Objects in the mirror are closer than they appear - Auto finance industry keeps its sights on impending regulation

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Objects in the mirror are closer than they appear - Auto finance industry keeps its sights on impending regulation
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                www.pwcregulatory.com

                Objects in the
                mirror are closer
                than they appear
                Auto finance industry keeps its
                sights on impending regulation
December 2013

                                                  FPO
Objects in the mirror are closer than they appear - Auto finance industry keeps its sights on impending regulation
Objects in the mirror are closer than they appear - Auto finance industry keeps its sights on impending regulation
Contents

Is your organization ready for increased
regulatory scrutiny?                               1

Six areas of focus:
Working together to meet regulatory requirements   6

How PwC can help                                   16

Contacts                                           17
Objects in the mirror are closer than they appear - Auto finance industry keeps its sights on impending regulation
Objects in the mirror are closer than they appear - Auto finance industry keeps its sights on impending regulation
Is your organization ready
for increased regulatory
scrutiny?

Although most auto dealers are               What’s on the horizon?
exempt from the Consumer Financial
Protection Bureau’s (CFPB’s)                 Auto loans in today’s marketplace
supervisory authority, CFPB’s oversight      are most often executed indirectly,
of automobile finance transactions is        between the consumer and an
expanding. In the upcoming months,           automobile dealer, rather than directly,
auto lenders and dealers are likely          with a bank, captive automotive
to see increased regulatory scrutiny         finance entity, or private finance
around consumer protection matters,          company. And depending on the
and this could mean significant              channel in which the financing is
changes for the industry. For the auto       conducted, regulatory oversight could
finance industry and those entities that     impact the industry mainly in two
help consumers with financing options        ways: it could be directly enforced by
for automobile purchases and leases,         the CFPB (i.e., for a supervised lender
now is the time to assess the changing       subject to CFPB oversight), or the CFPB
regulatory landscape, evaluate               may influence the lender through its
where the stress points will be, and         relationship with other regulatory
prepare for an increase in oversight         agencies (i.e., related to a lender’s
and attention from the CFPB or other         interactions with a dealer).
supervisory or enforcement agencies.

                      Auto lenders and dealers are likely to see
                      continued increased regulation – and
                      this could mean significant changes for
                      the industry.

                                  Objects in the mirror are closer than they appear   1
Objects in the mirror are closer than they appear - Auto finance industry keeps its sights on impending regulation
Meanwhile, many leaders in the                          consumer protection concerns. In           With greater regulation
automotive finance industry expect                      2012, for instance, a credit card issuer
that auto lenders will bear significant                 was ordered to refund tens of millions
                                                                                                   on the horizon, dealers
responsibility for helping dealers                      of dollars for what were described         and lenders should work
adhere to the evolving framework of                     as illegal credit card practices. Some     together to enhance their
federal consumer lending regulations.                   of the violations cited included
For example, in a recent bulletin, the                  deceiving consumers who had signed         regulatory compliance
CFPB encouraged auto lenders to                         up for certain credit card programs        frameworks.
review whether they have appropriate                    and misleading consumers about the
controls in place to comply with the                    benefits of paying off old debt.
federal fair lending laws in connection
with dealer markups and dealer                          These rulings go to the heart of the
compensation policies.1                                 CFPB’s mission, to make markets for
                                                        consumer financial products and
Another example of the impact of the                    services work for Americans. The
CFPB’s oversight can be found in its                    actions taken to date by the CFPB
recent enforcement action against auto                  against auto lenders and credit card
lenders for deceptive marketing and                     issuers are evidence that unfair or
lending practices. In this enforcement                  misleading sales, marketing, pricing,
action, the CFPB ordered refunds of                     and collection tactics will continue to
over $6 million for borrowers subject                   be a focus for federal regulators across
to financial protections given their                    consumer lending.
status as military service members.
According to the CFPB, the lenders                      But for the auto finance industry, the
had failed to properly disclose all                     traditional fair lending considerations
fees charged to program participants                    relating to prohibited basis pricing
                                                        disparities are just the tip of the
and misrepresented the true cost and                                                               Prohibited basis –
coverage of after-market products                       regulatory iceberg. The CFPB, Federal
                                                        Trade Commission (FTC), and other          Under the Equal Credit
financed by these borrowers.
                                                        regulators are likely to continue to       Opportunity Act,
Such actions are not without precedent,                 scrutinize many legacy sales and           creditors aren’t allowed to
and we are seeing dramatic increases                    marketing practices related to auto
in the amounts of penalties and                         finance and after-market product           discriminate in any aspect
customer reimbursements required                        sales to be certain that consumers are     of a credit transaction
by the CFPB and other regulators for                    treated fairly.                            based on certain
                                                                                                   prohibited factors.

1   CFPB Bulletin 2013-02, “Indirect Auto Lending and
    Compliance with the Equal Credit Opportunity Act”

2            PwC Consumer Finance Group
Objects in the mirror are closer than they appear - Auto finance industry keeps its sights on impending regulation
The road ahead:                                           • Limit CFPB oversight to only those         And despite not having direct
                                                            dealers that make direct loans with        regulatory authority over most dealers,
Prepare now
                                                            consumers and that generally don’t         the CFPB can influence dealer behavior
Although it’s not yet clear how these                       transfer those loans to third parties      by restricting these lenders’ abilities to
agencies intend to regulate these                           (i.e., “buy here, pay here” dealers).      contract and do business with dealers
practices and the broader auto finance                                                                 that do not follow CFPB or other
                                                          • Give the CFPB supervisory authority
industry, one thing is certain: with                                                                   regulatory requirements. The CFPB is
                                                            over certain auto lenders, such as
greater regulatory scrutiny on the                                                                     also addressing specific components of
                                                            large banks participating in auto
horizon, dealers and lenders should                                                                    traditional dealer transactions, such as
                                                            lending.
begin to work together to enhance their                                                                dealer reserves and add-on products,
regulatory compliance processes and                       • Give the CFPB the power to issue           demonstrating that the CFPB is able
controls. This paper explores important                     rules to larger industry participants      to serve as a de facto regulator using
ways in which increased oversight                           as a way to supervise these lenders,       indirect means.
could impact the industry in the near                       such as captive auto finance
                                                            companies.                                 The CFPB is also working with other
future, and six areas that lenders and
                                                                                                       enforcement agencies that have
dealers should begin focusing on now
                                                          Large banks and captive finance              influence or jurisdiction over lenders
to prepare for the road ahead.
                                                          entities, supervised by the CFPB,            and dealers, such as the FTC and the
Provisions contained within the                           typically make up the primary source         Department of Justice (DOJ). Lenders
Dodd-Frank Wall Street Reform and                         of consumer funding for nearly every         and dealers should actively monitor
Consumer Protection Act (Dodd-Frank)                      auto dealership. It’s the growing            CFPB, FTC, and DOJ regulations
generally2:                                               regulation of these entities that has        and adapt as necessary. (For more
                                                          captured the attention of auto dealer        information about potential regulatory
                                                          association and trade groups.                impact, please see the following table).

2   Dodd-Frank Act Title X, Subtitle B, Section 1029(b)                                     Objects in the mirror are closer than they appear   3
Objects in the mirror are closer than they appear - Auto finance industry keeps its sights on impending regulation
At a glance: DOJ enforcement actions

2007                           2007                         2008                         2009
Auto dealer                    Regional bank                Auto financing               Regional bank
                                                            company
Entered into Consent           Entered into Consent         Entered into Consent         Entered into partial
Order related to allegedly     Order related to allegedly   Order related to allegedly   Consent Decree related
charging higher interest       discriminating against       refusing to finance          to allegedly charging
rate markups to certain        individuals based on         car loans to certain         higher markups to certain
borrowers.                     marital status.              borrowers.                   borrowers.
Terms of settlement: Fine,     Terms of settlement: Fine,   Terms of settlement: Fine,   Terms of settlement: Fine,
changes to practices           changes to procedures,       changes to policy, and       investment in consumer
related to markups, and        and training.                training.                    financial education,
training.                                                                                and various additional
                                                                                         requirements.

4         PwC Consumer Finance Group
Objects in the mirror are closer than they appear - Auto finance industry keeps its sights on impending regulation
A snapshot of regulatory considerations

Regulatory subject       Comments and considerations

CFPB Bulletin 2013-02:   • Lenders should confirm that they are operating in compliance with the ECOA and Regulation B as
Indirect Auto Lending      applied to dealer markup and compensation policies.
and Compliance           • Lenders should be certain that dealer markup and compensation policies are appropriately
with the Equal Credit      controlled and monitored to guard against prohibited basis pricing disparities. Remediation policies
Opportunity Act (ECOA)     for addressing unexplained pricing disparities should be implemented.
                         • Another important tool for limiting fair lending risks in indirect auto lending is the development and
                           implementation of a robust fair lending compliance management program.

CFPB Bulletin 2012-03:   • Lenders are expected to have an effective process for managing the risks of service provider
Service Providers          relationships; in the auto finance industry, this would include dealerships assigning retail sales
                           finance contracts and leases to the lenders.
                         • To limit the potential for statutory or regulatory violations and related consumer harm, lenders
                           should make certain their business arrangements with service providers do not present
                           unwarranted risks to consumers.
                         • As a result of the service provider relationship between lenders and dealerships, lenders should
                           verify that the dealer understands and is capable of complying with all aspects of federal consumer
                           financial laws.

Dodd-Frank Act: FTC’s    • Dodd-Frank authorizes the FTC to use the same rulemaking procedures for dealers as other
improved powers            federal agencies use.
to regulate dealer       • The Administrative Procedure Act (APA) will help reduce FTC rulemaking to approximately one
financing                  year, rather than an average of seven years, which may have discouraged rulemaking in the past.

CFPB/FTC                 • Agencies have agreed to meet regularly to coordinate upcoming law enforcement, rulemaking,
Memorandum of              and other activities that may increase the CFPB’s indirect influence with other regulatory agencies.
Understanding            • Consumer complaints may be shared between the CFPB and FTC. With the CFPB’s complaint
                           website operational, dealer-related complaints may be made available to the FTC.
                         • The CFPB has agreed that it may provide examination reports from its supervision of non-banks
                           to the FTC, if requested to do so.

CFPB/DOJ                 • Outlines three primary areas of cooperation between the agencies: 1) information sharing and
Memorandum of              confidentiality, 2) joint investigation and coordination, and 3) referral and notice procedures.
Understanding            • Reiterates that both agencies have ECOA enforcement authority.
                         • The DOJ has a history of initiating enforcement actions against dealers, which has resulted in
                           multiple consent orders and settlement payments (see At a glance: DOJ enforcement actions).

CFPB joins Federal       • FFIEC is an interagency body empowered to prescribe uniform standards for the examination of
Financial Institutions     financial institutions by the Board of Governors of the Federal Reserve System (FRB), the Federal
Examination Council        Deposit Insurance Corporation (FDIC), the National Credit Union Administration (NCUA), the
(FFIEC)                    Office of the Comptroller of the Currency (OCC), and the CFPB.
                         • The Council also makes recommendations to promote uniformity in the supervision of financial
                           institutions.

                                                                               Objects in the mirror are closer than they appear    5
Objects in the mirror are closer than they appear - Auto finance industry keeps its sights on impending regulation
Six areas of focus:
Working together to meet
regulatory requirements

Just as lenders will now face additional     Front-line dealer employees are              The six areas of focus include:
regulatory scrutiny of their dealer          the “regulated” lenders’ primary
                                                                                          • Maintain high standards of
monitoring, the dealers themselves will      connection to the potential consumer.
                                                                                            transparency with customers
be under more pressure from lenders to       Dealers are also heavily involved
monitor and adjust their own practices       in executing specific fair lending           • Keep after-market products above
to help lenders meet regulatory              responsibilities related to the fair           board
requirements. Given that lenders and         treatment of customers. Even if the
                                                                                          • Apply lessons learned from other
dealers have a common interest in            ultimate regulatory responsibility is
                                                                                            industries
preparing for increased oversight, it        placed on lenders, they are reliant
only makes sense to work together            on the dealers’ actions to remain            • Examine current policies for
toward this mutual goal.                     in compliance. Front-line dealer               adherence to fair lending guidance
                                             employees should be capable of
Dealer groups should adjust their risk                                                    • Pay close attention to discretion
                                             complying with all regulatory
assessment and monitoring practices                                                         throughout the transaction
                                             requirements when originating
over their dealerships so that they can      transactions, and lenders will need          • Keep an eye on regulatory action
demonstrate compliance to lenders.           to educate their dealers on their              regarding credit origination and
Dealers may have to adjust their sales       compliance obligations to help them            pricing
and underwriting processes to meet           comply as well.
the requirements being enforced
by their lender partners or their            It’s clearly in the best interests of both
primary regulators. Because the CFPB         lenders and dealers to create a strong
ultimately holds lenders responsible         partnership focused on compliance
for their dealers’ actions, lenders may      with regulatory requirements,
choose to a) stop doing business with        collaborative support of the regulatory
dealers that can’t demonstrate their         and legal issues facing each of them,
compliance with fair lending and other       and achieving a lower risk profile
regulatory standards, b) limit flexibility   for both organizations. To help the
with these dealers for pricing or credit     auto finance industry prepare for the
exceptions, or c) restrict these dealers     possibility of enhanced regulatory
in other ways, such as exclusion from        requirements, we’ve identified six key       By addressing the CFPB’s
special programs.                            areas of focus that will help develop
                                             regulatory oversight, avoid costly
                                                                                          concerns and providing
This is a very significant change, and       penalties, and manage reputational           effective monitoring and
many dealers are still discovering           risks.                                       compliance documentation,
its full implications. Conversations
with dealer groups reveal that many                                                       dealers and lenders can
customer-facing sales and finance                                                         work together to satisfy
(F&I) personnel are largely unaware                                                       regulators and develop
of the CFPB’s recent bulletin on dealer
markups.                                                                                  effective relationships that
                                                                                          manage both of their needs.

6          PwC Consumer Finance Group
1
Maintain high                                              Preventing deceptive practices                            Training and monitoring programs
                                                                                                                     should begin with the areas that
standards of                                               To further underscore the need for                        typically involve the greatest potential
transparency                                               lenders and dealers to work together,                     for customer complaints and, therefore,
with consumers                                             consider the Dodd-Frank definition                        exposure to UDAAP violations. Dealers
                                                           of “deceptive.” An act or practice is                     should aim for transparency in five
UDAAP (unfair, deceptive, or abusive                       deceptive when3:                                          primary areas:
acts or practices) is the federal
regulatory consumer protection                             1. It misleads or is likely to mislead                    • Vehicle sales price. Present the
requirement that’s currently receiving                        the consumer;                                            price of the vehicle separately from
significant regulatory focus. It’s                                                                                     the price of any other additional
                                                           2. The consumer’s interpretation                            equipment, such as custom upgrade
applicable to lenders’ and dealers’
                                                              is reasonable under the                                  packages and audio, entertainment,
advertising, sales, credit origination,
                                                              circumstances; and                                       or navigation systems. Clearly
and other activities.
                                                                                                                       explain to the borrower state sales
                                                           3. The act or practice is material.
Preventing unfair practices                                                                                            tax, title, and required licensing
                                                           That is, an individual doesn’t have                         fees.
“Unfair” acts or practices are those that                  to intend to deceive or mislead a                         • After-market products.
can result in harm to a consumer that                      consumer for an act to be considered                        Negotiate the price of extended
the consumer cannot reasonably avoid.                      deceptive. To mitigate UDAAP risk,                          service contracts, guaranteed asset
Recent examples in mortgage servicing                      lenders should be sure their dealers                        protection (GAP) insurance, and
include mishandling of paperwork                           receive recurring, appropriate training                     other additional products typically
that resulted in failures to consider all                  and implement routine compliance                            sold by the dealer’s finance and
applicable information in connection                       monitoring and oversight programs for                       insurance offices separately from
with requests for loan modifications,                      all sales, finance, and other customer-                     the price of the vehicle. Clearly
and failing to notify borrowers that the                   facing dealer employees.                                    disclose product terms, conditions,
address for sending payments changed,
                                                                                                                       limitations, and restrictions as part
resulting in late fees. Therefore, it is
                                                                                                                       of the negotiation.
important to handle all aspects of each
transaction competently and to focus
                                                             5 areas to focus                                        • Vehicle trade-in value. Clearly
on maintaining a high standard of                            transparency efforts:                                     explain the equity from a vehicle
transparency with consumers.                                 • Vehicle sales price                                     trade-in applied toward the down
                                                                                                                       payment of the new purchase. The
                                                             • After-market products                                   “gross allowance” for the trade-in
                                                             • Vehicle trade-in value                                  should be supported with NADA,
                                                                                                                       Kelley, or Black Book calculations
                                                             • Truth-in-lending disclosures                            or comparable auction valuations.
                                                             • Payment amount

3   CFPB Bulletin 2013-07, “Prohibition of Unfair, Deceptive, or Abusive Acts or Practices in the Collection of
    Consumer Debts”

                                                                                                          Objects in the mirror are closer than they appear    7
Consistently calculate the allowance                 Preventing abusive practices               Powerful mitigation tools:
    for the trade-in and keep it                                                                    complaints management
    independent of the sales price of the                Recently, Dodd-Frank added the
                                                                                                    and training
    vehicle or “gross of the deal.”                      concept of “abusive” practices into
                                                         UDAAP. Abusive acts or practices are       Credit analysts and other dealer-
• Federal truth-in-lending                               defined as those that4:                    facing employees, and even a lender’s
  disclosures. Give borrowers
                                                         • Materially interfere with the ability    customers, are often the first to
  a clear, concise summary of the
                                                           of a consumer to understand a term       identify high-risk behaviors, so it is
  amount financed calculation and
                                                           or condition of a consumer financial     critical to leverage those resources
  the manner in which the annual
                                                           product or service, or                   to prevent enforcement actions. In
  percentage rate and total finance
                                                                                                    September 2013, for instance, the
  charges affect the total of payments                   • Take unreasonable advantage              FTC accepted agreements containing
  and the total price of the vehicle.                      of: 1) a lack of understanding on        proposed consent orders from two auto
• Payment amount. Because                                  the part of the consumer of the          dealerships charged with deceptive
  many consumers in effect purchase                        material risks, costs, or conditions     advertising involving discounts off the
  vehicles as “payment buyers,” they                       of the product or service; 2) the        MSRP for certain vehicle models. And
  should understand the monthly                            inability of the consumer to protect     in 2012, the FTC filed administrative
  payment calculation. Extending the                       their interests in selecting or using    complaints against five dealerships
  term to lower the monthly payment                        a consumer financial product or          for alleged deceptive conduct by
  is a common practice to make the                         service; or 3) the reasonable reliance   advertising to consumers that “we’ll
  payment more affordable. But the                         by the consumer on a covered             pay off your trade no matter how
  consumer should be made aware                            person to act in the interests of the    much you owe.” In reality, the dealer
  of potential drawbacks, such as                          consumer.                                was rolling the negative trade equity
  additional finance charges they                                                                   into the new transaction and may not
                                                         Since the concept of abusive acts
  could incur and the additional time                                                               have completely disclosed these facts
                                                         and practices is relatively new,
  it may take to establish equity in                                                                to consumers, implying instead that
                                                         there are few practical examples
  the vehicle.                                                                                      consumers would have no further
                                                         for lenders and dealers to reference
                                                                                                    obligation on the previous loan.
Another common industry practice                         or to use as a guide for building
that’s being closely watched by the                      operating practices. However, the          If the auto dealers had leveraged key
FTC is “spot delivering” vehicles. Spot                  CFPB Examination Manual suggests           personnel in the lending process, they
delivery is when the consumer signs                      that consumer complaints may play          might have been able to prevent the
the sales and financing agreement and                    a role in identifying abusive, unfair,     conduct that led to the enforcement
takes delivery of the vehicle before                     and deceptive acts and practices.          actions. For example, implementing a
financing is approved. This creates a                    For example, the manual notes that         multi-channel complaints management
disadvantage for the consumer if the                     complaints regarding consumers’ lack       program that allows customers to
lender either declines the application                   of understanding about a product’s         easily raise concerns will help identify
for credit or approves the application                   or service’s terms may indicate a          risky behaviors early and maintain an
with less attractive terms. Because                      need to conduct a detailed review of       open line of communication and a high
it could take several days for the                       the relevant practice.5 Both lenders       standard of transparency within the
dealer to exhaust all lending options,                   and dealers should have an effective       industry. Similarly, a dealer-monitoring
the consumer may not be notified of                      monitoring framework for customer          program that provides incentives to
a problem for a week or more after                       complaints and should collaborate          employees to report such activities, and
taking possession of the new vehicle                     regarding complaints that could be         a framework that follows through with
and, in many cases, after the dealership                 viewed as abusive under UDAAP.             investigations, can also go a long way
has sold their trade-in.                                                                            toward avoiding regulatory sanctions.

4   Dodd-Frank Act Section 1036(a)(1)(B) and 12 U.S.C. section 5536(a)(1)(B)
5   CFPB Supervision and Examination Manual, Version 2, October 2012

8            PwC Consumer Finance Group
2
Keep after-market                        • Product restrictions. Advise              • Product cost. Marketing material,
                                           customers of limitations that               product literature, and verbal
products above board
                                           could impact the value or terms             descriptions or “sales pitches”
When it comes to after-market              of a product. Examples include              should accurately disclose the true
products, parallels can be drawn           requirements to perform regularly           and complete cost of the product.
between auto lending practices and         scheduled maintenance or routine            Avoid general cost descriptions that
the recent enforcement actions against     oil changes for extended warranties,        could be subject to interpretation,
credit card issuers. In one instance,      payout or frequency limits on               and clearly disclose additional fees
the bureau required a refund of more       claims, and restrictions on service         or product options that could result
than $100 million to customers who         center locations for repairs and            in a higher cost to the consumer.
were allegedly misled into buying          inspections. Present a separate,
                                                                                     • No strings attached. Sales
credit card “add-on” products, citing      executable disclosure document
                                                                                       of after-market products should
such deceptive marketing practices         outlining these restrictions.
                                                                                       stand on their own, regardless of
as misleading consumers about the        • Product value/benefits.                     the vehicle purchase or financing.
benefits and nature of the products.       Customers want value from the               Customers shouldn’t be told that
Lenders and dealers should prepare         products they buy, and certain              credit approval or qualification
for additional scrutiny around after-      products, such as discounted                for a manufacturer’s incentive is
market products (such as extended          pre-sale oil changes, generally             contingent on the purchase of any
service warranties and GAP insurance       provide value. Companies                    after-market product or service.
policies), how they disclose and sell      should embed customer benefit               Companies should clearly disclose
them, and the products’ benefits to        considerations in new product               that the product or service is
consumers.                                 design and approval processes, and          optional, subject to the customer’s
                                           implement policies to prevent the           cancellation, and that the customer
                                           sale of insurance or other products         isn’t required to finance it.
Five policies to enact now
                                           that are unlikely to add value to the
To begin, put robust policies and          consumer. A consumer would not            Don’t ignore activation of after-
procedures in place governing the          likely benefit from GAP insurance,        market products
advertising, sale, and disclosure          for instance, if they financed less
requirements of after-market products,     than 50% of the value of the vehicle.     Don’t limit your focus to only the
including:                                 Similarly, an extended service            advertising and selling of after-market
                                           contract sold to a lease customer         products. Lenders have also received
• Product description. Give the            whose scheduled agreement will            regulatory inquiries about how they
  customer a clear and unexaggerated       terminate within the manufacturer’s       handle the activation of these products
  description of the primary benefits      warranty period may not provide           and how they account for any refund
  of the product. Many dealers are         value to the customer. These              due to the consumer for an unused
  turning to an electronic product         examples could be viewed as unfair        insurance premium when vehicles are
  menu option to help efficiently          acts.                                     returned or repossessed.
  increase penetration rates while
  minimizing compliance risk. This
  offers a consistent, unbiased,
  and auditable presentation of the
  product to every customer.                    Prepare for additional scrutiny around how
                                                you disclose and sell after-market products,
                                                such as extended service warranties and GAP
                                                insurance policies.

                                                                          Objects in the mirror are closer than they appear   9
A customer does not have to
                                                                           buy an after-market product
                                                                           in order to purchase or
                                                                           finance a vehicle.
                                                                           It’s critical that they
                                                                           understand after-market
                                                                           products are optional.

When a dealer sells an insurance           Both the lender’s and dealer’s                the product’s expiration. This
product, such as an extended service       compliance and audit frameworks need          refund should not only include
warranty or GAP insurance, the             to address two critical areas on behalf       the unused, prepaid percentage of
consumer is typically charged the          of the consumer in this scenario:             the wholesale premium but also
retail price of the product, which is                                                    the corresponding portion of the
included in the sales and financing        1. The dealer must remit the funds            dealer’s profit.
agreement funded by the lender. The           in a timely manner to the product
dealer is responsible for activating the      provider so the product is properly    Strong governance and ground rules
product with the provider by remitting        activated without significant lag      regarding each after-market product,
the product agreement, required               time.                                  robust training and supervision of
documentation, and payment for the                                                   the sales and finance professionals
                                           2. Both the dealer and lender             offering these products and services,
wholesale cost of the product. The            should have controls in place so       and a compliance and/or internal audit
difference between the retail price           any unused prepaid insurance           oversight plan can help mitigate the
paid (or financed) by the customer and        premiums are promptly refunded         regulatory, litigation, and headline
the wholesale price paid to the service       to the borrower if the vehicle is      risks associated with after-market
provider is the profit retained by the        returned or repossessed prior to       products.
dealer.

10        PwC Consumer Finance Group
3
Apply lessons learned
from other industries
It’s not always necessary to create              The following table summarizes actions
new processes from the ground up.                taken in the credit card industry and
Regulators have already been working             their potential parallels in automotive
with the credit card industry, and these         finance.
experiences can provide useful insights.

 Allegation          Credit card industry                        Auto finance industry ―

 Misled about        Consumers were sometimes led to             • Clearly disclose limitations on the scope of coverage or exclusions
 the benefits of     believe that the product would improve        from coverage.
 the product         their credit scores and help them           • Don’t represent extended warranty programs as a manufacturer
                     increase the credit limit on their credit     warranty unless approved by the manufacturer.
                     card. Additionally, they may have been
                     misled into thinking that the product or    • Make consumers aware of routine maintenance requirements to keep
                     service was required, not optional, or        the product activated/valid.
                     to believe it was an included feature in    • Fully disclose limitations on the number or aggregate amount of
                     the original transaction, which they then     claims.
                     paid extra for.

 Deceived about      Consumers were not always told that         • Clearly disclose that products are optional and cancellable on
 the nature of the   buying the products was optional. In          marketing materials and service agreements.
 products            other cases, consumers were wrongly         • Lenders and dealers should create policies and processes for product
                     told they were required to purchase           cancellation.
                     the product to receive full information
                     about it, but that they could cancel the    • Disclose repair facilities that are limited to a preapproved list of
                     product if they were not satisfied. Many      providers that may not be in convenient, close proximity to the
                     of these consumers later had difficulty       customer.
                     canceling.                                  • Replacement parts may be generic or overhauled rather than new and
                                                                   manufacturer certified.

 Misled about        In some cases, call center                  • Disclose limitations on the scope of coverage or exclusions from
 eligibility         representatives marketed and sold             coverage.
                     products to ineligible, unemployed,         • Take steps to be certain that both the borrowers and the vehicle
                     and/or disabled consumers. Despite            financed qualify for the service warranty sold.
                     paying the full fees, they could not get
                     all the benefits of payment protection.

 Misinformed         Consumers were sometimes led to             • Disclose all fees and costs in advertisements and marketing material.
 about cost of       believe they would be receiving a free      • Disclose deductible amounts.
 the products        product rather than making a purchase.
                                                                 • Disclose requirements for consumers to pay for repairs up front and
                                                                   then request reimbursement.

 Enrolled without    Some call center vendors processed          • Be certain dealers’ after-market sales processes are clear and
 consent             add-on product purchases without the          transparent.
                     consumer’s consent. Consumers were          • Implement a process to promptly cancel the warranty and refund all
                     then automatically billed for the product     unearned fees if a cancellation is requested by the consumer.
                     and often had trouble canceling it.

                                                                                     Objects in the mirror are closer than they appear    11
It’s not enough to act in good faith. Instead,
lenders and dealers should have an exhaustive
knowledge of fair practice regulations and take
proactive steps to avoid regulatory penalties.

    4
Examine current                                          any creditor to discriminate against         • Ongoing monitoring for compliance
                                                         a loan applicant in any aspect of a            with fair lending policies and
policies for adherence
                                                         credit transaction on the basis of race,       procedures
to fair lending rules                                    color, religion, national origin, sex,
                                                                                                      • Ongoing monitoring for compliance
While it may sound like a simple                         marital status, or age. The ECOA also
                                                                                                        with other policies and procedures
concept, fair lending includes an                        prohibits creditors from discriminating
                                                                                                        that are intended to reduce fair
entire continuum of trade practices,                     based on the fact that all or part of an
                                                                                                        lending risk (such as controls on
some of which might not be obvious.                      applicant’s income is derived from a
                                                                                                        loan originator discretion)
Discrimination and preferential                          public assistance program, or that an
treatment, for example, might seem                       applicant has in good faith exercised        • Review of lending policies for
like clear practices to avoid, but                       any right under the Consumer Credit            potential fair lending violations,
they’re often nuanced and may be                         Protection Act.                                including potential disparate impact
committed inadvertently, making                                                                       • Regular assessment of the marketing
lenders and dealers that have acted                      A fair lending framework                       of loan products
without malice potentially subject
                                                         The CFPB and other bank supervisory          • Meaningful oversight of fair lending
to significant regulatory penalties
                                                         agencies expect financial institutions         compliance by management and,
and litigation risk. Moreover, lenders
                                                         to have a compliance framework in              where appropriate, the financial
and dealers, although close partners
                                                         place to manage fair lending risks,            institution’s board of directors
in the financing realm, bear joint
                                                         and the CFPB provided guidance on
responsibility for adhering to fair                                                                   • Depending on the size and
                                                         its expectations for institutions’ fair
lending requirements, making lenders                                                                    complexity of the financial
                                                         lending programs in its Fall 2012
vulnerable to the practices of dealers                                                                  institution, regular statistical
                                                         Supervisory Highlights.6 The guidance
even though there may be no other                                                                       analysis of loan data for potential
                                                         states that every financial institution
legal relationship between the two.                                                                     disparities on a prohibited class basis
                                                         should establish fair lending policies,
In short, to adhere to fair lending                                                                     in pricing, underwriting, or other
                                                         procedures, and internal controls so
requirements, it’s not enough to act in                                                                 aspects of the credit transaction,
                                                         they’re operating in compliance with
good faith. Instead, lenders and dealers                                                                including both mortgage and
                                                         the ECOA in all of their relevant lines of
should have an exhaustive knowledge                                                                     non-mortgage products such as
                                                         business. The guidance also identifies
of fair lending regulations and other                                                                   credit cards, auto loans, and
                                                         common features of well-developed
requirements and take proactive steps                                                                   student loans
                                                         fair lending compliance programs.
to implement fair lending compliance
                                                         These features include:                      • Oversight of third-party service
processes and controls to mitigate risk.
                                                         • An up-to-date fair lending policy            providers’ compliance with laws and
Implemented by Regulation B, the                           statement                                    regulations, including fair lending
Equal Credit Opportunity Act (ECOA)                                                                     requirements
contains fair lending requirements for                   • Regular fair lending training for
auto financing in the United States.                       all officers, board members, and           Considering the recent spate of
The ECOA makes it unlawful for                             employees involved with any                interest from regulators on fair lending
                                                           aspect of the institution’s credit         compliance, lenders and dealers should
                                                           transactions                               examine their fair lending frameworks,
                                                                                                      processes, and controls for adherence
                                                                                                      with the guidance.
6    Consumer Financial Protection Bureau, “Supervisory Highlights: Fall 2012,” http://files.
     consumerfinance.gov/f/201210_cfpb_supervisory-highlights-fall-2012.pdf, accessed Oct. 7, 2013.

12            PwC Consumer Finance Group
CFPB Bulletin 2013-02 announced that
lenders will be held accountable for illegal,
discriminatory markups, even though the markup
may be at the sole discretion of the dealer.

    5
Pay close attention to                                    the opportunity to mark up the rate          • Monitor and address the effects of
                                                          to cover the incremental cost of               markup policies as part of a robust
discretion throughout
                                                          acquiring another similar vehicle for          fair lending compliance program
the transaction                                           its inventory. Because the factors that
                                                                                                       • Eliminate dealer discretion to
In auto finance, the most common fair                     go into pricing a transaction may be
                                                                                                         mark up buy rates and fairly
lending risks are the by-products of                      inherently subjective and dependent
                                                                                                         compensate dealers using a different
credit analyst discretion and the use                     on unique facts and circumstances
                                                                                                         mechanism that does not result in
of subjective characteristics to decide                   at the individual dealer level, there’s
                                                                                                         discrimination, such as flat fees per
on and price individual consumer                          the risk that the discretion permitted
                                                                                                         transaction
transactions. And the risks regarding a                   by these markup policies may result
dealer’s discretion to mark up interest                   in pricing differences on the basis          Fair lending responsibility doesn’t rest
rates has been the subject of the most                    of race or national origin, or on            only with lenders, however. The ECOA
discussion, largely because of the                        another prohibited basis. Although           defines “creditor” broadly to include “a
attention generated by the CFPB’s                         dealer markups are a current area of         person, who, in the ordinary course of
March 2013 Bulletin 2013-02 on the                        regulatory focus, it’s also important        business, regularly participates in the
subject.                                                  to assess underwriting and pricing           decision of whether to extend credit.”7
                                                          practices for potential fair lending         Also, the Commentary to Regulation
Typically, dealer markups come into                       compliance risk.                             B provides that a “creditor” “includes
play within the indirect lending                                                                       all persons participating in the credit
channel for auto finance lenders                          Lenders and dealers are                      decision,”8 implying that the ECOA
and involve a loan that’s originated                      both accountable for illegal,                applies to dealers as well as lenders.
through a dealer. While the lender                        discriminatory markups
may establish a specific permissible                                                                   Dealer trade groups contend that
range for the markup, usually between                     The CFPB Bulletin 2013-02 says that          changing the way lenders compensate
200 and 250 basis points, lenders                         lenders may be liable for its dealer         dealers without examining the effect
don’t typically guide the dealer on the                   markup and compensation polices              of this change could adversely affect
specific markup or rate to charge an                      if these policies result in pricing          the cost and availability of credit
individual customer.                                      differences on a prohibited basis, even      for consumers. They also say dealer
                                                          though the markup may be at the              sales could be impacted if they can’t
For example, if the dealership is able                    discretion of the dealer. The bulletin       recover their inventory and overhead
to sell the customer a vehicle that’s                     also indicates that indirect auto lenders    costs, which are partially recaptured
been in their inventory for a long time                   within the CFPB’s jurisdiction should        through dealer markups. However, the
or gain additional revenue through                        take steps to maintain compliance with       CFPB acknowledges a dealer’s right
the sale of an extended warranty, the                     fair lending laws as they apply to dealer    to compensation and maintains that
dealer may be less likely to mark up                      markup and compensation policies.            a change to “flat fee” reserve pricing
the interest rate. But if a customer                      These steps may include:                     is only one option. An alternative is
purchases a highly sought-after                                                                        imposing proper controls and closely
vehicle and is indifferent to price,                      • Impose controls on dealer markups,
                                                                                                       monitoring dealer markup and
the dealer may take advantage of                            or otherwise revise dealer markup
                                                                                                       compensation activities to address
                                                            and compensation policies
                                                                                                       unexplained prohibited basis pricing

7   15 U.S.C. Section 1691a(e)
8   12 C.F.R. pt. 1002, Supp. I, Section 1002.2, Paragraph 2(l)-1

                                                                                            Objects in the mirror are closer than they appear   13
disparities. All of these considerations                   Recent fair lending examination and                       to be exploring an improved proxy
underscore the need for a collaborative                    enforcement authority has been driven                     method, but it hasn’t yet released
effort among dealers and lenders to                        by this “disparate impact” theory.                        details on the methodology.
mitigate fair lending risk.                                This controversial legal approach
                                                           does not require specific evidence of                     In addition to enhanced processes
                                                                                                                     and controls around fair lending,
Defining disparate treatment                               discriminatory intent by the lender;
                                                           instead, enforcement actions are                          lenders should consider proactive
and impact
                                                           driven primarily by observed statistical                  statistical analysis of loan pricing
Disparate treatment in its purest                          differences in lending outcomes                           and underwriting practices to
form occurs when a lender bases a                          between protected and non-protected                       understand current fair lending risks
lending decision on one or more of the                     groups.9                                                  and replicate analyses conducted
prohibited bases as defined by the fair                                                                              by the regulators. Lenders should
lending laws. But it doesn’t require                       To be certain a lender isn’t applying                     also consider developing a dealer
proof of intention to discriminate.                        disparate treatment or that its                           monitoring program and consider
For example, in 2009 the Justice                           origination practices aren’t resulting                    monitoring pricing differences in
Department filed a lawsuit against                         in disparate impact, the CFPB will                        metropolitan statistical areas (MSAs)
two auto dealers and a bank. The suit                      generally apply statistical analysis to                   as well as dealer-level differences. Any
maintained that the organizations                          determine whether there are disparities                   monitoring program should include
violated the ECOA by charging certain                      within a dealer’s transactions and                        processes for corrective action, such
borrowers, predominantly those of                          across the lender’s portfolio of all                      as dealer disciplinary actions and
Latino descent, higher interest rate                       dealers’ transactions. The portfolio’s                    borrower remediation.
markups than other borrowers with                          aggregation of contracts assigned by
                                                           numerous dealerships further creates                      The scope of fair lending extends
comparable qualifications.
                                                           the possibility that the CFPB will find                   beyond approved transactions,
Disparate impact can occur when a                          discrimination to exist collectively,                     however; it also includes borrowers
group of customers on a prohibited                         even if an individual dealership did not                  who have been denied a loan
basis are disproportionately excluded                      engage in discriminatory conduct.                         altogether. In the eyes of a regulator,
or negatively affected by a policy                                                                                   if there’s evidence that a certain
or practice even though the policy                         Since lenders don’t collect demographic                   group of customers has a much higher
or practice applies consistently to                        information for auto loans, the                           approval or rejection rate than another
all customers across the board.                            CFPB uses proxies to determine or                         group of customers (even though both
For example, a lender may have                             approximate the age, gender, racial                       groups have the same risk profile),
a policy of not making auto loans                          background, etc. of borrowers and uses                    this may be evidence of a fair lending
for less than $10,000. This policy                         these proxies to determine whether                        violation. Lenders who use subjective
might disproportionately exclude                           evidence of fair lending disparities                      underwriting criteria and who depend
applicants who are members of a                            exists. Proxies are typically based                       on an underwriter’s discretion to
protected class who have lower                             on Census Bureau surname lists as                         make a decision on an application
income levels or lower collateral                          well as demographics of borrowers’                        should have additional safeguards and
values than the rest of the applicant                      home addresses (i.e., census tract                        oversight in place to avoid inconsistent
pool in the areas in which they live.                      demographics).10 The CFPB appears                         customer treatment.

9    Office of the Comptroller of the Currency, http://www.occ.gov/topics/consumer-protection/fair-lending/index-fair-lending.html, accessed Oct. 7, 2013.
10   Consumer Financial Protection Bureau, Letter from Richard Cordray to Chairman Bachus, August 2, 2013.

14            PwC Consumer Finance Group
6
Keep an eye on                                          by the dealer (the interest rate quoted
                                                        by the dealer to the consumer minus
regulatory action
                                                        the ‘buy rate’).”11 It’s possible that the
regarding credit                                        CFPB could begin to look more broadly
originations                                            at pricing considerations across the
and pricing                                             transaction, examining factors such as
                                                        the buy rate, price of the vehicle, and
In addition to subjective underwriting                  add-on products. Also, the CFPB has
criteria, lenders may also use risk-                    not specified their exact methodology
based pricing, which may lead to                        for their analyses of price variances
pricing variances among customers.                      or set a specific threshold for the level
As long as the variance is explained                    of variance that will be considered
by a business justification (such as                    to constitute a violation. In order to
competitive landscape, cost of funds,                   prepare for the CFPB’s potential review,
or cost of operations) that is not related              lenders should carefully evaluate their
to any of the protected characteristics                 pricing practices and their monitoring
covered by fair lending laws, pricing                   of pricing and dealer markups in order
variances are allowed and are a                         to demonstrate that they have effective
common practice across asset classes,                   controls in place to consistently price
from mortgages to auto finance.                         customers with the same risk profile.
Lenders with subjective discretion
in their pricing process should have
additional safeguards and oversight
so that customers with the same risk
profile are priced consistently.
                                                             The CFPB could begin looking more broadly at
                                                             pricing considerations. Factors such as the buy
It remains to be seen how the CFPB
will evaluate pricing variances. A letter
                                                             rate, price of the vehicle, and add-on products
addressed by CFPB Director Richard                           may come under scrutiny.
Cordray to members of Congress noted
that “A typical fair lending examination
of an indirect auto lender would
include a review of credit denials,
interest rates quoted by the lender to
the dealer (called ‘buy rates’), and any
discretionary markup of the buy rate

11 Consumer Financial Protection Bureau, Letter from Richard Cordray to Rep. Sewell, June 20, 2013.

                                                                                                      Objects in the mirror are closer than they appear   15
How PwC can help

With deep experience in the auto          For lenders:                              For dealers:
finance, regulatory compliance, and
                                          • PwC can help establish and review       • PwC can assist in developing
fair and responsible lending areas, PwC
                                            compliance management systems             material and providing training to
can assist lenders and dealers in the
                                            (CMS) and conduct assessments of          finance officers at dealerships on the
development of regulatory compliance
                                            fair lending, UDAAP, and vendor           UDAAP and fair lending regulatory
and fair lending policies, processes,
                                            management programs and                   requirements and expectations
training, and monitoring capabilities.
                                            processes against industry practices      relating to UDAAP and fair lending.
Because regulators will hold lenders
                                            and regulatory requirements.
and dealers jointly responsible for                                                 • PwC can help dealers develop
compliance, alignment of the activities   • PwC can help lenders develop fair         or strengthen their own internal
and consistency in the robustness of        lending statistical models and dealer     compliance policies, practices, and
the execution are critical. Lenders         monitoring programs.                      monitoring tools.
will serve as the key connection
                                          • PwC can conduct independent third-
point across multiple dealers and can
                                            party statistical analyses and other
facilitate collaboration and knowledge
                                            reviews to determine current fair
sharing to give dealers perspective
                                            lending risks and the state of fair
on what other dealers within their
                                            lending controls.
network have implemented, and to
maintain consistency in the collective
approach. PwC can help lenders and
dealers at any stage in the process,
bringing our knowledge of industry-
leading practices and experiences to
enhance the collaboration between
lenders and dealers.

16        PwC Consumer Finance Group
Contacts

Sam May                         Michael Stork
Consumer Finance Group Leader   Partner                                   Other reading material
(213) 356-6203                  (612) 596-6407                            of interest
samuel.may@us.pwc.com           michael.stork@us.pwc.com
                                                                                                         www.pwc.com

Rick Hanna                      Martin Touhey
Global & US Automotive Leader   Principal
(313) 878-8754                  (206) 790-8751                                                           Spotlight
                                                                                                         Lessee Accounting–
richard.hanna@us.pwc.com        martin.e.touhey@us.pwc.com                                               Automotive Industry
                                                                             July 2013

Eva Ziegler                     Anthony Ricko                                Transformational change
                                                                             Considering the impact
                                                                             of the proposed new lease

US Automotive Finance Leader    Managing Director
                                                                             accounting guidance on
                                                                             lessees in the automotive
                                                                             industry

(312) 298-3736                  (978) 985-1749
eva.ziegler@us.pwc.com          anthony.ricko@us.pwc.com

Ric Pace                        Doug Ekizian
Principal                       Senior Manager
(703) 624-3314                  (949) 517-8220
ric.pace@us.pwc.com             douglas.c.ekizian@us.pwc.com

Peter Pollini                   Wade Hampe                                Lessee accounting: Transformational
Principal                       Senior Manager                            Change - Considering the impact of the
(207) 450-9036                  (404) 915-4682                            proposed new lease accounting guidance
peter.c.pollini@us.pwc.com      wade.d.hampe@us.pwc.com                   on lessees in the Automotive Industry.

Follow us on Twitter @PwC_US_FinSrvcs

                                                               Objects in the mirror are closer than they appear               17
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www.pwc.com/consumerfinance
www.pwcregulatory.com

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