Addressing ECOA Risk in Marketplace Lending

August 25, 2016

By Lawrence D. Kaplan, Gerald Sachs & Kristin S. Teager*

As marketplace lending continues to be a growing segment of the financial service industry, participants are under a greater impetus to be fully aware of their compliance obligations in the face of growing regulatory attention. The marketplace lending industry, which has doubled in size roughly every nine months,[1] has been subject to recent cautionary guidance issued by many federal regulators, including the U.S. Department of the Treasury through its white paper entitled Opportunities and Challenges in Online Marketplace Lending,[2] the Federal Deposit Insurance Corporation (the “FDIC”) in recent proposed guidelines on third-party lending,[3] the Office of the Comptroller of Currency (the “OCC”) in its white paper on responsible innovation,[4] the Federal Trade Commission during its conference series on FinTech,[5] and the Consumer Financial Protection Bureau (the “CFPB”) through its recent announcement that it is now accepting consumer complaints related to marketplace lending[6] (collectively “the Agencies”). While the Agencies have generally acknowledged the potential benefits that marketplace lending could yield for consumers, those benefits are accompanied with a corresponding risk, particularly as related to fair lending and compliance with the Equal Credit Opportunity Act and its implementing regulation, Regulation B (collectively “ECOA”).

Marketplace loans are frequently marketed by nonbank financial technology companies in contractual relationships with banks. These FinTech firms leverage technological innovations that allow their bank counterparties access to a wider group of potential borrowers, facilitate credit determinations based on a more diverse set of criteria, provide borrowers with both a faster and less burdensome application process, and capitalize on the cost savings of forgoing a physical brick and mortar structure. As the recent U.S. Treasury white paper on marketplace lending noted,[7] while this technology may yield significant benefits in terms of facilitating credit for underserved markets, providing lower rates to consumers and small businesses, and allowing for faster credit determinations and greater convenience, such activities could also result in unintentional discriminatory treatment and must be monitored to ensure compliance with fair lending laws, including ECOA.

ECOA generally prohibits any lender from discriminating against any credit applicant on the basis of race, color, religion, national origin, sex, marital status, age, or because the applicant receives income from a public assistance program (discrimination on a “prohibited basis”). Lenders are prohibited both from engaging in disparate treatment of applicants, which occurs if a lender directly or overtly discriminates on a prohibited basis, and, more challengingly, lenders are prohibited from acting in a way that causes a disparate impact.[8] A lender may unknowingly cause a disparate impact if it engages in a facially neutral practice, but that practice has an adverse impact on members of a protected class and the lender is unable to demonstrate that the practice is justified by a legitimate business need and cannot reasonably be achieved by other less discriminatory means. What constitutes a “legitimate business need” is subject to sparse public regulatory guidance.[9] Similarly, guidance surrounding when a “legitimate business need” may reasonably be achieved by means that are “less disparate in their impact” is even more limited.

While ECOA poses compliance risks for all lenders, marketplace lenders face particularized risks based on a business model that relies upon the rapid use of technology instead of personal interaction with customers, the use of non-traditional credit scoring models, flexible loan pricing that could be based on investor “loan auctioning,” and targeted advertising to borrowers not already served by traditional bank lending. While lenders may be able to steer clear of disparate treatment or overt and explicit discrimination against protected groups, the risk of a disparate impact is significantly more challenging to avoid, and thus requires marketplace lenders to develop and implement a robust compliance and monitoring program to ensure compliance. Such compliance programs will be subject to regulatory review, as addressed by the FDIC’s recent proposed guidelines on third-party lending, which provides that banks that partner with third-party lenders “will receive increased supervisory attention,” and must ensure their own compliance programs are calibrated to address the fair lending risks that may arise through their marketplace lending partnerships.[10]

Accordingly, compliance and monitoring programs of marketplace lenders must address the unique risks faced by marketplace lenders, particularly with respect to their underwriting and marketing practices, as well as how they list or fund loans.

Underwriting:

Marketplace lenders often embrace non-traditional scoring models which can be a better predictor of creditworthiness than credit scores used by banks. While the use of non-traditional models can allow a lender to fairly easily avoid issues of disparate treatment, given the lack of regulatory guidance, even neutral credit factors could be subject to challenge under ECOA if such factors could result in a disparate impact to disadvantaged groups. At a minimum lenders must be able to document and justify their models, including the factors considered, the weight applied to those factors, and the credit cutoff determination, in order to demonstrate the empirical backing and legitimate business need of their specific model.

More nuanced underwriting models could benefit borrowers, as the updated models capture individuals who are more creditworthy than their traditional credit score may indicate, and thus provide these borrowers with needed access to credit. However, in searching for more accurate models marketplace lenders face a risk of incorporating proxy factors that could result in an ECOA violation. A study by the Board of Governors of the Federal Reserve found, for example, that married individuals may be more creditworthy than their credit scores indicate,[11] however, if in attempting to craft a more accurate model a lender screened applicants using a good proxy for marriage, such as joint ownership of property, that practice could violate the ECOA prohibition on consideration of marital status in credit determinations. It may not be immediately apparent that a facially neutral factor is either a prohibited proxy, or causes a disparate impact. Marketplace lenders must engage in vigilant empirical analysis of their credit scoring models to maintain ECOA compliance.

Marketing:

While traditional lenders tend to focus on their preexisting customers or customers within their geographic area, marketplace lenders’ business model tends to require finding creditworthy borrowers who are underserved by traditional lenders regardless of their geographic location. As such, marketplace lenders typically engage in more targeted advertising, and may focus to a greater extent on online and social media advertising channels. As such, marketplace lenders’ marketing and advertising practices could face greater scrutiny under ECOA, which prohibits a creditor from making an oral or written representation that would discourage, on a prohibited basis, a reasonable person from making or pursing a credit application. Marketplace lenders must carefully monitor their marketing tactics to ensure that by virtue of where they are directing their advertisements, or how their marketing materials are designed, they are not indicating that their products are only offered to certain classes of borrowers. Careful consideration of ECOA requirements, balanced against efficient advertising, will be necessary to mitigate the regulatory risk.

Listing and Funding:

Unlike a traditional loan securitization model whereby a lender originates a loan with a goal to sell it, some marketplace lending involves investors agreeing to purchase a loan before it is originated, subject to terms and conditions agreed to in advance by the investors frequently through a type of auction process. This process subjects marketplace lenders to a greater degree of risk of causing a disparate impact as the effect of investors agreeing only to purchase certain types of loans could result in unmet needs by borrowers not satisfying the investors’ criteria. As such, marketplace lenders should carefully consider the design of their lending platform and balance the desire of investors to have as much information about the borrower as possible, with the borrower’s rights to non-discriminatory treatment by an entity setting the terms of credit.

As marketplace lenders have developed in size and sophistication, some lenders have already elected to modify the original structure of their platform in order to limit the types of information about borrowers that investors will have access to before agreeing to purchase a loan. For example, restricted data points could include photographs, hometown, full zip code, or unverified personal statements, as this information often allows lenders to either determine or infer a borrower’s race, age, or gender.[12] In many cases when investors were able to determine borrower demographics, minority borrowers were treated less favorably on a platform, and often provided with less favorable lending terms compared to similarly situated white borrowers. Investors, unlike lenders, are not subject to ECOA; however lenders could still be held liable if their platforms are designed in such a way that results in discriminatory treatment.

Action Items:

Marketplace lenders must consider ECOA obligations in connection with their operations by:

Engaging in robust testing of the credit model used during the underwriting process to analyze any potential disparate impact;
Reviewing any manual processes associated with the underwriting process and any data used or available to individuals during the manual process;
Reviewing data disclosed to loan investors and evaluating if certain borrowers are subject to inferior loan terms by investors on a prohibited basis;
Evaluating any unusual statistics distribution across borrowers of loan terms and developing a justification for such irregularity; and
Reviewing marketing materials and practices to evaluate how borrowers are being targeted.

*Research for this StayCurrent was contributed to by Wei Liu, Summer Associate, Columbia Law School (J.D. Expected 2017).

[1] From the People, For the People, The Economist, May 8, 2015.

[2] U.S. Department of Treasury, White Paper Opportunities and Challenges in Online Marketplace Lending, May 10, 2016, https://www.treasury.gov/connect/blog/Documents/Opportunities_and_Challenges_in_Online_Marketplace_Lending_white_paper.pdf.

[3] See FDIC, FDIC Seeking Comments on Proposed Guidance for Third-Party Lending, FIL-50-2016, July 29, 2016, https://www.fdic.gov/news/news/financial/2016/fil16050b.pdf.

[4] OCC White Paper, Supporting Responsible Innovation in the Federal Banking System: An OCC Perspective, Mar. 2016, http://www.occ.treas.gov/publications/publications-by-type/other-publications-reports/pub-responsible-innovation-banking-system-occ-perspective.pdf.

[5] Federal Trade Commission, FinTech Series: Marketplace Lending, https://www.ftc.gov/news-events/events-calendar/2016/06/fintech-series-marketplace-lending.

[6] The CFPB, which was provided authority over Equal Credit Opportunity Act pursuant to the Dodd-Frank Wall Street Reform and Consumer Protection Act, announced it was accepting consumer complaints related to marketplace lending in March, 2016. See CFPB Press Release, CFPB Now Accepting Complaints on Consumer Loans from Online Marketplace Lender, Mar. 7, 2016, http://www.consumerfinance.gov/about-us/newsroom/cfpb-now-accepting-complaints-on-consumer-loans-from-online-marketplace-lender/. The CFPB also announced in its Fair Lending report that it will focus on fair lending to small businesses. See Fair Lending Report of the Consumer Financial Protection Bureau, Apr. 2016, http://files.consumerfinance.gov/f/documents/201604_cfpb_Fair_Lending_Report_Final.pdf.

[7] Id.

[8] 12 C.F.R. §§ 1002.4(a), 1002.6(a).

[9] The CFPB notes that “[t]here is very little authoritative legal interpretation of [when a disparate impact may be justified by “business necessity”] with regard to lending.” See CFPB Supervision and Examination Manual v. 2 at Procedures 28, Oct. 2012. Similarly, the fair lending guidance published by the Federal Financial Institutions Examination Council does provide any examples of business necessity to justify a practice that has a disparate impact. Interagency Fair Lending Examination Procedures at iv, FFIEC, August 2009. Furthermore, FDIC guidance provides one such example, but that no business necessity existed. FDIC Policy Statement on Discrimination in Lending, FDIC 5000-3860 Apr. 15, 1994.

[10] FDIC, FDIC Seeking Comments on Proposed Guidance for Third-Party Lending, FIL-50-2016, July 29, 2016, https://www.fdic.gov/news/news/financial/2016/fil16050b.pdf.

[11] Report to Congress on Credit Scoring and Its Effects on the Availability and Affordability of Credit, The Federal Reserve Board, Aug. 2007, http://www.federalreserve.gov/boarddocs/rptcongress/creditscore/default.htm.

[12] Kadhim Shubber, FT Alphaville, Lenders Can’t Discriminate, but What About Investors?, Jan. 13, 2016, http://ftalphaville.ft.com/2016/01/13/2150093/lenders-cant-discriminate-but-what-about-investors/.

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