What is “Preemption”?

Jeffery E. Smith
Bricker & Eckler LLP
August 2006

The dual banking system in this country has existed since Congress authorized establishment of the national bank charter over 200 years ago. Since that time, both the federal government and the states have exercised authority to charter banks and thrifts that, up to relatively recent times, rarely operated outside of the state in which their main office was located.

While issues pertaining to federal preemption in the banking arena have been around since the inception of the dual banking system, along with the growth of multi-state banking operations, technological advances, and a more mobile customer base came an increased focus on how banks and thrifts operating across state lines could address compliance with the patchwork of state laws and regulations impacting their operations. Further, since their inception national banks and thrifts have had to address conflicts between state and federal laws and regulations which impact their operations and structure in the states in which they operate.

A somewhat confusing array of state and federal laws and regulations intending to address multi-state banking issues and operations arose in the 1990’s including federal legislation such as the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994, regional and multi-state state-level “compacts”, and state “parity” laws which, while making great work for those of us in the legal profession, still resulted in a relatively murky path to multi-state compliance.

Enter the Comptroller of the Currency in January, 2004, issuing comprehensive regulations setting forth the OCC’s position with regard to areas of lending, deposit-taking and other banking operations where federal law preempts state and local law, and those areas where state law continues to govern even federally-chartered national banks. The Comptroller’s rule also sets forth the OCC’s position with respect to the proper applicability of state-level licensing, regulation, and oversight with regard to national banks. The general rule as expressed by the OCC’s issuance is that, except as made applicable by federal law, state laws that obstruct, impair, or condition a national bank’s ability to fully exercise its authorized powers do not apply to national banks. A federal statute may, in fact, require the application of state law in certain instances or may incorporate (or “federalize”) state standards. The OCC also takes the position that the same preemption standards apply to national bank operating subsidiaries. The extension of preemptive rights to national bank operating subsidiaries has generated litigation concerning that topic in a number of courts including a pending case that is referenced later.

In addition, federal thrift affiliates of large insurance companies have become more active in marketing banking products nationally through existing insurance agency channels, prompting litigation by state regulators over the preemptive authority of the OTS (and conversely the ability of state banking regulators to license and/or oversee the banking activities) in these instances. Several high-profile cases remain pending nationally, and the decisions in those cases could have an important impact on the ability to distribute banking products through non-traditional sales channels.

It is important to note that courts have, for the most part, strongly upheld the concept of federal preemption and the authority of the OCC and the OTS in issues involving preemptive rights of federally-chartered institutions. The OCC rules are for all intents identical to those of the OTS for federally-chartered thrifts. The Comptroller’s 2004 issuance endeavored to, in essence, consolidate and “codify” historical OCC interpretations and court decisions involving preemption issues, but was seen by some as a usurpation of the legislative process and states’ rights. Irrespective, it provides guidance to national banks concerning those situations where the Comptroller will support national banks in taking the position that state or local law is preempted by federal law, where the OCC will “occupy the field” of regulation of those activities, and a more clear and concise “safe harbor” at least where the OCC is concerned. State banking agencies and attorneys general may or may not agree.

The OCC and OTS rules are not, however, exclusive and court-established precedent continues to apply to other areas of bank and thrift operations and activities which are subject to the concept of federal preemption.

So just what is “preemption” and how does it impact your institution?

Preemption

For purposes of banks and thrifts, preemption is the concept whereby federal laws and regulations in essence “trump” state and local laws and regulations as they may otherwise apply to the institution. It enables federally-chartered institutions to look to, and to rely on, federal statutory and regulatory guidelines for compliance in most instances, irrespective of state and local laws which may sometimes be in direct conflict.

The concept of preemption applies to certain areas of law and regulation and does not apply to others. It provides continuity and uniformity for federally-chartered institutions, especially those operating in a multi-state environment, and the ability of federally-chartered institutions to rely on federal law and regulation for some aspects of their operations. Under the concept of federal preemption, state law continues to apply in instances where federal law is silent and where legal precedent would indicate that applicability of state law is appropriate. The concept of preemption of state law and regulation applies for federally-chartered institutions irrespective of whether they are addressing multi-state operational issues or issues within a single state of operation where that state’s laws and regulations may come into conflict with federal laws and regulations otherwise applicable to the institution.

Examples

Examples of how preemption works in the bank and thrift industry include the applicability of federal law and regulation to institutions in the areas of engaging in permissible non-bank activities (direct and through subsidiaries such as mortgage companies), licensing and regulation (chartering, licensing, and examination authority), certain loan terms and conditions (such as state LTV ratios, PMI requirements, credit disclosures, interest rates, etc.), predatory lending, and deposit relationships (such as state requirements regarding disclosure requirements, funds availability, and deposit terms), and other areas of bank activities and operations.

Examples of state laws which continue to apply to federally-chartered institutions include state laws pertaining to real estate matters, contracts, fiduciary considerations, some consumer law considerations, torts, public safety, criminal matters, collection of debts, acquisition and transfer of property, and taxation. Again the foregoing lists are not exclusive but rather examples of areas of state and local law that are not specifically preempted, assuming state and local law does not significantly interfere or conflict with national bank operations or authority.

To the extent that federal law and regulation may provide more flexible or lucrative contract terms, broader bank and non-bank powers, fewer restrictions on lending rates or terms, less governance, easier examination, less disclosure, less compliance burden, or less restrictive loan classification, for example, it may provide an advantage for federally-chartered institutions over their state-chartered counterparts. Or vice versa.

Some states authorize state banking regulators to provide (sometimes-limited) “parity” to enable state banks to match their federally-chartered competitors. However, such parity rulings are sometimes limited in duration (which can result in divestiture and operational concerns and limit effectiveness) and institutions relying on such parity rulings must also consider any FDIC and/or Federal Reserve restrictions which may apply.

Again, the examples are not exclusive and the federal agencies retain the right to address other types of state laws on a case-by-case basis to make preemption determinations under applicable standards.

Issues

Critics charge that the OCC has overstepped its authority in application of the preemption rules, however that authority has more often than not been reinforced by the courts. Critics also charge that preemption enables federally-chartered institutions to ignore state laws protecting consumers and expose consumers to abuse and predatory tactics, a charge which is difficult to substantiate upon further examination insofar as the federal agencies enforce federal consumer laws and regulations against their respective charters.

Charter considerations

Some argue that a federal charter provides the continuity and predictability necessary for financial institutions to operate successfully on a multi-state basis, while others contend that state-chartered institutions are, for all intents and purposes, able to engage in the same activities and enjoy the same advantages as their federally-chartered competitors. As with all such considerations, each institution must examine the tangible and intangible pros and cons based on their own business plan and unique circumstances to determine which form of charter works for best for their specific purposes. And they must keep in mind that charter considerations may change as the institution’s business, as well as it’s market and customers, change in order to maximize business opportunities. The fact that the dual-charter system remains alive and well is evidence that the preemption opportunities provided for federally-chartered institutions do not automatically make a federal charter the preferred charter, or the charter of choice, for all institutions.

What’s next

While the courts have consistently upheld the concept of federal preemption as applied to federally-chartered financial institutions, and Congress has not acted to restrain the Comptroller or the OTS in the application of their preemptive authority, it is not inconceivable that the tide could turn and courts and/or Congress could limit or revoke some or all of the broad federal authority in this area. State banking regulators and activist state attorneys general have been visibly involved in challenging the preemptive authority of federal agencies, and the outcome is uncertain.

In addition to the pending cases involving federal thrift affiliates of insurance companies, there is an important decision pending before the United States Supreme Court involving Michigan state regulators and Wachovia regarding Wachovia’s Michigan-chartered mortgage affiliate. The case involves the OCC’s contention that federal law governs state-chartered non-bank firms like mortgage companies which are structured as operating subsidiaries of national banks. The position of the Michigan regulators (and regulators from 31 other states and the District of Columbia who have joined in the suit) revolves around the issue of whether the Constitution provides deference to federal agencies such as the OCC to the detriment of state sovereign powers reserved under the Tenth Amendment.

The decision in the Wachovia case is critical in that it will establish important precedent for the exercise of preemption authority by federal agencies, and the ability of federally-chartered institutions to rely on OCC and OTS rulemaking, particularly in multi-state operating environments. If the Court denies or limits the preemptive authority, the case could call into question all of the business of such mortgage company operations as unlicensed entities in the states where they conducted business in reliance on preemptive authority.

Interestingly, a federal appeals court ruled on August 10, 2006, in favor of the OCC in a case involving preemption of Maryland licensing requirements related to mortgage company operating subsidiaries of National City Bank of Indiana, a national bank. The ruling involved proposed application of Maryland law limiting prepayment penalties on adjustable-rate mortgage loans from the operating subsidiaries of the bank, and supported the notion that national bank operating subsidiaries must be treated like national banks for preemption purposes and are not governed by state consumer protections laws.

Depending on the outcome of the Wachovia case, Congress may also get into the act to protect, or to curtail, the authority of federal agencies to exercise rulemaking authority which preempts state and local law. Either way, the Wachovia decision will be an important indication of the right of states to govern organizations when there is an affiliation with a federally-chartered institution.

Conclusions

While the concept of preemption for federally-chartered institutions remains the law of the land, the recent focus on preemption and the industry interest generated by the OCC’s 2004 rulemaking, as well as some high-visibility court cases, may have a significant impact on preemption going forward. Whether Congress steps into the fray remains to be seen, and until that happens, or the Supreme Court acts to curb the authority of federal agencies to preempt state and local law, federally-chartered institutions will continue to have the ability to rely on preemption when dealing with potentially conflicting state law and regulations. That fact alone does not necessarily provide federally-chartered institutions with an advantage over their state-chartered counterparts, but rather each institution must look to their own unique individual circumstances and business plan, and intangible as well as tangible benefits to each type of charter, to determine the most advantageous charter for their operations. And insofar as laws, regulations, and business plans can and do change, that consideration should be undertaken whenever appropriate for the institution to address a changing environment.