United States: Mitigating Fair Lending Risk

Fair lending, particularly the manner in which regulators interpret "disparate impact," is a significant compliance issue for financial institutions and has recently been a major enforcement priority of federal agencies. The U.S. Department of Justice ("DOJ") has commenced a record number of fair lending matters within the past two years and the financial and strategic implications for institutions have been profound. In the past two months three institutions announced that they were the subject of a fair lending investigation. Moreover, the Consumer Financial Protection Bureau ("CFPB"), and its focus on these issues, has created an even greater challenge for lenders and fair lending compliance. The CFPB has issued fair lending guidance that raises difficult compliance and liability issues. The CFPB has stated that fair lending enforcement is a top priority and that it will use all available legal avenues, including disparate impact. Although disparate impact has garnered a lot of attention lately due to the pending U. S. Supreme Court case (Township of Mount Holly vs. Mt. Holly Gardens Citizens in Action) and recent statements by the DOJ and CFPB, discriminatory pricing, steering, and redlining on the basis of race and national origin also continue to be prevalent in recent DOJ settlements. In addition, in a recent press release the CFPB appears to be foreshadowing its use of Home Mortgage Disclosure Act ("HMDA") data to identify financial institutions that may be discriminating, stating that the HMDA data "can shed light on lending patterns that could be discriminatory."

Financial institutions should be sensitive to the reality that fair lending investigations not only cost a significant amount of time and money, but also may result in lost opportunity and increased reputational risk. Government fair lending investigations typically last for an extended period of time. During the pendency of a fair lending investigation a financial institution is generally very limited in its ability to pursue certain strategic options and effect expansion strategies.

Common Themes in Fair Lending Enforcement

A common theme in fair lending enforcement cases is apparent. The federal agencies appear to focus on (1) policies and procedures governing discretion of lenders and certain third parties, (2) documentation of loan pricing and exceptions to lending policies, (3) compensation policies tied to loan pricing or high cost loan products, (4) the use of internal and external fair lending analyses and (5) fair lending monitoring and audit policies. In addition, fair lending enforcement actions have also recently focused on the oversight of third parties involved in the lending process, including mortgage brokers/originators and outside law firms. Along these lines, various U.S. Attorney Offices, the DOJ and the U.S. Department of Housing and Urban Development ("HUD") are investigating whether certain law firms specializing in foreclosures engaged in deceptive conduct by possibly committing fraud in overcharging for services they provided. Subpoenas have been issued to several law firms specializing in foreclosures, and the financial institutions servicing the loans, requesting records relating to the foreclosure fees and expenses.

Reducing the Risk of Fair Lending Actions

These common themes have made it clear that vague policies and procedures that result in, or permit, broad discretion, incentives tied to loan pricing or high cost loan products and a lack of effective oversight of an institution's fair lending compliance program greatly increase the risk of a costly fair lending investigation. In order to reduce these risks financial institutions should take certain proactive steps. First, a financial institution should implement clear fair lending policies and procedures that avoid discrimination based on a prohibited basis, establish regular fair lending training and analyses, define and limit lending discretion, require documentation of the underlying reasons for any pricing adjustment or exception to policy and dictate a regular review of loan files. In connection with these policies and procedures, a financial institution must confirm that its systems are capable of capturing, storing and exporting the data needed for monitoring fair lending compliance. Second, quality control testing and regular reporting to monitor adherence to the fair lending policies and procedures should be implemented. A financial institution's internal audit or compliance department must also ensure that any violation of these fair lending policies and procedures, even technical violations, are consistently identified and remedied. Technical violations of the Equal Credit Opportunity Act ("ECOA") or Regulation B can be viewed as red flags by a regulatory agency and may prompt a fair lending investigation. As part of an effective fair lending compliance, financial institutions should also regularly perform regression analyses or other similar self-tests to identify statistically significant disparities. The federal agencies typically use regression analyses in connection with their fair lending investigations. As a result, regression analyses have become an important element of an effective fair lending compliance program and are used to remediate issues in advance of regulatory examinations, identify non-discriminatory factors that tend to explain disparities and can also be used to persuade regulators to end or limit the scope of a fair lending investigation.

Self-Test Privilege – Safe Harbor

A limited self-test privilege or safe harbor is available to financial institutions in the event voluntary self-testing reveals potential discrimination provided certain requirements are met. The self-test privilege covers examinations or investigations into fair lending complaints or efforts to prove a violation of fair lending laws and extends to both government agencies and applicants, provided an institution meets the applicable requirements. However, the self-test privilege does not extend to claims of discrimination under state law.

Under the regulations a self-test is limited to a self-test that creates new factual data. Specifically, a self-test must: (1) be designed or used specifically to measure compliance with the ECOA or the Fair Housing Act, or both, and Regulation B; and (2) create data or factual information that is not available and cannot be derived from information that already exists in loan application files or other documentation relating to credit transactions that exists at the institution. As a result, information relating to fair lending compliance that is generated through a procedure related to another compliance function will not be subject to the privilege. In addition, the privilege will not apply to any information that could have been derived from a loan application or loan file, including any self-analysis of loan files. Finally, a financial institution must take appropriate corrective action promptly for the privilege to be applicable. To retain the self-test privilege, the corrective action taken by the institution must be designed to resolve the underlying cause of the discrimination and cannot be superficial. In the event a fair lending self-test or regression analysis appears to reflect disparate impact, an institution should take certain steps in connection with its corrective action, including: (1) identifying and reviewing the policy or procedure that resulted in the potential disparate impact; (2) analyzing the business necessity of the policy or procedure; (3) determining whether there is any viable alternative policy or procedure that would eliminate the potential disparate impact; (4) implementing an effective policy or procedure to eliminate the underlying cause of the discrimination and prevent a reoccurrence; and (5) documenting the steps taken in connection with the corrective action.

Institutions should be aware that the self-test privilege is limited and nearly all documents that relate to its fair lending compliance program, including emails, lending software files and external analyses, will likely be discoverable in a fair lending enforcement action. Accordingly, protection of the self-test privilege is of paramount importance. To facilitate an institution's ability to rely on the self-test privilege it is extremely useful to conduct the self-testing process through outside legal counsel. For example, an institution's audit committee would be tasked with the responsibility for the oversight of the self-test process. The audit committee would engage outside legal counsel to assist in the matter who would then engage an outside consultant to perform the fair lending self-test. All reports generated in connection with the self-test would be furnished directly to outside legal counsel. In this structure the institution would have the benefit of the self-test privilege and attorney-client privilege, provided all applicable requirements are met.

Typically, bank examiners will request and may obtain information related to an institution's self-test program and its approach to self-testing, but not the results of self-testing. This may include a request for information derived from a loan application or loan file, including any self-analysis of loan files. Financial institutions should be careful not to inadvertently waive the self-test privilege in connection with these requests. The self-test privilege can be waived if a self-test report or the results of the self-test report is disclosed voluntarily. In addition, in certain limited instances financial institutions may be compelled to produce self-test materials by their primary bank regulators under certain bank regulations.

Regardless of the structure an institution employs for self-testing, an institution should focus on the following key points:

  • Carefully design the self-test solely for fair lending compliance purposes; and
  • Focus the internal self-test team, outside legal counsel and outside consultant on:

    • fair lending compliance as the sole purpose of the self-test;
    • taking appropriate steps to prevent any disclosure of the self-test;
    • marking all self-test documents as subject to the self-test privilege;
    • reaching a conclusion and developing an action plan to take appropriate corrective action if required as a result of the self-test; and
    • following document retention procedures to ensure the self-test materials are retained for at least 25 months.

Self-Test – Benefits

Self-testing can benefit an institution in a few ways. Regular self-testing ensures the institution that it is in compliance with applicable law and regulatory guidance. In addition, self-testing may also indirectly provide valuable consumer information that an institution can use to improve certain marketing, lending functions or products. Moreover, regular self-testing can help detect and resolve consumer issues that may be violations before those issues become a complaint or allegation. Detecting and resolving consumer issues at the outset can help prevent more serious reputational issues or an investigation. Provided the self-testing institution identifies violations and takes appropriate corrective measures, and if accomplished through outside counsel, an institution has the benefit of the self-test privilege and attorney-client privilege and may shield test results or reports from any credit applicant, or agency seeking to obtain or use such test results in an ECOA or FHA action or any examination or investigation relating to compliance. Finally, as mentioned above, self-testing is an important element of an effective fair lending compliance program and is viewed positively by government agencies and regulators. In some instances, regular self-testing and an effective fair lending compliance program, has been a persuasive factor in limiting and ending investigations.

Planning Ahead

Fair lending will continue to be a major enforcement priority of federal agencies for the foreseeable future. Institutions should assess their current fair lending compliance program and be vigilant in maintaining an effective fair lending compliance program in the face of increased fair lending enforcement.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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Michael Mancusi
Erich Hellmold
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