While the phrase “regulatory due diligence” sometimes strikes a mixture of dread and boredom across the legal profession, loan investors, bank partners, companies that utilize consumer-facing vendors, and others in the consumer financial services industry now rely on strong regulatory due diligence programs more than ever before. In recent years, regulators have closely scrutinized how different institutions in the consumer financial services market work with one another, as evidenced by several recent enforcement actions and supervisory highlights. An appropriately tailored regulatory due diligence program can reduce legal, regulatory, and reputation risk. And perhaps most importantly to in-house lawyers, a strong regulatory due diligence program helps mitigate credit risk by minimizing the risk that a partner’s practices may unintentionally result in higher rates of loan default or, for loan investors, claims under applicable law such as the Holder Rule that can diminish prospective returns. As two lawyers with extensive experience conducting regulatory diligence across asset classes, product/service types, company sizes, and geographies, we believe that there are a few key elements to designing a comprehensive regulatory diligence program that facilitates strong partnerships while protecting against regulatory and credit risk.
Asset-Class and Product or Service Structure
In addition to legal and regulatory expectations, two key determinations in scoping a regulatory diligence are (1) in what asset class(es) a prospective partner operates, and (2) what products or services a prospective partner offers.
Legal risk, reputational risk, regulatory issues, risk tolerance, and actual practices vary significantly across asset classes. Some asset classes present structural risk. For example, home improvement financing often involves a merchant or dealer engaged in consumer-facing activities including solicitation and application taking, such that the finance company may not have full oversight of the merchant or dealer’s conduct and representations made to the consumer. This can present risk under the Federal Trade Commission's (“FTC”) Holder Rule, which can subject a subsequent purchaser, i.e., the finance company or loan purchaser, to claims and defenses that a borrower could assert against the seller of the goods or services, i.e., the merchant or dealer. Solar financing, a growing area within the home improvement industry, can present additional risk under the Holder Rule given complex tax incentives and the potentially speculative nature of energy saving estimates, which may result in merchants or dealers engaging in high-pressure sales tactics and/or consumer misunderstanding over the value proposition of the solar equipment. Such dealer-related risks are not present for entities that solely extend unsecured personal loans.
On the other hand, certain asset classes are subject to more regulatory attention or changes in the underlying regulatory framework than others. Automobile financing has been the recent target of regulatory scrutiny, as the FTC issued a proposed Motor Vehicle Dealers Trade Regulation Rule that would impose additional disclosure requirements about vehicle cost and add-on products and services, as well as prohibitions against specific misrepresentations in automobile sales. Student loan servicers face a myriad of new state licensing and practice requirements that have only been imposed in recent years. Such new requirements present operational challenges for companies operating in these asset classes to stay abreast of and compliant with relevant law.
Meanwhile, the products and services offered by potential partners impact both the level of risk associated with those partners’ activities and the compliance considerations associated with them. For instance, collections activity can be associated with substantial reputational risk, so companies evaluating prospective collection agencies usually are mindful of these considerations and may decide to review not only a company’s compliance program, but also its communications with borrowers and collections practices. On the other hand, companies that merely provide lead generation services have historically been subject to less regulatory scrutiny and reputational risk, depending on their business model, though recently the CFPB has contemplated additional regulation for digital marketers who engage in certain activities for consumer financial services companies.
In general, the more public- or consumer-facing a company is, the more reputational risk and regulatory scrutiny it attracts. Publicity can be due to factors like media reports, litigation or regulatory enforcement, political agendas, or even the nature of company leadership. It is often prudent to consider how the publicity a prospective partner has generated may impact how regulators or a court would view the company and what compliance concerns are likely to be especially significant for such companies.
The structure of a transaction impacts risk tolerance as well as relevant regulatory considerations. An equity investment that involves change in ownership or control, which state law may define as a change of 10% or more, may require either regulatory preapproval or post-transaction notification filing depending on the licenses that the target holds. Meanwhile, forward flows in which loans are being purchased by an investor may involve higher levels of risk than warehouse lines where loans purchased by the warehouse borrower are simply pledged to the warehouse lender. While a default may result in foreclosure of the collateral for warehouse lines, a loan purchaser may also be subject to claims related to the underlying loans.
All entities conducting regulatory diligence have different levels of risk tolerance. Companies that are extremely risk averse will want to do deeper diligence than companies that are willing to take on more risk. Similarly, companies that are extremely risk averse may avoid entire asset classes or categories of service providers, require considerable research before entering new asset classes, or exclude investments in certain jurisdictions with known aggressive regulators. They also generally prefer to perform due diligence in-house or engage outside counsel as opposed to or in concert with using other service providers or relying on general market willingness to work with a particular company.