The Structure of a Subprime Transaction
By Keith E. Whann
The Fair Credit Reporting Act regulates the use of credit reports in an effort to protect a consumer's privacy. All users of a credit report must have a permissible purpose under the Fair Credit Reporting Act in order to obtain a credit report. While there are a number of permissible purposes listed under the act, generally speaking, there are three which are applicable in a motor vehicle transaction. The first permissible purpose is whenever the consumer gives permission in writing. The second is whenever the extension of credit is as a result of an application for credit from a consumer. The third and more complicated permissible purpose is when there is a legitimate business need in connection with a business transaction that is initiated by the consumer.
Recently, in a large metropolitan new car dealership during a dealership legal and regulatory compliance review the topic of subprime lending was being discussed with the dealership’s management team. One of the F&I managers told a story about how he got a customer financed who “should not have been able to buy a bicycle”. He proceeded to discuss the new subprime lending source the dealership was using from which he was able to obtain the financing. The manager also stated that, if it had been up to him, he never would have financed the customer. You can imagine the look on his face when he was informed he had, in fact, just financed that debtor.
In a motor vehicle transaction which is financed through traditional means, the lender will have the dealership sign a dealer agreement which authorizes the dealership to offer financing to retail customers on behalf of the lender. When the dealership sells a vehicle to a customer, it enters into a retail buyer’s order (sales contract) with the customer. The dealership also completes a finance agreement between the customer and the lender to provide financing for the transaction. Note that the finance agreement is two-party paper. That is, it is an agreement between the finance company and its customer.
In a motor vehicle transaction which is financed through subprime means, the dealer agreement is still between the lender and the dealership and the retail buyer’s order is still an agreement between the dealership and the customer, but the financing relationship can be very different. The dealership often executes a retail installment sales agreement which creates a contractual relationship between the dealership and the customer. The retail installment sales agreement is then either sold or assigned to the lender. This arrangement is referred to as “three-party” paper. Until such time as the installment sales contract is sold or assigned, however, the dealership is financing the transaction.
With respect to the subprime transaction which involves “three-party” paper, it is critical for the dealership to recognize that it has a direct contractual relationship with the customer and that a transaction structured in this fashion can and will create additional, and in many cases unfamiliar, liabilities for the dealership. For example, under most state unfair and deceptive acts and practices statutes (UDAP) transactions between lenders and their customers are exempt, while transactions between motor vehicle dealerships and their customers are covered. This can present some special problems for dealerships if they are utilizing forms provided by third parties who are not familiar with state consumer protection laws and have not revised their forms to comply with these state requirements. Unfortunately for dealers, in some cases subprime lenders have attempted to shift the responsibility for forms legal compliance along with the liability for noncompliance to the dealership. The lender will typically cover this and other similar issues in its dealer agreement. As a result, it is very important for the dealer to carefully review a subprime lender’s dealer agreement prior to conducting business with the lender.
In addition to the consumer’s and/or lender’s ability to enforce legal and contractual obligations against the dealership, in many instances there may be an additional party to contend with. Remember, in subprime financing defaults are to be expected. In cases where a consumer or lender has filed bankruptcy, a bankruptcy trustee will enforce any claim the party may have against the dealership. Claims can include everything from the trustee attempting to invalidate a lien or set aside the transaction to applying the cram-down provision of the bankruptcy code. |
