The “Adam’s Rib” of assignee liability ̶ the “Holder Rule” issued by the Federal Trade Commission (“FTC”) in 1976 ̶ is up for review. Imposing liability on innocent purchasers of consumer credit loans for the legal violations of the originating creditors has long been a controversial issue in the capital markets. The FTC is seeking public input as it reviews the Trade Regulation Rule Concerning Preservation of Consumers’ Claims and Defenses, commonly known as the Holder Rule.[1] Although the Rule has not garnered significant attention over its 40-year existence, industry members should consider commenting by the February 12 deadline. Changes to the Holder Rule, including the scope and types of claims and defenses that can be asserted against a holder, could have a material impact on the market. The Consumer Financial Protection Bureau can also enforce the Holder Rule against covered institutions.[2]

The FTC seeks comments on 15 questions about the Holder Rule encompassing the following:

• The economic impact and continuing need for the Rule;
• Developments in case law that should be reflected in the Holder Rule; and
• Industry changes that may warrant changing the Rule.[3]

I. What Is the Holder Rule?

a. Basic Requirements
The Holder Rule requires sellers of consumer goods or services to include the following notice (“Holder Notice”) in at least 10-point, boldface type to consumers in connection with covered consumer credit contracts:

ANY HOLDER OF THIS CONSUMER CREDIT CONTRACT IS SUBJECT TO ALL CLAIMS AND DEFENSES WHICH THE DEBTOR COULD ASSERT AGAINST THE SELLER OF GOODS OR SERVICES OBTAINED PURSUANT HERETO OR WITH THE PROCEEDS HEREOF. RECOVERY HEREUNDER BY THE DEBTOR SHALL NOT EXCEED AMOUNTS PAID BY THE DEBTOR HEREUNDER.

It is an unfair or deceptive act or practice, in violation of Section 5 of the FTC Act, to fail to include the Holder Notice in certain consumer credit contracts.[4]

b. History and Purpose
When promulgating the Rule in 1975, the FTC explored the parade of horrors that could result from allegedly unsavory practices associated with sale of consumer goods and services and the subsequent assignment of those contracts to other institutions. The Holder Rule sought to shift the risk of a seller’s breach to the assignee: the consumer would no longer be obligated to pay the assignee, and the assignee would in turn likely have a claim to indemnification from the seller. Without the Holder Rule, under the Uniform Commercial Code’s holder in due course doctrine, if a seller were to breach its obligations to the consumer, the consumer’s sole remedy would be against the seller, and the consumer would continue to be obligated to pay the assignee of the contract. If a holder or assignee meets the legal test for holder in due course status, then that assignee can enforce the debtor’s obligations notwithstanding many defenses to payment, or counterclaim for recoupment or setoff, that the debtor may have had against the original payee.[5] When promulgating the Rule, the FTC noted that in consumer credit transactions, “defeating holder in due course status is always difficult and almost impossible.”[6]

The FTC explained that the Holder Rule’s cost- and risk-shifting approach is appropriate in covered consumer contracts because the assignee is in a better position—both in terms of economic power and ability to bear costs pending resolution—than the consumer is to prevent seller misconduct and transfer back to the seller any costs of the misconduct that may occur.[7] Under the Holder Rule, a consumer who no longer has recourse against a seller who delivers defective goods and then goes out of business, would have recourse against the assignee of the associated credit contract.

The Holder Notice allows the consumer to assert claims and defenses to defeat or diminish the right of a creditor to be paid under the contract, where a seller who arranges financing for a buyer breaches the contract or is guilty of misconduct in connection with the transaction.[8]

II. Who Is Subject to the Holder Rule
The Holder Rule applies to credit extended to consumers, defined as natural persons who seek or acquire goods or services for personal, family, or household purposes.[9] The Holder Rule only applies to two types of covered loan transactions: purchase money loans and credit sales. A purchase money loan is a cash advance which a consumer receives in return for a finance charge (as defined under the Truth in Lending Act and implementing Regulation Z), which is applied, in whole or substantial part, to a purchase of goods or services from a seller who (1) refers consumers to the creditor or (2) is affiliated with the creditor by common control, contract, or business arrangement.[10] The Holder Rule uses the TILA and Regulation Z definition of credit sale, defined as a sale in which the seller is a creditor, including a bailment or lease (unless terminable without penalty at any time by the consumer) under which the consumer: (i) Agrees to pay as compensation for use a sum substantially equivalent to, or in excess of, the total value of the property and service involved; and (ii) Will become (or has the option to become), for no additional consideration or for nominal consideration, the owner of the property upon compliance with the agreement.[11]

The Holder Rule applies to sellers, defined as a person who, in the ordinary course of business, sells or leases goods or services to consumers.[12] Case law applying the Rule has traditionally focused on installment contracts for goods, such as automobiles and retail goods and services, and the Statement of Basis and Purpose highlights unsavory seller practices in the sale of goods and services such as furniture, appliances, and alarm systems.[13] The Holder Rule does not apply to mortgage loan originators or arrangers.[14]

III. Why Should We Care?
The Holder Rule can have a material impact on the value of assets a holder acquires and can subject assignees to certain claims and defenses for conduct that the assignee may not have initially taken part in or considered. In particular, industry participants should take note of the types of claims that the consumer can assert against the holder and, given the already expansive nature of the Rule, to which products and services the Rule applies.

a. Claims and Defenses
For transactions subject to the Holder Rule, the claims and defenses that may be asserted against the assignee are not limited to contractual claims or defenses, but may include fraud, tort, or unfair or deceptive acts or practices (“UDAP”).[15] The consumer may assert claims as defenses to collection and payment or as counterclaims if the assignee enforces the debt against the consumer.

However, whether the consumer may bring any affirmative claims against the assignee is not clear. Read literally, the plain language of the Holder Notice suggests that any defense or affirmative claim that could be brought by a consumer against the seller could similarly be brought against an assignee of the consumer credit contract. The Statement of Basis and Purpose, however, indicates that the term “claims and defenses” should be interpreted in a more limited fashion. The Statement of Basis and Purpose explains:

This Rule is directed at the preservation of consumer claims and defenses. It will require that all consumer contracts generated by consumer sales to include a provision which allows the consumer to assert his sale-related claims and defenses against any holder of the credit obligation. From the consumer’s standpoints, this means that a consumer can (1) defend a creditor suit for payment of an obligation by raising a valid claim against the seller as a setoff, and (2) maintain an affirmative action against a creditor who has received payments for return of monies paid on an account. The latter alternative will only be available where a seller’s breach is so substantial that a court is persuaded that rescission and restitution are justified. The most typical example of such a case would involve non-delivery, where delivery was scheduled after the date payments to a creditor commenced.[16]

The FTC further explained,

[c]onsumers will not be in a position to obtain an affirmative recovery from a creditor unless they have actually commenced payments and received little or nothing of value from the seller.[17]

Despite these statements demonstrating that the FTC originally sought to effectively eliminate holder in due course status for purchasers, and limit the types of affirmative claims that could be brought against an assignee, case law is mixed on the issue. Some courts have interpreted the Rule more broadly and held that the language of the Holder Notice allows affirmative claims (in addition to defenses against enforcement).[18] Other courts have limited affirmative claims pursuant to the FTC’s original guidance, where rescission and restitution are justified.[19] The recent trend in the case law has been to limit circumstances in which a consumer can affirmatively recover from an assignee.[20]

In addition to the mixed case law, the FTC appears to have scaled back its original opinion on limited affirmative claims in recent agency guidance. The FTC issued additional guidance on the application of the Holder Rule in 1999 as a staff letter and in 2012 as a formal Commission advisory opinion, criticizing court cases interpreting the Holder Notice as restricting affirmative recovery by a consumer to circumstances where he or she is entitled to rescission or similar relief under state law.[21] The FTC did not attempt to withdraw or amend the language from the original Statement of Basis and Purpose, but instead suggested that the comments used to limit consumer’s affirmative recovery have been misinterpreted and taken out of context.

The FTC’s formal 2012 advisory opinion expresses the FTC’s current position that the Holder Rule is “unambiguous” and should not be limited to matters of defense or setoff and that consumers should be entitled to recover all of the funds that they have paid, even in circumstances where rescission is not warranted.[22] “It remains the Commission’s intent that the plain language of the Rule be applied.”[23] At least one court has cited the FTC’s 2012 advisory opinion in permitting any affirmative claim for recovery against an assignee, and rejecting a test to determine whether the seller’s breach renders the transaction practically worthless to the consumer.[24]

b. Applicability
The FTC is also seeking comments on whether the Holder Rule should be expanded to other goods and services. When promulgating the rule in 1975, certain consumer protections either did not exist or were in their infancy, such as the prohibition on unfair, deceptive, or abusive acts or practices; state protections for various retail sales; and protections under the Fair Debt Collection Practices Act. Indeed the policy justifications for the Holder Rule have been hotly debated by state legislatures and Congress, particularly in the mortgage context.

Congress has considered and, in some cases, applied, various options to narrowly expand assignee liability for certain mortgages. In 1994, Congress extended certain aspects of the Holder Rule nearly verbatim to “high cost” mortgages under the Home Ownership Equity Protection Act (“HOEPA”).[25] Congress also extended assignee liability in the ability to repay rules where a borrower may assert a defense to foreclosure against a holder of a non-qualified mortgage loan based on alleged ability to repay violations by the originator.[26] Assignees may also be liable for violations of the TILA-RESPA Integrated Disclosure rule where violations are apparent on the face of the disclosure statement provided to the consumer.[27] Finally, the Uniform Home Foreclosure Procedures Act, which states have the ability to adopt either in whole or in part, also contains controversial assignee liability provisions that would subject a holder to certain claims and defenses that the borrower could assert against the originator.[28] Given the history of activity in states and Congress of narrowly expanding assignee liability in limited mortgage contexts, when revisiting the Rule the FTC should not be able to use its UDAP authority and the Holder Rule to further expand assignee liability.

*           *           *

Industry members should consider commenting on the following aspects of the Holder Rule:

1. Whether the Holder Rule is even necessary in today’s regulatory environment.
2. If so, should the scope of the Holder Rule follow the original intent of limiting holder in due course status for assignees and preserving defenses, rather than authorizing affirmative claims for consumers.
3. Whether the FTC should expand the Rule to apply to other industries.

Comments are due by February 12, 2016 and can be submitted electronically at https://ftcpublic.commentworks.com/ftc/holderrule/.

Notes:
[1] 16 C.F.R. part 433.

[2] Bureau of Consumer Financial Protection, Identification of Enforceable Rules and Orders, 76 Fed. Reg. 43,569 (July 21, 2011)

[3] Federal Trade Commission, Rules and Regulations Under the Trade Regulation Rule Concerning Preservation of Consumers’ Claims and Defenses, 80 Fed. Reg. 75,018 (Dec. 1, 2015).

[4] 16 C.F.R. § 433.2.

[5] U.C.C. § 3-305(a)(1). The full list of conditions under the U.C.C. for holder in due course status are that: (1) the instrument when issued or negotiated to the holder does not bear such apparent evidence of forgery or alteration or is not otherwise so irregular or incomplete as to call into question its authenticity; and  (2) the holder took the instrument (i) for value, (ii) in good faith, (iii) without notice that the instrument is overdue or has been dishonored or that there is an uncured default with respect to payment of another instrument issued as part of the same series, (iv) without notice that the instrument contains an unauthorized signature or has been altered, (v) without notice of any claim to the instrument described in Section 3-306, and (vi) without notice that any party has a defense or claim in recoupment described in Section 3-305(a). 

[6] Federal Trade Commission, Statement of Basis and Purpose, Trade Regulation Rule Concerning the Preservation of Consumers’ Claims and Defenses, 40 Fed. Reg. 53,506, at 53,508 (Nov. 18, 1975).

[7] Id. at 53,523.

[8] Federal Trade Commission, Staff Guidelines on Trade Regulation Rule Concerning Preservation of Consumers’ Claims and Defenses, 5 (May 4, 1976) [hereinafter “Staff Guidelines”].

[9] Id. § 433.1(b).

[10] Id. § 433.1(d).

[11] 12 C.F.R. § 1026.2(16).

[12] 16 C.F.R. § 433.1(j).

[13] 40 Fed. Reg. 53,506, 53,510-11 (Nov. 18, 1975).

[14] See also Staff Guidelines, at 9 (“… only purchases of goods and services are covered by the Rule. Sales of interests in real property are unaffected…”). Note that home improvement loans used to purchase goods and secured by real property are subject to the Holder Rule.

[15] Id. at 9.

[16] 40 Fed. Reg. 53,524 (Nov. 18, 1975) (emphasis added).

[17] 40 Fed. Reg. 53,527 (Nov. 18, 1975).

[18] See, e.g., Eachen v. Scott Hous. Sys., Inc., 630 F. Supp. 162 (M.D. Ala. 1986); Mayberry v. Said, 911 F. Supp. 1393 (D. Kan. 1995); Hardeman v. Wheels, Inc., 565 N.E.2d 849 (Ohio App. 1988); Wales v. Arizona RV Centers, LLC, No. CIV.A. 14-2115 (E.D. La. Jan. 9, 2015).

[19] See, e.g., Rollins v. Drive-1 of Norfolk, Inc., No. CIV A 206CV375, *3 (E.D. Va. Aug. 29, 2006) (“the commentary appears to significantly curtail the use of the Holder Rule as a ‘sword,’ restricting the consumer from availing himself of its benefits to those situations where ‘rescission and restitution are justified.’”); Comer v. Person Auto Sales, Inc., 368 F.Supp.2d 478, 490–91 (M.D.N.C.2005); Crews v. Altavista Motors, Inc., 65 F.Supp.2d 388, 390-1 (W.D.Va. 1999).
Within these types of decisions, courts may evaluate whether the seller’s breach renders the transaction “practically worthless” to the consumer in order to determine whether rescission or restitution are justified, thereby allowing an affirmative claim. See, e.g., Irby–Greene v. M.O.R., Inc., 79 F.Supp.2d 630, 635–36 (E.D.Va.2000); Crews v. Altavista Motors, Inc., 65 F.Supp.2d 388, 391 (W.D.Va.1999).

[20] In a notable Eighth Circuit case, however, the court found held that a consumer could not bring affirmative claims against a lender despite the presence of the Holder Notice in the contract because the applicable Minnesota law relating to assignees of credit contracts only permitted claims and defenses to be raised against the assignee defensively. This ruling suggests that—at least in some jurisdictions—state law may prevail even when it is less protective to the consumer. See LaBarre v. Credit Acceptance Corp., 175 F.3d 640 (8th Cir. 1999). 

[21] Letter from David Medine, Associate Director, Division of Financial Practices, Federal Trade Commission, to Jonathan Sheldon, National Consumer Law Center (Sept. 25, 1999); Letter from Donald S. Clark, Secretary, Federal Trade Commission to Jonathan Sheldon, et al., National Consumer Law Center (May 3, 2012) [hereinafter “2012 Advisory Opinion”].

[22] 2012 Advisory Opinion, at 3-4.

[23] Id. at 3.

[24] See Lafferty v. Wells Fargo Bank, 213 Cal. App. 4th 545, 561 (2013), as modified on denial of reh'g (Feb. 27, 2013). Note that, despite the conflicting interpretations of when affirmative recovery is available under the Holder Rule, courts have almost uniformly held that recovery by consumers cannot exceed the total amount of money paid by the consumer under the contract.

[25] 12 C.F.R. § 1026.34(a)(2) (“A creditor may not sell or otherwise assign a high-cost mortgage without furnishing the following statement to the purchaser or assignee: “Notice: This is a mortgage subject to special rules under the Federal Truth in Lending Act. Purchasers or assignees of this mortgage could be liable for all claims and defenses with respect to the mortgage that the consumer could assert against the creditor.”).

[26] 15 U.S.C. § 1640(k).

[27] 15 U.S.C. § 1641(e).

[28] See Larry Platt, Mortgage Banking, “Push Them Back, Shove Them Back, Way Back” (Oct. 2015), available at  http://www.klgates.com/files/Publication/8dd9e4af-ad8c-41db-9779-ae854ab800c3/Presentation/PublicationAttachment/42821e8f-1dc0-4005-93bf-b4e6b002e0b2/Push_Them_Back_article.pdf.