by Kenneth J. Benton, Consumer Regulations Specialist
This is the second article in a two-part series addressing a bank’s potential
liability for violating the Truth in Lending Act (TILA) or Regulation Z, TILA’s
implementing regulation. The first installment, which appeared in the fourth
quarter 2006 issue of Compliance Corner, examined a bank’s potential
damages to its customers in a private lawsuit for violations of TILA or
Regulation Z. This article reviews the circumstances in which a bank’s regulator
will order reimbursement to the bank’s customers because of TILA violations.
The federal banking agencies—the Board of Governors of the Federal Reserve
System (Board), the Federal Deposit Insurance Corporation (FDIC), the Office of
the Comptroller of the Currency (OCC), the Office of Thrift Supervision, the
National Credit Union Administration, and the Farm Credit Administration
(collectively the agencies)—periodically examine the banks they supervise to
verify compliance with applicable federal consumer laws. Regulation Z is one of
the laws for which they verify compliance, and section 108 of TILA (See 1)
provides the framework for the agencies’ enforcement authority and the protocol
they follow when determining whether a violation warrants reimbursement to the
customer. Section 108 specifies that each agency must examine the financial
institutions they supervise for compliance with TILA and Regulation Z, while
authorizing the Federal Trade Commission (FTC) to enforce it for all other
creditors. (See 2)
It also specifies the circumstances under which the agencies must order the
banks they supervise to reimburse their customers for TILA violations.
Violations Triggering Reimbursement: Understated APR or Finance Charge
To implement section 108’s requirements, the agencies published a
“Joint Statement of Policy on the Administrative Enforcement of the Truth in
Lending Act—Restitution” in 1980. It identifies the procedures the agencies
follow for reimbursement and the type of violations that will trigger
reimbursement. Because of subsequent amendments to TILA, the agencies revised
the guidance (the revised policy statement) in 1998, which is the latest
statement from the agencies on this issue. (see 3)
As section 108 requires, the revised policy statement states that the only TILA
violations subject to reimbursement are an understated annual percentage rate
(APR) or an understated finance charge. An understated APR or finance charge
occurs when a creditor discloses an APR or finance charge in the TILA disclosure
statement that is less than the actual APR or finance charge for the
transaction. (See 4)
For example, an APR is disclosed as 10 percent when it is actually 15 percent.
Or a finance charge is disclosed as $10,000 when it is actually $13,000. The
obvious harm here is that the customer is being charged an interest rate or
finance charge that is higher than what the creditor disclosed. (See 5)
An understated APR or finance charge will always require restitution to the
customer if it falls into one of three categories of behavior: 1) a clear and
consistent pattern or practice of violations, 2) gross negligence, or 3) a
willful violation that was intended to mislead the person to whom the credit was
extended. If none of these circumstances are present, the agencies still have
the authority to order reimbursement for isolated violations of an understated
APR or finance charge, but they are not required to do so.
Tolerances for Errors
Regulation Z contains tolerances for both open- and closed-end credit
transactions that must be considered when determining whether an understated APR
or finance charge requires restitution. A tolerance provides a small,
permissible margin of error for disclosures within which the APR and finance
charge are still considered accurate. For open-end transactions, the tolerance
for the APR is one-eighth of a percent. (See 6)
For example, if the actual APR on a home equity line of credit is 10 percent,
the creditor is not in violation for an understated APR if the disclosed APR is
between 9.875 percent and 10 percent. For closed-end credit, the tolerance
varies depending on whether the loan’s amortization is less than 10 years or
more than 10 years. If it is less than 10 years, an APR is accurate if it is
within one-quarter of a percent. For loans with repayment greater than 10 years,
the tolerance is either one-eighth of a percent for regular loans (in which the
amount of the payment always remains the same) or one-quarter of a percent for
irregular loans (in which the amount of the payment varies).
To determine the finance charge tolerance, section 108(e)(1) of TILA and the
revised policy statement instruct regulators to convert the applicable APR
tolerance for the credit transaction into a dollar equivalent for the finance
charge. For example, if the amount financed on an open-end loan were $100,000,
the applicable APR tolerance of one-eighth would convert to a finance charge
tolerance of $125. Note, however, that the tolerances do not apply to violations
that are willful and intended to deceive.
A special tolerance rule applies for closed-end credit secured by real estate or
a dwelling: even if the understated APR exceeds the applicable tolerance for
regular and irregular loans, the APR will be considered accurate if: (1) the
finance charge is not understated by more than $100 on loans made on or after
September 30, 1995, or $200 for loans made before that date, and (2) the APR is
not understated by more than the dollar equivalent of the finance charge error,
and the understated APR resulted from the understated finance charge
that is still considered accurate.
The revised policy statement provides an example to help clarify the application
of the tolerance: “consider a single-payment loan with a one-year maturity that
is subject to a one-quarter of one percent APR tolerance. If the amount financed
is $5,000 and the finance charge is $912.50, the actual APR will be 18.25
percent. The finance charge generated by an APR of 18 percent (applying the
one-quarter of one percent APR tolerance to 18.25 percent) for that loan would
be $900. The difference between $912.50 and $900 produces a numerical finance
charge tolerance of $12.50. If the disclosed finance charge is not understated
by more than $12.50, reimbursement would not be ordered.”
Calculating Restitution
After a banking agency determines that a bank has made a TILA error subject to
restitution, the next question is how to calculate the amount the bank must pay.
Section 108 specifies that consumers are not obligated to pay amounts in excess
of the disclosed APR or finance charge. However, when calculating restitution,
the agencies always add the tolerance to the APR the creditor disclosed. For
example, if the creditor disclosed the APR on an irregular mortgage transaction
as 10 percent, when the actual APR was 14 percent, the regulator would treat the
disclosed APR as 10.25 percent because of the tolerance. This reduces the amount
of the reimbursement the creditor will have to pay by the amount of the
tolerance.
Restitution can be very expensive when the number of violations is significant.
For example, Providian National Bank entered into a $300 million settlement with
the OCC and the San Francisco District Attorney’s Office in 2000 concerning,
among other deceptive practices, its Regulation Z violation for failing to treat
the processing fee for credit card applications as a finance charge since it
only charged that fee to customers approved for credit. This resulted in an
understated finance charge and APR. And in 2004,
the Board ordered Citigroup to pay a civil money penalty of $70 million for
violating Regulation B and the predatory lending restrictions of Regulation Z by
making loans without regard to the borrower’s ability to repay them. (See 7)
Failing to disclose the APR or finance charge. The revised
policy statement also addresses the situation in which the creditor fails to
disclose the APR or finance charge. If the APR is not disclosed, the interest
rate specified in the promissory note is treated as the APR. If the note does
not specify a rate, consumers do not have to pay an amount greater than the
actual APR reduced by one-quarter of one percent for first lien mortgage
transactions. For all other loans, the rate is reduced by one percent of the
actual rate. If the creditor fails to disclose the finance charge, no adjustment
is awarded.
Obvious errors. If an APR is disclosed correctly, but the
disclosed finance charge is understated, or if the finance charge is disclosed
correctly, but the disclosed APR is understated, the agencies will not require
adjustment if the error involved a disclosed value that is 10 percent or less of
what should have been disclosed.
Methods of adjusting consumer accounts. When a creditor must
reimburse a customer, the revised policy statement allows creditors to select
one of two methods for calculating the adjustment: the lump sum method or the
lump sum/payment reduction method. Under the lump sum method, the creditor makes
a cash payment equal to the total adjustment ordered by the regulator. Under the
lump sum/payment reduction method, the total adjustment to the consumer is made
in two stages: 1) a cash payment that fully adjusts the consumer's account up to
the time of the cash payment and 2) a reduction of the remaining payment amounts
on the loan.
Period subject to reimbursement. Another important issue for
creditors facing restitution is the backward time period during which violations
are subject to reimbursement. This is known as the “corrective action period”
(CAP). Under the Joint Statement, the CAP for open-end credit transactions is
the last two years preceding the current examination. For closed-end credit
transactions, the CAP applies to transactions containing the violation that were
consummated since the date of the immediately-preceding examination. (See 8)
However, if the closed-end violation was willful and intended to mislead the
consumer, adjustments must be made to all affected consumer transactions since
July 1, 1969—TILA’s effective date.
In addition, if an understated APR or finance charge arises out of a practice
that was identified during the prior examination and was not corrected by the
date of the current examination, loans consummated since the bank received
written notice of the violation are subject to reimbursement. For loans that
have terminated and have not been previously identified as having an understated
APR or finance charge, reimbursement is not required if the loan consummated
more than two years prior to the current examination.
Agency discretion to not award restitution. Section 108
authorizes the agencies to waive restitution, even though a violation occurred,
if they determine that the disclosure error resulted from unique circumstances
that involve a clearly technical and non-substantive disclosure violation that
did not affect the information disclosed to the consumer or otherwise mislead
the consumer. Statistics from the FDIC suggest that banks are unlikely to obtain
a waiver under this provision. In 1997, the FDIC reported that it had received
63 requests for a waiver between 1991 and 1996, only one of which was approved.
In that instance, the FDIC determined that Regulation Z was not, in fact,
violated. (See 9)
Safety and soundness exception. The agencies also have some
discretion with reimbursement if requiring an immediate adjustment would
adversely affect the safety and soundness of the creditor. In this situation,
the agency can order partial adjustment or full adjustment over an extended
period of time.
Other Restitution Issues
Following are other issues creditors should be aware of in order to avoid
restitution.
Inaccurate credit insurance disclosures. The TILA disclosures
that must be used when a credit transaction includes credit insurance have
always been problematic for creditors. Section 226.4(a)(7) of Regulation Z
requires that charges for credit life, accident, health, or loss-of-income
insurance that are written in connection with a credit transaction are
considered a finance charge unless the creditor complies with the three
requirements of section 226.4(a)(7): 1) the creditor discloses that the
insurance is optional, 2) the premium is disclosed, and 3) the customer signs or
initials a written request to receive it. If a creditor fails to comply with all
three requirements, but nonetheless excludes the premiums for credit insurance
from the calculation of the finance charges, its TILA disclosures will
understate the APR and finance charge. If either the understated APR or finance
charge exceeds the tolerance, the creditor will be ordered to reimburse the
customer for the amount of the violation exceeding the tolerance, and the credit
insurance will remain in effect for the remainder of its term. This violation
has resulted in large penalties from regulators or court settlements in private
class actions. For example, in 1997, the FTC ordered the Money Tree to pay up to
$1.2 million in restitution because it failed to disclose that credit insurance
was optional and therefore should have treated the insurance premiums as a
finance charge.
Liability of assignee of a creditor. If a creditor voluntarily
assigns a credit transaction to another creditor, and a Regulation Z violation
is apparent on the face of the Truth in Lending disclosure statement, the
assignee is subject to regulatory penalties. But if the assignment is
involuntary, the assignee is not subject to regulatory action.
Conclusion
The revised policy statement provides a roadmap for creditors so they can
calculate how much their regulator will order them to reimburse customers for
TILA violations involving an understated APR or finance charge. The potential
for a large damage award when many customers are affected by a violation is a
reminder of the importance of banks maintaining a stringent compliance program
and a system of internal and external controls to verify that the program is
working properly.
The views expressed in this article are those of the author and are not necessarily those of this Reserve Bank or the Federal Reserve System.