High-Cost Credit in the Courts

Can the interest rate on a consumer loan be so high that the loan contact cannot be legally enforced? We are not talking about 20 or 30 percent, but interest rates of 96 to 135 percent. A company called CashCall had offered loans with exactly those eye-wateringly high interest rates. In a decision called De La Torre v. Cashcall, the state supreme court of California court ruled that the high-interest rate alone might be a defense to repayment of these loans. The decision has not received much notice in the mainstream press, but it could have far-reaching implications.

Legislatures usually regulate interest rates with caps known as usury laws. The problem is that it is notoriously difficult to pass effective usury laws because lenders can quickly find loopholes to evade them. For example, when the California legislature capped interest rates on loans up to $2,500, lenders simply started offering loans for $2,600. The lender in the case argued that without any interest-rate cap for loans over $2,500, it could charge whatever interest rate to which the customer might agree if the was loan over that amount. The borrower’s lawyers pointed to a general principle of contract law as a defense. Courts will refuse to enforce contracts that are unconscionable. A contract that is unconscionable is so one-sided that is not really a contract at all. Of course, there are many one-sided contracts that are just hard bargains. The dividing line between what is a “hard bargain” and an “unconscionable” contract is a fuzzy one.

In deciding whether a contract crosses the line, courts look at both the substance of the deal and the process by which the parties came to a deal. The classic case on unconscionability involved an appliance store that catered to low-income consumers. The appliance store had the consumer sign a contract that divided repayments on old and new purchases in a way that kept the consumer in perpetual indebtedness. In refusing to enforce that contract, the court cited both the harsh terms of the deal and the mathematical trick in the contract that the consumer was unlikely to understand.

The California Supreme Court ruled the unconscionability doctrine could apply to high-interest rate consumer loans. The case now heads back to the lower courts for further proceedings to decide on which side of the line this particular loan falls. Important factors will be the way the loans are marketed, the communities to which they are marketed, and the availability of alternatives for customers. The California Supreme Court’s decision is important because it relies on general principles of contract law rather than the legislature’s usury laws. It puts the judicial branch into the business of policing predatory interest rates like the 135 percent rate in the case. The court rejected arguments that the legislature’s failure to act meant the judiciary had no role to play.

I think the court got that right. The doctrine of unconscionability has a long history in the common law. For that matter, there are many contract doctrines that have a long history. There is no reason to think the legislature’s silence means the courts are not to apply these long-standing contract law principles to a consumer loan contract. Some state legislatures have been unwilling to regulate high-cost consumer credit. Other legislatures have been willing, but the ever-changing terms of consumer loans have made them difficult to regulate. In the unconscionability doctrine, the California court has identified a flexible, context-specific rule that gives the judiciary a tool to police abusive loans. The California decision is not binding on courts in other states, but the California Supreme Court is a prominent court whose opinions are noticed. If the result spreads to other states, it could have a big effect on payday lenders and the rest of the high-cost consumer credit industry as witnessed by CashCall having closed its consumer lending business in the wake of the decision.