New Lending Rules & Due Diligence Should Be at the Top of Your CU To-Do List

Now that the NCUA’s “Financial Innovation” amendments have been posted in the Federal Register, beginning Oct. 30 federal credit unions and state charters, depending on their state laws and regulations, will have more flexibility to engage with third-party lenders in general and with fintechs, in particular. By, among other things, codifying legal opinion letter 15-0813 to clarify indirect lending arrangements, narrowing regulatory limits on the purchase of eligible obligations and trying to simplify the legal distinction between loan participations and eligible obligations, the NCUA has removed much of the confusion in a fundamental area of banking. It should help smaller credit unions purchase more loan participations and give larger ones increased opportunities to purchase loans from third parties.

With this increased flexibility, however, comes increased risks and a concomitant responsibility to ensure that your credit union understands not only the benefits but the risks of its lending relationships and then implements appropriate policies and procedures to address these concerns.

For credit unions that choose to expand their lending and loan purchase activities based on these amendments, expect your due diligence program to be a “point of emphasis” on the part of your examiner.

Shortly before voting to approve these changes, NCUA Chairman Todd Harper stressed that managers and boards of directors choosing to use this new rule must ensure their third-party due diligence and vendor management policies are updated, followed and reflect the size and complexity of the credit union’s activities.

Why am I choosing to highlight due diligence requirements instead of the important changes made by these amendments? After all, the NCUA has been emphasizing the need for appropriate due diligence in lending relationships for decades. Because times have changed, and if your credit union takes on new initiatives based on these regulatory changes, now is the appropriate time to review and update your policies and procedures.

Today, credit unions can work with third-party loan facilitators to an extent that would have been inconceivable little more than a decade ago and these amendments will accelerate this trend. The result is that many credit unions will be buying and selling loans and parts of loans from banks and businesses with whom they have little firsthand knowledge. In addition, the more flexible lending rules are made the more important properly drafted contracts and sensible concentration limits become.

It was not until it issued its 2015 legal opinion that the NCUA authorized credit unions to engage in indirect lending relationships with dealerships in which a dealership would originate loans on behalf of a credit union, as opposed to sending loan applications to the credit union for its approval. As the legal opinion explained, a “narrow reading of the rule generally precludes a FICU from purchasing a participation in a loan from a lead lender that generated the loan through an indirect lending arrangement with a point of sale retailer because the lead lender is technically not the originating lender.” Nevertheless, the NCUA approved of the lending arrangement. It reasoned that so long as the loan was being made based on the credit union’s lending criteria and the loan was assigned “shortly after” it was originated, the retail lender was effectively acting as the credit union’s agent.

Today, there are plenty of companies that specialize in facilitating the purchase and sale of loans and loan participations over the internet. What makes these relationships so unique from a due diligence standpoint is that your credit union may know nothing about the bank or credit union that originally made the loan other than the fact that it works with the same third-party platform as your credit union.

Consequently, the amendments to the NCUA’s eligible obligations regulation include an extensive list of issues to be addressed in credit union policies such as conducting due diligence on the seller of the loans and other counterparties to the transaction prior to the purchase; establishing risk assessment and risk management process requirements that are commensurate with the size, scope, type, complexity and level of risk posed by the planned loan purchase activities; establishing internal underwriting and ongoing monitoring standards; and maintaining appropriate concentration limits by loan type and risk category.

The regulations also emphasize specific steps that must be taken to protect the legal interests of a credit union as it engages in the purchase and sale of eligible obligations. Policies must address “when a legal review of agreements or contracts will be performed to ensure that the legal and business interests of the credit union are protected against undue risk.” The preamble augments this requirement with a discussion of how counsel “should make sure the Board of Directors and management clearly understand the rights and responsibilities of each party.”

But wait, there is more!

Going forward, purchase agreements must include specific provisions such as a provision containing an “explanation of the duties and responsibilities of the seller, servicer and all parties with respect to all aspects of the loans being purchased, including servicing, default, foreclosure, collection and other matters involving the ongoing administration of the loans, if applicable; and the circumstances and conditions under which the parties to the agreement may replace the servicer when the seller retains the servicing rights for the loans being purchased, if applicable.”

There is one more reason not to underestimate the importance of having a robust due diligence framework. Even as he approved these changes, Chairman Harper remains concerned by the lack of oversight the NCUA can exercise over third-party vendors that work with credit unions. By emphasizing due diligence and comprehensive contract language, the NCUA may be able to mitigate some of these concerns.

Henry Meier is the former General Counsel of the New York Credit Union Association, where he authored the popular New York State of Mind blog. He now provides legal advice to credit unions on a broad range of legal, regulatory and legislative issues. He can be reached at (518) 223-5126 or via email at henrymeieresq@outlook.com.