The Consumer Financial Protection Bureau has proposed to use its rulemaking authority to define practices that are "unfair" or "abusive" for certain short-term and "high-cost" loans. Under the Dodd-Frank Act, the CFPB has the authority to promulgate rules that prohibit unfair, deceptive or abusive acts or practices. The CFPB has used similar authority under UDAAP in enforcement orders alleging that certain specific practices are unfair or abusive.
Historically, other federal agencies, including the Federal Trade Commission and the prudential banking agencies, have used their unfairness authority in both rules and enforcement actions. However, the CFPB has proposed a sweeping approach to determining whether a practice is "unfair" in its first UDAAP rulemaking.
The CFPB's proposed rule provides that it is unfair to make a covered loan unless the lender first makes a reasonable determination that the consumer will have the ability to repay the loan. Ability-to-pay determinations are not a new idea. Existing Regulation Z rules, based on statutory provisions, require creditors to consider a consumer's ability to repay credit card accounts and mortgage loans. However, the CFPB's proposal is not based on expressed statutory authority, but rather on the idea that it is unfair or abusive to make a loan without considering a consumer's ability to repay the loan.
The CFPB's proposal does not stop there. It also specifies how the determination must be made and mandates a series of specific requirements. Essentially the CFPB is establishing loan underwriting standards and finding that it is unfair not to follow those standards.
The CFPB is not simply stating that failing to consider a consumer's ability to repay a loan is unfair. Under the bureau's proposal, it would also be unfair if a creditor does not follow the CFPB specified criteria, or rather, fails to determine a borrower's ability to repay in the way the CFPB believes that determination should be made.
This approach goes far beyond the historical and widely-accepted use of the UDAAP provision by federal agencies to identify practices that are unfair. By specifically detailing how lenders must meet this standard, the proposed rule casts aside as unfair many legitimate ways of determining whether a consumer can repay a loan.
Under the proposal, a prospective lender is effectively prohibited from using underwriting standards that may be more cost-effective to implement or more predictive of a consumer's likelihood of repaying the loan (or both). In addition, the standards themselves are vague. While it might be argued that that vagueness provides lenders with flexibility, it also lays a trap for the innovative lender.
For example, to satisfy the ability-to-pay standard under the proposed rule, a lender must determine that a consumer's residual income is sufficient to make the loan payments and meet "basic living expenses." Those expenses are defined as expenditures needed to maintain the consumer's "health, welfare, and ability to produce income" as well as the health and welfare of the consumer's dependents.
In addition, a lender must make a reasonable projection of the consumer's net income and payments for major financial obligations for the term of the loan, in evaluating whether a consumer can meet basic living expenses. Moreover, a lender must "reasonably account for the possibility of volatility in the consumer's residual income and basic living expenses over the term of the loan." While a lender is not required to inquire about medical expenses, if the lender learns about such expenses — and they are significant — the lender must include that fact in the determination.
Mandating detailed underwriting processes that lenders must use as part of an unfairness test goes far beyond accepted and historical approaches to defining a practice as unfair, and seems wholly inconsistent with the very theory of an unfairness determination. Equally if not more important is the fact that such an approach will only serve to eliminate flexibility for lenders in evaluating a consumer's ability to repay a loan, with the likely result that many consumers may no longer be able to get loans for which they truly can repay. Such an approach can only harm the very consumers the CFPB seeks to protect.
Leonard N. Chanin is of counsel at Morrison & Foerster LLP. He was formerly assistant director of the Office of Regulations of the Consumer Financial Protection Bureau. Oliver Ireland is a partner at Morrison & Foerster.