Self-Testing for ECOA Compliance

QUESTION
We originate and service mortgage loans and consumer loans. We just completed a banking examination and had our exit discussion with the examiners. 

The examiners brought up that we should be doing self-testing and self-correction of the ECOA. They mentioned that there is a privilege that we can use in doing the self-test.

However, we were unable to prove that we do a self-test for the ECOA. They said the recommendation would be in the report they will issue to us soon.

We were told this self-test is going to involve our consumer loan products, which are not mortgage-related products. We know you specialize in residential mortgage compliance; however, we think many of your clients may also originate consumer loan products. So, we hope you will make an exception and answer our question.

We would like to understand what they expect of us. What is the self-testing of ECOA requirement? What kind of privilege is involved in undertaking the self-testing?

ANSWER

We concentrate on residential mortgage banking, originating and servicing, Many of our clients do also originate consumer loan products. It is not unusual for them to seek guidance involving their consumer loan products. As a courtesy, I will provide an answer to your question since I sense the urgency.

For your mortgage-related products, you might want to consider our Compliance Tune-up for the ECOA, the ECOA Tune-up. It provides an approach to the review criteria, is conducted independently, and provides a report and risk rating. It is not a good idea to wait for a regulator to determine that you are also not self-identifying ECOA compliance issues in your mortgage loan originations. Contact Us for more information.

Self-testing is designed to encourage lenders to voluntarily assess their fair lending compliance level and identify and correct any problems they find. The rules establish a legal privilege that prohibits financial institution’s regulatory agencies and private parties from obtaining information generated by voluntary self-tests for use in ECOA-related compliance examinations or investigations or in proceedings in which ECOA violations are alleged.

But the privilege applies only if the self-test is voluntary, meets the general standards outlined in the regulations, and the lender takes action to correct or address possible violations discovered in the self-test.

A self-test is best understood as any program, practice, or study that is designed and used specifically to determine the extent or effectiveness of a creditor’s compliance with the Equal Credit Opportunity Act (ECOA), or its implementing Regulation B, if it creates data or factual information that is not available and cannot be derived from loan or application files or other records related to credit transactions.

Regarding the privilege, it is designed to serve as an incentive by assuring that evidence of discrimination produced by a self-test will not be used against a creditor, provided the creditor takes appropriate corrective actions for any discrimination that is found. The privilege includes work papers and draft documents as well as final documents.

Self-testing may include using fictitious applicants for credit (i.e., testers), whether with or without the use of matched pairs. You could test, for example, a particular branch of your financial institution. Lender surveys or mortgage loan applications may also be taken to see if applications were processed properly.

But be advised, creditor reviews and evaluations of loan and applications files, HMDA data, or records such as broker or loan officer compensation are not considered a self-test and are not privileged.

Now, let’s drill down a little by taking a brief, cursory look at data collection, corrective action, and the types of relief.

Collection of Data

The Federal Reserve Board recently amended Regulation B to allow the collection of an applicant’s personal characteristics in connection with non-mortgage credit.

If you decide to conduct a self-test and request information about personal characteristics, you must disclose to applicants that providing the information is optional, that it is being collected to monitor compliance with the ECOA, that it will not be used in making the credit decision, and, where applicable, that information may be noted by visual observations or surname.

Correction Action

For the privilege to apply, a financial institution must take appropriate corrective action when the self-test shows that a violation likely occurred, even though no violation has been formally adjudicated. The action must likely remedy the cause and effect of the violation.

The collection of this data is only allowed in a self-test for compliance with the ECOA. Because of this, the self-test must meet the standards set by the regulations.

Types of Relief

Corrective action may include both prospective and remedial relief.

As a creditor, you are not required to provide:

- Remedial relief to a tester used in a self-test.

- Remedial relief only to applicants identified by the self-test, whose rights more likely than not were violated.

- Remedial relief to a particular applicant if the statute of limitations applicable to the violation expired before obtaining the results of the self-test or if the applicant otherwise is ineligible for such relief.

Jonathan Foxx, Ph.D., MBA

Chairman & Managing Director

Lenders Compliance Group

Sexual Orientation & Gender Identity Discrimination

QUESTION
As a lender in all the states, we are always going through state banking examinations. 

About three weeks ago, we learned that one of the states have taken the position that our ECOA policy does not adequately set forth guidelines for sexual orientation and gender identity. 

We thought our policy was comprehensive, it was reviewed by our attorneys, yet we need to update the policy and send it to the examiner. We are hoping you can provide some guidance. 

What are some features of sexual orientation and gender identity policy statements with regards to ECOA?

ANSWER
Your question is timely. The fact is discrimination in lending has drawn considerable litigation over the years. Frankly, you should not be too confident that you have a total grasp of the policy requirements. I think I can guess the state that issued the adverse finding. But one state issuing a finding with respect to matters such as discrimination is one state too many!

Recently, the Consumer Financial Protection Bureau (CFPB or Bureau) clarified that discrimination by lenders on the basis of sexual orientation and gender identity is illegal. On March 9, 2021, the CFPB issued an interpretive rule[i], effective immediately upon publication in the Federal Register, clarifying that the prohibition against sex discrimination under the Equal Credit Opportunity Act (ECOA) and its implementing Regulation B includes: sexual orientation discrimination, gender identity discrimination, discrimination based on actual or perceived nonconformity with traditional sex- or gender-based stereotypes, and discrimination based on an applicant’s social or other associations.

This clarification is consistent with the Supreme Court’s ruling in Bostock v. Clayton County, Georgia[ii], that the prohibition against sex discrimination in Title VII of the Civil Rights Act of 1964 (Title VII) encompasses sexual orientation discrimination and gender identity discrimination, as well as many of the public comments received in response to the CFPB’s July 28, 2020 request for information (RFI) on whether the Bostock decision should affect how the CFPB interprets ECOA. I am sure the CFPB will review and update its publications and examination guidance documents, as needed, to reflect this interpretive rule and take enforcement actions to hold financial institutions accountable for ECOA violations.

In a sense, this is not the first rodeo for the CFPB to react to such concerns. Before the issuance of the Bostock opinion, at least twenty states and the District of Columbia prohibited discrimination on the bases of sexual orientation and/or gender identity either in all credit transactions or in certain (i.e., housing-related) credit transactions. Consequently, financial institutions subject to such laws were required to comply with those mandates prior to the issuance of the Bostock opinion. Many financial institutions recognize sexual orientation and/or gender identity to be protected classes under State laws and may have determined to incorporate practices that prohibit discrimination on these bases.

After the Supreme Court issued the Bostock opinion, though, diverse stakeholders asked the Bureau to clarify that ECOA’s and Regulation B’s prohibition of “sex” discrimination includes discrimination on the bases of sexual orientation and/or gender identity. Many comments to the Bureau’s recent Request for Information on the Equal Credit Opportunity Act and Regulation B (RFI)[iii] from a variety of stakeholders, including consumer and civil rights advocates, a local government official, an academic institution, and industry representatives, reiterated this request for regulatory clarification. Thus, the Bureau issued this interpretive rule to address any regulatory uncertainty that may still exist under ECOA and Regulation B as to the term “sex” so as to ensure the fair, equitable, and nondiscriminatory access to credit for both individuals and communities and to ensure that consumers are protected from discrimination.[iv]

There is considerable litigation surrounding the fact that the ECOA and Title VII are generally interpreted consistently. Like Title VII, ECOA prohibits sex discrimination (among other bases) and does not require that sex (or other protected characteristics) be the sole or primary reason for an action to be discriminatory. Indeed, intent is removed as a defense. As the applicable statute provides, “Disparate treatment on a prohibited basis is illegal whether or not it results from a conscious intent to discriminate.”[v]

Like Title VII, the ECOA applies to sex discrimination against individuals, not just to situations where all men or all women (or any other group of people with a common protected characteristic) are discriminated against categorically. In fact, in Bostock it was held that “an employer cannot escape liability [under Title VII] by demonstrating that it treats males and females comparably as groups”.[vi] Indeed, Regulation B clarifies that ECOA prohibits discrimination based not only on the characteristics of an applicant but also based on the characteristics of a person with whom an applicant associates.[vii]

The Bureau clearly believes that even though the term “sex” is not defined in ECOA or Regulation B, the prohibitions against discrimination on the basis of “sex” under ECOA and Regulation B are correctly interpreted to include discrimination based on sexual orientation and/or gender identity.

In sum, the Bureau has determined that under ECOA and Regulation B:

(1) sexual orientation discrimination and gender identity discrimination necessarily involve consideration of sex;

(2) an applicant’s sex must be a “but for” cause of the injury, but need not be the only cause; and

(3) discrimination against individuals, and not merely against groups, is covered.

If you have not heard of the “but for” cause of injury, it is simply a test that an action is a cause of an injury if, but for the action, the injury wouldn't have occurred. This theory often occurs in negligence cases. In other words, would the harm have occurred if the defendant hadn't acted in the way they did? If the answer is NO, then the action caused the harm. In most cases, the “but for” test is sufficient.

The Bureau also clarified that ECOA’s and Regulation B’s prohibition against sex discrimination encompasses discrimination motivated by perceived nonconformity with sex-based or gender-based stereotypes, as well as discrimination based on an applicant’s associations.

Amongst a host of caveats and prohibitions, here are three basic rules:

1. Sexual orientation discrimination and gender identity discrimination necessarily involve consideration of sex.

2. Sex does not have to be the sole or primary reason for an action to be discriminatory.

3. Sex discrimination against individuals is applicable, not just to situations where all men or all women are discriminated against categorically.

Furthermore, there is a prohibition regarding discrimination on the basis of “sex” motivated by perceived nonconformity with sex-based or gender-based stereotypes, including those related to gender identity and/or sexual orientation, as well as discrimination based on an applicant’s associations. This has been given the term associational discrimination.

The CFPB’s interpretation regarding associational discrimination is similarly consistent with the Court’s reasoning in Bostock regarding how discrimination based on the sex, including sexual orientation and/or gender identity, of the persons with whom the individual associates is prohibited under Title VII.

It is relatively easy to fall into the associational discrimination trap. For instance, a creditor engages in such associational discrimination if it requires a person applying for credit who is married to a person of the same sex to provide different documentation of the marriage than a person applying for credit who is married to a person of the opposite sex.

The Bureau’s interpretation is consistent with the principle, applied by Federal agencies for decades, that credit discrimination on a prohibited basis includes discrimination against an applicant because of the protected characteristics of individuals with whom they are affiliated or associated (i.e., spouses, domestic partners, dates, friends, coworkers). Moreover, the Bureau has previously established that a creditor may not discriminate against an applicant because of that person’s personal or business dealings with members of a protected class, because of the protected class of any persons associated with the extension of credit, or because of the protected class of other residents in the neighborhood where the property offered as collateral is located.

Thus, the ECOA and Regulation B prohibition against discrimination on the basis of “sex” includes discrimination or discouragement based on sexual orientation and/or gender identity, including but not limited to discrimination based on actual or perceived nonconformity with sex-based or gender-based stereotypes and discrimination based on an applicant’s associations.

Jonathan Foxx, Ph.D., MBA
Chairman & Managing Director
Lenders Compliance Group

__________________________
[i] Interpretive Rule, Bureau of Consumer Financial Protection, 12 CFR Part 1002, Equal Credit Opportunity (Regulation B); Discrimination on the Bases of Sexual Orientation and Gender Identity, March 9, 2021
[ii] Bostock v. Clayton Cty., Georgia, 140 S. Ct. 1731, 207 L. Ed. 2d 218 (2020)
[iii] 85 FR 46600 (Aug. 3, 2020)
[iv] 12 U.S.C. 5493(c)(2)(A), 5511(b)(2)
[v] See Official Staff Commentary, 12 CFR 1002, supp. I, ¶ 4(a)-1)
[vi] Bostock, 140 S. Ct. at 1734
[vii] 12 CFR 1002, supp. I, ¶ 2(z)–1

Marketing Services Agreement: Playing Favorites

QUESTION
I know you have written about Marketing Services Agreements. One of our takeaways is that you advise not to get into them without the guidance of highly competent compliance professionals.

A competitor of ours could have used your advice because they got into a world of trouble with the state banking department over these agreements. They are licensed in many states, so all the other states jumped on board. It was like a feeding frenzy!

That kept us from getting into Marketing Services Agreements. But now we have a new sales manager who decided that most of our loans come from three real estate firms. He says those firms are really doing the marketing for us. So he wants to reward them by giving them a monthly fee because they are doing the marketing for us. Is it permitted to have such an arrangement?

One other thing. If the Marketing Services Agreement can't be done, the sales manager wants to have a contest for all the real estate firms. The winner gets an all-expense paid vacation. Is this permitted?

ANSWER
I could use a few more details. However, if you were a client and I had all the facts, I would certainly point out a few compliance concerns. Since evaluating an MSA to determine if it would survive regulatory scrutiny is a very complex compliance review, you should contact us HERE to discuss this matter in more detail.

Regulatory agencies have been particularly aggressive in diminishing the viability of Marketing Services Agreement (MSA) relationships. Do not get into MSAs without working closely with expert compliance professionals.

Let’s set the stage by briefly elucidating three Section 8 caveats.

Section 8(a) of the Real Estate Settlement Procedures Act (RESPA) prohibits the transfer of a thing of value pursuant to an understanding that business will be referred to any person. Regulation X, RESPA’s implementing regulation, adds the general rule that “[a]ny referral of a settlement service is not a compensable service.”

 

Section 8(b) prohibits the splitting of any charge made or received for the performance of a settlement service except for services actually performed.

 

Section 8(c) goes on to list a few payments and arrangements not prohibited by Section 8, such as the payment of a bona fide salary or other compensation for goods or facilities actually furnished or services actually performed.

On the face of it, it appears that your sales manager is suggesting an MSA, in which one person agrees to market or promote the services of another and receives compensation in return. In this case, the compensation or “thing of value” being suggested is the monthly fee.

While the suggestion may not seem unusual or peculiar, it suffers from a significant compliance defect from the start. The sales manager is obviously looking for a way to reward two or three real estate firms in your company’s various market areas for their past referrals of business and, presumably, for continued referrals. RESPA § 8 frowns on this kind of reward.

An acceptable, RESPA-compliant MSA would be structured and consistently implemented as an agreement for the performance of actual marketing services, where the payments under the MSA are reasonably related to the value of the services performed.

For example, an MSA might require the real estate firm to decide on and coordinate direct mail campaigns and media advertising for your company. Simply agreeing to make more referrals in the future would be entirely invalid and violate Section 8.

When we review an MSA’s structure, we determine whether a particular activity is a referral or a marketing service based on fact-specific information. Referrals include any oral or written action directed to a person when the action has the effect of affirmatively influencing the selection of a particular provider of settlement services or related business by a person paying a charge attributable to the service or business.

For example, a settlement service provider (such as a real estate agent) directly hands a consumer the contact information of another settlement service provider (such as your company for a potential lender) that happens to result in the consumer using the other settlement service provider.

In contrast, a marketing service is not meant to be directed to a particular consumer, but is instead generally targeted to a wide audience. For example, placing advertisements for a settlement service provider in a newspaper or on a website is a marketing service.

RESPA prohibits MSAs that involve payments for referrals, but may permit MSAs that involve payments for marketing services. Put it this way: the determination of whether an MSA is lawful depends on whether it violates RESPA Section 8(a) or 8(b) or is permitted under Section 8(c).

To be permitted, an MSA must involve marketing services that are actually provided, with payments reasonably related to the provided services' market value only (and not also to the value or perceived value of any referral).

In other words, the value of the referral – that is, any additional business that the referral might provide – cannot be taken into consideration when determining whether the payment has a reasonable relationship to the services provided.

With respect to the contest, the CFPB has recently opined on such arrangements in its Real Estate Settlement Procedures Act FAQs issued in October 2020. The issuance reiterates the same answer as Question 16 in the old HUD Industry FAQs About RESPA and various HUD rulings issued long ago.

The relevant paragraph in the CFPB's 2020 FAQs reads as follows:

"... if a settlement service provider gives current or potential referral sources tickets to attend professional sporting events, trips, restaurant meals, or sponsorship of events (or the opportunity to win any of these items in a drawing or contest) in exchange for referrals as part of an agreement or understanding, such conduct violates RESPA Section 8(a). 12 CFR § 1024.14(b). Such an agreement or understanding need not be written or oral and can be established by a practice, pattern, or course of conduct. 12 CFR § 1024.14(e)." [My emphasis.]

Jonathan Foxx, Ph.D., MBA

Chairman & Managing Director
Lenders Compliance Group

Inaccurate Reporting of Mortgage Interest

QUESTION
We are a servicer with a large portfolio. We specialize in servicing FHA loans. Recently, our internal audit picked up that we did not report interest correctly on a very small percentage of loans.

Obviously, we are rectifying the situation; however, the change is coming too late for some borrowers who have already filed their tax returns.

Our external counsel has taken the position that sending out inaccurate information is a violation of the loan agreement. I don’t want to quibble with them, but I do not see how there is a violation if we have corrected the information quickly.

I told them I would be asking you, and they encouraged me to contact you.

So, does inaccurate information of interest cause a violation of the loan agreement?

ANSWER
There are a few aspects of your question that require some unpacking. And I will defer to your counsel in the legal interpretation of provisions in the loan agreement. I would like to add some context to your question.

Let’s start with the basics: a mortgage lender that receives $600 or more annually in mortgage loan interest payments from a borrower is required to complete IRS Form 1098, Mortgage Interest Statement, under specified circumstances. Specifically, Internal Revenue Code (i.e., 26 U.S.C. § 6050H, or “Section 6050H”) requires a mortgagee to issue a Form 1098 to the payor and the IRS stating the amount of mortgage interest “received” from the borrower during each year. The term “mortgage” refers to any obligation secured by real property.

But mistakes in the accuracy of such information can be made, and these mistakes are not all that unusual.

To discuss a recent matter, let’s look at a situation that wound up in court due to the “mistakes were made” scenario. Reporting of interest received by a lender may seem fairly straightforward. Still, a recent decision in Strugala v. Flagstar Bank by the U.S. Court of Appeals for the 9th Circuit illustrates how a court views this particular mistake regarding the reporting of interest.[i]

In 2007, Strugala obtained a 30-year negative amortization mortgage loan from Flagstar Bank. Strugala chose a “minimum payment” option under which she often paid less than the interest due for the month, in which case the interest was “deferred” and added to principal. According to Strugala, the bank over-reported her interest each year from 2007 through 2011 because the bank included both the actual interest amount she paid and the amount of interest she did not pay that was deferred and added to principal.

Strugala sued the bank, on behalf of herself and other borrowers, asserting breach of contract and other claims based on the bank’s incorrect reporting of both paid and unpaid interest. She alleged that the misreporting prevented her from filing correct tax returns, required her to file amended returns, and caused permanent loss of tax deductions.

Bottom Line: the district court dismissed her claims, and the 9th Circuit affirmed, because the mortgage contract contained no express terms concerning the bank’s mortgage interest reporting practices.

Let’s look a little more closely at why the court decided in favor of Flagstar Bank.

Regarding the breach of contract claim, the courts looked to California's applicable state law, which disfavors implied terms and reads them into contracts only on the grounds of necessity. California requires satisfaction of a 5-part test before accepting implied terms:

(1) the implication either arises from the contract’s express language or is indispensable to effectuating the parties’ intentions; 

(2) it appears that the implied term was so clearly within the parties’ contemplation when they drafted the contract that they did not feel the need to express it; 

(3) legal necessity justifies the implication; 

(4) the implication would have been expressed if the need to do so had been called to the parties' attention; and 

(5) the contract does not already address completely the subject of the implication.

The courts rejected Strugala’s assertion that compliance with the applicable statute was an implied term of the contract (viz., the Note). 

Strugala had argued that ...

“all applicable laws in existence when an agreement is made, which laws the parties are presumed to know and to have had in mind, necessarily enter into the contract and form a part of it, without any stipulation to that effect, as if they were expressly referred to and incorporated.”

The district court quipped:

“It may be that when Strugala entered into agreement with Flagstar Bank for her loan, Section 6050H was in existence and present in her mind. However, the same cannot be said for Flagstar Bank.”

It distinguished the case Strugala cited in support of her position by noting that the decision cited had dealt with the interpretation of a contract that included language pointing to statutes that were part of the contract. The contract had stated “pursuant to the provisions of the [Burns-Porter Act] … and other applicable laws.” In contrast, Strugala’s Note contained no comparable provision and did not mention Section 6050H.

There was an alleged violation of a breach of an implied covenant. This general assumption in the law of contracts is a rather complex area of the law, but, at its essence, an implied covenant is an implied obligation that assumes that the parties to a contract will act in good faith and deal fairly with one another without breaking their word, using deceitful means to avoid obligations, or denying what the other party plainly understood.

Turning to the theory of breach of an implied covenant, Strugala alleged that the bank had a duty to act in good faith with respect to contracts with its borrowers. She alleged that the bank had breached this covenant by: (1) failing to report to the IRS payments of deferred interest it received; (2) depriving borrowers of tax deductions by providing inaccurate Form 1098s; (3) failing to inform borrowers in 2011 that previous Form 1098s were inaccurate; and (4) changing its reporting policies in 2011 without telling its borrowers.

But the courts rejected this theory because the contractual terms of the Note did not imply the alleged duty. The covenant of good faith and fair dealing, implied by law in every contract, exists merely to prevent one contracting party from unfairly frustrating the other party’s rights to receive the benefits of the agreement actually made. The covenant does not impose substantive duties or limits on the parties beyond those incorporated into their agreement's specific terms.

In this case, the Note did not contain any provision regarding how the bank should report mortgage interest, paid or unpaid. The Note also did not contain any provision or any language specifying that the bank had a duty not to conceal and/or fully and unambiguously disclose any changes the bank made regarding mortgage interest reporting.

The Note also did not confer any obligation on the bank to safeguard Strugala’s tax benefits. Those were not benefits under the Note but rather under the exclusive management and authority of the U.S. government and the IRS.

As to the fraud theory, the courts rejected it because the only facts she alleged concerning the bank’s knowledge of falsity was the bank’s changing its mortgage interest reporting practices in 2011. Although this fact was consistent with knowing deception, it was “just as much in line” with a lawful change in business practices.

Finally, regarding misrepresentation, even if the bank reported the wrong amount of interest, it did not conceal that fact. The bank clearly reflected the amount it reported for each year on all copies of IRS Form 1098 sent to Strugala and the IRS. Section 6050H did not require the bank to report any misreporting or change in reporting policy.

So, here’s what I would conclude. The district court noted the obvious – something persons perceiving themselves to be mistreated often tend to overlook – that a borrower herself had obligations, one of which was to use her knowledge of the interest she paid and independently track the status of her mortgage interest.

As a borrower, Strugala had an independent obligation to file her taxes properly. If the bank misreported her interest, she could have raised the issue with the bank or the IRS at any time. It is interesting to note that the district court observed that Strugala actually ignored the amount on Form 1098 when she filed her tax return. The amount she claimed on her tax return was neither the amount provided by the bank nor the alleged amount of interest paid, but a different amount her accountant advised her to report. It doesn’t really moot the matter, but it sure does come close!

The district court observed that another issue was at the heart of the action. That issue was whether Section 6050H was ambiguous and had lacked sufficient guidance as late as 2012. Strugala and the bank differed as to the definition of “received” and “interest” within the meaning of the statute. 

According to the court, it could not be said “based on a plain reading of Section 6050H whether or not the statute’s use of the term ‘interest’ encompasses capital interest.” Interestingly, the court stayed its action for a period of time to allow for guidance from the IRS - which did not arrive. This put into question any attempt to characterize the bank’s behavior as false or misleading.

Strugala included a claim for violations of Section 6050H in her original complaint. The district court dismissed this claim without leave to amend, presumably because Section 6050H does not offer a remedy for the taxpayer to assert, while it authorizes the IRS to impose penalties.

Jonathan Foxx, Ph.D., MBA
Chairman & Managing Director 

Lenders Compliance Group

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[i] Strugala v. Flagstar Bank, FSB, 2020 U.S. App. (9th Cir. Dec. 11, 2020)