Christine Adams, on Behalf of Herself and All Others Similarly Situated v. Plaza Finance Company, Inc. ( 1999 )

POSNER, Chief Judge.

This class suit against Plaza Finance Company seeks statutory (not compensatory) damages for violation of the Truth in Lending Act, 15 U.S.C. §§ 1601 et seq.-, § 1640(a). The district court granted summary judgment for the defendant largely on the basis of a district court decision, since reversed by the Fifth Circuit in Edwards v. Your Credit, Inc., 148 F.3d 427 (5th Cir.1998), in a case virtually identical to this one. A number of similar cases are pending elsewhere. Alvin C. Harrell, “Consumer Credit,” 52 Consumer Finance L.Q. Rep. 104,106 (1998).

In view of the procedural posture of our case, we construe the facts as favorably to the plaintiff as the record will permit. The defendant specializes in making small, short-term loans to individuals who have bad credit (the default rate on its loans is 25 percent). It lent the named plaintiff $307 for ten months, of which $7 went to pay for a premium for “nonfiling insurance,” that is, insurance against losses to the finance company resulting from its failure to file (record) its security interest. The Truth in Lending disclosure form that the plaintiff was given listed, besides $307 as the “amount financed” (see Federal Reserve Board Regulation Z, 12 C.F.R. § 226.18(b)), a “finance charge” (basically the amount of interest charged for the loan, but including certain service charges as well, see 15 U.S.C. § 1605(a)) of $128 and an annual interest rate of 83 percent. In computing the interest rate for Truth in Lending purposes, the finance company uses the finance charge as the interest and the amount financed as the principal. Hence, other things being equal, the disclosed interest rate is higher the higher the finance charge and lower the higher the amount financed. This creates an incentive for lenders, who want the interest rate to look as low as possible, to shift items from the finance charge (interest) to the amount financed (principal).

The loan to the plaintiff was secured by a wage assignment plus a security interest in various items of the borrower’s personal property, such as a television set. Unless such an interest is recorded in the local UCC registry of security interests in personal property, the holder of the interest will not be able to enforce it against a subsequent secured creditor who records his own security interest. UCC § 9-312(5)(a), 810 ILCS 5/9-312(5)(a); Midwest Decks, Inc. v. Butler & Baretz Acquisitions, Inc., 272 Ill.App.3d 370, 208 Ill.Dec. 455, 649 N.E.2d 511, 516 (Ill.App.1995). (Filing generally is unnecessary to perfect a purchase-money security interest, UCC §§ 9-302(l)(d), 307(2), 810 ILCS 5/9-302(l)(d), 307(2), but that type of security interest is not involved in this case.) Because the rules in Article 9 of the Uniform Commercial Code regulating filing are complex and demanding, see, e.g., UCC §§ 9-103, 9-401, 9-403(2), it is easy for a lender to make a mistake, such as filing in the wrong place or failing to renew the filing statement after its expiration; and lenders sometimes insure themselves against the consequences of such a mistake by buying nonfiling insur-anee. The Truth in Lending Act permits a lender to include as a service fee a premium for such insurance. 15 U.S.C. § 1605(d)(2). The $7 that Plaza charged the plaintiff was the per-loan premium it pays to Voyager Property and Casualty Insurance Company. This is the same insurance company that was involved in the Fifth Circuit’s Edwards decision. Although Voyager is licensed to sell nonfiling insurance in Illinois, where the loan to the plaintiff was made, there is no suggestion that Illinois has determined that Voyager’s contract with Plaza and its performance of that contract are consistent with the terms of the license or the insurance law of Illinois. Indeed, we can find nothing in the record or in the law of Illinois to indicate what Illinois understands by “nonfiling insurance.”

The plaintiff argues that the “insurance” which Voyager has sold Plaza either is not insurance at all, or is not nonfiling insurance but instead default insurance — and a premium for default insurance, unlike a premium for nonfiling insurance, must be included in the finance charge. 12 C.F.R. § 226.4(b)(5). Interest is compensation not only for the time value of money but also for the risk of default, and so a charge to the borrower that is intended to compensate the lender for that risk is functionally part of the borrower’s interest expense. A premium for default insurance is such a charge, and so it belongs in the “finance charge” (interest) column of the disclosure form.

The usual purpose of insurance is to shift risk from an individual or other entity that is risk averse, and so would prefer to substitute a cost certain (a fixed insurance premium) for the risk of incurring a larger cost, to an entity that by pooling independent risks can minimize the overall risk to itself. Union Labor Life Ins. Co. v. Pireno, 458 U.S. 119, 127-31, 102 S.Ct. 3002, 73 L.Ed.2d 647 (1982); Group Life & Health Ins. Co. v. Royal Drug Co., 440 U.S. 205, 211, 99 S.Ct. 1067, 59 L.Ed.2d 261 (1979); Clark Equipment Co. v. Dial Corp., 25 F.3d 1384, 1388 (7th Cir.1994); Sears, Roebuck & Co. v. Commissioner, 972 F.2d 858, 863 (7th Cir.1992). The simplest example is life insurance. A person who does not want to bear the financial risk of dying young can buy life insurance, for which he pays a fixed premium. The financial risk of his early death is shifted to the insurance company, which by pooling that risk with the risk of its policy holders who die old can eliminate the risk of incurring an unexpectedly steep loss from a premature death. By pooling, the insurance company shields itself from that risk; by joining the pool, the insured eliminates the risk to himself.

No risk-shifting purpose is discernible in the arrangement between Plaza and Voyager. Their original contract expressly capped Voyager’s potential liability to Plaza at 90 percent of the premiums paid by Plaza. This meant that no risk was shifted to Voyager. If Plaza paid Voyager premiums of $50,000, and had insured losses of $100,000, for a total loss-related cost of $150,000, it would receive $45,000 in insurance proceeds from Voyager, leaving it with a net cost of $105,000 ($150,-000 - $45,000) — a net cost greater than the premiums, greater even than the incurred loss, that is, the loss against which Plaza nominally insured. Plaza was in effect a self-insurer, and the cost of self-insurance is not within the dispensation to exclude premiums for nonfiling insurance from the finance charge. 12 C.F.R. Part 226, Supp. I, § 226.4(e)(4) (Official Staff Commentary on Regulation Z).

Of course insurance policies always have limits; but when the limit is at or below the premium, the insured is not shifting risk by buying the policy. This cannot be the end of the analysis, however. Insurance has other functions besides risk-shifting, including smoothing costs over time, providing assistance in defending against claims (liability insurers typically provide a defense if their insured is sued for conduct covered or even just arguably covered by the policy), and exploiting various tax opportunities. Wisconsin Power & Light Co. v. Century Indemnity Co., 130 F.3d 787, 791 (7th Cir.1997); Sears, Roebuck & Co., supra. But at argument Plaza’s lawyer was able to identify only one possible function of Voyager’s insurance, and that is to avoid having to include $7 in the finance charge. By its lawyer’s own acknowledgment, Plaza is getting nothing in the way of a service from its so-called insurer, whether for bearing risk or for anything else, in exchange for the $7 that it pays Voyager — or rather for the 70$ it pays Voyager, for it gets the rest of the $7 back. If the only function of the insurance policy is to monkey with the disclosed interest rate, it is not a bona fide policy; it is a fraud.

And that is, so far as the record indicates, the only function of the “nonfiling insurance” that Plaza bought from Voyager: to enable the lender (Plaza) to shift $7 of what otherwise would be an interest charge from the finance-charge column on the Truth in Lending disclosure form to the amount-financed column. See 12 C.F.R. § 226.18(b)(2). The expense to the borrower is the same, but the disclosed annual interest rate is lower. Remember that items added to the finance charge count as interest in computing the disclosed annual interest rate, and so increase that rate, while items added to the amount financed increase the denominator in the interest-rate calculation and so reduce the disclosed rate. In this case, the disclosed interest rate would have risen to 89 percent if $7 had been subtracted from the amount financed and added to the finance charge. The smaller the loan, the bigger the difference that the shift of $7 makes. Consider a very simple example: a one-year loan (amount financed) of $50 (and Plaza makes loans that small), and a finance charge of $40 payable at the end of the year, and hence an annual interest rate of 80 percent. (Simple rather than compound interest is assumed, to keep the example simple.) If $7 is shifted from the amount financed to the finance charge, the annual interest rate skyrockets to 109 percent ($47/$43). That’s a scary figure; it might frighten off even the necessitous borrowers who are Plaza’s principal customers.

During the period covered by the complaint, the insurance contract with Voyager was altered to drop the 90-pereent-of-premi-ums cap. This change eliminated the most illusory feature of the contract. But the plaintiff, who received her loan from Plaza after the change, contends that Voyager and Plaza have an informal understanding that Plaza will not submit claims in excess of 90 percent of the premiums that it has paid during a given period; hence the change in the policy was merely cosmetic. If so, the inference that the arrangement between these two companies is not an insurance policy of any sort, but a sham that has no purpose other than to facilitate an evasion of the Truth in Lending Act’s requirements, would be compelling in the absence of contrary evidence not yet presented by Plaza. It is true that the Fifth Circuit in Edwards granted summary judgment for the finance company on this, the “complete sham” claim of a Truth in Lending violation, 148 F.3d at 442-43, but it did so on a record that, unlike the record in this case, did not contain the 90 percent of premiums cap. But we note that if the plaintiff decides to pursue the “complete sham” claim on remand, a division of the class into subclasses (see Fed.R.Civ.P. 23(c)(4)(B); Marisol A. by Forbes v. Giuliani, 126 F.3d 372, 378-79 (2d Cir.1997); 7B Charles A. Wright, Arthur R. Miller & Mary K. Kane, Federal Practice and Procedure § 1790, pp. 276-84 (2d ed.1986)) may be indicated because persons who borrowed from Plaza before it changed the terms of the insurance policy have an even stronger claim than those who, like the named plaintiff, borrowed after the change.

The plaintiffs alternative ground for contending that Plaza has violated the Act is, however, both of uniform strength across the entire class and solid. It is that if there is real insurance here, and not a complete sham, it is insurance against default rather than insurance against the consequences of not filing a security interest. A lender files a security interest only if it thinks it might want to seize the collateral in the event of default. The plaintiff has presented evidence from which it can be inferred, with enough confidence to defeat summary judgment, that Plaza does not want to seize the collateral for its loans, because they are tiny loans to people who own no valuable property. The taking of the security interest is intended merely to frighten the borrower. FTC, Trade Regulation Rule on Credit Practices, 49 Fed.Reg. 7740, 7762-63 (March 1, 1984); American Financial Services Ass’n v. FTC, 767 F.2d 957, 973 (D.C.Cir.1985); Kathleen E. Keest & Gary Klein, Truth in Lending § 3.9.6.3, p. 142 n. 729 (3d ed.1995). Had the named plaintiff defaulted on her $307 loan, it would not have been worth Plaza’s while to institute legal process to obtain and sell her personal property. Rather than wanting to file and occasionally through neglect failing to do so and wanting insurance against that eventuality, Plaza doesn’t want to bother to file, has no desire for insurance against the consequences of not filing (there are no consequences, so there is nothing to insure against), and never has submitted a nonfiling claim to Voyager.

Most of the claims that it submits to Voyager are for losses caused by a default by a borrower who cannot be located (a “skip”). In these cases, the borrower’s property can’t be located either. Failure to have recorded a security interest in the property can have no consequence for Plaza in such a case; Plaza can’t enforce a security interest in property that it can’t find. Some of the claims involve borrowers who have defaulted because they died, and a few involve borrowers who have entered Chapter 7 bankruptcy. But in neither of these classes of case is there any indication that property in which Plaza had a security interest was ever snatched away from it by a creditor who had a superior interest by reason of having recorded it.

Insurance companies sometimes pay claims that don’t actually come within the scope of the insurance policy. They do so because of their own inadvertence, fraud by the insured, ambiguity in the policy, or a desire to maintain good relation with valued customers. We want to emphasize, lest lenders find themselves obliged by innocent mistake to pay potentially very large statutory damages in class actions, that nonfiling insurance doesn’t cease to be so merely because the insurance company sometimes pays on claims that don’t fit within the strict terms of the policy. But so far as the record discloses, Voyager has never paid a claim by Plaza for a loss due to nonfiling. Not rarely; never. So far as the record discloses, the insurance contract is in fact a contract for default insurance, not nonfiling insurance, and the law treats the two types of insurance differently.

If an insurance company issues an automobile liability policy to a person who does not own or drive an automobile, and then pays the claims that the person submits for accidents caused by his bicycle, the policy would not be an automobile liability policy but a bicycle liability policy. Cf. Nolker v. Wallace, 317 So.2d 4 (La.App.1975). And so it is here: penetrating form to substance is the right approach in a Truth in Lending Act case in which an insurance policy says “non-filing” but all the claims submitted and paid under it are for defaults the costs of which to the insured have nothing to do with the insured’s having failed to record a security interest. This is not just our idea, or that of the Supreme Court, Ford Motor Credit Co. v. Cenance, 452 U.S. 155, 158, 101 S.Ct. 2239, 68 L.Ed.2d 744 (1981) (per curiam); the Federal Reserve Board, in its regulation interpreting and applying the Act, has made clear that it is the actual character of a policy of insurance — what it really insures — rather than the name, that controls its classification for purposes of the Act. See 12 C.F.R. Pt. 226, Supp. I, § 226.4(d)(10), p. 314 (1998) (Official Staff Commentary).

We emphasize that in speaking of penetrating the outer form to find the inner substance, we (and the Supreme Court, and the Federal Reserve Board) are not referring to the “substance” of the credit transaction. The Act is not a usury law; it does not limit interest rates; all it requires is truthful and (it is hoped) informative disclosure of the interest rate and the other terms of credit. The relevant substance is truth; and its protection is inconsistent with allowing a lender to call something “nonfiling insurance” that is not insurance against nonfiling losses and indeed may not be insurance at all. Since the Truth in Lending Act permits premiums for nonfiling insurance to be included in the amount financed but requires default insurance premiums to be included in the interest charge, a lender cannot be permitted to designate a premium as being for nonfiling insurance if it is really, clearly, and always for default insurance. Otherwise the Act would be easily evaded, cf. Mourning v. Family Publications Service, Inc., 411 U.S. 356, 366-68 and n. 26, 93 S.Ct. 1652, 36 L.Ed.2d 318 (1973); Gibson v. Bob Watson Chevrolet-Geo, Inc., 112 F.3d 283, 287 (7th Cir.1997), as appears to be happening here.

At argument Plaza’s lawyer reminded us that his client did not conceal the $7 charge from the plaintiff; she knew she was paying it. What she didn’t know was what interest rate she was paying. Maybe she didn’t care. But the provision of the Truth in Lending Act that requires disclosure of the annual interest rate assumes that borrowers, or some appreciable number of them at any rate, do care; and we are not at liberty to question the premises of a valid statute. Id. at 287.

We do worry about opening a can of worms in which class action lawyers can rummage for discrepancies between the terms and actual performance of contracts relating to the various service charges that the Act permits to be included in the amount financed. But to forbid inquiry into performance would open a big loophole, as a host of cases (besides Edivards, a virtual clone of this case) attest. Ford Motor Credit Co. v. Cenance, supra, 452 U.S. at 158, 101 S.Ct. 2239 (expressly refusing to place form over substance); Mourning v. Family Publications Service, Inc., supra, 411 U.S. at 366-68, 93 S.Ct. 1652; Walker v. Wallace Auto Sales, Inc., 155 F.3d 927, 932-33 (7th Cir.1998); Adiel v. Chase Federal Savings & Loan Ass’n, 810 F.2d 1051, 1053 (11th Cir.1987). Nothing in the language or history of the Act, or the cases interpreting it, authorize courts to forbid plaintiffs to prove if they can that a finance charge has been mislabeled as part of the amount financed in circumstances that negate an inference that the mislabeling is due to a mistake by a third party, such as a nonfiling insurer who occasionally pays what is really a loss due to default rather than nonfiling. We need not consider the outer bounds of “occasionally,” since the plaintiffs submission is that the parties to the so-called insurance contract never intended for any nonfiling claim to be submitted and paid and that no such claim ever was submitted or paid.

We emphasize that the facts recited in this opinion are merely those adduced in the summary judgment proceedings and viewed in a light favorable to the plaintiff. The trial may cast the facts in a different light. But the grant of summary judgment was error.

REVERSED.