Equal Credit Opportunity Act and Indirect Lending
By: Laura Pringle
June 12, 2013
Fair lending examinations of financial institutions by their primary federal regulators during the past few years in some cases have identified violations of the Equal Credit Opportunity Act (“ECOA”) in direct automobile lending and in indirect lending which required corrective action. A strong new light has been shown on these indirect lending issues by the Consumer Financial Protection Bureau’s (“CFPB”) guidance in Bulletin 21, 2013, “Indirect Auto Lending and Compliance with the Equal Credit Opportunity Act (ECOA).” While that guidance was provided by the CFPB for indirect auto lenders within the CFPB’s jurisdiction, the CFPB’s recommendations, as well as the directives of the other federal financial institutions regulators, include reminders to indirect lenders of all sizes and charter types to take appropriate actions to prevent discriminatory lending. This article will provide perspective and practical considerations on these significant legal issues.
CFPB’s Immediate Concern and Other Regulators’ Approach for all Financial Institutions
The CFPB’s Bulletin was directed at its immediate concern apparently discovered or confirmed through its supervisory experience over certain indirect automobile lenders. That is, the CFPB is concerned that some dealers are marking up interest rates beyond those rates which would otherwise be available to certain borrowers. Sometimes this mark up to an interest rate that may be called the “buy rate” is part of a practice which includes establishing what may be called a “reserve.” Allowing this practice provides an incentive to the dealer to increase earnings both for the lender and for the dealer.
The CFPB states that there is a significant risk that this practice will result in pricing disparities on the basis of race, national origin, and other prohibited bases under the ECOA. Other regulators have since provided context for other lenders to this Bulletin with reminders that these issues and other indirect lending concerns can be expected to be part of every financial institution’s fair lending examinations. See, e.g., the Federal Reserve Bank of San Francisco’s letter dated April 5, 2013. www.frbsf.org.
Liability of Both the Dealer and the Financial Institution or Other Lender
The CFPB carefully explains in the Bulletin that the ECOA covers “creditors”, which include those who regularly extend credit and “any assignee of an original creditor who participates in the decision of whether or not to extend credit.” Again, the CFPB explains that the types of business relationships between lenders and dealers are quite varied in the indirect lending business, but the liability for discriminatory practices is not avoided by the dealer or the lender by the various sorts of contractual or more informal relationships between the lenders and dealers.
Steering may be a concern in allowing mark ups on interest rates on loans to individuals who may be in protected classes. That is, those lenders which permit mark ups to increase earnings are providing a compensation incentive to dealers to steer borrowers to those lender(s) who would not only be willing to make the loan but also provide the highest return to the dealer and the lender. This can occur both when an automated system that forwards information to several prospective indirect lenders is used and when there is a relationship between a dealer and one primary, or even a sole, lender.
The CFPB provided background information in its Bulletin on the various sorts of relationships between dealers and lenders and assignees. The specific concern addressed in the Bulletin can be expected to arise when the dealer is allowed discretion in these relationships to vary from either “rate sheets” or from more complicated rate systems which may establish creditworthiness standards including credit scores, and also product types and credit terms, such as length of the loan, as well as other criteria and options. It is this discretion that can be the cause of discrimination in direct lending and in indirect lending because the decision-making authority with discretion would allow a person to increase the cost of borrowing to a person in a protected class.
Because disparities may exist within an indirect lender’s portfolio, the CFPB states that lenders may be liable under the fair lending legal doctrines of both disparate treatment and disparate impact. The CFPB references in this Bulletin the document in which the CFPB had separately reaffirmed that the legal doctrine of disparate treatment remains applicable in its supervision and enforcement authority for compliance with the ECOA and Regulation B , i.e., CFPB Bulletin 2012-14 (April 18, 2012). In this more recent Bulletin, the CFPB makes clear that those disparities in pricing caused by mark-ups and compensation arrangements alone may be sufficient to trigger liability for both the dealer and the lender and/or assignee.
Those sorts of compensation issues are also the subject of another pending regulatory proposal directed more at business risks instead of ECOA compliance. Compensation and incentives which encourage more aggressive lending practices are part of the concerns addressed in the Incentive-Based Compensation Arrangements proposal, published by the OCC, Federal Reserve, FDIC, NCUA, and other federal regulatory agencies, pursuant to Section 956 of the Dodd-Frank Act. http://www.gpo.gov/fdsys/pkg/FR-2011-04-14/pdf/2011-7937.pdf. These provisions are discussed under the subheading “Incentive Based Compensation Proposal and Current Safety and Soundness Standards” in a recent article entitled “Loan Originator and Other Compensation Rules” published on ComplianceHeadquarters.com in March, 2013. These compensation incentives may be provided by lenders to an individual or groups of lending officers and/or dealer liaisons and raise other risks in addition to the ECOA risks of liability.
Contracting and Ongoing Monitoring
The CFPB explained in its most recent Bulletin that there are steps that can be taken by lenders to try to limit this potential liability and stated that those steps may include but are not limited to:
- imposing controls on dealer markup and compensation policies, or otherwise revising dealer markup and compensation policies, and also monitoring and addressing the effects of those policies, so as to address unexplained pricing disparities on prohibited bases; or
- eliminating dealer discretion to mark up buy rates and fairly compensating dealers using another mechanism, such as a flat fee per transaction, that does not result in discrimination.
The CFPB also specifically emphasized again the importance of a “robust fair lending compliance management program” and referenced its Consumer Financial Protection Bureau, Supervisory Highlights: Fall 2012 (Oct. 31, 2012), available at www.consumerfinance.gov/reports/supervisory-highlights-fall-2010. The CFPB explained in this Bulletin the features of such a program which are applicable in the indirect lending context to include the following:
- an up-to-date fair lending policy statement;
- regular fair lending training for all employees involved with any aspect of the institution’s credit transactions, as well as all officers and Board members;
- ongoing monitoring for compliance with fair lending policies and procedures;
- ongoing monitoring for compliance with other policies and procedures that are intended to reduce fair lending risk (such as controls on dealer discretion);
- review of lending policies for potential fair lending violations, including potential disparate impact;
- depending on the size and complexity of the financial institution, regular analysis of loan data in all product areas for potential disparities on a prohibited basis in pricing, underwriting, or other aspects of the credit transaction;
- regular assessment of the marketing of loan products; an
- meaningful oversight of fair lending compliance by management and, where appropriate, the financial institution’s board of directors.
The CFPB emphasized that additional compliance management components may be necessary and gave as an example those lenders who continue to allow mark ups or other compensation and specifically recommended the following monitoring and corrective action:
- sending communications to all participating dealers explaining the ECOA, stating the lender’s expectations with respect to ECOA compliance, and articulating the dealer’s obligation to mark up interest rates in a non-discriminatory manner in instances where such markups are permitted;
- conducting regular analyses of both dealer-specific and portfolio-wide loan pricing data for potential disparities on a prohibited basis resulting from dealer markup and compensation policies;
- commencing prompt corrective action against dealers, including restricting or eliminating their use of dealer markup and compensation policies or excluding dealers from future transactions, when analysis identifies unexplained disparities on a prohibited basis; and
- promptly remunerating affected consumers when unexplained disparities on a prohibited basis are identified either within an individual dealer’s transactions or across the indirect lender’s portfolio.
Add On Products
Add-on products in indirect lending can be a factor in creating ECOA liability even if no other term of a loan such as interest rate is varied by the dealer. That is, if the cost of borrowing is increased by the addition of ancillary products which may be purchased by the borrower from the dealer or from the lender, discriminatory practices or disparate impact may result. Again, compensation and incentives may increase the likelihood of liability, and it is very important to be reviewing contract terms and monitoring loan practices and loans made as well as taking other steps to address these risks.
These sorts of issues also were addressed in a broader issuance in a Bulletin issued by the CFPB on July 18, 2012, and the related enforcement actions by the CFPB and the OCC involved deceptive sales and marketing practices of add-on products where the CFPB stated as follows: “Although this bulletin focuses on credit card add-on products, institutions should take the guidance that is provided into consideration when they offer similar products in connection with other forms of credit or deposit services.” Although the CFPB expectations state that those institutions supervised by the CFPB should take steps which are listed in the Bulletin to address legal and other concerns, this Bulletin also provides helpful guidance for all financial institutions and importantly, the controls include not only the review of scripts and manuals and monitoring and oversight of affiliates and third-party service providers for marketing add-on products, but also for the handling of cancellation requests by consumers. This Bulletin can be found at the following address: http://files.consumerfinance.gov/f/201207_cfpb_bulletin_marketing_of_credit_card_addon_products.pdf.
The CFPB, as well as the primary federal regulators of financial institutions, have made clear that all lending practices and particularly indirect automobile lending, will be reviewed in fair lending examinations. Disparities within portfolios are red flags that require heightened attention and clear justification and timely corrective action to be taken to address disparities which may have caused discrimination in lending. Incentives and any earnings pressures should be also reviewed prior to upcoming examinations to determine whether compensation practices may encourage mark ups, changes in terms and other lending practices and/or sales of products which could be heightening the risks of ECOA liability.
This Article was also published at Wolters Kluwer’s Compliance Headquarters™ website: www.complianceheadquarters.com.