Industry News

A Surprising Contrarian in Payday Trend.

Since federal guidelines that went into effect in July seriously curtailed payday lending, most of the publicly traded specialists in the field have turned to an alternative model: the credit services organization.

The shift has been most profound in Texas, where several of the large lenders are headquartered. Not long after the restrictions came down, the Texas Legislature closed its session without passing an "enabling" bill that would have expressly asserted that the payday business is legal. The next session will not start until 2007.

The credit services organization model, in which a company collects as much as 20% in fees for arranging a short-term loan from a third- party lender, has proven lucrative. The business is largely unregulated, at least in Texas. Cash America International Inc. has adopted the model in other states, and First Cash Financial Services Inc. touts its potential in presentations to investors.

But conspicuously absent among the adopters is Ace Cash Express Inc., one of the nation's largest payday lenders and its largest check- casher. Ace sees too much legal risk in the model. Instead, it has started offering an installment loan which, though perhaps less profitable, it considers a safer bet.

High-interest payday-type products like the CSO loans "typically bring a lot of criticism ... and potential litigation," Jay B. Shipowitz, Ace's president and chief operating officer, said in an interview last week.

Ace is proceeding with caution not only because the new model is largely unregulated, but also because there is no "enabling legislation" that expressly permits the loans or provides for their regulation, he said.

"Payday lending is one of many lending products we offer in our stores," but an offering "is always premised upon a safe harbor that it is legal and regulated" and that businesses are licensed, Mr. Shipowitz said.

J. Scott Sheehan, a Houston lawyer who has set up Texas CSO businesses for several payday lenders, including Advance America, said a CSO typically advertises the loans and provides a letter of credit to the third-party lender "to back up the loan on the borrower's behalf."

The lender then "disburses the loan" through the CSO, and the loan typically matures in two weeks, Mr. Sheehan said. Some CSOs receive their fee in advance, but others get it when the loan is repaid, he said.

Mr. Sheehan and other boosters of the model take comfort in a ruling the U.S. Court of Appeals for the Fifth Circuit handed down in January. In Lovick v. Ritemoney, two of the three judges found that a company acting as a broker is free to charge fees on a loan it arranges, and that the fees do not count as interest, so they are not limited by Texas' usury cap of 10% interest.

The majority of the judges also reiterated that under Texas law, third-party lenders can make unregulated loans if they stay under the 10% cap, which is not an annual percentage rate and could apply to a two-week loan.

But in a dissenting opinion, Judge E. Grady Jolly wrote that the plaintiff had presented enough facts to merit discovery on the issue. The broker-lender arrangement in that case "may amount to usury ... or it may suggest a conspiracy to commit usury," Judge Jolly wrote.

Mr. Shipowitz at Ace said the dissent was "one piece of data which we looked at to help us make our decision."

This is not to say Ace hasn't looked hard at offering the loans.

"We've had meetings with both the Attorney General and the Consumer Credit Commissioner [in Texas] to give us the clarity we need to really consider offering the product," Mr. Shipowitz said. The attorney general indicated "he would look into the matter and advise us if he thought there were any issues."

In fact, Ace's hesitance has a lot to do with its experience with an attorney general from another state. In August 2001, North Carolina allowed its payday loan-enabling legislation, a four-year experiment, to expire. However, payday lenders stayed in the state. Ace did so using a "rent-a-charter" arrangement with Goleta National Bank, a federal bank in California.

The situation soon got messy. The following January, Attorney General Roy Cooper sued Ace to force it to stop making payday loans in North Carolina. In October, Ace and Goleta agreed to consent orders with the Office of the Comptroller of the Currency to stop doing business in the state. In December 2002, Ace agreed with Mr. Cooper to cease operations there.

It has not gone back, nor is it doing business in Maryland or Georgia, because of similar legal barriers, Mr. Shipowitz said.

First Bank of Delaware, a new partner for Ace, funds its installment loans, which debuted in Texas, Arkansas, and Pennsylvania in August. They top out at $ 425, as do Ace's payday loans, which Republic Bank and Trust of Louisville is still funding. The new product is paid off in 10 installments over 20 weeks, and Ace offers it only after the borrower has taken out the government's limit of six payday loans a year.

"There's no question that an installment loan is less profitable than a payday loan," Mr. Shipowitz said. "But over the long term, making that decision and waiting to see if there is any clear guidance on being able to offer the CSO" is better for Ace's investors and customers. Ace has not said how much it expects the installment loans to affect profits.

Mr. Shipowitz said he hopes that the new loans will attract the attention of Texas lawmakers, because his competitors are charging more than they were for payday loans.

"The ironic turn of events here in Texas is that the Legislature's failure to pass an enabling payday loan bill has resulted in higher rates and fees for borrowers in Texas who are customers of companies" that are using the CSO model, he said.

Several companies, including CashAmerica and First Cash, both of which reported earnings last week, did not return requests for comment. But in its investor presentation, First Cash said that in Texas, it is getting 20% a loan in fees through the CSO model, versus 16% under the payday model.

Richard Eckert, an analyst with Roth Capital Partners LLC, said that the CSO model may have contributed to First Cash's record third- quarter performance.

Mr. Shipowitz said that with about 400 stores, Ace is the largest payday lender in Texas, so it would suffer more than others if it adopted the CSO model only to later have that model challenged. "We have the most to gain and the most to lose."

Richard Timlinson, one of the plaintiffs' attorneys in the Lovick case, said only the Texas Attorney General's Office could mount a realistic legal challenge to the CSO model.

"Private enforcement ... may not count as much, because most payday lenders have arbitration clauses" that prevent access to the courts, he said.

Texas Consumer Credit Commissioner Leslie Pettijohn said that the state's attorney general has "general enforcement powers" over CSOs, but her office regulates payday lenders, and it is taking a look at the CSO loans, because payday lenders are operating in "uncharted waters."

The loans could come under Ms. Pettijohn's jurisdiction if they are treated as consumer loans under a certain chapter in state law. But if there are "no conflicts with state law, we may not do anything," she said.

She agreed that word of the 20% fees might force Texas lawmakers to revisit payday-enabling legislation. Even payday lenders "have said, 'We wouldn't be doing this if we had a better alternative.' "

And other states may prove inhospitable for CSOs.

The model seems like "another situation of a payday lender trying to evade state lending laws and complying with the FDIC regulation as well," Mr. Cooper, the North Carolina attorney general who chastened Ace, said in an interview. "I would believe this type of activity we would find to be illegal in North Carolina."