads too a regulatory morass.
The court suggests that the issues be taken up on a case-by-case basis. This is not a practical solution. Until a vehicle is found to resolve comprehensively most if not all the issues, debt cancellation contracts will continue to languish.