Regulators Targeting Lenders Based on Loan Underwriting Practices

By Stefan Palys and Bryce Langford

Federal and state regulators are targeting lenders for their underwriting practices for consumer loans. Santander Consumer USA, a finance company, and the Massachusetts and Delaware State Attorneys General recently entered into a widely reported settlement agreement. While the settlement was under Delaware law, lenders should take notice of this regulatory playbook because there is a similar federal law and analogous state laws across the country, which federal and state regulators are already using to assert claims like Santander faced against other companies.

Terms of Settlement Agreement

Santander purchased car loans originated by auto dealers. The settlement agreement claims that dealers were inflating applicants' income so they would qualify for loans. Additionally, according to the settlement, the dealers were claiming the cars included packages that they actually did not, because the additional value allowed dealers to sell additional services that the applicant could not otherwise afford. The settlement recites that Santander knew of these fraudulent practices from spot-checks of information provided by the dealers, or should have learned of them through more robust audits. Loans impacted by these practices had default rates approaching 50 percent.

Notably, the settlement states that both Santander and the dealers themselves had tried to crack down on these illegal practices. Santander required dealers to provide additional verifications of income and had forced dealers to repurchase some of the impacted loans. Dealers themselves had also asked Santander to impose additional oversight as a way to police the dealers' sales staff.

Despite this, the AGs came after Santander for allegedly failing to adequately monitor the dealers' origination work. According to the AGs, Santander had violated Delaware's Consumer Fraud Act by "recklessly purchasing" certain loans that "borrowers were not likely to be able to repay . . . ." The AGs required Santander to fund a trust to refund impacted consumers. One could ask whether Santander was the victim of this fraud rather than the perpetrator of it.

"Unfair" Practices

Finance companies should not disregard this enforcement action as just a Delaware issue. Nearly every state has a similar law, all of which are similar to Section 5 of the Federal Trade Commission Act. The statute in Delaware broadly prohibits "unfair" practices in the sale of merchandise (which includes making a loan). Broad statutory language gives regulators huge leeway to allege that a particular practice is "unfair"—leeway the AGs took advantage of against Santander. In fact, the Consumer Financial Protection Bureau and two state attorneys general are currently pursuing a student loan company on a similar theory: that it made loans it allegedly knew could not be repaid.

Last year the Consumer Financial Protection Bureau promulgated rules that would penalize certain lenders for originating loans without a "reasonable basis . . . for concluding that the consumer will be able to make payments under the covered loan while also meeting the consumer's major financial obligations and meeting basic living expenses."

Many state statutes provide for private causes of action. So it is possible that borrowers could claim the "unfair" practice as a defense to loan enforcement, or a class might someday advance such a lender liability claim.

What can lenders do? Lenders can adopt policies to ensure their origination decisions are documented. For example, lenders could document the applicants' income and other expenses so the lender can show their reasonable belief that they will be repaid. If lenders originate or purchase loans through third parties, more rigorous oversight and audits of the third parties is required.

If challenged by a regulator or a private party, a lender has arguments it can make. Stinson has experience with lender liability claims. Claiming originating/underwriting decisions are a basis for liability because they are "unfair" is arguably a stretch. At common law, a lender does not owe any duty to a borrower—they’re adversaries, not fiduciaries. Further, underwriting is for a lender’s protection, not a borrower’s. No lender wants to make a loan that will not be repaid because it may not recover the funds advanced.

But no lender wants to be the test case. Consult with legal counsel to proactively shape policies and ensure proper data collection.

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