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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 TILA1 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.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.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.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.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.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."
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.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.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.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.
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.