Resolving an ambiguity in the California Finance Lender's Law (CFLL), the California Supreme Court unanimously held that borrowers may use the unconscionability doctrine to challenge the interest rate on consumer loans of $2,500 or more, despite the fact that the CFLL has deregulated interest rates on such loans.

Although unconscionability claims of this nature will be difficult to maintain for the reasons discussed below, the decision creates heightened risk for nonbank consumer lenders doing business in California, particularly when lending at high rates. Furthermore, because the decision could be followed in other states or applied in other contexts, such as small business lending, it also could impact loans made under other statutes that have deregulated interest rates, as opposed to statutes that affirmatively authorize interest rates established by contract.

As discussed in our prior alert, last year the U.S. Court of Appeals for the Ninth Circuit sought guidance from the California Supreme Court, asking, "Can the interest rate on consumer loans of $2,500 or more governed by California Finance Code § 22303 render the loans unconscionable under California Finance Code § 22302?"

While Section 22302 provides that unconscionable loans violate the CFLL, Section 22303 sets maximum interest rates for consumer loans but provides that its usury limits do not apply to loans of $2,500 or more. In analyzing the interplay between Sections 22302 and 22303, the California Supreme Court has now held that "the interest rate on a consumer loan—even one of at least $2,500—may render the loan unconscionable," and therefore in violation of Section 22302 and California's Unfair Competition Law (UCL), which provides remedies for "unlawful" conduct, among other things.

The underlying Ninth Circuit case, De La Torre v. CashCall, Inc., involved an unsecured $2,600 loan, payable over a 42-month period and carrying an annual percentage rate of between 96 and 135 percent. The plaintiffs alleged that the rates on the loans—combined with marketing supposedly targeted at consumers who lacked the ability to repay them—rendered the loans unconscionable. After class certification, the district court awarded summary judgment to the defendant lender, reasoning that "[t]he California Legislature long ago made the policy decision not to cap interest rates on loans exceeding $2,500," and allowing an unconscionability attack would improperly intrude on the Legislature's power to make economic policy.

After the plaintiffs appealed, the Ninth Circuit punted the question of whether the lender's summary judgment argument and the district court's ruling were correct to the California Supreme Court. In answering "no" to that question, the California Supreme Court focused primarily on the existence of Section 22302, which it held was a decision by the Legislature to subject these loans to unconscionability analysis.

In the near term, the De La Torre decision introduces substantial uncertainty into the marketplace for consumer lending to California borrowers under the CFLL. The decision affects all consumer loans of $2,500 or more, secured or unsecured—and even mortgage loans, although interest rates on first mortgage loans are likely preempted by Section 501 of the Depository Institutions Deregulation and Monetary Control Act of 1980. With no assurance that higher-rate loans will be immune from unconscionability scrutiny and attack, lenders now cannot be certain that any particular interest rate will be permitted. Moreover, high-rate lenders are likely to face copycat lawsuits alleging their interest rates are unconscionable. It is even possible that the California Attorney General, local prosecutors, or the California Department of Business Oversight (which has regulatory and supervisory jurisdiction over CFLL licensees) will pile on. The De La Torre court noted the possibility of disruption but dismissed its likely severity.

Although federal preemption should foreclose the application of De La Torre to out-of-state banks, the impact of the decision on California depository institutions is unclear. Like Section 22303 of the CFLL, the California Constitution imposes usury limits and provides exemptions, including one for California depository institutions. However, California depository institutions are not subject to any analogue of Section 22302, which makes it a violation of law by licensed lenders (but not depository institutions) to make an unconscionable loan.

To the extent unconscionability principles apply to loans by California depository institutions, it would appear that—in the proper circumstances—they might create a defense to enforcement of a loan rather than an affirmative cause of action under the UCL. This is the likely result in other states with similar statutory frameworks, at least where the courts accept the underlying premise of the De La Torre decision that a statute deregulating rates is not the same as one affirmatively authorizing the rates agreed upon by the borrower and lender.

Despite the concern that the decision is rightly creating, we think it important to keep its limits in mind. The court did not find the loans to be unconscionable. Further, the court stressed that in order to find that an interest rate is unconscionable, courts must conduct an individual analysis of whether "under the circumstances of the case, taking into account the bargaining process and prevailing market conditions" a "particular rate was 'overly harsh,' 'unduly oppressive,' or 'so one-sided as to shock the conscience.'" This analysis is "highly dependent on context" and "flexible," according to the court. The court warned that lower courts should be wary of and must avoid remedies that amount to an "across-the-board imposition of a cap on interest rates."

Thus, while the decision creates an opportunity for plaintiffs to employ unconscionability claims to challenge de-regulated interest rates, it simultaneously makes clear that such claims are difficult to prove and even harder to bring on a class action basis (even putting aside the hurdle of well-crafted arbitration clauses with class action waivers).

As we wrote in our prior alert, plaintiffs have the burden of proof and will have to address important issues such as whether the lender "operated in a noncompetitive market or charged interest at rates that departed significantly from rates charged by competitors," and whether the rates were excessive in relation to costs and/or generated excessive profits. That said, we note that the Legislature has the ability to end this uncertainty and restore the credit availability destroyed by De La Torre by simply repealing Section 22302 or amending it to clarify that the interest rate in a loan agreement may not be found unconscionable.