On January 15, 2010, the Federal Reserve Board (“FRB”) and the Federal Trade Commission (“FTC”) published the final rules implementing the risk-based pricing provisions of the Fair and Accurate Credit Transactions Act of 2003 (FACTA). FACTA added a new provision to the Fair Credit Reporting Act (FCRA) that requires creditors to provide risk-based pricing notices in certain circumstances. The notice is intended to alert consumers to the fact that their credit report may contain adverse information, and provides them both their credit score and the opportunity to obtain a free copy of their consumer report from the consumer reporting agency that provided the credit score to the creditor. Theoretically, the notice will increase accuracy of consumer reports because consumers who receive a risk-based pricing notice will check their credit reports and correct any inaccurate information. Practically, the notice adds yet another regulatory compliance requirement to the growing list of new laws with which creditors must comply.
In a nutshell, creditors must provide a risk-based pricing notice when, based on information in a consumer report, the creditor offers credit to the consumer on terms that are less favorable than the best credit terms the creditor offers to most other consumers. Specifically, the rule says that a person must provide a consumer with a risk-based pricing notice if the person “uses a consumer report in connection with an application for, or a grant, extension, or other provision of, credit to that consumer that is primarily for personal, family, or household purposes,” and “based in whole or in part on the consumer report, grants, extends, or otherwise provides credit to that consumer on material terms that are materially less favorable than the most favorable material terms available to a substantial proportion of consumers from or through that person.” Go ahead and read that sentence again – it epitomizes the complexity and compliance challenges the rule presents.
The rule contemplates a case-by-case analysis of whether a particular consumer has received materially less favorable terms than the best terms available to most of the creditor’s other consumer customers. This undoubtedly requires sophisticated systems and significant programming time to implement and maintain appropriately. Recognizing this, the rule provides for two alternate methods to determine whether the notice is required.
The first alternative is the credit score proxy method under which the creditor can determine the cutoff credit score at which approximately 40 percent of its consumers have higher credit scores and below which approximately 60 percent of its consumers have lower credit scores. The creditor would then provide a risk-based pricing notice to all consumers who are granted credit who have a credit score lower than the cutoff. Creditors will need to update their cutoff every two years by looking back at their consumer’s scores over the immediately preceding two years.
The second alternative is the tiered pricing method. Creditors who use consumer reports to assign consumers to one of several pricing tiers must provide the notice to consumers who receive credit offers at rates not in the top pricing tier or tiers. While this method may be more appealing, it will still require significant systems alterations to implement and maintain as tiers tend to change fairly often.
Despite the alternative compliance methods offered by the rule, its broad application to the universe of creditors dictates that many creditors simply lack the operational sophistication to accurately determine which customers should get a risk-based pricing notice. Even those with the ability to comply with the rule will find it difficult to develop operational rules to ensure compliance over the long term, and the costs of doing so is likely to be quite expensive.
These practical realities were recognized by the FRB and FTC in drafting the final rule, although there was early disagreement between the two agencies. The FRB favored a more generic notice that could be given to all credit applicants and the FTC favored a more customer-specific notice. The compromise they reached is the exception to the risk-based pricing notice requirement, i.e., the credit score disclosure exception.
The credit score disclosure exception permits the creditor to avoid the more complex risk-based pricing analysis if the creditor provides every consumer who applies for credit with their credit score and certain additional information about the credit score, including how it compares to other consumers’ credit scores. All of the information required on this form is available from the consumer reporting agencies, which will likely develop cost effective products to offer creditors who want to use the exception. Practically speaking, the exception notice should be far preferred by the consumer reporting agencies as they do not require the agencies to provide the free consumer reports mandated in the risk-based pricing notice.
Finally, the risk-based pricing rule applies to all creditors who offer or extend consumer credit with pricing based on information in a consumer report. For some small consumer finance lenders, the rule presents a unique challenge. These lenders offer products with annual percentage rates that are fixed depending on the amount borrowed. For example, on a $500 loan product, the APR is always 30%. On a $1,500 loan product, the APR is always 20%. There is no discretion to offer a consumer a higher or lower APR based on their credit report. Given these fixed credit terms, it seems that the creditor is not engaged in risk-based pricing. However, because the creditor has discretion to offer the consumer the higher dollar amount loan, the risk-based pricing rule may apply. Fortunately, these creditors and all others can avoid the complex material terms analysis and opt for compliance and operational ease by implementing the credit score disclosure exception.
Meghan S. Musselman is an associate in the Maryland office of Hudson Cook, LLP. Basis Points readers can reach Meghan at 410-865-5403 or by email at mmusselman@hudco.com.
Michael A. Benoit is a partner in the Washington, D.C., office of Hudson Cook, LLP. Basis Points readers can reach Michael at 202-327-9705 or by email at mbenoit@hudco.com.