The following article is reprinted from Basis Points® , Vol. 3, Issue 2, Copyright © 2004, with the permission of CounselorLibrary.com, LLC. All Rights Reserved. Further reproduction is prohibited without permission.

The OCC has issued its long awaited preemption rules for national banks. If the rules survive court challenge, they will allow national banks to ignore most state laws that affect a bank's lending operations. Even more surprisingly, the rules would prevent state regulators and enforcement agencies from enforcing the laws against national banks and their operating subsidiaries.

The response from the states has been less than enthusiastic. Leading the disenchanted, New York State Attorney General Eliot Spitzer has filed an action against an operating subsidiary of First Tennessee Bank, asserting that his office has the authority to enforce New York State consumer protection laws against national banks and their operating subsidiaries. According to a press release from the Attorney General's office, Spitzer's office had attempted to resolve the matter with First Horizon before filing the lawsuit. But when an attorney from Spitzer's office contacted the bank, bank officials reportedly said they could not discuss the matter because the OCC had issued a directive advising its officials not to talk to state attorneys general.

What is Preemption?

"Preemption" is a fancy word that means when state and federal laws conflict with one another, the federal law controls. The origins of federal preemption reside in the decision by our nation's founding fathers to create a nation of multiple sovereigns. Under our federal structure, each of the states is a sovereign entity. The federal government is also a sovereign entity. What happens when the interests of the two sovereigns conflict? Under the Supremacy Clause of the US Constitution, if a federal law and a state law conflict with one another, the federal law wins. Article VI of the US Constitution contains the following language:

This Constitution, and the laws of the United States which shall be made in pursuance thereof; and all treaties made, or which shall be made, under the authority of the United States, shall be the supreme law of the land; and the judges in every state shall be bound thereby, anything in the Constitution or laws of any State to the contrary notwithstanding.

The "laws of the United States" include federal statutes and regulations issued by federal regulators. So, unless Eliot Spitzer and the rest of the horned off state regulators can establish that the OCC's broad preemption regulations are unlawful under federal law, those regulations will preempt the right of states to regulate the lending activities of national banks.

The Supreme Court has identified three ways in which preemption may occur. First, Congress can adopt express language setting forth the existence and scope of preemption. Second, Congress can adopt a framework for regulation that "occupies the field" and leaves no room for states to adopt supplemental laws. Third, preemption may be found when state law actually conflicts with federal law. Conflict occurs when either:

• Compliance with both laws is a "physical impossibility;" or
• When the state law stands "as an obstacle to the accomplishment and execution of the full purposes and objectives of Congress."

Substantive Law and Visitorial Rights

There are two parts to the OCC's preemption rules. First, the rules establish that national banks find the authority to make loans under federal law and, with a few core exemptions, are not subject to state lending rules. So, state laws that affect the substance of a lending business, such as state disclosure requirements or limitations on fees, simply do not apply to national banks or their operating subsidiaries. These are the substantive rules.

Second, state regulators have no business regulating national banks (or their operating subsidiaries) or enforcing substantive state laws against national banks. This second part of the preemption rules is known as the "visitorial powers" because it prohibits a state regulator from "visiting" a national bank.

The OCC's position on visitorial powers is not really new and has triggered litigation in the past. In California, a state mortgage regulator (the Department of Corporations) tried to enforce a state law limiting how interest can accrue on mortgage loans against Wells Fargo Mortgage. Wells thought that federal law preempted the state law. When the regulator persisted, Wells turned in its lending licenses in California and told the regulator that he no longer had the authority to enforce California law against them because they were an operating subsidiary of a national bank. The regulator sued. In the most recent decision, the court first found that only the OCC has the power to enforce laws against a national bank operating subsidiary.

The Substantive Preemption Rules

Under the new rule, state laws that obstruct, impair, or condition a national bank's ability to fully exercise its federally authorized real estate lending powers do not apply to national banks (except where federal law makes the state law applicable.) What does this mean? Well, try to imagine a state law or regulation that does not "obstruct, impair or condition" your business. It is next to impossible for a state to enact a law that makes you do something or that stops you from doing something under this standard.

The following areas are listed as expressly preempted under new Section 34.4 of the OCC regulations.

Licensing, Reports, Record Keeping. State laws that require licensing, registration (except for purposes of service of process), filings, or reports by creditors do not apply. So, any state law that requires a lending license or imposes record keeping or reporting requirements is preempted.

PMI, Collateral Insurance, Credit Enhancements. State laws that limit or condition a lender or servicer's right to require or obtain private mortgage insurance, insurance for other collateral, or other credit enhancements or risk mitigants, in furtherance of safe and sound banking practices, do not apply. But beware. Remember that the general preemption rule says that state laws are preempted "except where they are made applicable by Federal law." The Gramm- Leach-Bliley Act included provisions that could make state insurance laws applicable to national banks under some circumstances.

LTV. State restrictions on loan-to-value ratios do not apply.

Payment Schedule, Amortization, Minimum Payments, Term, Demand Features. State laws that limit or restrict the terms of credit, including the schedule for repayment of principal and interest, amortization of loans, balance, payments due, minimum payments, or term to maturity of the loan, including the circumstances under which a loan may be called due and payable upon the passage of time or a specified event external to the loan do not apply. Note that the OCC may have some additional work to do to explain how this rule works in relation to the general authority to make adjustable rate mortgage loans contained in a different subsection of Part 34 of the OCC regulations. The OCC's current ARM rule (Section 34.20 though 34.25) authorizes a national bank to make purchase money and refinance of purchase money ARM loans, subject to certain limitations on the selection of the interest Index used to set adjustments. The new rule seems to confirm what people have assumed all along - that national banks may make other types of ARM loans (such as HELOCs and cash out refinances), without regard to state law limitations.

Aggregate Limits. Limitations on the aggregate amount of funds that may be loaned upon the security of real estate are preempted. Some states have tried to limit high loan-to- value loans (the old 125% LTV loans).

Escrow/Impound Accounts. Limitations on escrow accounts, impound accounts, and similar accounts are preempted. Some states impose requirements on tax and insurance impound accounts, such as requiring that the funds be maintained in a depository institution in the borrower's home state or imposing specific monthly/annual notice requirements.

Security Property. Limitations on the types of security property a lender may require, such as leaseholds, are preempted.

Access to Credit Reports. Limitations on a creditor's ability to access and use credit reports are preempted. But beware. Remember that the general preemption rule says that state laws are preempted "except where they are made applicable by Federal law." National banks will have to monitor the preemption rules in the Fair Credit Reporting Act, which, in some circumstances, make creditors subject to state laws regulating access to and use of consumer reports.

Disclosure and Advertising Requirements. The rule preempts state disclosure and advertising requirements, including laws requiring specific statements, information, or other content to be included in credit application forms, credit solicitations, billing statements, credit contracts, or other credit-related documents.

Processing, Servicing, or Selling Loans. The rule preempts state laws that affect processing, originating, servicing, selling, purchasing, investing or participating in mortgages.

Disbursements. The rule preempts state requirements that affect disbursements and repayments.

Usury. The rule preempts state restrictions on interest rates. But beware. This is not general usury preemption. National banks will still look to Section 85 of the National Bank Act for general rate authority. That section says that a national bank may charge interest:

• At the rate allowed by laws of the state where it is located,
• At a rate of 1% in excess of the discount rate on 90-day commercial paper in effect at the Federal Reserve Bank for the district where the national bank is located,
• If a different rate is permitted for banks organized under state law, then a national bank may charge that rate.

This law is the source of what people generally refer to as the "most favored lender" rate authority. Case law under the "most favored lender" authority has generally held that a national bank is subject to any state restrictions that are "material" to the determination of the rate if the lender wants to use the "most favored rate." A loan provision is material to a determination of the interest rate if it:

• Pertains to the manner in which the numerical rate of interest is calculated (such as 360/360 or 365/260 interest accrual, discounting or compounding) or
• Defines the class of loans in such a way (as by size, type of borrower, LTV limitation or maturity).

The question that must be clarified over the next few years is whether the new rule constitutes a new rate authority, independent of Section 85. The answer should be no because there is no statutory basis for the OCC to create a general usury preemption for national banks. If not, then does the bank subject itself to state restrictions that are "material" to the determination of the rate if it has to rely on the most favored lender rate? The answer would seem to be yes. Again, the new rule says that it preempts state law, "except where [state law is] made applicable by Federal law."

Due on Sale. State limitations on due-on-sale clauses are preempted, except to the extent provided in 12 U.S.C. 1701j-3 and 12 CFR part 591.

Lease Covenants. The rule preempts state restrictions on covenants and restrictions that must be contained in a lease to qualify the leasehold as acceptable security for a real estate loan.

State Laws Not Preempted

State laws on the following subjects are not inconsistent with the real estate lending powers of national banks and apply to national banks to the extent that they only incidentally affect the exercise of national banks' real estate lending powers:

• Contracts;
• Torts;
• Criminal law;
• Homestead laws specified in 12 U.S.C. 1462a(f);
• Right to collect debts;
• Acquisition and transfer of real property;
• Taxation;
• Zoning; and
• Any other law the effect of which the OCC determines to be incidental to the real estate lending operations of national banks or otherwise consistent with those powers and purposes.

Effective Date

The new rules are effective as of February 12, 2004.

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Basis Points® is a concise, easy-to-read, monthly legal update for the mortgage lending industry. Basis Points® addresses complex legal issues from an industry perspective and keeps you informed on new legal developments affecting your business. Written in plain English, Basis Points® provides familiar factual scenarios, identifies the legal issues involved, presents real court resolutions and suggests how you might avoid similar legal pitfalls. Topics featured in Basis Points® include: Predatory Lending; Yield-Spread Premiums; RESPA - Fee Splitting and Up charges; Privacy; RESPA - Joint Venture; Bankruptcy; Fair Lending and Discrimination; and Truth in Lending/ Regulation Z. Basis Points® is published by CounselorLibrary.com, LLC, an affiliate of the Hudson Cook, LLP law firm. The CounselorLibrary.com, LLC is also the publisher of CARLAW®, HouseLaw®, Spot Delivery®, and the Counselor Library Series. For more information, please visit: www.counselorlibrary.com.