A recent guidance published by the Consumer Financial Protection Bureau is a helpful reminder of one of the risks associated with indirect auto lending. [1] The guidance is directed toward auto lenders who rely upon auto dealers to generate consumer loans.  The auto dealer may provide vehicle financing directly to the consumer, or may facilitate indirect financing for a vehicle purchase through a financial institution, a nonbank affiliate of a financial institution, or an independent or “captive” nonbank.

With indirect financing, the auto dealer often commences the loan process by collecting basic information required by the lender for the application for credit, and forwards that information to several potential lenders.  Interested lenders will provide the dealer with a “buy rate”, i.e, the minimum interest rate at which it is willing to purchase the loan.  In many cases, the auto lender will have a policy that permits the dealer to mark up the rate, or offer the loan to the consumer, at a higher rate.  The lender may then pay the dealer the difference in interest revenue between the two rates, or the “reserve” or “participation”, as compensation for originating the loan.   After the loan is consummated, the loan is then sold to the lender.

According to the CFPB Guidance, auto lenders with policies that permit dealers to mark up lenders’ buy rates and compensate dealers for the mark-ups incur a significant risk of fair lending violations arising from the potential disparities in application of the mark-ups based upon race, gender, national origin, and other prohibited bases.

Are indirect lenders “creditors” under the ECOA?  The Equal Credit Opportunity Act makes it illegal for a creditor to discriminate in any aspect of a credit transaction, and the ECOA and Regulation B define “creditor” to include any person who regularly extends credit, as well as “any assignee of an original creditor who participates in the decision to extend, renew, or continue credit.”  The Commentary to Regulation B further elaborates by including all persons who participate in the credit decision, which may include an assignee or potential purchaser of the loan who influences the credit decision based upon its criteria for purchase.

While the CFPB is aware that there is a wide range of indirect lender participation in credit decisions, from no participation to exclusive control over the decision, and a variety of practices and conduct by indirect lenders, the Guidance states that information it has gathered indicates that the prevalent practices by indirect lenders will likely cause them to be considered creditors under the ECOA.

Are markup and compensation policies in violation of the ECOA?  On their face, markup and compensation policies do not violate the ECOA.  A violation occurs if the application of the policies result in pricing disparities or other discrimination on a prohibited basis.  For example, when a lender provides rate sheets to a dealer establishing buy rates and allows the dealer to mark up those buy rates, and the dealer marks them up for female borrowers and not male borrowers, such a practice would be considered discriminatory under ECOA

What if the lender has no knowledge of its dealers’ markup practices?  Regulation B provides that a person will not be liable for violations of ECOA unless it “knew or had reasonable notice of the act, policy, or practice that constituted the violation before becoming involved in the credit transaction.”  The intent of this provision is to limit a creditor’s liability for the illegal acts and practices of another creditor.  However, it does not limit a creditor’s liability for its own violations, and a creditor could be deemed to have had reasonable notice of a dealer’s discriminatory behavior under some circumstances.

What precautionary measures should an indirect auto lender take?    The CFPB Guidance discusses several steps to minimize risk of liability for ECOA violations from the use of markup and compensation policies, such as: 

  • Use of controls on markup and compensation policies
  • Monitoring the application and effects of the policies for pricing disparities on prohibited bases
  • Elimination of dealer discretion to markup the buy rates and replace with a flat fee.

Adoption of a comprehensive fair lending compliance program will also help to detect any potential violations.  The components of a strong fair landing compliance program were published last fall in the CFPB’s Supervisory Highlights [1] , and include adoption of a fair lending policy statement, regular training, ongoing monitoring, and regular analysis of loan data for potential disparities.

As the economy recovers and new car sales reach levels not seen in five years, the competition for financing those sales increases as well.  Financial institutions active in indirect lending are faced with offering terms that are competitive and that attract the auto dealers’ attention.  However, financial institutions must be careful not to ignore the fair lending risks that accompany this increased lending activity.  In light of this recent CFPB Guidance, indirect auto lenders are well-advised to review their policies and practices for any indications of fair lending violations in their loan portfolios.