1. BACKGROUND

On January 20, 2013, the Consumer Financial Protection Bureau (CFPB) issued its final rule (the Final Rule) regarding mortgage loan originator compensation and qualification requirements1 under the Truth in Lending Act (TILA), as amended by the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act). The Final Rule modifies existing compensation and qualification requirements under Regulation Z.2 It prohibits a creditor from compensating a loan originator based on a term of a transaction or a “proxy” for a term of a transaction. It also codifies the existing ban on “dual compensation,” in which a loan originator receives compensation from the consumer and an additional party other than the originator’s organization, but creates an exception allowing a loan originator organization to pay its employees or contractors a commission provided that the commission is not based on a term of a loan. The Final Rule provides a complete exemption from the statutory ban on the consumer payment of upfront points and fees. The Final Rule also includes requirements regarding loan originator qualifications, licensing, and recordkeeping, and implements statutory provisions regarding mandatory dispute resolution and the financing of credit insurance in connection with a residential mortgage loan.

The Final Rule is designed to protect consumers, who generally rely on the services of mortgage brokers or loan officers to secure a mortgage loan, from being “steered” to loans with unnecessarily high interest rates or other “unfavorable” terms. Individual loan originators are most commonly compensated by commission, which is correlated to the amount of the loan.3 Prior to 2010, and particularly during the rapid expansion of the mortgage market in the early-to-mid 2000s, commissions paid to loan originators varied considerably and were often higher in the case of high-interest loans.4 Accordingly, due to the presence of financial incentives, concerns were raised about the practice of steering consumers to loans with high interests rates and/or significant upfront fees and charges. The Final Rule is the latest in a series of actions taken by lawmakers and regulators to address this practice and further regulate the qualifications of loan originators and the services they provide to consumers.5

  1. STATUTORY FRAMEWORK AND PRIOR RULEMAKING ACTIVITY

The Dodd-Frank Act granted the CFPB jurisdiction over the “consumer financial protection functions” previously vested in other federal agencies, including the authority to issue regulations under TILA. Prior to the transfer of TILA jurisdiction to the CFPB, the Board of Governors of the Federal Reserve System (the Board) issued a number of regulations pertaining to loan originator compensation practices under its then-existing TILA authority.6 The CFPB’s Final Rule was necessary to implement a number of TILA amendments enacted through the Dodd-Frank Act7 and to provide additional official interpretations of these regulations. The Final Rule contains select modifications to the rule as originally proposed by the CFPB8 and provides additional analysis in response to comments submitted by the public.

The majority of the Final Rule becomes effective January 10, 2014. However, the rule’s prohibition on mandatory arbitration clauses and waivers of certain consumer rights became effective on June 1, 2013. The rule’s ban on the financing of single-premium credit insurance in connection with a consumer credit transaction secured by a dwelling was originally intended to also take effect on June 1, 2013, but recent CFPB amendments have delayed its effective date until January 10, 2014.9

  1. ANALYSIS OF THE FINAL RULE
  1. Definitions and Scope

The Final Rule clarifies or redefines a number of important terms that serve to establish the Final Rule’s reach. Most notably, the Final Rule adopts a broad definition of “loan originator” in order to establish consistency with the definition of “mortgage originator” under TILA, as amended by the Dodd-Frank Act. The CFPB’s stated objective in aligning the meaning of these terms is to ensure consistent regulation of any person who, early in the loan origination process, may have financial incentives to steer consumers to loans with particular terms. Accordingly, the Final Rule defines a “loan originator” as a “person who takes an application, offers, arranges, assists a consumer in obtaining or applying to obtain, negotiates, or otherwise obtains or makes an extension of consumer credit for another person.”10 Therefore, under the Final Rule, “loan originators” include not only individual loan originators, loan originator organizations, mortgage brokers, and many creditors,11 but also those engaging in certain referral actions, certain seller financers,12 and those assisting with several aspects of a credit transaction.13 The definition of a “loan originator,” however, expressly excludes certain persons and functions, including those who perform purely administrative or clerical tasks or real estate brokerage activities.

The CFPB’s approach to establishing the scope of covered transactions mirrored its approach to determining covered persons and entities. Rather than exclude specific credit products from the rule,14 the CFPB adopted a broad definition of covered transactions, which includes any “closed-end consumer credit transaction secured by a consumer’s principal dwelling.”15 The Final Rule noted that no underlying statute provided for different treatment based on transaction type, and therefore the CFPB declined to do so in its rulemaking.

  1. Prohibition on Compensation Based on a Term of a Transaction

The Board’s 2010 final rule amended Regulation Z to generally prohibit compensation based on a transaction’s terms. The CFPB’s Final Rule further amends Regulation Z by implementing Section 1403 of the Dodd-Frank Act, which created Section 129B(c) of TILA.16 This new provision produces an important distinction between the two rules: under the CFPB’s Final Rule, compensation restrictions apply to all residential mortgage loans, whereas under the Board’s 2010 rule the restrictions apply only to compensation arising from transactions in which any person other than the consumer pays the loan originator. The CFPB’s Final Rule, unlike the Board’s rule, provides no exception for loan originators when receiving compensation directly from the consumer. Additionally, the CFPB has further clarified the components of the ban, including the method for determining its application to compensation based on a “proxy” for a term of the transaction.

A “term” of a transaction is defined as “any right or obligation of the parties to a credit transaction.”17 Several methods of compensation are, however, deemed not to be based on a transaction’s terms and are therefore permissible. For example, compensation paid directly to a loan originator by a consumer is not barred simply because that compensation is itself a term of the transaction. Additionally, compensation in the form of a fixed percentage of the amount of credit extended is permitted, as is compensation based on a loan originator’s overall dollar volume across a number of credit transactions. The Final Rule also clarifies what constitutes a “proxy” for a term or factor of a transaction by providing a two-prong methodology. A term or factor will be a “proxy” if (1) it consistently varies with a factor or term over a significant number of transactions, and (2) the loan originator has the ability to manipulate (e.g., add, remove, or change) the factor.

The CFPB provided a number of additional clarifications regarding the application of these prohibitions after receiving significant inquiry from commenters. First, as mentioned above, the Final Rule sets out a number of illustrative examples of compensation that is not based on the terms of a transaction and is also not subject to proxy analysis.18 Second, the CFPB noted that the Final Rule applies to compensation that is directly or indirectly based on the terms of a single transaction from a single loan originator, the terms of multiple transactions from a single loan originator, and the terms of multiple transactions from multiple loan originators. Thus, with certain exceptions, compensation based on profits derived from mortgage-related business would be subject to the Final Rule. For example, the Final Rule permits contributions paid to, and benefits derived from, designated tax-advantaged plans, provided that such contributions are not based on the terms of the individual loan originator’s transactions.19 Additionally, compensation under a non-deferred profitsbased compensation plan is permitted if the compensation paid does not exceed 10% of the loan originator’s “total compensation” or if the loan originator served in that role for ten or fewer transactions during the twelve-month period preceding the date in which compensation is determined.20 Third, the Final Rule extends Regulation Z’s prohibition on compensation in connection with a pricing concession, which is generally a reduction in compensation based on a change in a transaction’s terms, out of a concern that the practice could lead to increased originator compensation in connection with higher interest-rate loans. The Final Rule, however, provides an exception for circumstances in which a pricing concession is offered to defray unexpected increases in settlement costs.

  1. Prohibition Against Dual Compensation

Regulation Z contains a prohibition on “dual compensation.” Specifically, it bars loan originators from receiving compensation in connection with a transaction from both the consumer and another person, typically a creditor. The Final Rule generally preserves this prohibition.21 However, under current regulations, if a loan originator receives direct payment from a consumer, that person is prohibited from receiving any form of payment from another person, such as a commission from a creditor. Commenters contended this prohibition was economically infeasible because of the practical challenges associated with paying individual loan originators a salary or an hourly wage. In an effort to create flexibility for both loan originators and consumers, the CFPB responded in the Final Rule by permitting a loan originator organization to compensate individual loan originators (e.g., offer a commission) provided that neither party’s compensation is based on the terms of the underlying transaction. In addition, the Final Rule contains guidance on circumstances in which payments by a consumer are not deemed to be “compensation received directly from a consumer” for purposes of the rule.22

  1. Waiver of Prohibition on Consumer Payment of Upfront Points and Fees

A component of the TILA provision underlying the ban on dual compensation permits a loan originator to receive “an origination fee or charge” from a person other than the consumer on the condition that the loan originator does not receive any compensation directly from the consumer and the consumer does not make an upfront payment of discount points, origination points, or fees.23 However, TILA, as amended by the Dodd-Frank Act, also authorizes the CFPB to waive or create exceptions from the statutory prohibition on the payment of upfront points and fees when doing so “is in the interest of consumers and in the public interest.”24 Under this authority, and in response to a wide variety of criticism from commenters, the CFPB decided in its Final Rule to adopt a complete exemption from the statutory ban on consumer payment of upfront points and fees. The CFPB initially proposed a partial exemption to the above statutory prohibition25 out of concern that implementation of the statutory ban would (a) produce higher mortgage interest rates as a result of creditors’ inability to recover significant origination costs through consumer payment of points and fees, and (b) limit the range of pricing options available to consumers, ultimately curtailing access to credit. The CFPB determined, however, that its proposed alternative to the statutory ban suffered from design flaws and its operation and effectiveness was uncertain. Accordingly, the Final Rule notes that the CFPB intends to further study the issue and conduct consumer testing to determine the full effect of the complete exemption and whether additional action might be warranted.26

  1. Prohibition on Steering; Loan Originator Qualification and Identifier Requirements

Regulation Z currently prohibits loan originators from “steering,” or directing a consumer to execute a transaction based on the fact that doing so will result in higher compensation for the originator as paid by the creditor. Current regulations also provide a safe harbor for the loan originator if certain “loan options” are presented to the consumer. The Final Rule provides additional guidance on a loan originator’s qualification for the safe harbor. Specifically, for each type of transaction in which the consumer has expressed interest, the loan originator must present the consumer with loan options for which the loan originator has a good faith belief that the consumer is likely to qualify. Those options include, generally:

  1. the loan with the lowest interest rate;
  2. the loan with the lowest interest rate without negative amortization, a prepayment penalty, interest-only payments, a balloon payment in the first seven years of the life of the loan, a demand feature, shared equity, or shared appreciation; and
  3. the loan with the lowest total dollar amount of discount points or origination points or fees.

The Final Rule also contains a number of non-compensationoriented requirements pursuant to the Dodd-Frank Act27 that require mortgage originators to be “qualified” and appropriately licensed and registered.28 Accordingly, under the Final Rule, loan originator organizations must comply with existing state and federal law, particularly with respect to requirements for legal existence and those that authorize the organization to transact business in a state. Additionally, loan originator organizations and all those employed by the organization (including independent contractors) must comply with the licensing, registration, and other regulatory provisions of the Secure and Fair Enforcement for Mortgage Licensing Act (SAFE Act).29 For employees not required to be licensed and registered under the SAFE Act or associated state implementing laws,30 the Final Rule requires employing loan originator organizations to obtain a state and national criminal background check, a credit report, and information from the National Mortgage Licensing System and Registry (NMLSR) regarding any administrative, civil, or criminal findings by any government agency involving those employees. Furthermore, the Final Rule establishes standards for review of the information obtained by loan originators for purposes of determining whether an employee is qualified in the same manner as a SAFE Act-compliant loan originator. These standards are generally consistent with those that apply when SAFE Act-covered employees apply for a license. The Final Rule also requires periodic training to ensure that non-SAFE Act employees possess sufficient knowledge and skill, as well as an understanding of the legal requirements that apply to the individual’s loan origination activities.

Finally, loan originators that are primarily responsible for the origination of a loan are required under the Final Rule to include both their NMLSR identification numbers and their names on all loan documents to assist consumers in their evaluation of the risks associated with transacting with the loan originator.

  1. Prohibition on Mandatory Arbitration Clauses and Single Premium Credit Insurance

The Dodd-Frank Act amended TILA to add Section 129C(e) (1), which prohibits consumer credit transactions secured by a dwelling from containing terms that mandate arbitration as the prescribed method of dispute resolution, and further provides that no agreement related to the transaction may be applied to bar a consumer from seeking judicial relief in connection with a violation of federal law.31 The Final Rule implements this statutory prohibition. The CFPB was careful to note that neither the statute nor the rule is interpreted to ban all settlement agreements. Rather, a consumer and a creditor are permitted to agree to settle a dispute or claim, provided that the settlement agreement does not bar the consumer from pursuing a judicial remedy for any subsequent disputes that arise if he or she chooses to do so.

Under Section 129C(d) of TILA, created pursuant to Section 1414 of the Dodd-Frank Act, creditors are prohibited from financing any premiums or fees for credit insurance in connection with a closed-end consumer credit transaction secured by a dwelling. This prohibition does not apply to credit insurance32 for which premiums are calculated and paid in full on a monthly basis. As stated above, the prohibition on mandatory arbitration clauses became effective June 1, 2013. The CFPB originally intended for restrictions on the financing of credit insurance premiums to become effective on the same date, but it delayed the effective date of this provision to January 10, 2014 to further consider its applicability to transactions other than those in which a lump-sum premium is added to a loan amount at closing and to provide the mortgage industry with sufficient time to comply with any clarifications.

  1. Recordkeeping and Miscellaneous Provisions

Regulation Z currently requires that creditors maintain evidence of compliance with the regulation and sets out standards for doing so. However, certain provisions of the Dodd-Frank Act imposed statutory changes33 that prompted the CFPB to expand upon these recordkeeping requirements in its Final Rule for purposes of achieving consistency with the statutory law. Therefore, the Final Rule extends the length of the recordkeeping requirement under Regulation Z and mandates that creditors and loan originators maintain evidence of compliance for three years after the date of payment. The Final Rule applies to both creditors and loan originator organizations, while individual loan originators are excluded from compliance. The Final Rule also provides guidance on the substantive elements of its recordkeeping requirements.34

  1. CONCLUSION

The CFPB’s Final Rule implements a number of statutory requirements that build upon the existing regulation of mortgage loan originators’ compensation and business practices. The Final Rule will impact the operations of creditors, loan originator organizations, and individual loan originators in a variety of ways, including training, registration, licensing, and the structuring of compensation and benefit plans, as well as other aspects of the loan origination process, such as recordkeeping. Creditors, individual loan originators, loan originator organizations, and those employed by or under contract with loan originator organizations should carefully review the Final Rule’s requirements and, when applicable, its exceptions, and should start making the necessary modifications to policies, procedures, and systems to implement appropriate changes.

Also contributing to this advisory:

Anthony Raglani