The CFPB has filed a lawsuit in a South Carolina federal district court against Heights Finance Holding Co. f/k/a Southern Management Corporation and a group of its wholly-owned, state-licensed subsidiaries (collectively, Southern) in which the CFPB alleges that Southern violated the Consumer Financial Protection Act’s UDAAP prohibition by “churning payment-stressed borrowers in fee-laden refinances.”

In its complaint, the CFPB describes Southern’s business model as follows:

Put payment-stressed borrowers in unaffordable refinances; when they fall behind on their payments, refinance them again and again; with each refinance, front-load collection of unearned interest and insurance premiums while harvesting a new round of upfront fees; and repeat this cycle for as long as possible.

The CFPB describes Southern as “a high-cost installment lender that operates over 250 brick-and-mortar storefronts located in the states of Texas, Oklahoma, Alabama, Georgia, Tennessee, and South Carolina.”  According to the complaint, Southern’s installment loans have a median annual interest rate of 92%, a median loan principal of $85, and are typically repayable in nine to eleven monthly installments.  More than 70% of Southern’s portfolio consists of refinanced loans with nearly 10% of Southern’s borrowers refinancing their loans 12 or more times. Refinances generate 40% of Southern’s net revenue.

The complaint includes the following allegations regarding Southern’s underwriting, sales, and servicing practices:

• Because Southern’s automated loan-decision model weights an applicant’s past, repeated refinancing as a positive attribute in refinanced loan applications, Southern routinely lends to borrowers who have refinanced multiple times even if they clearly cannot afford to service their debt to Southern without refinancing. 
• Because Southern routinely lends to borrowers with little or negative free income and because its refinanced loan approval model prioritizes frequent refinancers, many of Southern’s borrowers predictably have trouble with repayment and become delinquent.
• Once borrowers become 14 or more days past due, Southern engages in a systematic effort to induce them into refinancing.  Solicitations sent to past due borrowers characterize refinanced loans as “fresh starts,” “solutions,” and the “best option” for resolving a delinquency even though, for most borrowers, refinancing prolongs their indebtedness and increases their total borrowing costs.  To drive more refinancings, Southern refuses to accept partial payments or extend due dates.
• Southern’s incentive compensation programs reward employees who are most successful in inducing borrowers to refinance and employees who fail to meet refinancing targets are threatened with negative consequences such as nighttime or weekend shifts.  (The complaint includes the text of numerous emails sent by Southern supervisors to employees intended to motivate employees to refinance past due borrowers.)
• Southern takes security interests in borrowers’ household goods or car primarily as leverage to induce borrowers to refinance.
• The principal fees imposed on Southern’s installment loans are (1) upfront, non-refundable origination fees, (2) precomputed interest, and (3) where allowed by state law, insurance premiums.  None of the origination fee is refunded to borrowers who refinance and Southern uses the Rule of 78s to calculate unearned interest and insurance charges which allows it to retain a disproportionate share of these charges when a borrower refinances.

The complaint alleges that these “loan-churning practices” constitute unfair and abusive acts or practices in violation of the CFPA.  In addition to permanent injunctive relief, the complaint seeks consumer redress and a civil money penalty.

Under the circumstances, consumer finance and debt management companies should review their business models and operational practices carefully, as the complaint alleges that Southern engages in practices that are drawing increasing scrutiny not just from the CFPB but from consumer groups (who often pejoratively refer to these practices as “flipping and packing”) and state and other federal regulators alike.  Such practices include the frequent refinancing of prior loans, the ways in which refinancing is marketed, the use of compensation plans that ostensibly create incentives for misconduct, the taking of security interests in property that is never repossessed, the use of the Rule of 78s instead of the more consumer-friendly actuarial method to calculate unearned interest, and high credit insurance penetration rates.  Moreover, in light of this complaint, all lenders that use targeted marketing aimed at profitable consumers, including credit card companies directing marketing to their cardholders who are revolvers, should also consider reviewing their related credit criteria and marketing practices with their in-house and outside counsel.    

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