Final Rules From HUD And FRB On Self Testing Privilege

After long debates and analysis of public comment, the Federal Reserve Board and HUD have issued final rules to implement the privilege provided for findings of possible discrimination in a self-test. This privilege was supposed to be a safe harbor, but upon analysis of the final regulations, the harbor is small and the entrance is very narrow.

The agencies have developed substantially similar rules with the intent that the two regulations function as one and not result in different applications of ECOA and the Fair Housing Act. This much is good.

The primary differences are in the structure of the two regulations. The FRB has created a new 202.15 which contains the new rules. HUD has similarly added part 100.140 et sec to its fair housing regulation. However, the FRB continues to use its commentary format for explanation and interpretation of the basic regulation. HUD, not having a commentary, has included similar provisions in the regulation itself.

Self-test defined
The act used the term "self-test" but left it to the agencies to determine what a self-test includes. The HUD and the FRB have applied a very narrow interpretation to self-test. It is limited to self-testing that creates new factual data. It specifically excludes analysis of existing loan files. As newly defined, a self-test has two required elements. First, it must be designed or used specifically to measure compliance with the Equal Credit Opportunity Act (or the Fair Housing Act or both) and Regulation B. Information relating to fair lending compliance that is generated through a test designed for another purpose, such as measurement of quality service, is thus not subject to the protection because it is not designed specifically for the purpose of measuring compliance with fair lending laws. The second required element of the definition is that the undertaking must 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 that exists in the bank. The definition includes activities that have been traditionally referred to as testing or mystery shopping but excludes all self-analysis of loan and application files. It excludes any information that could have been derived from the loan application or loan files.

The definition also includes activities other than mystery shopping that meet the two criteria of purpose and new facts or data. So, for example, surveys of applicants which are designed for evaluating compliance with Regulation B and which ask questions beyond information that already exists in the loan file would meet the definition of self-test.

Traditional approaches to measuring compliance, such as audits or statistical analysis of loan and application files are excluded from the definition. Thus, these established procedures are not subject to the privilege. Any work or findings that are generated as part of a file review or analysis cannot be subject to the protection.

Information that is privileged
The privilege applies to the new information generated and to any analysis of that new information. It also extends to reports on the self-test. Workpapers as well as final documents are included in the privilege. Thus, reports or data sheets filled out by testers, compilation of the information in those reports, and analysis of the findings in the test are privileged as long as the project first meets the definition of self-test. In addition, recommendations can be subject to the privilege.

Not privileged
Basically, anything not identified as subject to the privilege remains subject to discovery. The regulation specifically itemizes several types of documents that are not subject to privilege even if the self-test meets the regulation's definition. First, the fact that the creditor conducted a self-test is not subject to privilege. Examiners, investigators, and litigants can obtain information about whether the creditor conducted a self-test, the methodology and scope of the self-test.

Privilege does not extend to files that are related to credit transactions nor does it extend to any information that is derived from existing files. Thus, any work by compliance or audit to analyze lending patterns by type of loan, location of loan, identity of borrower, by branch or by loan officer is not subject to the privilege. This means that the work and any conclusions drawn from it and any action taken based on the findings is discoverable and can be used against the bank.

The regulation is careful to exclude this kind of work. It identifies as not subject to the privilege any work that is based on or drawn from information in application and loan files, including information that is "aggregated, summarized, or reorganized to facilitate analysis." This clearly excludes statistical analysis of any kind.

Appropriate corrective action
Taking appropriate corrective action is essential for the privilege to apply. The privilege only applies if the lender, upon finding possible discrimination, takes appropriate corrective action. Thus, before using the privilege, the lender must be able to demonstrate either that no discrimination was found, or that action has been taken to correct any findings of possible discrimination. The regulation therefore has to clarify what appropriate corrective action would be.

First, the requirement for corrective action is triggered by a finding or fact situation showing that it is "more likely than not" that a violation occurred. This rule of thumb is based on an interpretation of the findings, the facts that the self-test generates. It does not depend on any adjudication of the findings. The lender is responsible for studying the findings and determining whether discrimination is "more likely than not" to have occurred.

Second, the lender must take action that will reach the cause of the problem. The scope of corrective action necessary to maintain the privilege is broad. Corrective action includes identifying the policies or practices that are the likely cause of the problem. Lenders finding a problem fact situation should therefore be prepared to conduct a thorough review of all policies and practices with an eye to change. This review cannot be superficial; it must focus on underlying causes of behavior and what people actually understand the policies and procedures to say.

In addition to identifying the causes of possible problems, corrective action must include relief for anyone adversely affected by the practice. Thus, the finding would trigger a wider scope review to determine the extent and scope of the problem.

Effective corrective action might include revisions to policy, development of new procedures and the training to make sure the new procedures are understood and followed, and remedial relief.

How to lose the privilege
Even if the lender complies with all of the requirements for privilege, the lender can lose the privilege for an otherwise qualified project by taking one or more actions that the regulation specifies. First, the lender will lose the privilege by voluntarily disclosing any part of the report or results to an applicant, a government agency such as the regulatory agency or the Department of Justice, or the public. This means that if the lender believes that the findings appear to show no discrimination and announces that fact, privilege is waived and others are free to review the study and draw their own conclusions.

Second, disclosing any information from the self-test as a defense also waives the privilege. Thus, if a lender is accused of discrimination and lender has conducted a self-test that did not - in the lender's opinion - reveal discrimination problems, the lender should use care before using the test as a defense. Others may draw a different conclusion from the data and the report. Moreover, the self-test may not have been directed at the practice being challenged. Then, using the test as a defense merely adds the issues in the test to what is being challenged while forfeiting any privilege.

Finally, recordkeeping failures will cause loss of the privilege.

Record Retention
The final regulation modifies 202.12(b), Preservation of Records, to require that all written or recorded information about the self-test is subject to the 25 month record retention requirement. Failure to retain records and to produce them upon request can forfeit the privilege.

ACTION STEPS

Brief management on the scope of the self-testing regulations. Make sure management understands what is and is not subject to privilege.
Review your policies and procedures with respect to fair lending. Think carefully about the instructions and information they give. Is it sufficient? Is it practical?
If your bank is interested in self-testing, research costs. Contact several companies that provide testing services and get estimates for a project.
Review carefully the scope of any proposed testing project. Determine what you will really learn from it. Also determine what it may not tell you. Consider the impact that possible findings may have on your compliance audit. Remember, the findings in the compliance audit cannot be privileged.
Talk with several banks that have used self-testing. Find out what they actually learned. If you run a self-test and believe you came up clean, congratulate yourself and others in the bank but don't brag about it to anyone outside the bank. Remember, you lose the privilege if you do this.