Operation Choke Point: Payday Lending, Porn Stars, and the ACH Syst...

Pop quiz:  what do payday lenders have in common with on-line gun shops, escort services, pornography websites, on-line gambling and the purveyors of drug paraphrenalia or racist materials?  

You can read my testimony for this Thursday's House Judiciary Committee, Subcommittee on Regulatory Reform, Commercial, and Antitrust Law's hearing on Operation Choke Point to find out. Or you can just keep reading here.  

What all of these businesses have in common is that they are considered high-risk customers by banks. What makes these industries high-risk for banks? Many of their payments are disputed. Sometimes the issue is consumer fraud, sometimes merchant fraud:  happily married men vehemently deny subscribing to porn sites or having paid for an escort service. Or a payday lenders might demand an ACH payment without authorization.  All of this matters to banks because banks make various warranties when they transmit or demand payments within the payment system. If a payment isn't authorized, the bank can be stuck with the loss. 

So here's the back story.  In early 2013 the Department of Justice commenced Operation Choke Point, a crackdown on consumer frauds. Operation Choke Point recognized that consumer fraudsters need to get paid for their crimes to pay, so choking off their access to the financial system is a great way to combat consumer fraud.  (I suggested something analogous as a general regulatory strategy in an early article.) DOJ has done this by investigating banks (resulting in one law suit to date) that provide access to the automated clearing house (ACH) payment system for payday lenders through third-party payment providers to ensure that the banks are complying with the Bank Secrecy Act/Anti-Money Laundering duty of making sure they know who their actual customer is and that the customer's business is legitimate and that the bank is not itself being used as an instrument of a consumer fraud.  In other words, this is a money laundering issue.  While we tend to think of money laundering as being about drug money or terrorism finance, money laundering concerns cover all sorts of crimes.  

The fringe right has gotten up in arms about Operation Choke Point, suggesting that it is cutting off legitimate businesses from the financial system and that DOJ has no authority to do this.  In particular, critics have pointed to banks terminating the accounts of high-risk businesses, such as porn stars, in the wake of Operation Choke Point. Of course, no one has actually been able to show that there was a causal connection with the account terminations, which might have been due to any number of other issues (as subsequent reporting indicates). Other critics, such as the inimitable Todd Zywicki, have raised the concern of a slippery slope, namely that the DOJ will seek to squeeze other politically disfavored businesses (abortion clinics, Wikileaks, Teaparty) out of the payment system. Yet other critics have complained about the unfair dragooning of banks into the role of policemen. ("Do you really expect us to look at every image on a porn site to determine if it's kiddie porn?")

Not surprisingly, these high-risk businesses and the banks that want their business have gone wailing to Congress, seeking succor and relief from the oppresive regulatory fist of the DOJ.  Or, put another way, these high-risk businesses have gone to Congress to ask to be functionally exempted from anti-money laundering regulations. DOJ is pressuring banks to take AML seriously, and that means higher compliance costs for dealing with high-risk businesses.  Some banks think it's more cost efficient to terminate accounts than to reprice them.  But unless one thinks that there is complete market failure in the banking industry, surely some of our nearly 16,000 banks and credit unions will be willing to take on these high-risk businesses as customers.  It will just be at a higher price, which is what these high-risk businesses don't like. Quite rationally, these high-risk businesses have determined that it's cheaper to make campaign contributions than to have to pay their own freight.  Politics is just a business decision. And this shows us what the uproar over Operation Choke Point is really about.  

Put succinctly, the fuss over Operation Choke Point is about whether we want to subsidize high-risk businesses such as payday lenders, escort services, on-line gun dealers, purveyors of drug paraphrenalia or racist materials, and porn sites.  Now these may all be good old American pastimes ("...the heart and soul of Springfield's in Our Maison Derriere..."), but do we really want to put payday loans and porn ahead of homeland security? Apparently some members of Congress think so.

As for the statutory authority issue, FIRREA requires that there be a predicate crime, such as a wire fraud,  "affecting a federally insured financial institution."  Courts have uniformly held that "affecting" does not require an actual loss, just a risk of loss.  Now recall that banks are making warranties about the authorization of payment (and in the ACH system, at least, about the lawfulness of the payments).  It's pretty clear, then, that consumer frauds using the ACH system are "affecting federally insured financial institutions." Of course, one would actually have to read the NACHA rules to know about the warranties, which is something I suspect none of the Operation Choke Point critics have done. There's really no question that DOJ is within its statutory authority under FIRREA to pursue consumer fraudsters by cutting off their access to the financial system through Operation Choke Point.  

So we're right back to the question, then, of whether we want to subsidize payday loans and porn at the expense of homeland security.