United States: Important Lessons Involving Indirect Auto Lending

The federal bank regulatory agencies have recently become more aggressive with respect to examination and investigation of potential violations of law and regulation involving indirect auto lending by community banks in Virginia and across the mid-Atlantic. In our opinion, this more aggressive posture is attributable, at least in part, to the assertive stance of the CFPB with respect to larger financial institutions and the strong desire of the federal bank regulatory agencies (Fed, OCC and FDIC) not to lose their examination and enforcement authority in these consumer lending areas to the CFPB.

The federal banking regulatory agencies' direct regulatory authority extends to financial institutions with $10 billion or less in assets regarding the Equal Credit Opportunity Act, or ECOA, and its implementing regulation, Regulation B. Community banks that engage in indirect auto lending, however, should pay attention to statements and actions by the CFPB. As the most vocal and active federal regulator in advancing legal, regulatory and policy views on this issue, the CFPB can provide insight into compliance risks to the entire industry and could become the de facto arbiter of compliance "best practices." Both the CFPB and the federal bank regulatory agencies involve the U.S. Department of Justice (DOJ) in formal enforcement actions.

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Indirect auto lending occurs when a prospective car buyer submits an application for credit to an auto dealer, who in turn submits the application to potential assignees of the retail installment contract. A potential assignee will evaluate the credit application according to its risk-based underwriting and pricing models, taking into account the borrower's creditworthiness and other permissible, credit-risk related data. The lender (often a bank) provides the dealer with a wholesale rate at which the lender would be willing to purchase the contract. This wholesale rate is often called the "buy rate." Some indirect auto lenders will permit dealers to charge the borrower a rate higher than the buy rate, with the difference between the two rates being referred to as the "dealer markup." The revenue from the dealer markup may be used to compensate the dealer or is otherwise handled as agreed between the lender and the dealer.

In March 2013, the CFPB issued a guidance bulletin and related press release stating that certain parties offering auto credit through dealerships are "responsible for unlawful, discriminatory pricing." In particular, the CFPB noted that pricing differentials between car buyers based on permissible bases of creditworthiness and credit risk will already be reflected in a lender's buy rate. In light of this, the CFPB stated that lender policies permitting an additional, discretionary dealer markup increase the risk of pricing disparities among borrowers based on race or other impermissible considerations.

Notably, the CFPB and the federal bank regulatory agencies now rely on "disparate impact" theory in their allegations of violations of the ECOA. Under disparate impact analysis, there need not be any direct showing of discriminatory intent; a lender can be penalized if the negative effects of a policy disproportionately affect a legally protected class, regardless of the lender's intent. Controversially, because auto credit applications generally do not contain information about the race or national origin of the applicant, the CFPB and the federal bank regulatory agencies assess discrimination in dealer markups by assigning race and national origin probabilities to applicants based on geography- and name-based probabilities calculated using U.S. Census Bureau data.

Since the issuance of the 2013 guidance bulletin, the CFPB has moved aggressively to police and reform the indirect auto lending market:

In February 2016 the CFPB and the DOJ, resolved an action against a large non-bank captive auto finance company under which it will: (1) change its pricing and compensation system to substantially reduce dealer discretion and financial incentives to mark up interest rates; and (2) pay up to $21.9 million in restitution to African-American, Asian and Pacific-Islander borrowers who paid higher interest rates than white borrowers without regard to creditworthiness.

In September 2015 the CFPB and DOJ ordered a large regional bank to: (1) pay $18 million in restitution for alleged auto lending discrimination against African-American and Hispanic borrowers; and (2) change its indirect auto credit pricing and compensation system to minimize the risks of discrimination.

In July 2015 a large non-bank captive auto finance company agreed to: (1) pay a $24 million settlement of claims that its dealers offered higher financing rates based on race and ethnicity, rather than permissible aspects of creditworthiness; and (2) change its pricing and compensation system to substantially reduce dealer discretion by capping dealer markups.

In December 2013 the CFPB and DOJ ordered a leading auto financial services company and bank holding company and its subsidiary bank to: (1) pay $80 million in damages to African-American, Hispanic, Asian and Pacific-Islander borrowers; (2) pay $18 million in penalties due to what the CFPB called a "discriminatory pricing system;" and (3) implement a compliance program to prevent further discrimination through dealer education, prompt corrective action against dealers when there are dealer disparities, and portfolio-wide analysis for pricing disparities. The companies were given the alternative choice of using a non-discretionary dealer compensation structure, which would eliminate the obligation to monitor the fair lending risk of ongoing dealer markups.

These enforcement actions involve significant cash settlements and require pricing practice revisions to limit discretion in setting dealer markups. Notably, in the three most recent actions, each lender was specifically ordered to reduce dealer discretion to mark up the interest rate to only 1.00% to 1.25% (depending on the credit term) over the buy rate or to implement non-discretionary dealer compensation. In addition, the terms of the CFPB's consent orders indicate that the CFPB believes that policies that permit a discretionary dealer markup must be accompanied by a compliance management system reasonably designed to assure compliance with federal consumer financial laws, including the EOCA. Such a compliance management system should address written policies and procedures regarding variations from a standard markup, dealer education efforts, statistical monitoring of the portfolio and specific dealers for impermissible disparities, and corrective action when such disparities are detected.

Recent settlements in community bank actions brought by the DOJ and federal bank regulatory agencies have yielded smaller fines and/or payments, but similar findings and requirements to amend policies and procedures.

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Although the CFPB's direct regulatory authority generally does not extend to financial institutions with $10.0 billion or less in assets, the CFPB may include its own examiners in regulatory examinations by a community bank's federal bank regulatory agency. In addition, regulatory positions taken by the CFPB and administrative and legal precedents established by CFPB enforcement activities, including in connection with supervision of larger bank holding companies, could influence how the DOJ will handle referrals involving community banks from the federal bank regulatory agencies regarding consumer protection laws and regulations.

Recent enforcement actions by the CFPB, federal bank regulatory agencies and DOJ are clear: the CFPB views discretionary dealer markups in connection with indirect auto lending as red flags for potentially impermissible discrimination under the ECOA. Given the factors discussed above, community banks should view discretionary dealer markups as a source of regulatory risk (particularly the more such markups are permitted to exceed the 1.00 to 1.25% markups permitted by recent regulatory orders) and should review their indirect auto lending policies with a view towards understanding and managing that risk.

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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Authors
Alan D. Wingfield
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