The gathering storm: COVID-19-related disputes in the financial services sector – A transatlantic perspective

This article was originally published on CDR Magazine on 29 September 2020 and is reproduced with permission from the publisher.

COVID-19 has caused the largest shock to the global economy in living memory. The sudden shutdowns in the United Kingdom and United States drove a historic downturn that has seen the UK economy shrink by 20%, US unemployment hit 10%, and interest rates slashed to near zero. Initial rounds of government relief staved off some of the economic distress, but corporate sentiment is now characterised by uncertainty and caution about the future and some predict that an economic recovery will not happen before 2022. Whilst economic uncertainty, financial distress and market turmoil usually trigger increased levels of commercial litigation, the extreme conditions created by COVID-19 have primed the landscape for a pan-sector surge in financial services-related disputes.

The financial services (FS) sector has been better placed than most to withstand the initial shockwaves of the pandemic. This is due not just to its systemic importance to the global economy, but also the various post-2008 structural reforms designed to increase the resilience of global banks in the face of exactly this type of macro-economic disruption. The greatest risks posed by COVID-19 to the international FS sector are arguably more indirect, arising from: banks” front line involvement in governmental relief efforts, exposure to customers in the hardest hit industries, and the challenge of maintaining operations in a shifting political, regulatory and technological environment. Whilst these risk factors are capable of crystallising into a wide variety of disputes, heightened regulatory scrutiny, and operational challenges, there are a number of emerging legal flashpoints and trends to date.

Government loans programmes – Litigation risk

The UK and US Federal governments responded to the pandemic with a series of loan programs designed to protect small to medium-sized businesses, shore up employment, and prevent an eviction crisis in the face of a sudden and sustained loss of revenue.

The UK government has launched multiple financial assistance schemes for business, the most prominent being the “Coronavirus Business Interruption Loan Scheme” (CBILS), launched on 23 March 2020. CBILS provides emergency debt finance of up to GBP5 million to companies across almost all sectors with an annual turnover of less than GBP45 million. Whilst the debt is provided by private lenders, it is partially secured by a government-backed guarantee for 80% of the outstanding facility balance. The UK government also covers the first 12 months of interest payments and any lender fees through a “Business Interruption Payment”. The funding is available in the form of term loans, overdrafts or asset and invoice finance over a potential term of between three and six years. To qualify, the applicant must have a borrowing proposal which the lender would deem viable “were it not for the pandemic”. The ultimate decision to grant a loan rests with the lender and is subject to its existing lending criteria.

Whilst tens of thousands of CBILS loans have now been issued, several elements of the program carry the potential for generating and/or contributing to disputes between applicant and lender. These factors include: the discretionary role required of the banks and the high, existential stakes at play for the applicants. Similarly problematic are the pressures being exerted on the loan diligence process by remote working and the expectations from the government and customers that the applications will be assessed quickly.

However, claims have yet to really emerge in the UK and a “favoured” basis of claim is yet to be established. As experienced in the aftermath of the 2008 crisis, this environment may prompt mis-selling type claims for losses incurred as a result of the borrower's business failing before the loan can be paid out, or the debt burden created by an approved CBILS loan allegedly causing or contributing to its failure. Equally, claimants may attempt to impose more general types of tortious liability in circumstances where a loan application is rejected and the business subsequently fails. However, such approaches contain numerous potential pitfalls in establishing duty, breach, causation and loss. Much will therefore depend on the facts of individual cases. Whether these types of claims develop is still an open question, but based on the experiences of 2008, the obstacles for those bringing claims are legally challenging and costly.

In the US, the Paycheck Protection Program (PPP) was established on 27 March 2020 under the Coronavirus Aid, Relief, and Economic Security (CARES) Act. Originally a USD349 billion program intended to quickly provide unsecured, low interest loans to small businesses, PPP was expanded in late April, by a further USD310 billion. PPP loans are funded by private lenders, including banks and non-bank lenders, and fully guaranteed by the Federal government through the Small Business Administration (SBA). The terms of PPP require borrowers to use at least 60% of the loan proceeds to fund payroll and employee benefits costs, while the remaining 40% can be spent on mortgage interest payments, rent, lease payments and/or utilities. For borrowers that comply with these guidelines, PPP provides loan forgiveness up to the full principal amount.

Although there is no private right of action under the CARES Act or PPP, plaintiffs” lawyers began filing lawsuits against PPP lenders almost immediately. These lawsuits attack loan processing and underwriting practices, alleging that banks imposed unlawful eligibility restrictions such as requiring PPP loan applicants to either have a pre-existing borrowing relationship or deposit account with the lending bank, or an existing borrowing relationship with another bank. There are also at least 50 pending class actions by alleged borrower agents seeking payment of fees generated in the PPP application process which, they claim, have been unlawfully withheld by banks.

However, one of the first decisions (Sport & Wheat CPA PA et al v ServisFirst Bank Inc et al) found that, in the absence of any express agreement for the lender to pay agency fees, the CARES Act and enacting rules do not create such an obligation, nor is the lender required to share its own fees with alleged borrower agents.

Other lawsuits allege improper PPP loan prioritisations based on factors like loan amount, origination fee amount, size of applicant, and pre-existing relationships, rather than on a first-come, first-served basis. Additional litigation challenges are expected relating to borrowers” uses of PPP funds and loan forgiveness, as well as lawsuits and state enforcement actions arising from lenders” failures to comply with a developing regime of new state and local relief measures (for example foreclosure moratoriums, loan forbearance, limitations on interest and fees, and reporting requirements) that may, in some cases, conflict with federal obligations. Furthermore, if PPP-related litigation is any guide, similar legal challenges, including the possibility of False Claims Act litigation, may arise from the Main Street Lending Program – the Federal Reserve's USD600 billion credit commitment to support small to mid-size businesses with up to 15,000 employees or annual revenues of up to USD5 billion that were in a sound financial condition before the COVID-19 crises.

Government loans programmes – Regulatory risk

Regulatory and Congressional scrutiny of the PPP program is already underway, and instances of fraudulent PPP loan applications and misuse of PPP funds are already public fodder. While Congress” rush to implement PPP left some open questions about the program, lenders” obligations under the Banking Secrecy Act and “fair lending” principles are likely unchanged. The rushed implementation and conspicuous lack of clarity around PPP”s terms create a number of uncertainties from a regulatory perspective, not least concerning loan underwriting and the impact on SBA guarantees. This era of unpredictability combined with the heavy burden of loan forgiveness obligations and processes presents major operational challenges to US lenders. Meeting these challenges in a legally compliant manner may be made more complex by certain post-2008 regulations, including those mandating how distressed loans are accounted for, categorized, and charged off to accurately reflect the bank's true capital and liabilities. Lenders may also face regulatory scrutiny under federal law for their marketing practices if such practices could be viewed as misrepresenting the lenders as approved under the PPP when they are not. (for example, Federal Trade Commission v Ponte Investments).

By contrast the regulatory picture in the UK is somewhat different. Commercial lending to small and medium-sized businesses is, for the most part, a non-regulated activity. As such, a majority of CBILS loans could fall outside the scope of the Financial Conduct Authority (FCA) rules, putting them beyond the reach of meaningful regulatory intervention. Furthermore, in a bid to support the roll-out of the scheme, the FCA relaxed certain of the rules applying to those CBILS loans which are regulated, including the Consumer Credit Sourcebook rules relating to bank assessments of loan affordability. However, the other applicable rules remain in full force.

Despite this flexibility, the FCA seems to be keenly aware of the need to protect borrower interests and has stated in its “Dear CEO” letter of 15 April 2020 that whilst lending to SMEs largely sits outside the FCA”s jurisdiction, the FCA”s Senior Managers and Certification Regime applies to all activities conducted by banks, whether they are regulated or not, and that it expects SMEs to be treated fairly. The FCA”s response seems to be aiming to strike an even balance between the customer's interests on the one hand and making allowances for the difficult position in which the banks now find themselves on the other.

Cybercrime and fraud

The pandemic has created a race to transform business interactions from in-person to digital-based services provision, but this has also fostered opportunities for cybercrime and other fraud. Scams perpetrated against bank customers are varied and sophisticated, ranging from: fake investment opportunities, insurance policies and pension transfers advertised over social media – frequently involving the crypto assets; phishing schemes using fake emails from government departments offering access to grants, COVID-19 relief funds and even tax reductions; malware, spyware and Trojan viruses embedded in websites such as interactive coronavirus maps; and “authorised push payment fraud” whereby the cybercriminal exploits hacked information obtained from the victim to pose as a known counterparty and redirect funds intended for the legitimate recipient to the criminal.

Although bank customers are perhaps the most obvious target for these scams, the banks themselves are also in the firing line. Bank employees are vulnerable to these threats and are also now facing a much harder task, given digital identity manipulation, in performing anti-money laundering and client due diligence checks and detecting fraudulent product applications. Banks' electronic back-office and customer-facing systems are also targets for more sophisticated cyber-attacks, including attempts to obtain confidential customer information through the hacking of internal video conferencing and communications software. The threat of cyber criminals accessing and/or disrupting a bank's computer systems raises a number of potential liabilities relating to privacy, confidentiality and breach of account terms and conditions, whether independently or as part of a class action and will likely become an increasingly central focus as the pandemic continues.

Third-party funding

Prior to the pandemic there was already a significant expansion underway in the use of third-party litigation funding in the UK and growing interest in the US. For many corporates, the heightened liquidity risk and diminished revenues caused by COVID-19 will only increase the appeal of funding, as pursuing disputed receivables will be one of the few available means of securing working capital, yet insufficient cash reserves may mean that it is impossible to self-fund any dispute to the point of recovery. As was the case post the 2008 crisis, the deep pockets of the FS sector make it an attractive prospect for funders. For this reason, it should be assumed that funders will drive further innovation and activity in FS-related litigation, particularly in the areas of consumer class actions and fraud.

Conclusion

In many ways banks and financial services companies are well placed to handle a wave of COVID-19- related disputes. The lessons learned from the 2008 crisis, including complaint handling, claims management and regulatory compliance, stand them in good stead to weather the similar challenges posed by the pandemic. However, as the economic uncertainty continues, economic relief programs expire, and distress deepens, both banks and financial services companies should assume there will be increased consumer and business disputes, including lender liability disputes and claims in insolvency proceedings. The reality is that the longer it takes to return to a “new normal” and the stronger the economic headwinds, the greater the pressure will become. The removal of government support schemes could prove to be a decisive turning point, leading business to consider using litigation as the economic process for mitigating losses.

Practical steps FS providers can take now to protect their positions and mitigate against future claims are robust governance and compliance programmes, including:

• Ensuring that all lending criteria against which CBILS or PPP loans are assessed is consistently and fully adhered to.
• Clearly documenting the decision to refuse or grant government-backed loans and ensuring clear and consistent guidelines regarding eligibility for and the features and availability of loans.
• Ensuring internal governance and compliance systems are robust and up-to-date and that all staff are fully aware of their obligations thereunder.
• Providing adequate training and frequent updates on internal security procedures and emerging threats.
• Implementing company-wide monitoring programmes to track and respond to complaints and claim trends.