The Foxhunt

The most recent fair lending development comes, not from the U.S. Department of Justice ("DOJ") but from a "friendly" regulator, the Board of Governors of the Federal Reserve System ("FRB"). In December, the FRB announced that the Federal Reserve Bank of Chicago had entered into a written agreement with Foxdale Bank of South Elgin, Illinois.

There are several aspects of this written agreement that are precedent setting. First, the agreement involves indirect lending. This is the first clear-cut regulatory enforcement order that holds the bank responsible for the actions of dealers selling loans to the bank. The theory of the case is that the bank is responsible for actions of the dealer that the bank knew or should have known were discriminatory.

Second, this action sets up the banking industry as the traffic cop of indirect lending, making the banking industry responsible for avoiding deals that contain or may contain discriminatory elements. The action holds the bank responsible for the actions of the dealers and places a clear responsibility on the bank to take steps to know whether or not the dealer is discriminating on a prohibited basis against any of its customers.

Finally, Foxdale is a small bank of approximately $45 million in assets. However, the scope of the agreement is in no way affected or minimized by that fact. In short, the FRB's enforcement action is not influenced by the bank's small size. In that respect, the violation is absolute. There is no consideration given in the agreement to what the bank is capable of doing or the cost of doing so.

Corrective Action
The agreement requires Foxdale bank to search its files for the preceding 24 months. The written agreement thus covers the full two-year statute of limitations of the ECOA. Foxdale must search its files over this time period to identify all indirect consumer loan borrowers who received more onerous terms on a prohibited basis.

The agreement broadly applies to "more onerous loan terms on a prohibited basis." The agreement specifies several terms that the bank must research and compare but does not limit the order to these specific terms.

The terms that the written agreement identifies include higher APRs, higher finance charges, and shorter loan maturities. In these three factors, Truth in Lending is used as the measurement tool for differences in terms.

The agreement also requires Foxdale Bank to review all direct consumer loans for the same 24-month period. The review of direct loans must be essentially the same as that for indirect loans, including loan and financing terms given to customers.

Once the Bank has identified loans containing discriminatory terms, the Bank must take steps to make the consumer borrowers whole. The remedy again looks to Truth in Lending for measurement of how to make corrective action. In effect, corrective action becomes restitution based on the difference between the terms of the loan and the terms of similar loans that did not involve discrimination.

The Bank must pay reimbursement to borrowers identified in the file search, using either the lump sum method or the lump sum/payment reduction method. Repayment includes loans that are in default status and loans that have been paid off. Needless to say, this file review and adjustment are at the expense of the Bank. No costs may be passed on to the consumers.

During the same time period, the Bank must develop written policies and procedures to ensure future compliance. These documents must be specific and give detailed guidance on the rates, points, fees and any other costs to be charged for each type of direct and indirect consumer product offered by the Bank.

The procedures must identify the specific criteria that the Bank will use to evaluate creditworthiness. In addition, the Bank must have a written exceptions policy that specifies the circumstances and situations that permit an exception to policy.

The procedures must include a requirement that all loan decisions must be reviewed by a senior loan officer to ensure consistency with policies and procedures. Many banks currently do this under the umbrella of "second review." This is a review to ensure that loan officers did follow policy and is not necessarily the type of second review designed to identify discrimination.

Documentation in the file for decisions, particularly for exceptions to standard policy, is essential. The written agreement requires Foxdale Bank to maintain documentation in every loan file. Documentation must contain the whole explanation of the loan and, in particular, fully explain any exceptions to written policy.

As part of its communication with third parties, the Bank must develop and distribute pricing sheets for the Bank's loan officers and for third parties such as the car dealers, that participate in credit decisions with the Bank. This should ensure that all lenders, whether in the bank or working for a dealer, will offer the same terms to customers.

Finally, the Bank must review adverse action notices to determine whether applicants were given incorrect reasons for denial. The Bank must correct any such notices and continue the review process on a quarterly basis going forward.

Compliance Program
The Bank must appoint a "qualified consumer compliance officer" to administer the Bank's consumer protection compliance program. This individual must report directly to the Bank's board of directors or a committee of the board.

The new position of compliance manager must have full authority - from the board of directors - to implement all corrective measures under the agreement. While the agreement does not specify that the compliance position be full time, the compliance officer must "devote sufficient time to the program to assure the Reserve Bank that the Bank's compliance with applicable consumer protection laws and regulations will be achieved and that there will be continuous compliance thereafter." (Emphasis added.)

Not only must the Bank submit the compliance manager's job description to the FRB-Chicago for review, the Bank must also "require" the compliance officer "to attend appropriate compliance schools, seminars, or workshops, as available." The FRB will review this attendance at the end of each year.

Defensive Actions
What can your bank do to head off this type of problem at the pass? There are no guarantees, but there are some solid and effective steps that you should be taking. These don't really amount to anything new in the arena of fair lending. However, there is now a heightened sense of urgency and importance to these steps.

The real goal of your compliance management program should be to never let the examiner smell a fox. If that happens, the hunt begins. The best offense is a good defense - an ongoing compliance program. This agreement clearly spells out what the agency thinks belongs in a good compliance program, beginning with a qualified compliance manager empowered by the board.

Next, have clear lending policies and procedures. Each loan officer - and each dealer - should be able to understand and follow the bank's policies and procedures. The result should be that the lending decisions of each officer are consistent with those of other loan officers.

The bank should also have a process for reviewing the terms and conditions of the loan made to ensure that they are consistent. This review becomes the focus of a second review process. The attention here, however, is less on whether or not there is discrimination and more on assessing consistency of every loan decision.

Any bank involved in indirect lending should take steps to ensure that the dealers bringing them business are fully aware of the bank's commitment to fair lending and what that means in specific terms. It is probably not enough to use a generic letter that states that the dealer "understands and agrees to comply with Regulation B." The letter should identify specific practices and refer to or attach the bank's policies.

Some lawyers are going further and recommending that the bank require the dealer to sign an agreement indemnifying the bank from any discriminatory acts of the dealer. This may or not be feasible in the market. However, you should at a minimum make clear the bank's lending criteria and the bank's expectation that the dealer with only bring deals to the bank that are consistent with these criteria.

The final option, of course, is to get out of the indirect lending business. With the fair lending stakes this high for the banks, this may become a popular decision. It will also have unfortunate consequences for consumers. If banks exit from indirect car lending, consumers will be left with finance company funding.

ACTION STEPS

If your bank makes indirect loans, establish regular review criteria for terms and conditions.
Review your pricing grid to ensure that it does not encourage discrimination. For this purpose, the ranges for risk-based pricing should be narrow and the determinants of risk should be specific.
Review and update as appropriate your lending policies and procedures. Share these policies and any pricing standards with dealers.
Review any letters or agreements that your bank has with dealers. Be sure that they clearly state that the bank expects the dealer to comply with fair lending.
Use Truth in Lending tools and calculations in comparing terms and conditions of the loan. Don't stop here, however. Slight differences in an APR may be the result of one additional or excessive finance charge.
Use the written agreement in your next request for support, authority, or budget, including training. It amounts to a clear statement that the regulators expect compliance to be managed with adequate resources and commitment.