Identity theft, whereby thieves use people’s personally identifying information to open new accounts and misuse existing accounts, is a growing problem. The FTC, working with other federal agencies including federal bank regulatory agencies and the National Credit Union Administration, issued regulations — known as the Red Flags Rule — which require financial institutions and creditors to develop and implement written identity theft prevention programs as part of the Fair and Accurate Credit Transactions Act of 2003. See 16 C.F.R. §681.2. The programs must identify, detect and respond to the warning signs, or “red flags,” that could indicate identity theft.

Who Must Comply?

The Red Flags Rule applies to all “financial institutions” and “creditors” with “covered accounts.” Under the rule, a “financial institution” is defined as a state or national bank, a state or federal savings and loan association, a mutual savings bank, a state or federal credit union, or any other person that, directly or indirectly, holds a transaction account belonging to a consumer. See 16 C.F.R. §681.2(b)(7); see also 15 U.S.C. 1681a(t). Examples of financial institutions under the FTC’s jurisdiction include state-chartered credit unions and institutions that offer accounts where the consumer can make payments or transfers to third parties.

The rule more broadly defines a “creditor” to include any person or business that arranges for the extension, renewal or continuation of credit and includes all businesses or organizations that regularly permit deferred payments for goods or services. See 16 C.F.R. §681.2(b)(5); see also 15 U.S.C. 1681a(r)(5). Under this broad definition, a “creditor” encompasses commercial transactions; not only are credit card companies and financial institutions subject to the rule, but so are automobile dealers, finance companies and any other company that regularly extends or merely arranges for the extension of credit or makes credit decisions. The definition also includes any company that regularly participates in the decision to extend, renew or continue credit, including setting the terms of credit.

Given the breadth of the “creditor” definition, the rule arguably applies to businesses ranging from utilities and telecommunications companies to health care providers, lawyers, accountants and other professionals. Presumably, it could also apply to secured lenders, as well as players in the equipment leasing industry, which are in any way involved or participate in the extension of credit or renegotiation of credit terms or merely credit decisions.

The breadth of the rule’s definition of “creditor” and a lack of sufficient guidance from the FTC has created much confusion and uncertainty in some industries as to their coverage under the rule and resulted in the FTC’s repeated delay in its enforcement. The FTC has been accused of applying the rule to entities that were not intended by Congress to be encompassed by the definition of creditor and, most recent, the American Bar Association brought suit in the U.S District Court for the District of Columbia challenging the FTC’s broad application of the rule and was granted an order barring the FTC from forcing rule compliance by attorneys and law firms.

Once a business has concluded that it is a financial institution or creditor, it must determine if it has any covered accounts. “Covered accounts” encompass both existing and new accounts and fall into two categories. See 16 C.F.R. §681.2(b)(3). The first category is a consumer account that is offered to a company’s customers primarily for personal, family or household purposes, and involves or is designed to permit multiple payments or transactions. Examples include credit card accounts, mortgage loans, automobile loans, margin accounts, cell phone accounts, utility accounts, checking accounts and savings accounts.

The second category is “any other account that a financial institution or creditor offers or maintains for which there is a reasonably foreseeable risk to customers or to the safety and soundness of the financial institution or creditor from identity theft, including financial, operational, compliance, reputation or litigation risks.” Examples provided by the FTC include small business accounts, sole proprietorship accounts or single transaction consumer accounts that may be particularly vulnerable to identity theft.

The FTC examples, however, do not provide any guidance as to what may constitute a “small” business account and could open the door to an inference that accounts with large businesses do not fall within this category of covered accounts. However tempting that inference may be, the FTC has given indication that the size of the account or creditor is not the determinative factor. Rather, the key factor in determining whether an account falls into the second category is if the risk of identity theft is “reasonably foreseeable.” To make this determination, take into consideration how the account is opened and accessed. For example, if an account can be accessed remotely by telephone or the Internet there may be a reasonably foreseeable risk of identity theft, regardless of whether the account is with a small business, sole proprietor or large corporation. Whether or not a business finance lease, for example, may be a covered account will turn on whether it presents a reasonably foreseeable risk of identity theft.

How to Comply?

Companies subject to the Red Flags Rule (covered companies) are required to design and implement a written Identity Theft Prevention Program, which must be designed to prevent, detect and mitigate identity theft in connection with the opening of new accounts and the operation of existing ones. The program must be uniquely tailored to a covered company’s size, complexity of business and the nature and scope of its activities. The height of a covered company’s identity theft risk or the variety of covered accounts that it may have could impact its need for a program more comprehensive than the program of a company with lesser risk or covered accounts.

Identify the Relevant Red Flags

According to the FTC, red flags are potential patterns, practices or specific activities that indicate the possibility of identity theft. See 16 C.F.R. §681.2(b)(9). Different kinds of risk may be associated with different kinds of accounts. Therefore, in identifying the relevant red flags, a covered company should take into consideration the types of accounts that it offers or maintains, the methods used to open covered accounts, how access is provided to those accounts and the company’s previous experience with identity theft.

To further aid in the identification of red flags, a covered company may consider other sources of information as a resource. Other sources may include, where available, the experience of other members in its industry (perhaps available, for example, from news or industry reports or “talk on the street” between industry members). Another source is consideration of how identity theft may have previously affected the covered company’s business, as past experience could lend aid in identifying patterns, practices or specific activities that indicate the possibility of identity theft.

Supplement A to the Red Flags Rule lists five categories of common red flags that a covered company should consider for inclusion in its program, as appropriate to that company’s business: 1.) alerts, notifications or other warnings received from a credit reporting company (for example, an address discrepancy provided by a credit reporting agency or a fraud alert on a credit report); 2.) the presentation of suspicious documents (for example, identification of applications that look forged); 3.) suspicious personal identifying information (for example, a bogus address or inconsistencies with available information); 4.) suspicious account activity (for example, an inactive account is suddenly in use) and 5.) notice from other sources, such as a customer, a victim of identity theft or law enforcement authorities.

Detect Red Flags

Once a covered company has identified the red flags of identity theft for its business, the company’s program must address the procedures and policies for detecting them in the company’s day-to-day operations. When verifying a person’s identity when opening a new account, reasonable procedures may include obtaining and verifying the person’s name, address and identification number or government-issued identification card, such as a driver’s license or passport. For existing accounts, a company’s program may include reasonable procedures to authenticate customers, monitor transactions and verify the validity of change-of-address requests.

Prevent and Mitigate Identity Theft

When a covered company has spotted a red flag, it should be prepared to respond appropriately. The rule does not require any specific practice or procedures for an “appropriate” response but, rather, gives a covered company the flexibility to tailor its program to the nature of its business and the risks it faces. As a practical matter, this flexibility may make it that more difficult to respond “appropriately” without further guidance from the FTC. The appropriate response will depend upon the degree of risk posed and may need to accommodate other legal obligations that a covered company may be subject to (for example, the obligation to file a Suspicious Activity Report (SAR) for those financial institutions and creditors that are subject to the SAR rules).

The FTC guidelines in the Red Flags Rule offer illustrative examples of some appropriate responses, which include: monitoring a covered account for evidence of identity theft; contacting the customer; changing passwords, security codes or other ways to access a covered account; closing an existing account; reopening an account with a new account number; or notifying law enforcement. One or more of these options, or some other option altogether, may be the appropriate response depending upon the facts of each particular case.

Update the Program

The Rule requires periodic updates to a company’s program to ensure that it keeps current with identity theft risks, recognizing that new red flags may emerge as technology changes or identity thieves change tactics.

How to Administer Your Program

The Red Flags Rule also enumerates steps that a covered company must take to administer its program, including obtaining board approval, training of staff, ensuring oversight by the board or a senior management designee, and reporting on compliance, at least annually, to name a few.

The FTC has delayed enforcement of the rule from November 1, 2009 until June 1, 2010 to give creditors and financial institutions more time to develop and implement their compliance programs. Once enforcement begins, failure to comply with the Red Flags Rule could result in civil monetary fines and lawsuits so it is important that covered entities make a good faith, reasonable effort to comply. Enforcement of the rule can only be done by federal and state government agencies that are authorized by statute, including the FTC. The FTC can file a complaint against the non-compliant entity, which seeks both monetary civil penalties, as well as injunctive relief for violation of the rule.

In a situation where the complaint seeks civil penalties, a lawsuit is typically filed in federal court by the U.S. Department of Justice on behalf of the FTC. The maximum civil penalty per violation is currently $3,500 and each instance in which the company has violated the rule is a separate violation. Injunctive relief may require the parties being sued to comply with the law in the future, in addition to providing reports, retaining documents and taking other steps to ensure compliance with both the rule and court order. Failure to comply with the court order could subject the parties to further penalties and injunctive relief. While there is no private right of action by consumers under the rule, consumers can file a complaint with the FTC about a company’s program, which complaint the FTC may use to target its law enforcement efforts.

Marc L. Hamroff, a partner with Moritt Hock Hamroff & Horowitz LLP, heads up the firm’s financial services practice group, which includes, among others, its creditors’ rights, bankruptcy and equipment leasing practice areas. Terese L. Arenth., a partner with the firm, co-chairs the firm’s promotions and marketing law practice area, in addition to having significant involvement in the firm’s equipment leasing and commercial litigation practice areas.

Moritt Hock Hamroff & Horowitz LLP with offices in Long Island and Manhattan is a broad-based corporate law firm that represents finance companies, secured and asset-based lenders, financial institutions and creditors in the fields of: equipment leasing, secured lending, financial services, creditors’ rights and business succession, in addition to having a unique niche in promotions and marketing law.