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Debt Cancellation Contracts and Debt Suspension Agreements

Outline

Background

Debt cancellation contracts (DCCs) and debt suspension agreements (DSAs) are banking products that substitute for credit insurance. A DCC or DSA relates to a loan or line of credit (in this article the term "loan" is used to refer to both closed end and open end credit). A DCC provides that part or all of the borrower's obligation on the loan will be canceled upon some triggering event. For example, a DCC may provide that if the borrower dies, the loan is canceled so that the loan does not have to be paid out of the borrower's estate.

A debt suspension agreement (DSA) provides that the borrower's repayment obligation on the loan will be suspended upon the occurrence of some triggering condition and will remain suspended so long as that condition continues. For example, payments may be suspended so long as the borrower is disabled or unemployed.

The borrower usually pays the lender a fee for a DCC or DSA.

National banks, federal thrifts, and federal credit unions are authorized to enter into DCCs. National banks and federal credit unions are authorized to enter into DSAs. Depending upon the jurisdiction, some state chartered entities may also be authorized to enter into DCCs and DSAs.

Not Credit Insurance

To a borrower, a DCC may seem similar to credit insurance. But there is no insurance company involved so the lender can keep the entire fee. The Office of the Comptroller of the Currency (OCC), the Office of Thrift Supervision and the National Credit Union Administration have determined that national banks, federal thrifts and federal credit unions can sell DCCs (and, in the case of national banks and federal credit unions, DSAs) without being subject to state insurance laws. The DCC/DSA must be offered by the lender making the loan, not by an affiliate of the lender.

Credit Insurance vs. DCCs/DSAs

Here are some advantages of debt cancellation/debt suspension over credit insurance for a national bank:

• No licensing is required.
• The financial institution is not subject to state insurance regulation.
• A broader array of coverages may be available (e.g., coverage for a Family Medical Leave).
• The product can be the same in all states.
• The financial institution does not share the premium with the insurance company.

Here are some disadvantages, or offsetting considerations:

• Need to determine how to price the coverage to cover claims.
• Risk of unexpectedly high claims experience.
• Cancellation of the debt may be taxable to the customers or their heirs, and may impose a reporting requirement on the bank. But see IRS Private Letter Ruling 200131027, 8/3/2001, to the effect that a bank need not report the cancellation in the program described in the letter.
• Need claims processing.
• For financial reporting, claims may be an expense, while insurance commission is pure revenue.

Some of these disadvantages may be overcome by purchasing a program from a vendor who will provide insurance backing the contracts.

OCC Regulation

Recently the OCC issued a final regulation regarding DCCs and DSAs. The regulation is at 12 CFR part 37. Explanatory material can be found in the September 19, 2002, Federal Register, Volume 67, at pages 58962-78. That regulation replaces 12 CFR §7.1013. Since most of the information in this article is about this regulation, it applies only to national banks, not to other financial institutions. Initially, the entire regulation was effective June 16, 2003. While that effective date is still generally in place for DCCs or DSAs offered by national banks, this effective date has been indefinitely delayed for certain provisions of the regulation in the case of DCCs and DSAs offered by national banks through unaffiliated, non-exclusive agents in connection with closed end credit (“agented closed-end credit”). The OCC cites a car loan made through a car dealer as an example of this agented closed-end credit. The OCC’s delayed effective date gives the OCC time to better understand and evaluate the feasibility of the regulations in connection with these types of agented closed-end credit. The provisions whose compliance deadline is delayed in connection with those specific transactions will be noted in the remainder of the article.

The regulation does four things:

• Authorizes national banks to offer DCCs and DSAs.
• Prohibits or limits certain practices by national banks in connection with DCCs and DSAs.
• Requires national banks to make disclosures to their borrowers, and obtain the borrowers' written acknowledgements that they received the disclosures and written elections to purchase DCC/DSAs.
• Requires national banks to manage the risks associated with DCCs and DSAs in accordance with safe and sound banking principles.

A DSA or DCC is covered by the regulation even though the national bank does not require the borrower to pay a fee. The suspension under a DSA cannot be triggered just by the borrower's choice. For example, a "skip-a-payment" program, where the borrower can choose to skip a payment in a month like January when holiday shopping bills come due, is not a DSA.

This article gives only general information about the regulation. Please contact your lawyer for further information, including information on how the regulation might apply to your national bank.

Requiring a DCC or DSA as a Condition

A national bank cannot require the borrower to enter into a DCC or DSA in order to receive a loan, or in order to obtain better terms on a loan. For example, a bank may not give a better interest rate to a borrower who purchases a DCC. This is similar to the OCC regulation on credit insurance.

Rules About Contract Terms

Unilateral Changes

You may be familiar with "unilateral changes" from credit card agreements. A "unilateral change" is a change that the lender can make without the borrower's (card holder's) consent. There are limitations on national bank DCC/DSAs that permit the bank to make unilateral changes. If the change is one that is not favorable to the borrower or for which the borrower is charged, then the national bank must notify the borrower of the change, and give the borrower a reasonable time (generally 30 days, says the OCC) within which to cancel the contract before the change goes into effect. The regulation does not require national banks to specify under what circumstances they might make an unfavorable unilateral change. But the OCC says it may be helpful for the contract to specify those circumstances "to avoid misunderstandings."

Single (Lump Sum) Fees

If you are familiar with credit insurance, you know that it may be paid for in a single premium or in a series of monthly (or other periodic) premium payments. Single premium insurance is more common with closed end credit, since the principal balances during the term of the loan are known at the outset. Monthly premiums are more common with open end credit, since the premium amount can be computed each month based on the monthly outstanding balance (sometimes called "MOB") on the account.

A DCC or DSA offered by a national bank may be paid for in a single (lump sum) initial fee, or in monthly or other periodic payments. There are some restrictions on lump sum fees. A DCC/DSA cannot be paid for in a lump sum if the underlying loan is a residential (one-to-four family) mortgage loan. For other loans, excluding loans made by un-affiliated, non-exclusive agents of the national bank, a lump sum payment is permitted but only if the borrower has also been offered a contract with fee payments made monthly or otherwise periodically (“periodic payment option”). That periodic payment contract cannot be deliberately priced in a way to discourage a borrower from choosing it. The OCC has had recent concerns that the periodic payment option may present unique issues in the context of agented closed-end credit offered by national banks. Accordingly, the OCC has delayed the effective date for complying with the requirement to offer a periodic payment option on a DCC or DSA that otherwise permits lump sum payments, when a DCC or DSA is offered by a national bank in connection with agented closed-end credit. Because the availability of the periodic payment option also triggers other disclosures, the OCC is also delaying effective dates for provisions that are linked to this periodic payment requirement, as explained below.

Refund of Fees Upon Prepayment or Other Termination

A lump sum fee for a DCC or DSA is typically a payment for coverage during the entire expected term of the loan. If the coverage terminates early because loan is paid off early or otherwise, then part of the fee is "unearned." The OCC regulation on DCC/DSAs permits a contract that does not provide for a refund of "unearned" fees upon prepayment or cancellation, but only if the borrower has also been offered a comparable contract that does provide for a refund. The amount of the refund in the comparable contract must be calculated in a way that is at least as favorable to the borrower as the actuarial method. This requirement to at least offer a comparable contract that does provide for a refund does not have to be complied with in situations where a national bank is offering a DCC or DSA in connection with agented closed-end credit.

The OCC admits that the "no refund" contract is likely to have a lower fee than the "refund" contract. However, the "refund" contract cannot be priced or otherwise structured in a way that "deters the customer from selecting that option."

Form of Contract

A DCC or DSA may be a separate agreement, or it may be part of the loan agreement or another loan document.

The regulation does not limit the amount of fees that may be charged for a DCC or DSA.

Disclosures, Acknowledgements and Elections

Two kinds of disclosure are required. The "short form" disclosures are generally given to the borrower earlier in the sales process. The "long form" disclosures must be written and are generally given later. Before the purchase of the contract is completed, the borrower must have received the long form disclosures, acknowledge that he or she has received the disclosures, and then affirmatively elect to the purchase the contract. (A document by which the borrower can acknowledge receipt of the long form disclosures is referred to in this article as an "acknowledgement form." A document by which a borrower can both acknowledge receipt of the long form disclosures and affirmatively elect to purchase the contract is referred to as an "acknowledgement/election form.")

Neither the long-form disclosure requirement nor the written acknowledgement of receipt of disclosures requirement needs to be complied with until further notice, for national banks that offer DCCs or DSAs in connection with agented closed-end credit. However, the OCC does expect that those customers who aren’t required to receive a long-form disclosure be informed by the bank that they will get a copy of the DCC or DSA before they have any obligation to pay under that contract.

Timing and Method of Disclosures, Acknowledgements and Elections

When and how the disclosures, acknowledgement and election are handled depend on how the borrower is solicited for a DCC or DSA.

• If the borrower is solicited for the product face-to-face:
  1. The short form disclosures must be given orally during the first solicitation.
  2. The long form disclosures must be given in writing at the same time.
  3. Before the purchase is complete, the borrower must sign an acknowledgement/election form. (Presumably, the bank would obtain this signature at the same face-to-face meeting.)
     
     
• If the borrower is solicited for the product by phone:
  1. The bank must give the short form disclosures to the borrower orally during the first phone solicitation.
  2. The bank must mail an acknowledgement/election form, the long form disclosures and, if appropriate, a copy of the contract to the borrower within three business days after the first phone solicitation.
  3. If the borrower elects to purchase the contract over the phone, then the bank may accept that election (instead of getting the signed acknowledgement/election form back) if it does the following:
     1. Keeps records showing that the borrower received the oral short form disclosures and elected to purchase the contract.
     2. Makes a reasonable effort to get the signed acknowledgement/election form back from the borrower.
     3. Keeps a written record of those efforts.
     4. Permits the borrower to cancel the contract without penalty within 30 days after the bank mails the long form disclosures to the borrower.
  4. If the borrower does not make an election to purchase over the phone, or the bank does not comply with 3. a-d, then it must obtain the signed acknowledgement/election form from the borrower before putting the contract into effect.
     
     
• If the borrower is solicited for the product by mail or a "take-one" application:
  1. The short form disclosures must be provided in the mailed materials or "take-one" application.
  2. The bank must mail the long form disclosures and an acknowledgement form to the borrower within three business days after the borrower contacts the bank in response to the solicitation.
  3. If the bank does not receive the signed acknowledgement form back from the customer, it may still put the contract into effect if it does the following:
     1. Keep records showing that bank sent the acknowledgement form to the borrower.
     2. Make a reasonable effort to get the signed form back from the borrower.
     3. Keep a written record of those efforts.
     4. Permit the borrower to cancel the contract without penalty within 30 days after mailing the long form disclosures to the borrower.
  4. If the bank receives the signed acknowledgement form from the borrower, it can put the contract into effect without complying with the requirements of 3. a-d.
     
     
• If the borrower is solicited electronically by email or at a web site:
  1. The short form disclosures must be made to the borrower at the time of the first solicitation. They must be made in accordance with the Electronic Signatures in Global and National Commerce Act (E-SIGN). E-SIGN permits disclosures to be made electronically after certain conditions are met.
  2. The long form disclosures must be made to the borrower before the contract is put into effect. They, too, may be made in accordance with E-SIGN.
  3. Before the purchase is complete, the borrower must "sign" an acknowledgement/election form. This can be done in accordance with E-SIGN as well.
     
     
• General advertising for DCCs and DSAs:
  Advertising and promotional materials must include the short form disclosures unless the ad or materials are of a general nature describing or listing the bank's products.

Any of the disclosures may be provided electronically in accordance with E-SIGN.

These timing and method rules as to phone and mail solicitation for DCCs/DSAs are similar but not identical to those for credit insurance.

Disclosure Contents

These are the topics that may have to be covered in the disclosures, depending on the terms of the contracts that the national bank offers:

• That the product is optional.
• Explanation of the DSA concept (long form only).
• Amount of fee (long form only).
• Lump sum payment of fee (that the borrower may instead pay monthly, etc., and that adding the lump sum fee to the loan balance will increase the cost). The effective date for this requirment (on both the short and long form) has been indefinitely delayed where a national bank offers a DCC or DSA through agented closed-end credit.
• Lump sum payment of fee with no refund (that the borrower may choose either a refund or no-refund version). The effective date for this requirement has been indefinitely delayed where a national bank offers a DCC or DSA through agented closed-end credit.
• Refund of fee paid in lump sum (when, if at all, the borrower may cancel to get a full refund of fees).
• Whether use of a credit card or line is restricted when a DSA or DCC is activated (long form only).
• Right, if any, of the bank or borrower to terminate a DCC or DSA (long form only).
• That additional information will be given (short form only). The effective date for this “additional information” component on the short form disclosure has been indefinitely delayed where a national bank offers a DCC or DSA through agented closed-end credit.
• Eligibility requirements, conditions, and exclusions that could prevent the borrower from receiving benefits under the contract.

Appendixes A and B of the regulation provide acceptable forms of the short form and long form disclosure text.

The regulation also says national banks cannot mislead anyone in connection with a DCC or DSA, or any of the disclosures required under the regulation. For example, the bank cannot make claims in an ad that conflict with a disclosure. There are similar provisions in the OCC credit insurance regulation.

Form of Disclosures, Acknowledgements and Elections

The disclosures, acknowledgements and elections must be simple, direct and readily understandable. They must also be conspicuous and designed to call attention to the nature and significance of the information provided. They must be in a meaningful form. The regulation suggests methods to accomplish these goals, like using headings, boldface type, distinctive type style, and shading and sidebars.

Safety and Soundness

The national bank must manage the risks associated with its DCA/DSA program. The regulation does not explicitly require the bank to maintain a special loss reserve, or to purchase stop-loss insurance to cover the risk, although those actions may be appropriate. The OCC plans to issue examination guidance on safety and soundness in 2003.

One OCC examiner advises banks to involve the bank's manager for consumer lending in the development and management of the product. He says that management information systems for the product should be in place before it is offered. The bank should ensure that it is properly accounting for income and expenses on the product and that it does not overstate income. It should also maintain strong operational controls, this examiner says.

Regulation Z and DCC/DSAS

Debt cancellation is referred to twice in Regulation Z. Click here to read about that.

Conclusion

The new OCC regulations give national banks certainty that if they design and sell DCCs and DSAs properly, the contracts will not be treated as insurance under state laws. Some industry persons believe that DCC/DSAs will become widespread and will largely replace credit insurance. Do you agree? Does your institution offer them, or are you considering offering them? Will you offer lump sum fee contracts? Do you have questions about DCC/DSAs? If you are a national bank that offers DCCs or DSAs in connection with agented, closed-end credit, do you think there are any compliance issues or problems posed by providing the periodic payment option ? Do you think that the OCC intends to subject indirect lenders to this regulation, by arguing that indirect lenders are “agents” of national banks if they assign the retail contract to a national bank after is has been originated? We would be happy to hear about your plans, to help us make available what you need. And we will try to answer your questions. Please contact us at consumer@complianceheadquarters.com.

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